KOBAYASHI Keiichiro: This time I would like to focus on "Avoiding Liquidity Traps" by Benhabib, Schmitt-Grohe, and Uribe (
Journal of Political Economy
, vol. 110 (3): 535-563) (2002), and look at deflationary equilibrium and the effectiveness of reflationary policy.
Classical deflationary equilibrium resulting from a decrease in the quantity of money in circulation
Japan's "two lost decades" have been marked by continuing long-term deflation. The possibility of falling into a condition of long-term deflation was a concern even for the European economy following the financial crisis. The model of deflationary equilibrium has recently drawn attention as a tool for the analysis of long-term deflation (Bullard, 2010, among others). Deflationary equilibrium refers to a state of equilibrium in which deflation continues indefinitely.
The classical model of deflationary equilibrium is the equilibrium that occurs when central banks apply the Friedman Rue.
Econo-kun: The Friedman Rule is the monetary policy of reducing the quantity of money by the same rate as the real interest rate, isn't it? When this scheme is implemented, the nominal interest rate becomes zero. Because the quantity of money in circulation is reduced, deflation occurs (the value of money increases in relation to goods and services).
KOBAYASHI Keiichiro: That's right. The model considered by Bullard (2010) simplifies the model suggested by Benhabib et al. (2002), and assumes that the asset "money" does not exist. Money was incorporated in the model originally presented by Benhabib et al. Since the quantity of money is reduced in a deflationary equilibrium in this model, it displays virtually the same mechanism as the generation of deflation in the Friedman Rule.
Deflation as a rational bubble
Econo-kun: But deflation (or the fear of deflation) has continued over the long term in the Japanese and the European economies, despite the fact that central banks have increased the quantity of money in circulation. Isn't this situation different from the classical model of deflation that you have been discussing (i.e., deflation occurs because the quantity of money decreases)?
KOBAYASHI Keiichiro: The hypothesis that deflation is a rational bubble in the value of the asset "money" is effective in explaining a deflationary equilibrium, in which deflation continues despite an increase in the quantity of money.
A rational bubble occurs when everyone knows that the price of an asset exceeds its fundamental value, and when everyone believes that they can sell the asset later at the highest price, with no expectation of the possibility of a loss. Because everyone believes that they can necessarily sell at the highest price, despite the fact that there is a bubble situation in which the price of the asset continues to increase, there will still be a potential market for the asset.
If we regard money as an asset, then an increase in the value of money is equivalent to a decrease in commodity prices (deflation). Despite the fact that everyone may think that the value of money is too high (commodity prices are too low), as long as everyone believes that they can sell money for the highest price, deflation will continue as a rational bubble in the value of money.
Econo-kun: I get it. Whether or not a particular economy falls into an equilibrium marked by a rational bubble is determined by the degree of rationality expected by the participants in the economy.
KOBAYASHI Keiichiro: When all of the people participating in the economy believe that everyone is rational (we can term this a "strong rational expectation"), then a rational bubble cannot occur. This is because strong rational expectation does not produce the expectation that the individual will be able to sell the asset that has increased in price in the bubble to other participants in the economy at the highest price. In this case, the individual predicts that because the other actors are as rational as he or she, they will not buy the high-priced bubble asset, and the individual will therefore be unable to sell the bubble asset at the highest price. The price of the asset will then return to its fundamental value.
The condition for the occurrence of a rational bubble is that everyone believes in their rationality, and that individuals who are not rational necessarily exist among other people (this can be termed a "weak rational expectation"). Because this generates the expectation that only the rational individual will be able to sell the bubble asset at the highest price (to irrational individuals), a rational bubble occurs.
In technical terminology, "strong rational expectation" indicates that in a condition of equilibrium, people's actions satisfy both first order conditions (FOC) and the transversality condition (TVC), and "weak rational expectation" indicates that while their actions satisfy FOC, they do not satisfy the TVC. Therefore, the defining characteristic of an equilibrium in which deflation continues as a rational bubble is that the TVC is not satisfied.
Rational bubbles and the effectiveness of reflationary policy
If long-term deflation is a rational money bubble, the economy is characterized by weak rational expectation (the TVC is not satisfied). Everyone expects that while they are rational, the majority of other people are irrational and do not think that money is overvalued in relation to goods and services.
Under these conditions, reflationary policies (policies that seek to foster expectations of inflation by means of extreme increases in the quantity of money) lose their effectiveness (at least theoretically).
Econo-kun: Why is that?
KOBAYASHI Keiichiro: The core of Paul Krugman's argument (Krugman, 1998) and Ben Bernanke's argument (in a 2004 lecture in Japan) is the logic that the TVC should be satisfied in an economy in equilibrium. Therefore, if the quantity of money is increased, its value should decline (i.e., generate inflation). Krugman and Bernanke assume strong rational expectations. Under conditions of strong rational expectation, people do not believe that they will be able to sell their asset for the highest price if money remains overvalued indefinitely (because they believe other people to be just as rational as themselves). Given this, if the central bank increases the quantity of money, it will induce inflationary expectations (the expectation that the value of money will decline).
By contrast, if everyone thinks that only they will be able to sell at the highest price regardless of how long money continues to be overvalued, no matter how much the central bank increases the quantity of money, it will not generate the expectation that the value of money will decline. And regardless of how much the quantity of money is increased, the expectation of each individual that they will be alone in their ability to sell at the highest price (because there are so many irrational people) will persist.
Using technical terminology, if a deflationary equilibrium occurs as a rational bubble, then the TVC is not satisfied in that nation's economy. At the same time, for reflationary policies to be able to foster inflationary expectations, TVC must be satisfied in the nation's economy. Therefore, theoretically speaking, in an economy marked by a continuing deflationary equilibrium in the form of a rational bubble, we cannot consider that reflationary policies will foster inflationary expectations.
