Which Should be the Leader in Inducing Inflation, the Government or the BOJ?

KOBAYASHI Keiichiro Faculty Fellow, RIETI

The Canon Institute for Global Studies (CIGS) Conference on Macroeconomic Theory and Policy 2017, an annual seminar conference in which I am involved as an organizer, was held on May 29-30. This year, Japanese and foreign economists presented on their research concerning the significance of and the future prospects for unconventional monetary policy with the common theme "Monetary Policy in the 21st Century." The participants, including researchers from the Bank of Japan (BOJ) and the U.S. Federal Reserve Bank, engaged in lively discussions.

The results of various academic research works were presented. One researcher argued that while companies whose debt burden is light increase investment in response to monetary easing, heavily indebted ones show no such response. Another contended that the inflation rate can be fully controlled through the "Quantitative and Qualitative Monetary Easing with Yield Curve Control," which is now being exercised by the BOJ.

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Particularly notable was the research work of LUISS Guido Carli Professor Pierpaolo Benigno who made a presentation titled "A Central Bank Theory of Price Level Determination." He argued that a country's price level is determined by the central bank's monetary policy, rather than by the government's fiscal policy. His theory is squarely at odds with Sims' theory, which has attracted intense attention recently in Japan.

Princeton University Professor Christopher Sims argues that Japan can overcome deflation and achieve mild inflation if the government deliberately aggravates the fiscal balance. In Japan, the BOJ's monetary policy has not pulled Japan out of deflation. In Japanese political circles, Sims' argument has fueled hopes that if the BOJ's monetary policy is ineffective in overcoming deflation, the government may be able to do so by loosening fiscal discipline.

The Benigno theory implies that if the government can overcome deflation, there is no reason why the BOJ cannot do so in the first place. This is a warning that it would be too easy if Japan were to embrace the idea of letting the government take the place of the BOJ in leading the fight against deflation if the central bank cannot overcome it.

The Sims theory is based on the Financial Theory of Price Level (FTPL), which maintains that the price level is determined not by monetary policy alone but mainly by fiscal policy. Sims is one of the proponents of the FTPL. Let me use the equation shown in the Figure to explain the FTPL based on an economic model that has only two time horizons: the present and the future. For the purpose of simplification, the interest rate is fixed at zero.

Figure: Sims and Benigno theories
Figure: Sims and Benigno theories

Under the model, it is assumed that, at present, debts owed by the "integrated government" (comprised of Japanese government bonds and BOJ notes), namely, the government integrated with the BOJ, already exist. The nominal value of the debts is represented by "B." The integrated government must finance the repayment of the debts "B" with future tax revenue and seigniorage (the difference between the nominal value and the printing and minting cost). The real value of the total sum of future tax revenue and future seigniorage (fiscal surplus) is represented by "s," while the future price level is represented by "P." In this case, the nominal value of the total sum of future tax revenue and seigniorage is represented by P×s. The current debts "B" match "Ps," which stands for the future repayment amount. In other words, equation (i) in the figure holds.

Here, the debts "B" are already fixed and cannot be changed. If the integrated government determines the fiscal surplus "s," the future price level "P" is determined through equation (i). The FTPL assumes that the price level "P" is determined by the government's fiscal policy because "s" is determined by the fiscal policy and asserts that if the government is committed to aggravating the fiscal balance (reducing "s"), that raises the price level "P," thereby causing inflation. This is the basis of Sims' argument.

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Meanwhile, Benigno argues that if some conditions are put in place, the central bank can determine the price level without support from the fiscal authority. The key to his argument is looking at the integrated government fiscal surplus "s" as divided into the government's portion of the surplus (future tax revenue "t") and the central bank's portion (seigniorage, etc. "m"). In short, with the integrated surplus expressed as the formula "s = t + m," equation (ii) in the figure holds.

Here, "m" represents funds transferred from the BOJ to the government. The BOJ transfers surplus funds, such as profits obtained through currency issuance (seigniorage), to the government.

Let us consider the case of a policy regime (framework) under which the value of "m" is fixed at zero. In this case, the BOJ ceases currency issuance and keeps the currency supply in the market at a certain level. As the value of "s" matches that of "t" in the case, it is not the BOJ's monetary policy but the government's fiscal policy "t" that changes "s." Consequently, the price level "P" is determined by fiscal policy, which is consistent with the argument based on the FTPL. This may be called a regime of "fiscal policy leadership over monetary policy" because fiscal policy plays the leading role in determining the price level while the central bank manages monetary policy so as to maintain consistency with that.

Next, let us look at the case of a policy regime under which the value of "t" is fixed at zero. In this case, "s" matches "m," which means that the central bank has the power to determine the value of "s." That is because if the currency supply volume is increased, it generates additional seigniorage, which is earned by the central bank as income "m." It is not fiscal policy but monetary policy (the central bank's decision on the currency supply volume) that determines the price level "P." This may be called a regime of "monetary policy leadership over fiscal policy" because monetary policy plays the leading role in determining the price level while the government observes budget constraints so as to avoid inconsistency.

As described above, the price level is determined by fiscal policy as predicted by the FTPL when a policy regime of "fiscal policy leadership over monetary policy" is adopted, whereas it is determined by the central bank when a regime of "monetary policy leadership over fiscal policy" is adopted. Meanwhile, Benigno argues that if the central bank has a high degree of independence, a regime of "monetary policy leadership over fiscal policy," monetary policy will play the leading role in determining the price level. In this case, the price level can be raised through monetary policy without loosening fiscal discipline.

The Benigno theory holds that if the government can cause inflation, the BOJ should be able to do so by the same logic. The BOJ's failure to overcome deflation through its monetary policy does not mean that we may resort to the easy option of letting the government aggravate fiscal policy. His theory inherits the ideas of the standard economic theory in recent years that the central bank can control the price level without relying on fiscal policy and that the central bank's monetary policy should be considered as being independent from fiscal policy.

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However, the Benigno theory does not rule out the possibility that neither the BOJ nor the government can cause inflation. Nor does this theory explains why Japan's deflation has continued for a long time. To explain factors behind Japan's prolonged deflation, another theory, different from either of the Sims and Benigno theories, is necessary.

Moreover, if inflation is caused through a mechanism based on either of these two theories, the government's debt burden will be reduced. However, that would be a situation different from the scenario of overcoming the deflation through a rise in the inflation rate due to an increase in demand arising from improved economic conditions. The inflation's effect of reducing the government's debts indicates its nature as a "tax" (inflation tax). As inflation reduces the value of cash and deposits held by the people, it has the same effect as imposing tax on assets.

Under the FTPL as advocated by Sims, inflation works exclusively as tax, which means that the resulting situation is equivalent to the government repaying its debts with tax revenue. His theory does not predict any economic-boosting effect (such as increasing production or employment) of inflation. Although both theories predict that the government's debts will be reduced through "inflation tax," they remain silent on whether or not the inflation will lead to better economic conditions. Unless inflation turns out to generate extremely strong economy-boosting effects, it is a sure bet that it will reduce the value of the Japanese people's assets.

>> Original text in Japanese

* Translated by RIETI.

June 15, 2017 Nihon Keizai Shimbun

July 24, 2017

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