ADBI-Keio Executive Training in Macroeconomics

3-7 November 2014 Conference Hall, North Building

Keio University, Mita Campus

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The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

Copy right @yoshino-Dean-ADB Institute

Abenomics and

Optimal Fiscal Policy Rule to make Fiscal Consolidations

Naoyuki Yoshino Keio University

yoshino@econ.keio.ac.jp Tetsuro Mizoguchi Reitaku University

November 2014

Abenomics: 3 Arrows (1) Aggressive Monetary Policy (2) Growth Strategy (3) Fiscal Consolidations

3

4

5

6

Gross Debt/GDP ratio, 2012 Japan, USA, EU

7 Source: CIA Fact Book

0

50

100

150

200

250 JapanGreeceItalyPortugalIrelandBelgiumFranceUnited KingdomSpainHungaryCyprusGermany

Money Supply

Money Demand

Household

Borrowings （-5）

Borrowings （-8）

Securities （+2）

PNFCs

Government

Borrowings （-3）

Bonds etc（+50）

Depository Corporations

Lending（+1）

Securities（+19）

Deposits（+29）

Securities （-2）

Life and Non-life Insurances Lending （-3）

Securities（+5）

Insurance & Pension Reserve（+1）

Other financial Intermediaries

Lending （-20）

Securities （-4）

Deposits with the Fiscal Loan Fund

（-1） Borrowings

（-7） Securities

（-7）

Financial Intermediaries

Household

Deposits（+10）

Securities （-4）

Insurance & Pension

Reserve （+1）

Deposits （+13）

Securities （-2）

PNFCs

Government Deposits with the Fiscal Loan Fund

（+1） Securities（+9）

2013 Money Flow in Japan Source: BOJ Flow of Fund

Changes in Japan’s Money Flow High Growth Period Households Savings Corporate Capital Investment Stock S I K Recent Period Corporate Savings Government Elderly people S G Abolish Retirement Age Increase working population Pension payment will start 65 or later Wage rate be based on marginal productivity

9

Population Trends in Japan

10

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060

Age 65 and over

Age 15-64

Age 14 and less

Aged to PopulationRatio

Employment toPopulation Ratio

Current Birth Ratio

Source: Ministry of Internal Affairs and Communication

Forecasts (2012 current) 10 of Thousands Current

Figures

11

Trends of Households’ Savings Ratio and Government debt/Households’ financial assets

12 Source: MOF

Budget Allocation of Central Government (Japan, 1985-2012)

13

Source: MOF Billion

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Bond Expenditure

Education and Science

Social Securities

Defense

Exp of Local Government

National land conservationand development

Issues of Various Government Bond

Short term 1 to 5 years (Banks, Postal Saving) 10 years (Trust Banks, Insurance) Inflation indexed bond 15 year (floating bond) 20 year (Insurance, Pension Funds, Kampo) 30 year (Insurance, Pension funds) 40 year (Pension fund, Insurance)

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15

Japanese Debt, 92% are held by Domestic Investors HOLDERS %

Banks and Postal Savings 45% Life and Non-life Insurances 20% Public Pension funds 10% Private Pension Funds 4% Central Bank of Japan 8% Overseas’ Investors 8% Households 5% Others 3%

16 Source: MOF

Greece, 80% of their debts are held by overseas’ Investors (2011)

HOLDERS ％ Eurozone 15% ECB 15% IMF 6% Greek banks & non-banks 23% Other European Banks 10% Non European Banks 8% Non-Greek non-Banks 23%

Source：Financial Times 17

Declining Bank Loans in Japan

1. Stricter Basel Capital Requirement (Basel III) 2. Government Bonds = Zero Risk 3. Declining Domestic Demands for Bank Loans Shift production from Japan to other Asia Low expected rate of return 4. Corporations’ Surplus Profits from Overseas’ production Cash rich companies

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Decline in Loan demand (80%)

20

出所、 Revankar and Yoshino (2008)

where

𝒓𝒓𝒕𝒕=Interest Rate 𝜼𝜼𝒕𝒕=Growth rate

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𝒃𝒃𝒕𝒕 − 𝒃𝒃𝒕𝒕−𝟏𝟏 =𝒓𝒓𝒕𝒕 − 𝜼𝜼𝒕𝒕𝟏𝟏 + 𝜼𝜼𝒕𝒕

𝒃𝒃𝒕𝒕−𝟏𝟏 + 𝒈𝒈𝒕𝒕 − 𝒕𝒕𝒕𝒕

𝒃𝒃𝒕𝒕 =𝑩𝑩𝒕𝒕𝒀𝒀𝒕𝒕

,𝒃𝒃𝒕𝒕−𝟏𝟏 =𝑩𝑩𝒕𝒕−𝟏𝟏𝒀𝒀𝒕𝒕−𝟏𝟏

,𝒈𝒈𝒕𝒕 =𝑮𝑮𝒕𝒕𝒀𝒀𝒕𝒕

, 𝒕𝒕𝒕𝒕 =𝑻𝑻𝒕𝒕𝒀𝒀𝒕𝒕

Domar Condition

Domar Condition • Domar (1974) studies the USA government debt

dynamics. In his paper, the primary balance can be interpreted in the context of Economics.

