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There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

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The Turkish demonstrations – and the usefulness of the AS/AD framework

Peter Dorman has a blog post that have gotten quite a bit of attention in the blogosphere on the AS-AD model and why he thinks it is not a useful framework. This is Peter:

“Introductory textbooks are supposed to give you simplified versions of the models that professionals use in their own work.  The blogosphere is a realm where people from a range of backgrounds discuss current issues often using simplified concepts so everyone can be on the same page.

But while the dominant framework used in introductory macro textbooks is aggregate supply—aggregate demand (AS-AD), it is almost never mentioned in the econ blogs.  My guess is that anyone who tried to make an argument about current macropolicy using an AS-AD diagram would just invite snickers.  This is not true on the micro side, where it’s perfectly normal to make an argument with a standard issue, partial equilibrium supply and demand diagram.  What’s going on here?”

I am somewhat surprised by Peter’s statement that the AS-AD framework is never mentioned on the econ blogs. That could indicate that Peter has never read my blog (no offense taken – I never read Peter’s blog before either). My regular readers would of course know that I am quite fund of using the AS-AD framework to illustrate my arguments. Other Market Monetarists – particularly Nick Rowe and Scott Sumner are doing the same thing quite regularly. See Nick’s discussion of Peter’s post here.

The purpose of this post, however, is not really to discuss Peter’s critique of the AS-AD framework, but rather to show the usefulness of the framework with a example from today’s financial news flow. Furthermore, I will do a Market Monetarist ‘spin’ on the AS-AD framework. Hence, I will stress the importance of monetary policy rules and what financial markets tell us about AD and AS shocks.

The Istanbul demonstrations as an AS shock 

Over the weekend we have seen large street protests in Istanbul in Turkey. The demonstrations are the largest demonstrations ever against the ruling AKP party and Prime Minister Erdogan. Mr. Erdogan has been in power for a decade.

The demonstrations today triggered a 10% drop in the Istanbul stock exchange so there is no doubt that investors think that these demonstrations and the political ramifications of the demonstrations will have a profound negative economic impact.

I believe a core insight of Market Monetarist thinking is that financial markets are very useful indicators about monetary policy shocks. Hence, we for example argue that if the US dollar is depreciating, market inflation expectations are rising and the US stock market is rallying then it is a very clear indication that US monetary conditions are getting easier.

While the focus of Market Monetarists have not been as much on supply shocks as on monetary policy shocks (AD shocks) it is equal possible to ‘deduct’ AS shocks from financial markets. I believe that today’s market action in the Turkish markets are a pretty good indication of exactly that – the combination of lower stock prices, higher bond yields (higher risk premium and/or higher inflation expectations) and a weaker lira tells the story that investors see the demonstrations as a negative supply shock. It is less clear whether the shock is a long-term or a short-term shock.

A short-run AS shock – mostly about disruption of production

My preferred textbook version of the AS-AD model is a model similar to the one Tyler Cowen and Alex Tabarrok use in their great textbook Modern Principles of Economics where the model is expressed in growth rates (real GDP growth and inflation) rather than in levels.

It is obvious that the demonstrations and unrest in Istanbul are likely to lead to disruptions in production – roads are closed down, damages to infrastructure, some workers are not coming to work and even some lines of communication might be negatively impacted by the unrest. Compared to the entire Turkish economy the impact these effects is likely quite small, but it is nonetheless a negative supply shock. These shocks are, however, also likely to be temporary – short-term – rather than permanent. Hence, this is a short-run AS shock. I have illustrated that in the graph below.

AS AD SRAS shock

This is the well-known illustration of a negative short-run supply shock – inflation increases (from P to P’) and real GDP growth declines (from Y to Y’).

This might very well be what we will see in Turkey in the very short run – even though I believe these effects are likely to be quite small in size.

However, note that we here assume a “constant” AD curve.

Peter Dorman is rightly critical about this assumption in his blog post:

“…try the AD assumption that, even as the price level and real output in the economy go up or down, the money supply remains fixed.”

Peter is of course right that the implicit assumption is that the money supply (or money base) is constant. The standard IS/LM model suffers from the same problem. A fact that have led me to suggest an alternative ISLM model – the so-called IS/LM+ model in which the central bank’s monetary policy rule is taken into account.

Obviously no analysis of macroeconomic shocks should ignore the monetary policy reaction to different shocks. This is obviously something Market Monetarists have stressed again and again when it for example comes to fiscal shocks like the ‘fiscal cliff’ in the US. In the case of Turkey we should therefore take into account that the Turkish central bank (TCMB) officially is targeting 5% inflation.

Therefore if the TCMB was targeting headline inflation in a very rigid way (ECB style) it would have to react to the increase in inflation by tightening monetary policy (reducing the money base/supply) until inflation was back at the target. In the graph above that would mean that the AD curve would shift to the left until inflation would have been brought down back to 5%. The result obviously would be a further drop in real GDP growth.

In reality I believe that the TCMB would be very unlikely to react to such a short run supply. In fact the TCMB has recently cut interest rates despite the fact that inflation continue to run slightly above the inflation target of 5%. Numbers released today show Turkish headline inflation was at 6.6% in May.

