Structural Change and Economic Dynamics

17 (2006) 466485

Stabilization policy in a KeynesGoodwin model

with debt accumulation
Toichiro Asada
Faculty of Economics, Chuo University, 742-1 Higashinakano, Hachioji, Tokyo 192-0393, Japan
Available online 27 September 2006

Abstract
In this paper, we investigate the macroeconomic impact of governments stabilization policy by using
an analytical framework of KeynesGoodwin model of growth cycle with debt accumulation. Formally,
our model is formulated as a five-dimensional system of non-linear differential equations. We consider
both of private debt and public debt, and we explicitly formulate the budget constraint of the consolidated
government including the central bank. We mainly study the case of liquidity trap under money and debt
financing of the government deficit.
We study the local stability/instability of the system and the conditions for the existence of cyclical
fluctuations analytically by means of the linear approximation method. We show that the sufficiently
active monetary/fiscal policy can stabilize the intrinsically unstable economy if the inflation targeting by
the central bank is sufficiently credible. We also present some numerical examples, which support our
analysis.
2006 Elsevier B.V. All rights reserved.
JEL classication: E12; E22; E24; E31; E32; E52; E62
Keywords: Stabilization policy; KeynesGoodwin model; Debt accumulation; Liquidity trap; Price expectation

1. Introduction
Richard Goodwins works on macroeconomic dynamics continue to be the sources of inspiration for non-neoclassical formulations of the dynamics of the capitalist economy.1 In particular,

Tel.: +81 42 674 3378; fax: +81 42 674 3425.

E-mail address: asada@tamacc.chuo-u.ac.jp.
1 The main contributions by Goodwin are collected in Goodwin (1982). Another source of inspiration will be, without
doubt, Kalecki (1971).
0954-349X/$ see front matter 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.strueco.2006.08.002

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

467

his short paper entitled A Growth Cycle (1967) had a great influence on the mathematical
studies of endogenous business cycles based on a Marxian tradition, which concentrate on the
conflict over income distribution between capitalists and workers.2 Goodwin (1967)s model is
a two-dimensional model based on the famous VolterraLotka system of the interaction between
predator and prey in mathematical biology. Although this model is very original and thoughtprovoking, it is insufficient as a model of the business cycle in a modern capitalist economy
because of the following reasons.
First, this model ignores the Keynesian principle of effective demand by assuming that the
investment expenditure is automatically adjusted to the saving to ensure the full capacity utilization
of the existing capital stock, which may be considered to be a form of classical Says law. Second,
the roles of money and finance are completely ignored. On the other hand, some authors developed
the so-called KeynesGoodwin model integrating some elements of Keynes (1936)s idea such
as the principle of effective demand and the role of the monetary factors into Goodwin (1967)s
growth cycle model.3
In this paper, we study a variant of the KeynesGoodwin model of the growth cycle with the
accumulation of private and public debt to investigate the effect of the monetary/fiscal stabilization
policies by the government and the central bank. Unlike most versions of the KeynesGoodwin
model, we incorporate both of the debt financing of private investment and the money financing as
well as the debt financing of government deficit.4 In our model, monetary and fiscal policies are
connected each other through the budget constraint of the consolidated government including
the central bank. Our model is reduced to a five-dimensional system of non-linear differential
equations, and we show that the sufficiently active monetary/fiscal policy can stabilize the intrinsically unstable economy even if the economy is stuck at the so-called liquidity trap like the
Japanese economy in the late 1990s and the early 2000s, under the environment that the inflation
targeting by the central bank is sufficiently credible.5
The paper is organized as follows. In Section 2, we formulate the model and derive a fivedimensional fundamental dynamical system of equations. In Section 3, we study the nature of the
long run equilibrium solution. In Section 4, local stability/instability of the system is investigated
analytically by means of the linearization method. In Section 5, we investigate the conditions
for the existence of cyclical fluctuations analytically. In Section 6, we present some numerical
examples, which support our analysis. Finally, in Section 7, economic interpretation of the main
results is presented.

See, for example, Fanti and Manfredi (1998), Flaschel and Groh (1995), and Sato (1985).
See, for example, Asada (1989), Franke and Asada (1994), Skott (1989), and Yoshida and Asada (2006). By the way,
Asada et al. (2003) and Chiarella et al. (2000) developed the so-called KMG model (KeynesMetzlerGoodwin model),
which integrates Keynes theory of effective demand, Metzlers theory of inventory dynamics, and Goodwins theory of
labor market dynamics. See also Flaschel et al. (2003) and Asada et al. (2006).
4 Asada (2001), Chiarella et al. (2001), and Keen (2000) consider the accumulation of the private debt, but in these
papers the money financing and the debt financing of the government deficit are not considered explicitly. On the other
hand, in Asada (1987), the private debt is not considered explicitly although the public debt is considered.
5 Asada (1989, 2006), Di Matteo (1984), Takamasu (1995), Wolfstetter (1982), and Yoshida and Asada (2006) provide
the analyses of monetary or fiscal stabilization policies by using various versions of Goodwin (1967)s growth cycle
model. But in their models monetary and fiscal policies are not connected, and the accumulation of the private debt is
ignored. Watanabe (2003) formulates the dynamic models of business cycles with debt financing of investment by using
mainly two-dimensional systems. Gong (2005) also studies a two-dimensional model with debt financing of government
and private expenditures. By the way, we must refer to Phillips (1954) as a pioneering model of fiscal stabilization policy
in a macrodynamic setting.
3

