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International Creditors under the World Dollar Standard: Japan’s Liquidity Trap Redux Ronald I. McKinnon (Stanford) Rishi Goyal (IMF) Thesis: Conflicted Virtue Creditor economies with: history of current account surpluses and build up of liquid foreign currency claims could face deflation and a liquidity trap Obvious example: Japan However, China and other East Asian creditors may follow Thesis described (1) The world is on a dollar standard creditor economies build up claims on rest of the world in dollars Exchange rate fluctuation (or anticipated appreciation) domestic currency value of dollar holdings fluctuates or may fall risky to hold dollar assets dollar assets must pay premium domestic interest rates lower than U.S. rates Thesis described (2) Risk premium could be large e.g. Japan: where financial institutions intermediating the claims have net worth close to the regulatory minimum Continued build up of dollar claims domestic interest rates could decline to low levels economy could fall into liquidity trap Thesis described (3) In liquidity trap: monetary policy: ineffective to halt deflation bank credit to private credit slumps: profit margins on lending low/negative; so, investment weakens; banks unable to recapitalize themselves; may need successive bailouts portfolio reallocation: private sector sells foreign currency assets and purchases domestic currency assets central bank purchases foreign currency assets large buildup in foreign currency reserves Investment is weak at low interest rates i Supply of loans, Ls Demand for loans, Ld Ld ' i Ls , Ld Note: Supply of loans is limited below i. Model (1) Modification of Mundell-Fleming Asset market equilibrium: i = i* + Dse + j (S NfxA/A; ss) Money market equilibrium: Ms/P = L(i, Y) (perfectly elastic at low interest rates) Model (2) Goods market equilibrium: Y = C(Y–T, i–pe–ra)+I(i,pe)+G+NX(q,Y–T) Real exchange rate and inflation: q = S P*/P pe = Dse + p*e – Dqe(Y – Yf ) Foreign asset accumulation: Ft+1 = (1+i*) Ft + NXt (Pt/St) Rest of the paper Analysis of the model Application to: outside and inside the liquidity trap sterilized and unsterilized interventions changes in the world real interest rate Japan, China, other East Asian creditors ongoing U.S. current account deficits Policy conclusions