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Source link: http://archive.mises.org/6399/the-yen-and-monetary-liquidity/

The Yen and Monetary Liquidity

March 20, 2007 by

The Bank of Japan’s zero interest rate policy since early 2001 has created an incentive to borrow in Japan at close to zero interest rates, and employ the borrowed money to buy high yielding assets such as US 10-year Treasury Notes. As long as the dollar stays stable or does not fall against the yen our investor is going to make a hefty return on his money. However, the whole thing could reverse very rapidly should the US dollar depreciate against the yen. FULL ARTICLE

{ 17 comments }

Stranger March 20, 2007 at 8:13 am

It’s comical that wealthy hedge funds and investment banks are profiting from a policy whose original stated purpose was to stimulate the economy in order to prevent unemployment.

That makes the world’s top financial centers, Wall Street and the Square Mile, the biggest welfare scammers in history. Reagan’s welfare queens pale in comparison.

Graham March 20, 2007 at 9:22 am

What I find unusual is the assumption that Japanese banks are the lenders for the Yen carry trade, and yet the growth in Japanese Bank lending has been negative.

I believe that I favour the theory that the Yen carry trade is, for the most part, local savings that have been allocated abroad (i.e. from Japan to the rest of the world). In other words, the carry trade will only unwind if the potential for gains at home starts to exceed the potential for gains in investments abroad.

This suggests that the unwinding of the “carry” trade would be bullish for Japanese assets, and close to neutral for the banks.

Graham.

Alex MacMillan March 21, 2007 at 10:14 am

Suppose there are two countries in the world: U.S. and Japan. The U.S. money stock is $100, the Japanese money stock is 100 yen and the exchange rate is $1US=1yen. U.S. goods and money are substitutes. At a permanently fixed exchange rate, U.S. and Japanese money would be perfect substitutes. And an increase in the money supply by one country would have a similar effect on each country as an increase in money supply by the other.

But under a flexible exchange rate, the two monies would be imperfect substitutes as Frank Shostak points out. But, even if the U.S. holds its money supply constant while the Japanese money supply increases, in the short run at least, is it not as if the U.S. had increased its money supply somewhat, since a substitute (albeit an imperfect substitute) money has increased in quantity? In the beginning to Frank’s piece he explains that the management of Japanese liquidity to maintain Japanese interest rates at zero increases the demand for U.S. financial instruments, raising their prices and reducing their yields. This has a similar effectd as an increase in the U.S. money supply would. Admittedly, it is a short run effect, highly dependent upon exchange rate expectations. But does not this imply that changes in Japanese liquidity do affect the U.S. economy?

Alan Dunn March 21, 2007 at 11:29 pm

Good article Frank. Its been a few years since I have read about this 0% rate in Japan. If my memory serves me correct Krugman investigated the situation and received a hiding from the likes of Kregal and others.

I found your article more to my liking although I probably have some reservations upon how Central banks would behave. However, given that your assumptions are clearly stated it may be an ideological blunder on my part and I have missunderstood something along the way.

“An increase in the supply of money for a given demand for money and for a given purchasing power of money will result in a surplus of money or an increase in monetary liquidity. (There is now more money than what people require at a given demand for money and a given purchasing power of money). A given stock of goods will now be exchanged for more money”.

The consequences here would surely depend on the behaviour of the central bank. If the Central Bank set interest rates exogenously like they do in Australia then the Central Bank would sek to reduce liquidity in the exchange settlement accounts held by member banks at the Central Bank.

The Central Bank would simply sell an interest bearing alternative to member banks to reduce liquidity in the exchange settlement accounts and maintain the target rate of interest they previously set.

Failure to do this would place downward pressure (in the short term) on the interest rate . Given the Central bank sets the rate exogenously its difficult to imagine them not actively seeking to maintain it. Certainly there is more than one interest rate, but all rates are to some degree based upon that which the Central Bank sets endogenously.

While I don’t agree with Central banks directing the economy (gimme a gold standard anyday) its prety much par for the course in a modern money economy.

cheers

Alan Dunn March 21, 2007 at 11:54 pm

Certainly there is more than one interest rate, but all rates are to some degree based upon that which the Central Bank sets endogenously.

My mistake here – it should say exogenously.

Frank Shostak March 22, 2007 at 12:25 am

Hi Alan,
If we would have been in a timeless set up than you are absolutely correct. But as I did mention in the article there is a time lag. In short, the central bank can fix the equilibrium in the cash market but the effect of this fixing on the other markets may take time. Thus the bond market reacts much faster to the central bank operation in the cash market (money market) than the stock market whilst the base metal market is likely to respond after a much longer time lag. To summarise on account of the time lag the central bank cannot remove the imbalances between the supply and the demand for money instantly by balancing the cash market. Also, no one knows what is the right level of the interest rate is, so the fixing of the target and maintaining it doesn’t equate with balancing the supply and the demand for money.
All the best,
Frank Shostak

Frank Shostak March 22, 2007 at 2:20 am

Hi Alan,
If we would have been in a timeless set up than you are absolutely correct. But as I did mention in the article there is a time lag. In short, the central bank can fix the equilibrium in the cash market but the effect of this fixing on the other markets may take time. Thus the bond market reacts much faster to the central bank operation in the cash market (money market) than the stock market whilst the base metal market is likely to respond after a much longer time lag. To summarise on account of the time lag the central bank cannot remove the imbalances between the supply and the demand for money instantly by balancing the cash market. Also, no one knows what is the right level of the interest rate is, so the fixing of the target and maintaining it doesn’t equate with balancing the supply and the demand for money.
All the best,
Frank Shostak

Alan Dunn March 22, 2007 at 8:49 am

Hi Frank,

Thanks for that explanation it certainly clears things up for me. I’ll blame the first 3 years I was force fed Keynesian economics at University for my error :0).