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T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

2. The model
We define the main symbols used throughout this paper as follows.6
Y = real output (real national income); K = real capital stock; y = Y/K = outputcapital ratio,
which is also called rate of capacity utilization; D = nominal stock of firms private debt;
B = nominal stock of public debt (public bond); p = price level; w = nominal wage rate; =
p/p
= rate of price inflation; e = expected rate of price inflation; d = D/pK = private debtcapital

ratio; b = B/pK = public debtcapital ratio; M = nominal money supply; = M/M

= growth rate of

nominal money supply; m = M/pK = moneycapital ratio; g = K/K

= rate of capital accumulation;
I = (g)K = real private investment expenditure7 ; G = real government expenditure; Cw = workers
real consumption expenditure; Cr = capitalists real consumption expenditure; = nominal rate of
interest of public bond; i = nominal rate of interest that is applied to firms private debt; W = pretax real wage income; P = pre-tax real profit; r = P/K = pre-tax rate of profit; Tw = real income
tax on workers; Tr = real income tax on capitalists8 ; tw = Tw /K; tr = Tr /K; N = labor employment;
s /N s = growth rate of labor supply = constant > 0; a = Y/N = average
Ns = labor supply; n1 = N
labor productivity; n2 = a /a = growth rate of average labor productivity (rate of technical
progress) = constant  09 ; n = n1 + n2 = natural rate of growth or potential rate of growth, which
is assumed to be a positive constant.
We shall present the building blocks of our model in order.
2.1. Investment and nance of the private rms
For simplicity, we assume that there are no issues of new shares, and we neglect the repayment
of the principal of private debt. In this case, we can express the budget constraint of the private
firms as follows:
= (g)pK sf (rpK iD)
D

(1)

where sf (0,1] is the rate of internal retention of firms, which is assumed to be constant for
simplicity. This equation means that the investment of the private firms must be financed through
the corporate debt and the internal retention of the net profit. Since we have the relationship:

p
K
D
D
d

=
g
=
D p K
D
d

(2)

from the definition d = D/pK, we can rewrite Eq. (1) as follows:

d = (g) sf (r id) (g + )d

(3)

In the normal situation, the corporate sector as a whole is expected to be the debtor. In this case,
we have d > 0. In some special situations such as the Japanese economy in the late 1990s, however,
it is possible that the corporate sector as a whole becomes the creditor so that we have d < 0.
6 For simplicity, we neglect capital depreciation, so that there is no distinction between gross and net variables. A dot
over the symbol denotes the derivative with respect to time.
7 The function (g) is the adjustment cost function of investment that is introduced by Uzawa (1969) with the properties
 (g)  1,  (g)  0.
8 We neglect corporate tax for simplicity.
9 This means that we are assuming Harrodian neutral exogenous technical progress. In this paper, we do not treat the
problems of endogenous technical progress and endogenous growth of population.

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469

For the determination of i and g, we assume the following functional relationships:

i = + (d) = i(, d);
id < 0

(d)  0,

id =  (d) > 0

for

d > 0,

for d < 0

g = g(r, e , d);

(4)
gr =

g
> 0,
r

g =

g
< 0,
( e )

gd =

g
<0
d

(5)

Eq. (4) captures the fact that the private debt and the public bond are the imperfect substitutes,
and the difference of the rates of interest of these assets reflects the difference of the degrees of
the risk of these assets. Eq. (5) is the investment function with Fisher debt effect.10
2.2. Effective demand and dynamic adjustment of the goods market
We assume the following Keynesian quantity adjustment process of the goods market disequilibrium:
Cw + Cr
I
G
C
=
, (g) = , v =
(6)
y = (c + (g) + v y);
c=
K
K
K
K
where is a positive parameter that represents the speed of adjustment in the goods market, and
c + (g) + v is the effective demand per capital stock.11 For the consumption expenditures of
workers and capitalists, we adopt the following Kaleckian postulate of the two-class economy
(cf. Kalecki, 1971):
Cw = W Tw = Y P Tw

 

 
D
B
Cr = (1 sr ) (1 sf )P +
+i
Tr
p
p

(7)
(8)

where sr (0,1] is the capitalists propensity to save, which is assumed to be a constant parameter.
Eq. (7) implies that workers spend all of their disposable income. On the other hand, Eq. (8)
implies that capitalists save a part of their disposable income, and capitalists buy public and private
bonds out of their saving.12 Substituting Eqs. (7) and (8) into Eq. (6), we obtain the following
expression, which may be called the dynamic law of effective demand:
y = [(g) + v + (1 sr )(b + id) {sf + (1 sf )sr }r tw (1 sr )tr ]

(9)

2.3. Dynamics of employment and wages

In this subsection, we formulate the dynamics of the labor market. By definition, we can express
the labor employment as follows:
N=

(Y/K)K
K
=y
Y/N
a

(10)

10 This type of investment function has some microeconomic foundations. In fact, we can derive this type of investment
function from the optimizing behavior of firms by assuming both of Uzawa (1968)s hypothesis of increasing cost (so-called
Penrose effect) and Kalecki (1937)s hypothesis of increasing risk of investment (cf. Asada, 2001).
11 We neglect the foreign trade for simplicity.
12 In this formulation, we also neglect the repayment of the principal of public and private bonds.