• Assuming that the economy grows, the soundness of public finance can be measured by the debt / nominal GDP ratio.

• Here we can suppose the nominal GDP at period t as 𝑌𝑌𝑡𝑡 and the bond level at period t as 𝐵𝐵𝑡𝑡. Then, we can write the debt/GDP ratio as 𝐵𝐵𝑡𝑡

𝑌𝑌𝑡𝑡.

22

Interest rate and Economic growth rate （1990-2012）

Source: MOF and Ministry Cabinet 23

Domar Condition does not hold in Japan

-8

-6

-4

-2

0

2

4

6

8

10

Nominal GDP GrowthRateLong-term Interest Rate

0

0.5

1

1.5

2

2.5Ja

nuar

y-00

Janu

ary-

01

Janu

ary-

02

Janu

ary-

03

Janu

ary-

04

Janu

ary-

05

Janu

ary-

06

Janu

ary-

07

Janu

ary-

08

Janu

ary-

09

Janu

ary-

10

Janu

ary-

11

Janu

ary-

12

Janu

ary-

13

5-year10-year

Source: MOF

Japanese Government Bond Yields

Japan’s Supply and Demand for Bonds

25

𝑟𝑟𝑡𝑡

∆𝐵𝐵𝑡𝑡

𝐸𝐸1 𝐸𝐸2

∆𝐵𝐵𝑡𝑡𝑆𝑆

𝐸𝐸3 𝐸𝐸4

∆𝐵𝐵𝑡𝑡𝐷𝐷

𝐸𝐸1 → 𝐸𝐸2 → 𝐸𝐸3 → 𝐸𝐸4

Gov long-term bond yield (Eurozone)

Eurozone 5-year CDS

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𝑟𝑟𝑡𝑡

∆𝐵𝐵𝑡𝑡

𝐸𝐸1 → 𝐸𝐸2 → 𝐸𝐸3 → 𝐸𝐸4 𝐸𝐸2

∆𝐵𝐵𝑡𝑡𝑆𝑆

𝐸𝐸3

𝐸𝐸4

∆𝐵𝐵𝑡𝑡𝐷𝐷

𝐸𝐸1

Greece Supply and Demand for Government bonds

Greek Case and Japanese Case • Greek Case Foreign fund → large Domestic Deposits →Small →In GGB market, Foreign funds flow out →Interest Rate goes up • Japanese Case Foreign fund → Small Domestic Deposits →Large →In JGB market, Domestic deposits flow into the JGB market →interest rate deflates, whereas the supply of JGB is sufficiently large.

Objective Loss Function of the Government (i) Sustainable Debt /GDP ratio, (ii) Stable Economic Growth, (iii)Smooth Government Spending (iv)Smooth Tax revenue Minimize the following loss function: 𝐋𝐋 𝑩𝑩𝒕𝒕,𝒀𝒀𝒕𝒕,𝑮𝑮𝒕𝒕,𝑻𝑻𝒕𝒕

=𝟏𝟏𝟐𝟐𝒘𝒘𝟏𝟏 𝑩𝑩𝒕𝒕 − 𝑩𝑩𝒕𝒕∗ 𝟐𝟐 +

𝟏𝟏𝟐𝟐𝒘𝒘𝟐𝟐 𝒀𝒀𝒕𝒕 − 𝒀𝒀𝒕𝒕

𝒇𝒇 𝟐𝟐

+𝟏𝟏𝟐𝟐𝒘𝒘𝟑𝟑 𝑮𝑮𝒕𝒕 − 𝑮𝑮𝒕𝒕−𝟏𝟏 𝟐𝟐 +

𝟏𝟏𝟐𝟐𝒘𝒘𝟒𝟒 𝑻𝑻𝒕𝒕 − 𝑻𝑻𝒕𝒕−𝟏𝟏 𝟐𝟐

where 𝑤𝑤𝑖𝑖 𝑖𝑖 = 1,⋯ , 4 , ∑ 𝑤𝑤𝑖𝑖 = 14𝑖𝑖=1 are the policy

weights which government chooses.

