Public Bonds as Money Substitutes at Near-Zero Interest Rates: Disequilibrium Analysis of the Current and Future Japanese Economy

In the past quarter century, Japan’s economy has seen rates of interest, including those on long-term public bonds, remain quite low despite colossal accumulation of public debt, while the price level has been mildly deflationary or almost constant despite rapid monetary expansion. In this chapter, these puzzling phenomena are interpreted using a simple disequilibrium analysis framework. The major reasons for adopting disequilibrium analysis are that 1) Japan’s economy often fell into excess supply in both goods and labor markets after short-term rates of interest were controlled below 0.5% in mid-1995, and 2) public bonds markets were clearly in serious excess supply given the expectation that the primary fiscal balance was not going to turn into surpluses in the future relevant to those bonds being issued. In the proposed disequilibrium model, excess supply in goods, labor, and public bonds markets is absorbed by excess demand in money markets, induced by strong money demand at near-zero interest rates. In particular, strong money demand absorbs public bonds not as investment instruments, but as money substitutes. This chapter also demonstrates that excess demand in money markets in disequilibrium analysis can be interpreted as public bond pricing bubbles in equilibrium analysis. Given the analogy between the two approaches, as long as a bubble is sustained, mild deflation and near-zero interest rates continue in spite of massive issues of public bonds and rapid expansion of money stocks. On the other hand, once a bubble bursts, money demand shrinks drastically, a wide range of interest rates rise suddenly, and the price level jumps abruptly. With the government’s credible commitment to future fiscal reforms, a one-off price surge would stop immediately at a level two or three times higher than before, but without the reforms, the price process would be hyperinflationary.