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T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

Therefore, we have
e=

K
N
=y s
Ns
aN

(11)

which means that the rate of employment is determined by four elements y, K, a, and Ns . Differentiating Eq. (11) with respect to time, we obtain:

s
y
K
N
y
a
y
e
= + s = + g (n1 + n2 ) = g n
e
y K N
a
y
y

(12)

This equation says that the dynamic of employment is governed by the dynamic law of effective
demand and capital accumulation, which is nothing but the core of the Keynesian macrodynamics.
For the dynamic of wage adjustment, we assume the following standard expectation-augmented
wage Phillips curve that reflects the state of the labor market:

w
= (e e ) + n2 + e
w

(13)

where is a positive parameter that represents the speed of wage adjustment, and e (0, 1) is the
natural rate of employment that is assumed to be constant.
2.4. Determination of price level and income distribution
For the pricing behavior of firms, we assume the following Kaleckian postulate of the mark
up pricing rule of the imperfectly competitive economy (cf. Kalecki, 1971):


wN
w
p=z
=z ; z>1
(14)
Y
a
where z is the mark up that reflects the degree of monopoly of the economy. Then, the share of
pre-tax profit in national income () becomes as follows:
 


 
P
Y W
W
(w/p)N
1
=
=
=1
=1
=1
(15)
Y
Y
Y
Y
z
We assume that z is constant so that is also constant for simplicity. In this case, the pre-tax
rate of profit becomes proportional to the rate of capacity utilization, that is to say:
r=

P
Y
=
= y
K
K

(16)

In this model, income distribution between wages and profit is determined by the average mark
up that reflects the degree of monopoly of the economy. Differentiating Eq. (14) with respect to
time, we have:
=

w
a
w
p
= = n2
p
w a
w

(17)

Substituting Eq. (13) into Eq. (17), we obtain the following standard type of the expectationaugmented price Phillips curve:
= (e e ) + e ;

>0

(18)

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471

2.5. Dynamic behavior of the monetary sector

Next, let us turn to the dynamic behavior of the monetary sector. Following Asada et al. (2003),
we specify the equilibrium condition of the money market as follows:
M = h1 pY + (0 )h2 pK;

h1 > 0,

h2 > 0,

0  0

(19)

Left-hand side of this equation is nominal money supply, and right-hand side is a type of
Keynesian nominal money demand function, where 0 is the lower bound of the nominal rate of
interest of the government bond. Solving this equation with respect to , we obtain the following
standard type of LM equation:
= 0 +

h1 y m
h2

(20)

The above equation is effective, however, only in the case of h1 y m  0. More accurate form
of the LM equation must be written as follows:

+ h1 y m if h y m  0
0
1
h2
= (y, m) =
(21)

if h1 y m < 0
0
The case of h1 y m < 0. corresponds the case of so-called liquidity trap, in which the nominal
rate of interest of government bond is stuck at its lower bound.
Furthermore, by differentiating the definitional relationship m = M/pK with respect to time, we
have the following dynamic law of motion of the moneycapital ratio:

M
p
K
=

=g
m
M
p K

(22)

2.6. Budget constraint of government and monetary and scal policies

Next, let us turn to the specification of monetary and fiscal policies. We can formulate the
budget constraint of the consolidated government including the central bank as follows (cf.
Asada, 1987):
+ B = pG + B pT = pG + B p(Tw + Tr )
M

(23)

This equation means that the government deficit must be financed through the issue of new
money or new bond.13 Dividing both sides of this equation by pK, we obtain the following
expression:
m + B b = v + b (tw + tm )

(24)

where B = B/B.
We assume that the government controls the public debt so as to keep the
following condition:
b=

B
= constant
pK

(25)

13 This equation is effective even if the government budget is in surplus. In this case, M
or B
(or both of them) must be
negative.

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T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

This means that

b
= B g = 0
b

(26)

Furthermore, we specify the monetary policy rule of the central bank as follows:
= 0 + (0 n );

0 > 0,

0

(27)

If > 0, this monetary policy rule becomes a type of inflation targeting rule (cf. Krugman,
1998; Asada, 2006). 0 is the long run target rate of growth of money supply, and 0 n is
the long run target rate of price inflation. Central bank announces this target rate of inflation to
the public, and adjusts the growth rate of money supply towards the realization of this target.
Substituting Eqs. (26) and (27) into Eq. (24), we obtain:
v = tw + tr + {0 + (0 n )}m + (g + )b

(28)

In this formulation, monetary policy of the central bank and the fiscal policy of government
are closely related each other, and it is impossible to treat them separately.
2.7. Dynamic of the price expectation formation
The final building block of our model is the dynamic of the expectation formation of the rate
of price inflation. In this paper, we adopt the following hypothesis of expectation formation,
which is a mixture of a kind of forward looking and backward looking (adaptive) expectation
formations (cf. Asada, Chiarella et al., 2003; Asada, 2006):
e = {(0 n e ) + (1 )( e )};

> 0,

01

(29)

In case of = 0, this equation is reduced to e = ( e ), which is a standard formulation

of the adaptive or backward-looking expectation formation. In case of = 1, it is reduced to
e = (0 n e ), which implies that the expected rate of inflation is adjusted towards the
target rate that is announced by the central bank. This means that the public considers that the
inflation targeting by the central bank is sufficiently credible.14 The specification of the expectation
formation mechanism closes our model.
2.8. Derivation of a system of fundamental dynamical equations
The model in this paper is reduced to the following five-dimensional system of non-linear
differential equations, which may be called the fundamental dynamical equations of our model:
(i) d = (g(y, (y, m) e , d)) sf {y i((y, m), d)d} {g(y, (y, m) e , d)
+ (e e ) + e }d F1 (d, y, e, e , m);
(ii) y = [(g(y, (y, m) e , d)) + {0 + (0 n (e e ) e )}m
14 In this case, the price expectation formation by the public may be said to be forward-looking in a sense. However,
the use of the term forward-looking may be somewhat misleading, because in our formulation perfect foresight is not
assumed in spite of the fact that the term forward-looking is usually used in the context of the rational expectation or
perfect foresight models. The author is grateful to Reiner Franke for pointing out this fact.

