Implications for the
Yen of Japanese Current
Account Adjustment
Keynote Speech by Maurice Obstfeld

This paper presents a quantitative evaluation of the effect on the yen ofsome alternative scenarios under which Japan reaches current accountbalance. The analytical framework is a global general equilibrium model,
based closely on Obstfeld and Rogoff (2005a, b), within which relative
prices clear the world markets for traded goods as well as the domestic
markets for nontraded goods. Depending on assumptions about the criticalsubstitution elasticities underlying the model, the yen could appreciate byas much as 10 percent for each 1 percent of GDP reduction in its current
account surplus. The effect would be smaller if substitution elasticities werelarger, or if adjustment were accompanied by an expansion of Japanese
nontradable output, the latter presumably implied by a return to a more
efficient level of labor utilization.
Keywords: Current account adjustment; International capital flows;
Japanese yen exchange rate
JEL Classification: F32

University of California, Berkeley (E-mail: obstfeld@econ.berkeley.edu)
I thank Kenneth Rogoff for allowing me to draw on our joint work. An earlier version of this paper
was prepared for the September 14, 2005 NBER/ESRI Meeting, Cabinet Office, Tokyo, Japan. My
discussant, Masahiro Kawai, as well as conference participants, offered very helpful comments onthat occasion.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006
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27

I. Introduction
In three papers written over the past five years, Kenneth Rogoff and I have analyzed
the possible impact on exchange rates of a rapid return by the United States to a
position of current account balance (Obstfeld and Rogoff [2000, 2005a, b]). Backin 2000, the U.S. deficit (though at a historically high level) was smaller than it isnow. Also, as has become clearer as a result of the very important work of Lane
and Milesi-Ferretti (2001, 2005) in assembling consistent data on international
asset and liability conditions, the widening of global net external imbalances has
been accompanied by an explosion in gross international positions, as countries—
especially industrial countries, but increasingly emerging markets—have leveraged
their international positions by effectively financing increasing gross foreign assets
through increasing gross foreign liabilities. This development has greatly expanded
economic interdependence, in part by creating conditions under which unexpectedexchange rate movements will cause large wealth redistributions among countries.
Some, notably Greenspan (2004), have argued that the enhanced depth of international financial markets should reduce the weight that large external imbalances
deserve in the list of policymaker concerns. Larger imbalances can be financed moreeasily, the argument goes, given the apparently greater willingness of financial market
participants to accumulate foreign claims. On the other hand, Rogoff and I haveargued that the exchange rate effect of current account adjustment, when it does
occur, depends only in a secondary way on the degree of integration of global asset
markets. Rather, it depends on the fluidity of goods markets, which remains limitedin the short run in both the domestic and (particularly) international arenas. The vast
extent to which the adjustment speed of global asset markets now outstrips that ofgoods markets creates a hazard: when asset markets allow the development of large
income-expenditure imbalances, they create the overhang of large potential exchange
rate adjustments, which may in turn provide the motivation for sharp fluctuations ininternational financial flows, or even panics. The avoidance of such volatility will
depend on the firmness of asset-market actors in taking a long view and providing
the finance needed for the long-term gradual adjustment of global imbalances. One
goal of my work on adjustment with Rogoff has been to assess the potential strain on
markets in the event that global investors prove fickle rather than firm.
Japan is one of several countries that have extended their surplus positions, inJapan’s case from around 2 percent of GDP in 2001 to more than 3.5 percent of
GDP in 2005. Figure 1 shows this development, as well as the accompanying
movement in the yen’s real effective exchange rate index (as reported by the OECD,
with an upward movement being an appreciation).1 Between 2000 and 2004, theyen depreciated by around 15 percent in real terms against trading partners’ currencies.
Indeed, the degree of negative correlation between the real exchange rate index andthe current account surplus is remarkable in Japan’s case, with real depreciations
1. Current account data are taken from the International Monetary Fund’s (IMF’s) World Economic Outlook, various
issues. The data on Japan’s saving and investment rates cited later in this paragraph also come from that source.
The real effective exchange rate series is taken from OECD, Main Economic Indicators.