In fact I believe that one with some justification can think of Turkish monetary policy as a “flexible NGDP growth targeting” (with horrible communication) where the TCMB effectively is targeting around 10% yearly NGDP growth. Interestingly enough in the Cowen-Tabarrok version of the AS-AD model that would mean that the TCMB would effectively keep the AD curve “unchanged” as the AD curve in reality is based in the equation of exchange (MV=PY).

The demonstrations could reduce long-term growth – its all about ‘regime uncertainty’

While the Istanbul demonstrations clearly can be seen as a short-run supply shock that is probably not what the markets are really reacting to. Instead it is much more likely the the markets are reacting to fears that the ultimate outcome of the demonstrations could lead to lower long-run real GDP growth.

Cowen and Tabarrok basically think of long-run growth within a Solow growth model. Hence, there are overall three drivers of growth in the long run – labour forces growth, an increase in the capital stock and higher total factor productivity (TFP – think of that as “knowledge”/technology).

I believe that the most relevant channel for affecting long-run growth in the case of the demonstrations is the impact on investments in Turkey which likely will influence both the size of the capital stock and TFP negatively.

Broadly speaking I think Robert Higgs concept of “Regime Uncertainty” comes in handy here.  This is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,”  … To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

I think this is pretty telling about the fears that investors might have about the situation in Turkey. It might be that the Turkish government is not loved by investors, but investors are clearly uncertain about what would follow if the demonstrations led to “regime change” in Turkey and a new government. Furthermore, the main opposition party – the CHP – is hardly seen as reformist.

And even if the AKP does remain in power the increased public disconnect could lead to ‘disruptions of production’ (broadly speaking) again and again in the future.  Furthermore, the government hard-handed reaction to the demonstrations might also “complicate” Turkey’s relationship to both the EU and the US – something which likely also will weigh on foreign direct investments into Turkey.

Hence, regime uncertainty therefore is likely to reduce the long-run growth in the Turkish economy. Obviously it is hard to estimate the scale such effects, but at least judging from the sharp drop in the Turkish stock market today the negative long-run supply shock is sizable.

I have illustrated such a negative long-run supply shock in the graph below.

LRAS shock

The result is the same as in the short-run model – a negative supply shock reduces real GDP growth and increases inflation.

However, I would stress that the TCMB would likely not in the long run accept a permanent higher rate of inflation and as a result the TCMB therefore sooner or later would have to tighten monetary policy to push down inflation (by shifting the AD curve to the left). This also illustrates that the demonstrations is likely to become a headache for the TCMB management.

Is the ‘tourism multiplier’ zero? 

Above I have primarily described the Istanbul demonstrations as a negative supply shock. However, some might argue that this is also going to lead to a negative demand shock.

Hence, Turkey very year has millions of tourists coming to the country and some them will likely stay away this year as a consequence of the unrest. In the Cowen- Tabarrok formulation of the AD curve a negative shock to tourism would effectively be a negative shock to money velocity. This obviously would shift the AD curve to the left – as illustrated in the graph below.

AD shock

Hence, we initially get a drop in both inflation and real GDP growth as the AD curve shifts left.

However, we should never forget to think about the central bank’s reaction to a negative AD shock. Hence, whether the TCMB is targeting inflation or some kind of NGDP growth target it would “automatically” react to the drop in aggregate demand by easing monetary policy.

In the case the TCMB is targeting inflation it would ease monetary policy until the AD curve has shifted back and the inflation rate is back at the inflation target.

This effectively means that a negative shock to Turkish tourism should not be expected to have an negative impact on aggregate demand in Turkey for long. This effectively is a variation of the Sumner Critique – this time, however, it is not the budget multiplier, which is zero, but rather the ‘tourism multiplier’.

Hence, from a macroeconomic perspective the demonstrations are unlikely to have any major negative impact on aggregate demand as we would expect the TCMB to offset any such negative shock by easing monetary policy.

That, however, does not mean that a negative shock to tourism will not impact the Turkish financial markets. Hence, there will be a change in the composition of aggregate demand – less tourism “exports” and more domestic demand. This likely is bad news for the Turkish lira.

Mission accomplished – we can use the AS-AD framework to analysis the ‘real world’

I hope that my discussion above have demonstrated that the AS-AD framework can be a very useful tool when analyzing real world problems – such as the present public unrest in Turkey. Obviously Peter Dorman is right – we should know the limitations of the AS-AD model and we should particularly be aware what kind of monetary policy reaction there will be to different shocks. But if we take that into account I believe the textbook (the Cowen-Tabarrok textbook) version of the AS-AD model is a quite useful tool. In fact it is a tool that I use every single day both when I produce research in my day-job or talk to clients about such ‘events’ as the Turkish demonstrations.

Furthermore, I would add that I could have done the same kind of analysis in a DSGE framework, but I doubt that my readers would have enjoyed looking at a lot of equations and a DSGE model would likely have reveal little more about the real world than the version of the AS-AD model I have presented above.

PS Please also take a look at this paper in which I discuss the politics and economics of the present Turkish crisis.

PPS Paul Krugman, Nick Rowe and Mark Thoma also comment on the usefulness of the AS-AD framework.

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