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

473

+ {g(y, (y, m) e , d) + (e e ) + e (y, m)}b

+ (1 sr ){(y, m)b + i((y, m), d)d} {sf + (1 sf )sr }y + sr tr ]
F2 (d, y, e, e , m; 0 , );

F2 (d, y, e, e , m; 0 , )
(iii) e = e
+ g(y, (y, m) e , d) n
y
F3 (d, y, e, e , m; 0 , );
(iv) e = {(0 n e ) + (1 )(e e )} F4 (e, e ; 0 , , ),
(v) m
= m[0 + {0 + n (e e ) e } (e e ) e g(y, (y, m) e , d)]
F5 (d, y, e, e , m; 0 , )

(30)

Substituting Eqs. (4), (5), (16), (18) and (21) into Eq. (3), we have Eq. (30)(i). Substituting
Eqs. (4), (5), (16), (18), (21) and (28) into Eq. (9), we have Eq. (30)(ii). In this equation, we
adopt a simplifying assumption tr = constant, following the procedure by Asada, Chiarella et al.
(2003).15 We obtain Eq. (30)(iii) substituting Eqs. (5), (16), (21) and (30)(ii) into Eq. (12). We
can derive Eq. (30)(iv) from Eqs. (18) and (29). Finally, we obtain Eq. (30)(v) substituting Eqs.
(5), (16), (18), (21) and (27) into Eq. (22).
3. Long run equilibrium solution
In this section, we study the long run equilibrium solution of the system (30) that satisfies
the following set of conditions:
d = y = e = e = m
=0

(31)

Substituting the set of conditions (31) into the system of Eq. (30), we have the following system
of equations that determines the long run equilibrium values of the endogenous variables (d* , y* ,
e* , e* , m* ) corresponding to a given parameter value of monetary policy 0 .
(i) (n) sf {y i((y, m), d)d} 0 d = 0;

(ii) (n) + 0 m + {0 (y, m)}b

+ (1 sr ){(y, m)b + i((y, m), d)d} {sf + (1 sf )sr }y + sr tr = 0;

(iii) g(y, (y, m) 0 + n, d) = n;

(iv) e = e ;

(v) = e = 0 n

(32)

These equations say that at the long run equilibrium point, the rate of capital accumulation is
equal to the natural rate of growth (n) and the rate of employment is equal to the natural rate
of employment (e), both of which are independent of the growth rate of nominal money supply
(0 ). Furthermore, the equilibrium rate of price inflation is equal to the difference between the
growth rate of nominal money supply and the natural rate of growth. Therefore, at first glance it
seems that the classical postulate of the neutrality of money applies to the long run equilibrium
of this system. This first impression is not correct, however, because of the following reasons.
First, the equilibrium values (d* , y* , m* ) depend on the value of monetary policy parameter
0 . Second, the long run equilibrium may not exist if the monetary authority chooses too small
15

This means that we neglect a destabilizing feedback mechanism through the positive correlation between tr and y.

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T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

value of 0 because of the following reason. The feasible equilibrium real rate of interest
( e )* must satisfy the following inequality, where 0 is the non-negative lower bound of the
nominal rate of interest.
( e ) = (y , m ) + n 0  0 + n 0

(33)

It is likely that the relatively low equilibrium real rate of interest is required to support the
natural rate of growth, since the economically feasible ranges of the variables y and d are restricted.
The inequality (33) means that the real rate of interest may be too high to keep the natural rate of
growth, if the monetary authority chooses too small value of 0 . This means that the monetary
authority must not choose too low value of target rate of inflation 0 n to ensure the existence
of the long run equilibrium solution, even if there is some degree of freedom for the choice of
such a value.16
It is worth noting that the parameter values , , , , and do not affect the long run equilibrium
values of the endogenous variables. But, in fact these parameter values affect the dynamic behavior
of the variables out of equilibrium. In particular, they influence the dynamic stability/instability
of the system. In the next section, we shall fully investigate this problem analytically.
4. Local stability/instability analysis
In this section, we study the local stability/instability of the long run equilibrium point by
assuming that there exists an equilibrium point that satisfies d* > 0, y* > 0, and m* > 0. We restrict
our formal analysis to the special case of liquidity trap (y, m) = 0 . In case of liquidity trap, we
can write the Jacobian matrix of the system (30) at the equilibrium point as follows:

F12
d
F14
0
F11

G21
G22
G23 (, )
G24 ()
0

G21

G22
e G23 (, )
G24 ()
(34)
e

0
J =
+
g
+
g
e

g
e

y
y
y
y

0
0
(1 )

F51
F52
F53 (, )
F54 ()
0
In Eq. (A1) in Appendix A, the detailed expressions of the partial derivatives in this matrix are
given. We adopt the following set of assumptions.
Assumption 1.
F11 < 0,

F12 > 0,

F14 > 0,

G21 < 0,

and

G22 > 0

These inequalities will be satisfied if  (n), gr , |g |, and |gd | are sufficiently large at the
equilibrium point. In other words, Assumption 1 will in fact be satisfied if the sensitivity of
adjustment cost of investment activity and sensitivities of investment with respect to the changes
of relevant variables are sufficiently large.