28 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Implications for the Yen of Japanese Current Account Adjustment

Figure 1 Japan’s Current Account and the Yen’s Exchange Rate

4.0

Current account (percentage of GDP)

Real effective exchange rate (2000 = 100)

105

Current account balance (left scale)Real effective exchange rate (right scale)
3.5
100

3.0
95
2.5
90
2.0

85
1.5

80

1.0
1996

97

98

99

2000

01

02

03

04

05

closely tracking increases in the surplus.2 Notwithstanding the claim that there has
been a global savings increase since the late 1990s that may be keeping world interest
rates low (Bernanke [2005]), Japan has not been a contributor. Since 1997,
Japan’s gross saving rate has fallen from 30.9 percent to an estimated 26.8 percent
of GDP in 2005 (that is, by 4.1 percentage points of GDP), whereas its investment
rate has fallen from 28.7 percent to an estimated 23.2 percent of GDP (that is, by
5.5 percentage points of GDP)—implying a 1.4 percentage point rise in the external
surplus over those same years.
What would be the effect of a rapid narrowing of this surplus on the yen’s
exchange value? Such a narrowing could reflect some sudden event abroad, such as acollapse in housing prices, that sharply reduces foreign current account deficits. The
conventional approach to the question would rely on econometric estimates basedon a trade model or some other framework focused on international transactions.
The approach below will take a different tack, however, one that recognizes that therelative price of traded and nontraded goods is a key component of the real exchange
rate, and that the GDPs of modern economies consist mostly of services and other

2. Over the period shown in Figure 1, the correlation between the real exchange rate lagged one year and the current
account ratio is –0.62.

29

nontraded goods. The model does take account of international trade, of course, but
as will be evident, that is not where all or even most of the action occurs.
As argued in Obstfeld and Rogoff (2005b), there is no single answer to thequestion of how much exchange rate change is associated with a given change in thecurrent account: even for a fixed set of fundamental parameters, the magnitude of
exchange rate change will depend on the precise scenario under which adjustment
occurs. Even less sensible is the question of how much current account adjustment iscaused by a given exchange rate change, because the exchange rate is one of the many
endogenous variables that will respond to the exogenous impulses causing the current
account to change. The model explored below suggests that for sufficiently low
substitution elasticities (between traded and nontraded, and between various traded
goods), and under a scenario in which sectoral output levels remain constant so thatthe main impulse is a change in saving behavior, a 1 percent fall in Japan’s surplus
could be associated with as much as a 10 percent yen appreciation.3 The exchange
rate impact would be smaller if the current account change is accompanied by a risein nontradable output in Japan, as part of a movement toward full employment.
Because Japan, like other industrial countries, has vastly expanded its gross foreign
assets and liabilities, and therefore holds substantial foreign currency assets abroad, ayen exchange rate change has a potentially large effect on Japan’s net external wealth.
In the case of a complete and unexpected adjustment to full current account balance,
the cost to Japan would amount to a substantial fraction of a year’s GDP.
The plan of the paper is as follows. Section II sets out the model. Section III
carries out the core simulations. Finally, Section IV lists some caveats and concludes.

II. The Model
The model deployed here is the two-region model of Obstfeld and Rogoff (2005a),
calibrated to represent Japan in relation to the aggregate of its trading partners.
I sketch the model’s main features, leaving it to interested readers to consult theearlier paper for a more detailed and technical discussion.
There are two regions, Home and Foreign. Each region produces a nontraded
good and an export good, while importing the other region’s export good, which isan imperfect substitute for its own. (Think of Japan and the rest of the world as thetwo regions.)
The model assumes that endowments are given exogenously for the various types of
outputs, thereby implicitly assuming that capital and labor are not mobile between
sectors in the short run. Over the longer run, one would expect factor mobility acrosssectors to dampen real exchange rate effects. The core analysis also assumes that
nominal prices are completely flexible. That assumption builds in an understatementof the likely real exchange rate effects of a current account reversal.

3. To the naked eye, incidentally, this number does not look grossly out of line with the association displayed in
Figure 1.

