JEI's Spin on the News

Krugman Monetary Proposal Looks Outrageous, But...

Thursday, May 25, 1998

Just flood the country with money! That apparently outrageous suggestion regarding the Japanese economy by Massachusetts Institute of Technology economist Paul Krugman has gained increasing attention as a consequence of Mr. Krugman's media appearances, articles in Nihon Keizai Shimbun, the economic daily, articles on his web page ( as well as a report in the Far Eastern Economic Review. Reduced to its essentials, the argument says that Japan needs to create inflationary expectations, one of the consequences of dropping money from the sky or otherwise putting more yen in the hands of Japanese households. To the extent that Japan's central bank succeeds in this bizarre endeavor, relatively low nominal interest rates (one consequence of expanding the money supply) will correspond to negative real interest rates (because of the inflationary expectations created.) Absent inflationary expectations, real interest rates could never go below zero because nominal interest rates necessarily are positive. (Would you put money in the bank if it promised you that it would deduct a percentage point or two from your balance each year as negative interest?)

Why would Japan want negative real interest rates? Because, according to Krugman, investment opportunities are so bleak that a negative rate is the market clearing rate. Absent a market clearing rate, one gets caught in what is known as a liquidity trap where, at least theoretically, monetary policy (printing money) loses its effectiveness (see JEI Report No. 14A, April 10, 1998, p. 6-7 for a discussion of the liquidity trap). Krugman is saying, in effect, if you are going to use monetary policy to get the economy going, really step on the gas to the point that inflation results (or at least is expected).

Although American economists who focus on Japan have been tossing around Krugman-type suggestions for years approvingly among themselves, Japanese economists appear to be aghast at the latest proposals. The Bank of Japan, Japan's central bank, is not likely to accept the proposal any more easily. Recommending inflation to a central banker is like advocating promiscuity to a conservative religious leader. The whole point of monetary policy is supposed to be preventing inflation, not creating it. On a more practical level, BOJ conducts monetary policy by targeting nominal interest rates, not the money supply directly. Under current procedures, they could not adopt Krugman's suggestion even if they wanted to since they cannot get to where he would want them to be by setting a new interest rate target. (This procedure is a matter of custom, not law.) Implicitly, Krugman is asking them to step outside this box by targeting money directly. Given these two obstacles — the need for both a dramatic policy shift and a new operating procedure — Krugman's suggestion is not likely to be adopted.

"JEI's Spin on the News" are the opinions of one of more members of JEI's staff and do not necessarily represent the views of the organization.

TopaaaaSpin Archive IndexaaaaHome