I fully agree that the “fixing of the target and maintaining it doesn’t equate with balancing the supply and the demand for money”.

If only a few central bankers understood this we’d be all better off. Under the current regime interest rates are either too high or too low – but never what the market would determine in a free market.

Add to this capital flows and the effects of a floating exchange rate in a market which in many respects is administered through dirtying the float and its no wonder central banks are always chasing their own tails.

cheers Frank and thanks for an excellent article.

Alex MacMillan March 22, 2007 at 3:36 pm

Frank,

Any comment about my contention that in the short run, even with flexible exchange rates, U.S. and Japanese money are substitutes (though imperfect)?

Alan Dunn March 22, 2007 at 8:22 pm

Hi Alex,

you certainly tackle the difficult questions :0)

I’ll, be honest and say I wouldn’t have a clue what would happen.

You suggest flexible exrates apply in your analysis.

Are you assuming that money is or isn’t tax driven in your analysis?

Because if the assumption is that money is tax driven then the loanable funds framework goes straight out the window and things get really wierd.

cheers and kudos to you for tackling the tough questions – I’m not that brave.

Peter March 22, 2007 at 9:59 pm

Alex,

An increase in the Japanese money supply whilst holding US money supply constant will not have a similar effect as an increase in US money supply as you suggest. All that may happen is that the holders of the US dollars (the Japanese) will allocate them to certain asset classes. However if the US money supply remains constant then this means the price of some asset classes will rise & other asset classes will have to fall. It doesn’t matter if they are perfect substitutes. USD can only be created by the American banking system as Yen can only be created by the Japanese banking system. Besides the fact that we have Yen & USD implies that they cannot be perfect substitutes.

Alan Dunn March 23, 2007 at 5:12 am

Frank,

“USD can only be created by the American banking system as Yen can only be created by the Japanese banking system. Besides the fact that we have Yen & USD implies that they cannot be perfect substitutes”.

I agree totally but this implies that the neutrality of money does not hold if we are in a system where a monopoly exists for a supply of a given fiat and that same fiat is the only acceptable unit for its citizens to meet its tax obligations.

IF this is correct then money is tax driven and as such the majority of economic principles held by economics in general must fall.

I have no idea how to solve this conundrum and I’m not sure why nobody else sees it as a problem for economics in general.

Can you help me out here and explain where I’m losing the plot. Given nobody else thinks this way I’m convinced I must be wrong.

cheers

Alex MacMillan March 23, 2007 at 12:29 pm

Peter or Frank,

The Japanese supply of money and credit increases. This lowers Japanese interest rates (in the short run). In the absence of an immediate change in the expected value of the yen in terms of U.S. $ to offset this interest rate differential, as Frank said, there will be an increase in the supply of loans to Americans in the U.S. (as the Japnese funds are employed to purchase U.S. Treasuries). How is this effect not similar in the short run to an increase in U.S. loans created through the U.S. banking system?

Alan Dunn March 24, 2007 at 2:53 am

Alex,

Your probably already aware but the Bank of International Settlements (BASLE) has some excellent papers / information that you may find useful for expanding or perhaps refreshing your knowledge of monetary theory.

I wouldnt recommend any texts on monetary theory to answer your question because they are mostly out of date as far as I am aware. In addition, different countries / monetary systems vary enough to render a once size fits all textbook dubious to say the least.

I mean no disrespect here just thought you might find some answers to your questions from the BIS (BASLE).

cheers

Alan Dunn March 24, 2007 at 3:29 am

Alex,
continued:

With respect to loans many of them are created through securitisation rather than from deposits per se. Asset backed commercial paper programs are also another source.

Do deposits create loans or loans create deposits ? Lots of cart before the horse for many here – myself included.

Securitisation also seems to be neglected in the textbooks and securitisation plays a big part in how loans function in a modern monetary economy.

This is why the loanable funds framework is effectively a waste of time .

Furthermore, the existence of a multitude of derivatives in the the economy and many bank operations occuring off-balance sheet make it “impossible” /”intractable” to actually control the money supply.

The only place the money supply can be held constant is in a textbook.

The Central bank essentially can only control exchange settlement accounts or the excess reserves of high powered money held with member banks (differences between countries and banking systems within obviously thwarting any one size fits all approach).

cheers

Alex MacMillan March 24, 2007 at 2:56 pm

Alan,

If you know of a specific paper that would answer my question as to why different country monies are not substitutes (as I say, “imperfect substitutes” but substitutes to some degree), I would be happy to read it.

As you say, there are many ways for Americans to obtain credit other than through the U.S. banking system. Again, this means that the credit created by U.S. central bank monetary expansion has its substitutes. And such substitutes may be created in a number of ways, one of which, it would seem to me, is a monetary expansion in Japan, or elsewhere, for that matter.

bhuvanes May 22, 2007 at 4:50 am

yesterday I was searching for the apartment price at my locality (CHENNAI). i was surprised, the price are sky rocketed in recent future. i blame yen carry trade have strong effect on india economy. when indian stocks dropped nearly 2000 points in bse sensex. then everybody was alerted . FII ‘s are withdrawing funds from indian market. due to yen massive recovery from 121.09 to 115.00 in a short perion of a month at that time BSE Sensex dropped to 14300 point to 12400 . now usd gained its strenth to 121.50 as of 22nd may.as BSE Sensex reached 14486.this is an alarming situation when carry trade saturates itself as interest rate
parity reduce considerably among developed countries would harm entire global economy. i am looking for a carry trade demise in short future to buy own apartment in chennai

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