30

31

Supply and Demand for Government bond 𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 + 𝑟𝑟𝑡𝑡𝐵𝐵𝑡𝑡−1 + 𝜃𝜃𝐺𝐺𝑡𝑡 = 𝐶𝐶𝑡𝑡 + 𝑆𝑆𝑡𝑡

Government Flow Budget Constraint (Bond Supply) 𝑌𝑌𝑡𝑡 − 𝑇𝑇𝑡𝑡 + 𝑟𝑟𝑡𝑡𝐵𝐵𝑡𝑡−1 + 𝜃𝜃𝐺𝐺𝑡𝑡 = 𝐶𝐶𝑡𝑡 + 𝑆𝑆𝑡𝑡 where 𝑆𝑆𝑡𝑡 = 𝛥𝛥𝐵𝐵𝑡𝑡 + 𝛥𝛥𝑊𝑊𝑡𝑡

𝐷𝐷 − ∆𝑊𝑊𝑡𝑡𝐹𝐹(Bond Demand)

𝐶𝐶𝑡𝑡 = 𝑐𝑐0 + 𝑐𝑐1𝑌𝑌𝑌𝑌𝑡𝑡 Consumption Equation 𝑊𝑊𝑡𝑡 = 𝑑𝑑0 + 𝑑𝑑1𝑌𝑌𝑌𝑌𝑡𝑡 + 𝑑𝑑2𝑟𝑟𝑡𝑡DepositEquation 𝑌𝑌𝑌𝑌𝑡𝑡 = 𝑌𝑌𝑡𝑡 + 𝜃𝜃𝐺𝐺𝑡𝑡 + 𝑟𝑟𝑡𝑡𝐵𝐵𝑡𝑡−1 − 𝑇𝑇𝑡𝑡 = 𝐶𝐶𝑡𝑡 + 𝑆𝑆𝑡𝑡 Disposable Income

Macroeconomic Model (Supply and Demand for Gov.

Bonds)

Optimal Fiscal Policy Rule

𝐺𝐺𝑡𝑡 − 𝐺𝐺𝑡𝑡−1 = 𝛼𝛼1 𝐵𝐵𝑡𝑡 − 𝐵𝐵𝑡𝑡∗ + 𝛼𝛼2 𝑌𝑌𝑡𝑡 − 𝑌𝑌𝑡𝑡𝑓𝑓

where 𝛼𝛼1 = −𝑤𝑤1𝑤𝑤3

1+ 𝑐𝑐1+𝑑𝑑1−1 𝜃𝜃 𝐵𝐵𝑡𝑡−1𝑐𝑐1+𝑑𝑑1 𝐵𝐵𝑡𝑡−1−𝑑𝑑2

,𝛼𝛼2 = 𝑤𝑤2𝑤𝑤3𝜃𝜃

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Optimal Tax Rule

𝑇𝑇𝑡𝑡 − 𝑇𝑇𝑡𝑡−1 = 𝛽𝛽1 𝐵𝐵𝑡𝑡 − 𝐵𝐵𝑡𝑡∗ + 𝛽𝛽2 𝑌𝑌𝑡𝑡 − 𝑌𝑌𝑡𝑡𝑓𝑓

where 𝛽𝛽1 = −𝑤𝑤1𝑤𝑤4

𝑑𝑑2𝑐𝑐1+𝑑𝑑1 𝐵𝐵𝑡𝑡−1−𝑑𝑑2

,𝛽𝛽2 = 𝑤𝑤2𝑤𝑤4

33

Stable Equilibrium level of Interest Rate & Bond

𝑩𝑩𝒕𝒕 = 𝒅𝒅𝟐𝟐 𝑻𝑻�−𝑮𝑮�

𝟏𝟏−𝒄𝒄𝟏𝟏−𝒅𝒅𝟏𝟏 𝒀𝒀𝒕𝒕𝒇𝒇− 𝟏𝟏−𝜽𝜽 𝟏𝟏+𝒄𝒄𝟏𝟏+𝒅𝒅𝟏𝟏 𝑮𝑮�+𝑾𝑾𝑫𝑫+𝑾𝑾𝑭𝑭− 𝒄𝒄𝟎𝟎+𝒅𝒅𝟎𝟎

𝒓𝒓𝒕𝒕� =𝑻𝑻̅ − �̅�𝑮 𝟏𝟏 − 𝒄𝒄𝟏𝟏 − 𝒅𝒅𝟏𝟏 𝒀𝒀𝒕𝒕

𝒇𝒇 − 𝟏𝟏 − 𝜽𝜽 𝟏𝟏 + 𝒄𝒄𝟏𝟏 + 𝒅𝒅𝟏𝟏 �̅�𝑮 + 𝑾𝑾𝑫𝑫� + 𝑾𝑾� 𝑭𝑭 − 𝒄𝒄𝟎𝟎 + 𝒅𝒅𝟎𝟎

𝒅𝒅𝟐𝟐𝑻𝑻̅ − 𝒅𝒅𝟐𝟐�̅�𝑮

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Generational Inequality Aged People have strong VOICE→Voting Right Young generation do not have any Voting Right. Young people do not go for Voting. Aged People wants to receive benefits. Japanese Pension Scheme -- Pay as you go system In 1950s, Retirement Age 55, Life expectancy 59 In 2010, Retirement Age 60,65, Life expectancy 88 We proposed to start pension payments from 60->65->70 by allowing old people to work Japanese Survey shows many people want to work

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