Deflation, Globalization and The New
Paradigm of Monetary Economics
Joseph E. Stiglitz
Ministry of Finance
April 16, 2003
Tokyo
Problems with traditional keynesian
macroeconomics
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Not based on micro-foundations
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In 70s, concern was that behavior could not be
deduced from hypotheses of rational actors
maximizing utility or profits
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Focused on problems arising from price rigidities
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In 70s, problem was inflation
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Today, many countries are worried about deflation
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Even in 30s, assumption of price and wage rigidity
not convincing
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Monetary theory based on transactions demand for
money especially problematic
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Money not needed for most transactions (credit used for most)
Most money is interest bearing
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Opportunity cost of ‘money’ (difference between interest
rate on CMA accounts and T-bills) simply determined by
transactions cost, unrelated to economic activity
Most transactions trades in assets and not directly related to
income generation
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Relationship between two not stable over business cycle
Seeming instability of velocity –Led to end of monetarism in
most countries.
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Empirical puzzles and problems (I)
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Relative stability of real interest rates
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Little evidence of effect of real interest rates on
investment (US)
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Considerable evidence of effects on nominal interest
rates
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Investment equations in which cash flow and net
worth appear significant
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Empirical puzzles and problems (II)
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Host of anomalies and questions
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Inventory – pro-cyclical rather than anti-cyclical
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Exports often do not seem to increase as much as
one would have expected after large devaluations
(East Asia Crisis)

Movements of real product and consumption wages
over business cycle
Why some shocks get amplified –standard theory
predicts economy should dampen shocks
Why the effects of some shocks seem so persistent
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Advances in economic theory
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Imperfect and asymmetric information leading
to imperfections in product, labor and capital
markets
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Systematic ‘irrationalities’ in behavior
(Kahnemann and Tversky)
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Two solutions
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New classical, real business cycle theory
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New keynesian theories
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Why new classical and real business
cycle theories failed? (I)
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Assumed away problem of unemployment
More broadly, ignored mounting theory and evidence
concerning imperfect and asymmetric information and
irrationalities
 Cannot have asymmetric information with
representative agent
 Stock market behavior exhibits irrational exuberance
and pessimism, herd behavior, etc (Shiller and others)
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Why new classical and real business
cycle theories failed? (II)
Host of corporate, accounting, and banking scandals in
US and Europe related to imperfect information,
significant macroeconomic effects
 Most of results had nothing to do with rational
expectations, but depended on perfect market
assumptions
o With market imperfections, rational expectations
may increase efficacy of government policy, not
diminish it (Neary-Stiglitz)
Rested on implausible assumptions
 Major source of disturbances are technology shocks
 Economy randomly becomes less efficient!
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Two branches of new ‘keynesian’
economics
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Rigid wages and prices
 But wages and prices not rigid
 And menu cost theories of explanation of price
rigidities unpersuasive
 Efficiency wage theories (Shapiro-Stiglitz) do help
explain real rigidities, but not nominal rigidities
Fisher debt deflation theories
 Developed by Greenwald and Stiglitz, based on
asymmetric information and asymmetries in speeds of
price adjustment
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Basic elements of theory (I)
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Credit rationing and equity rationing (imperfections of
capital markets limit use of equity markets in raising new
funds) mean that:
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Firms act in a risk averse way
Firm balance sheets matter –for production, investment,
employment, all decision
Firm cash flows matter
Household and government balance sheets and cash flow
also matter
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Basic elements of theory (II)
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Focuses on supply side as well as demand
 Since production is risky (and risk cannot be fully
divested) shocks to economy can affect willingness to
produce, especially relevant in small open economies
which in principle should face a close to horizontal
demand for their products –demand should not be a
problem
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Basic elements of theory (III)
Supply of credit can be a critical constraint
 Demand and supply intertwined
o Demand shocks in one period have consequences for
supply in subsequent periods
• Adverse effects on firm balance sheets lead to
lower production
• Adverse effects on bank balance sheets lead to
lower credit supply
Redistributions (e.g. caused by large price changes) matter
because of important non-linearities