16 In the special case of the liquidity trap, we have (y, m) = and ( e )* = + n . Even in this case, there
0
0
0
remains some degree of freedom for the choice of the value of 0 to ensure the existence of the long run equilibrium with
natural rate of growth and natural rate of employment.

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

475

The characteristic equation of the Jacobian matrix (34) can be written as:
() = |I J| = 5 + a1 4 + a2 3 + a3 2 + a4 + a5 = 0.

(35)

In particular, the detailed expressions of the coefficients a1 and a2 are given as Eqs. (A2) and
(A3) in Appendix A.
It is worth noting that both of the conditions a1 > 0 and a2 > 0 are necessary conditions for
local stability of the equilibrium point.17 By using this fact, we can prove the following interesting
propositions under Assumption 1.
Proposition 1. Suppose that m < b. Then, the equilibrium point of the system (30) is unstable
for all sufficiently large values of , and it is also unstable for all sufficiently large values of .
Proof. Suppose that m < b. Then, it follows from Eq. (A2) in Appendix A that:
e (b m)
a1 = F11 G22
()

(+)

(+)

(36)

which implies that a1 becomes negative for all sufficiently large values of , and it also becomes
negative for all sufficiently large values of . In both cases, one of the necessary conditions for
stable roots is violated.
Proposition 2. Suppose that both of and are close to zero. Then, the equilibrium point of the
system (30) is unstable for all sufficiently large values of .
Proof. Suppose that = = 0. Then, Eq. (A3) in Appendix A becomes as follows:



 G23 (0, ) G24 (0)

g 
 + A = e(G24 (0) g ) + A

y
y
a2 = e 

(+)


()

(37)

where A is independent of the parameter value . This implies that a2 becomes negative for all
sufficiently large values of , which violates one of the necessary conditions for stable roots. By
continuity, these results also apply even if and are positive, as long as they are sufficiently
close to zero.
We can summarize these propositions as follows, the economic interpretation of which will be
presented in Section 7.18
(1) Suppose that the monetary/fiscal policy is relatively inactive. Then, the high speed of the
quantity adjustment in the goods market (quantity flexibility) and the high speed of the wage
adjustment in the labor market (wage/price flexibility) tend to destabilize the system.
(2) Suppose that the monetary/fiscal policy is relatively inactive and the price expectation formation by the public is highly backward-looking (adaptive). Then, the high speed of expectation
adjustment (expectation adjustment flexibility) tends to destabilize the system.

17 This result follows from the Li

enardChipart version of the RouthHurwitz conditions for stable roots of the fivedimensional system (cf. Gandolfo, 1996, p.223).
18 Asada (2006) obtained the similar results by using a simpler model.

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T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

Next, we shall study the model in case of = 1. This corresponds to the case where the announcement of inflation targeting by the central bank is perfectly believable or credible. In this case,
the Jacobian matrix (34) becomes decomposable, and the characteristic equation (35) becomes
as follows:
() = |I J| = |I J4 |( + ) = 0
where J4 is a (4 4) matrix that is defined by:

F12
F11

G22
G21

J4 = G21
G22
e
e
+ gd
+ gr

y
y
F51
F52

(38)

d
G23 (, )
e G23 (, )
y
F53 (, )

(39)

Eq. (38) has a negative real root 5 = , and other four roots are determined by the following
equation:
4 () = |I J4 | = 4 + b1 3 + b2 2 + b3 + b4 = 0

(40)

where each coefficient can be expressed by Eqs. (A4)(A7) in Appendix A, where B and D are
independent of the parameter value .
Note that the RouthHurwitz conditions for local stability in this four-dimensional subsystem
become as follows (cf. Gandolfo, 1996; Asada and Yoshida, 2003; Yoshida and Asada, 2006):
bj > 0

(j = 1, 2, 3, 4);

= b1 b2 b3 b12 b4 b32 > 0

(41)

We shall consider the comparative dynamic analysis with respect to the changes of the monetary
policy parameter by adopting the following assumption.
Assumption 2. The values of the adjustment speeds and are so large that we have:
b1 (0) = F11 G22
()

(+)

e b
<0
y

(42)

It is apparent that under this assumption, the equilibrium point of the four-dimensional subsystem (i), (ii), (iii) and (v) of Eq. (30) becomes unstable for all sufficiently small values of the
monetary policy parameter  0.
We can easily see that all of the coefficients bj (j = 1, 2, 3, 4) are linear functions of the
monetary policy parameter , and we have the Eqs. (A8)(A12) in Appendix A because of the
fact that G23 (, )/ = F53 (, )/ = m.
Right-hand side of Eq. (A11) will be positive if |gd | is not extremely large, which means that
Fisher debt effect on investment activity is not extremely strong. On the other hand, both of the
right-hand sides of Eqs. (A10) and (A12) will be positive if |gd | is not extremely large or the target
growth rate of money supply 0 is sufficiently large compared with the magnitude of |gd |.19 We
assume that these conditions are in fact satisfied.
19 It is apparent that the value of the target growth rate of nominal money supply , which is chosen by the central bank,
0
can affect the dynamic stability/instability of the system. In particular, the too small value of 0 may be responsible for
the instability of the system if the Fisher debt effect is very strong. In other words, in our model, the choice of the target
rate of inflation 0 n is not neutral for the dynamic behavior of the system contrary to the teaching of the classical
macroeconomics.

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

477

Assumption 3. A set of inequalities b3 / > 0, b4 / > 0, and (b2 /)(b3 /)

(b1 /)(b4 /) > 0 are satisfied.
Under Assumptions 13, we obtain the following important result (for the proof, see Appendix
B).
Proposition 3. Suppose that the parameter value of the price expectation formation [0,1]
is sufficiently close to 1 (including the case of = 1). Then, the equilibrium point of the system
(30) is unstable for all sufficiently small values of the monetary policy parameter  0, and it is
locally stable for all sufficiently large values of > 0.
This proposition means that the central bank can stabilize the intrinsically unstable economy by
adopting the sufficiently active monetary policy rule (that is, is sufficiently large) if the inflation
targeting by the central bank is highly credible (that is, is close to 1), under some reasonable
conditions.
5. Existence of cyclical uctuations
Let us select the monetary policy parameter as a bifurcation parameter, and consider the
effect of the changes of this parameter value. It is obvious by continuity that there exists at least
one bifurcation point, at which the local stability of the equilibrium point is lost, as the value
of is increased. At such a bifurcation point, the characteristic equation of the four-dimensional
subsystem (40) must have at least one root with zero real part. Now, let us assume as follows.
Assumption 4. We have b4 (0 ) > 0, where 0 > 0 is the value of the parameter at the bifurcation
point.
Assumption 4 will in fact be satisfied if b4 (0)  0, since b4 is a linear increasing function of
under Assumption 3. However, the condition b4 (0)  0 is not necessary condition but just a
sufficient condition for Assumption 4 to be satisfied. Under Assumptions 14, we can obtain the
following result.
Lemma. At = 0 , the characteristic equation of the four-dimensional subsystem (40) has at
least one pair (at most two pairs) of pure imaginary roots, and it has no real root such that = 0.
Proof. By the very nature of the bifurcation point, the characteristic equation (40) must have
at least one root with zero real part at = 0 . But, we can exclude the real root such that = 0
because we have (0) = b4 (0 ) > 0 at = 0 under Assumption 4. This completes the proof of the
assertion.
A corollary of this lemma is that only the following two cases can occur under Assumptions
14.
Case 1. At = 0 , Eq. (38), which is the characteristic equation of the full five-dimensional
system in case of = 1, has a pair of pure imaginary roots and three roots with negative real parts.
Case 2. At = 0 , the characteristic equation (38) has two pairs of pure imaginary roots and one
negative real root 5 = .
Case 1 corresponds to the case of the so-called Hopf bifurcation. In this case, the existence
of the closed orbits is ensured at some parameter values , which are sufficiently close to 0 (cf.
Gandolfo, 1996).20 Case 2 does not correspond to the Hopf bifurcation, and the existence of
20 It is well known that the dynamic stability of the closed orbit depends on the third order partial derivatives of the
relevant functions, but it is not easy to give the economic interpretation of such a stability condition.

478

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

the closed orbits is not necessarily ensured. Even in this case, however, the existence of cyclical
fluctuations is ensured at all parameter values which are sufficiently close to 0 , because of
the existence of two pairs of complex roots. We obtained this conclusion in case of = 1. By
continuity, however, this conclusion also applies even if 0 < < 1, as long as is close to 1. Thus,
we have proved the following proposition under Assumptions 14.
Proposition 4. Suppose that the parameter value is close to 1 (including the case of = 1).
Then, at the intermediate range of values of the monetary policy parameter > 0, the endogenous
cyclical fluctuations occur.
6. A numerical illustration
In this section, we present some numerical examples, which support the analytical results in
the previous sections. Let us assume the following parameter values and the functional forms:
sf = sr = 1,
(g) = g,

= = = b = tr = 0.2,
e = 0.97,

0 n = 0.04,

n1 = 0.03,

= 0.1,

n2 = 0.02,

i = + d2,

= 0.01,

n = n1 + n2 = 0.05,

g = 0.1{1.8y ( ) 0.9d 0.19} + n = 0.18y

5

0 = 0.09,

+ 0.1e 0.09d + 0.03

(43)

We interpret 100, 100e , 100n, 1000 , and 100(0 n) as the annual percentages of nominal
rate of interest of government bond, expected rate of price inflation, natural rate of growth,
target growth rate of nominal money supply, and target rate (equilibrium rate) of price inflation,
respectively. The situation = 0.01 corresponds to the case of liquidity trap, where the nominal
interest rate of the government bond is stuck at its lower bound 0 = 0.01. For the initial conditions
of the variables, we assume as follows:
d(0) = 0.21,

y(0) = 0.18,

e(0) = 0.92,

e (0) = 0.01,

m(0) = 0.23

(44)

Furthermore, we introduce the following additional quite natural non-linearities, which mean
that the capacity utilization and rate of employment cannot exceed their exogenously given upper
bounds.21

if 0 < y < y = 0.32
F2 (d, y, e, e , m; 0 , )
(45)
y =
e
min[F2 (d, y, e, , m; 0 , ), 0] if y = y = 0.32

if 0 < e < 1
F3 (d, y, e, e , m; 0 , )
(46)
e =
e
min[F3 (d, y, e, , m; 0 , ), 0] if e = 1
In this case, we obtain Figs. 1 and 2, which show some alternative time paths of the variables
e, d, and .
In these figures, the following three alternative scenarios are considered.