 Losses to those who are worse off may lead to greater
reduction in aggregate demand than the offsetting increases
by those who are better off
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New monetary paradigm (I)
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Based on supply of credit (loanable funds)
Based on bank (and other) intermediation
 Information problem
 Ascertaining credit worthiness
 Monitoring and enforcing loan contracts
Banks are ‘firms’ that engage in these credit services
 Entails risk bearing
 Willingness and ability to perform service depends on
balance sheet
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New monetary paradigm (II)
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Theory focuses on how (1) shocks to the economy and (2)
policy (both macro-policy and regulatory policy) affect
banks’ (and others’, including firms’) ability and
willingness to provide credit
 Regulatory policy has macro-economic effects
Theory pays special attention to bankruptcy, credit
interlinkages among firms (as important as standard
general equilibrium product and factor interlinkages)
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New paradigm provides a framework for thinking
about deflation and alternative policy responses
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Deflation, particularly unexpected deflation, leads to real
balance sheet effects which can adversely affect aggregate
demand
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This is in addition to traditional real interest rate effects
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Globalization has led to some deflationary bias
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Closer integration could mean ‘deflationary contagion’ –in any
case, policies in other countries have major effects
More competition
Global reserve system means that substantial global income is
simply ‘buried’ in reserves every year
Focus on inflation limits ability of expansionary monetary
policy to offset – stability pact puts deflationary bias in Europe
Sum of trade surpluss equal sum of deficits, but there is
asymmetric policy response: pressure on deficit countries to
reduce deficits, with constraints on devaluation (fear of
inflation) and trade policy, reducing income is only instrument
in short run
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Prescription (I)
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Theory suggests focus on balance sheets
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Shifting from deflation to inflation may help balance sheets –
undoing damage that deflation has done in increasing real value of
debt
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But some institutions with a maturity mismatch may find their
balance sheet hurt –may need to have inflation or interest rate puts
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Shifting from deflation to inflation may lead to lower real interest
rates
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Prescription (II)
On average, devaluation will also improve Japan’s
balance sheet, given its large creditor status
And will help to reduce deflation
This is in addition to normal trade benefits from
devaluation
Conventional way of correcting bank balance sheet shifts
problem from banks to government
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But there are unconventional ways which provide as accurate a
picture of the true change in government’s position as
conventional method
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Specific policies: limited efficacy of
standard keynesian instruments (I)
Income tax cuts may be ineffective, if individuals think
they are temporary
Or even if they are believed to be permanent, they may
simply be used to ‘restore’ balance sheet
Temporary consumption tax cut more likely to be
effective, since the fact that it is temporary is more
incredible than the claim that the income tax is
permanent, and such a tax has an intertemporal
substitution effect
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But still may have limited effect
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Specific policies: limited efficacy of
standard keynesian instruments (II)
Spending financed by borrowing
stimulates the economy
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But leaves the country in debt
Worsening government’s balance sheet
Could set in motion bad dynamic
Households may worry about the future tax increases
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Key Questions
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How to devalue, how to reverse deflation?
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Possible solution: Financing some of deficit spending by
printing money
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No evidence of discontinuity: moderate amount will not set off
rampant inflation
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Advantage over debt finance: not treated as a liability
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Can be used to help recapitalize banks, enabling them to lend more
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Strategy was tried in Sweden in Great Depression - worked
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Important Lesson
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Even if this prescription works, it will not address
Japan’s longer run problems
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Failure to use innovations in manufacturing elsewhere in
the economy, especially in the service sector
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Unless, however, Japan does something about the
continuing short run lack of aggregate demand, there is a
real risk of exacerbating long run problem, as financial
problems mount and investments in new technology
wane.
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General conclusions
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Need for a new macro-theory, new paradigm for
monetary economics
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New theory provides better explanation of a host
of phenomena
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Most importantly, new theory provides insights
into how to think about a variety of policy issues
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