21 We can also introduce the exogenously given upper and lower bounds of the debt-capital ratio, although we do not
introduce them in the numerical simulations.

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

479

Fig. 1. Alternative time paths of e.

Fig. 2. Alternative time paths of d and .

Scenario A: = = 0 for all t  0.

Scenario B: = 0.8, = 0 for all t  0.
Scenario C: = 0.8, = 0 for 0  t < 5, and = 0.8, = 0.3 for t  5.
where t denotes time period, and we interpret a unit time as a year.22
Scenario A corresponds to the case where the price expectation formation is purely backwardlooking (adaptive) and the monetary/fiscal policy is inactive. In this case, serious depression that
is accompanied by debt deflation occurs. The initial high debtcapital ratio induces sharp reduction of investment activities, which entails sharp decrease of employment rate. The economy
begins to recover endogenously as the debtcapital ratio decreases through the reduction of the
debt-financed investment, but, the lower turning point comes too late because the serious deflation prevents the real value of debt from reducing sufficiently to induce the enough recovery of

22

We adopted the Eulers algorithm with the time interval t = 0.1 (years) for numerical simulations.

480

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

investment activities. Furthermore, at the time period t = 19 outputcapital ratio reaches its upper
bound y = 0.32, and then the economic recovery fails after all.
Scenario B corresponds to the case where the price expectation formation is considerably
forward-looking in a sense but the monetary/fiscal stabilization policy is inactive. In this case,
even if the stabilization policy is inactive, the economic recovery is accelerated through the
realization of the price inflation towards the target rate that helps to accelerate the speed of the
reduction of real value of debt, which helps to induce the increase of investment activities. But,
at the time period t = 21 the outputcapital ratio reaches its upper bound, and then the economic
recession is caused again.
In Scenario C, the way of price expectation formation is same as Scenario B, and the monetary/fiscal stabilization policy becomes considerably active since the time period t  5. In this
case, the economic recovery is further accelerated through the active stabilization policy by the
central bank and government that is combined with the considerable credibility of the inflation
targeting by the central bank. In this case, full employment of labor is attained at the time period
t = 19, and the outputcapital ratio reaches its upper bound at t = 19.5. Contrary to the other two
scenarios, however, the full employment of labor and full utilization of capital stock as well as
the excess demand in the goods market continue to be satisfied in this case.
In these examples, the nominal rate of interest is assumed to be fixed at its lower bound all the
time. In reality, however, it is very likely that the nominal rate of interest begins to rise at the later
stage of economic recovery. This will have the effect to somewhat lessen the speed of economic
recovery, but the qualitative nature of the process of recovery will not change seriously even if
this effect of increasing nominal rate of interest is introduced explicitly.
7. Economic interpretation of the main results
Now, we are in a position to interpret the economic implication of the analytical results of our
model. Proposition 1 in Section 4 means that high flexibilities of the quantity adjustment speed
in the goods market () and the wage/price adjustment in the labor market () tend to destabilize
rather than stabilize the system irrespective of the parameter values of the price expectation
formation, if the monetary policy by the central bank is relatively inactive ( is relatively small).
This fact is mainly due to the following reason.
Under the lack of the active counter-cyclical monetary policy, the following destabilizing
positive feedback mechanism, which is called Fisher debt effect after Fisher (1933), will become
dominant.
(e ) d = (D/pK) g y (e )

(FDE)

The increase of will reinforce the part y (e ), and the increase of will reinforce the
part (e ) . Without doubt, both of them are destabilizing.
Proposition 2 means that high speed of the adjustment of price expectation () also tends
to destabilize the system if the monetary policy is relatively inactive and the price expectation
formation of the public is highly backward-looking or adaptive ( is close to zero). This result
is related to the following destabilizing positive feedback mechanism through the impact of the
changes of expected real rate of interest ( e ) on investment expenditure, which is called
Mundell effect.
(e ) e ( e ) g y (e )

(ME)

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

481

The increase of will strengthen this destabilizing effect reinforcing the part e .23
On the other hand, Proposition 3 means that the sufficiently active monetary policy (large value
of ) combined with the sufficient credibility of the inflation targeting by the central bank (which
means that is close to 1) will stabilize the intrinsically unstable system. The large value of
has a direct stabilizing negative feedback effect on effective demand through the money-financed
fiscal policy, which is schematically represented by
(e ) v y (e )

(MFE)

We shall call this direct stabilizing effect money-financed fiscal policy effect. The increase
of will contribute to strengthen this effect reinforcing the part v . Even if monetary
policy is not strongly active, however, the sufficient credibility of the inflation targeting will have
a stabilizing effect to a certain extent because of the following reason. Suppose that the causal
chain
(e ) e

(ITE a)

works at the early stage of depression process. This means that the price expectation formation by
the public is backward-looking or adaptive at this stage. If the central bank succeeds to let them
believe that its announcement of the target rate of inflation (0 n) is credible, the following
stabilizing negative feedback mechanism, which may be called inflation targeting effect, will
begin to work.
0 n > e e ( e ) g y (e )

(ITE b)

It is worth noting that this effect works independent of the direct stabilization effect through
the money-financed increase of the government expenditure, although in our model the inflation
targeting effect is not enough to stabilize the economy unless the monetary policy is sufficiently
active. This result is consistent with the Keynesian view, which stresses the importance of the
subtle subjective factors such as expectation of the public and the credibility or the believability
of the attitude of the policy maker.
Acknowledgments
Thanks are due to the valuable comments by two anonymous referees. Needless to say, however, only the author is responsible for possible remaining errors. This research was financially
supported by Chuo University.
Appendix A. Partial derivatives and coefcients
In this appendix, we present detailed expressions of partial derivatives and coefficients, which
we referred to in the text.
F1
F11 =
= ( (n) d)gd 0 + sf ( id d + i);
d
(+)
(+)
()
F12 =

23

F1
= {( (n) d) gr sf };
y
(+)
(+)

F14 =

F1
= ( (n) d)g d;
e
(+)
()

The increases of and will also strengthen Mundell effect as well as Fisher debt effect.

482

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

G21 =

(F2 /)
= ( (n) + b)gd + (1 sf )( id d + i);
d
(+)
(+)
()

G22 =

(F2 /)
= [( (n) + b) gr {sf + (1 sf )sr }];
y
(+)
(+)

(F2 /)
= (b m);
e
(F2 /)
G24 () =
= ( (n) + b)g + b m;
e
(+)
()
G23 (, ) =

F51 =

F5
= mgd > 0;
d
()

F52 =

F5
= m gr < 0;
y
(+)

F5
= m(1 + ) < 0;
e
F5
= m[(1 + ) + g ] < 0
F54 () =
e
()
F53 (, ) =

(A1)

e G23 (, )
(?)

a1 = trace J = F11 G22

()

(+)

(A2)




F
 11 F12 
a2 = sum of all principal second-order minors of J = 

 G21 G22 


 



 

F11
d
1 
G22

  F11 F14 

+ e  G21

G21 (, )  + 
 + eG23 ()  G22
 0 
+ gr
 y + gd


y
y
y






 G23 (, ) G24 ()

G

G


g 
 22 G24 () 
 22 0 


y
y
+
+

+
e






 0
 F52 0 

 (1 )




 G23 (, ) G24 ()


g 


y
y
+ e 
(A3)

 F53 (, )

0
e G23 ( , )
b1 = trace J4 = F11 G22
()

(+)

(?)

= b1 ()

(A4)

e F11 G23 ( , )
b2 = sum of all principal second-order minors of J4 =
eG23 (, ) gr + B = b2 ()
(?)

(+)

(?)

()

y
(A5)

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

483

G22
(+)
+ gr
b3 = (sum of all principal third-order minors of J4 ) = e0 F53 (, )
y
()
(+)
2 e 0 F52 G23 (, )
()

(?)

+ eG23 (, )(F11 gr F12 gd ) + D = b3 ()

() (+)

(?)

(A6)

(+) ()

G22

(+)
+ gr F12 (G21 + gd )
b4 = det J4 = e0 F53 (, ) F11
()
y
(+)
()
()
(+)
()

G21

()
+ gd
(F11 F52 F12 F51 ) d F52
()
() ()
y
(+) (+)
()

G23 (, )
(?)

F51

G22

(+)

(+)

+ gr = b4 ()
(+)

(A7)

b1
e m
=
>0

(A8)

F11
b2
()
= e m
+ gr > 0

y
(+)

(A9)

F32
G22

b3
(+)
()
F11 gr + F12 gd
+ gr
= e m 0

y
y

() (+)
(+) ()
(+)

(A10)

G22

b4
(+)
= e m0 F11
+ gr F12 (G21 + gd ) + (F11 F52 + F12 mgd )

() y
(+)
()
() ()
(+) ()
(+)
()
(A11)

b2



F52
G22
 



b3
b1
b4
(+)
()

+ gr

= (em)2 gr F11 2 +0
y

y
(+)
(+)


F11 gr

() (+)

0
y

F11 F12 (G21 + gd ) F12 gd 0 m +

() (+)

()

()

(+) ()

F11
()

gr
(+)

(A12)

484

T. Asada / Structural Change and Economic Dynamics 17 (2006) 466485

Appendix B. Proof of Proposition 3

We prove the following result in case of = 1. By continuity, however, these results also applies
even if 0 < < 1, as long as is close to 1.
(i) It follows from Assumption 2 that we have b1 () < 0 for all sufficiently small values of  0,
which violates one of the necessary conditions for the stable roots.
(ii) It follows from inequalities (A8) and (A9) in Appendix A and Assumption 3 that all of the
coefficients bj (j = 1, 2, 3, 4) become positive for all sufficiently large values of > 0. On the
other hand, = b1 b2 b3 b12 b4 b32 becomes a cubic function of such that
= E 1 3 + E 2 2 + E 3 + E 4
where all of Ej (j = 1, 2, 3, 4) are independent of . In particular, we have
 

 



b2
b3
b1
b4
b1
E1 =

>0

(B1)

(B2)

because of the inequality (A8) and Assumption 3. This means that also becomes positive
for all sufficiently large values of > 0. In this case, all of the real parts of the roots of the
characteristic equation (38) become negative for all sufficiently large values of > 0, because
all of the RouthHurwitz conditions for the stable roots of the four-dimensional system (41)
are satisfied and another fifth root 5 = is a negative real root.
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