30 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Implications for the Yen of Japanese Current Account Adjustment

The Home consumption index depends on Home and Foreign tradables, as wellas domestic nontradables. It is written in the nested form

–––
–––
−1–  −1C =   CT  + (1 −  ) CN  ,



–––
−1
–

–1–

–1–



where CN represents nontradables consumption and CT is an index given by
 −1
––––

 −1
––––


–––
−1


C =  C  + (1 − )C   ,


1
––

T

1
––

H

F

where CH is Home consumption of Home-produced tradables, CF is Home consumption of Foreign-produced tradables, and  > 1/2. Foreign has a parallel index, butwith a weight * (* > 1/2) on consumption of its own export good. By assuming
substantial Home-export consumption preference, rather than identical tradables
baskets, I generate a Home consumption bias even within the category of tradable
goods. This feature will, in turn, generate a transfer effect—a ceteris paribus rise in acountry’s spending improves its international terms of trade. Furthermore, a ceterisparibus improvement in a country’s terms of trade will entail a real appreciation of its
currency, because the domestic export has a preponderant weight in the domestic
tradable consumer price index (CPI).4
The parameters  and  are central to our analysis. Parameter  is the (constant)elasticity of substitution between tradable and nontradable goods. Parameter  is the(constant) elasticity of substitution between domestically produced and imported
tradables. The two parameters govern the magnitudes of price responses to quantity
adjustments. Lower substitution elasticities imply that sharper price changes areneeded to accommodate a given change in quantities consumed.
The Home CPI corresponding to the preceding consumption index C, measured
in units of Home currency, depends on the prices of tradables and nontradables. It is
given byP =  PT1− + (1 −  )PN1−





1
––––
1−

,

where PN is the Home-currency price of nontradables and PT , the price index for
tradables, depends on the local prices of Home- and Foreign-produced tradables, PH
and PF , according to the formula
PT =  P



1− 
H

+ (1 −  )P

1− 
F



1
––––
1−

.

4. Strictly speaking (as will be evident from the formulas below), the transfer effect will operate whenever α + α * > 1.
For example, a very basic symmetrical monopolistic competition model without any home bias, in which thepreference weight attached to any good by any consumer in the world reflects that good’s share in world output,
would imply  +  * = 1. See, for example, Krugman (1989). In that case, there is no transfer effect.

31

In Foreign, there are an isomorphic nominal CPI and index of tradables prices, butwith the latter attaching the weight * > 1/2 to Foreign exportable goods. These exact
price indexes are pivotal in defining the real exchange rate.
If we assume the law of one price for tradables, then PF = PF* and PH* = PH /, where is the Home-currency price of Foreign currency—the nominal exchange rate
(I signify Foreign nominal prices with asterisks). The terms of trade are*PF–,
P–F = ––
 = ––*PH PH

and the real exchange rate isP–* .
q = –––P
Note that because of the home bias in consumption of tradables, purchasing power
parity does not hold for the differing preferred baskets of tradables in each country,
even if the law of one price holds for individual tradable goods. In terms of themodel’s notation, PT ≠ PT*.
Because the assumed utility functions imply constant elasticity of demand foreach of the endowment goods, we can conclude that the global market for theHome-produced good clears when
PH / −C *,PH– −C + (1 − *) ––––
YH =  ––
T
T
PT*
PT

( )

( )

where YH is Home’s endowment of its tradable good. There is a corresponding marketclearing condition for the Foreign tradable supply, YF . For Home nontradables, we havePN– −C ,(1 −  ) ––YN = ––––––
T

PT

( )

and, of course, there is again a corresponding Foreign condition.
The model abstracts from the underlying determinants of domestic and foreignsaving and consumption. Thus, it takes as given the tradable consumption levels CT
and CT*, along with the endowments YH , YF , YN , and YN*. Then the preceding marketequilibrium conditions allow us to solve for relative prices. There are three key relative
prices: those of exports to nontradables in each country, plus the terms of trade. And
by Walras’ Law, the four market-clearing conditions (two traded, two nontraded) yield
three independent conditions determining the three relative prices.
How does the level of external imbalance impinge on these goods markets? Home’s
current account surplus CA, measured in Home currency, is
CA = PHYH + iF −PTCT ,32 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Implications for the Yen of Japanese Current Account Adjustment

where F is net Home foreign assets (in Home currency units) and i the corresponding interest rate. Therefore, tradables consumption can be expressed as a function of
the current account via
PHYH + iF −CA
CT = ––––––––––––.
PT
For Foreign, of course, the corresponding relationship isCA * = PF*YF − iF − PT*CT* = −CA.
By letting CA change, the impact of a ceteris paribus change in consumption behavior
can be ascertained. More complex scenarios, for example, those involving productivity shifts, are analyzed by allowing CA to move along with some of the output
endowments. Letting CA → 0 yields the effect of a complete external adjustment(to a configuration with zero current accounts). Because the numerical effects areapproximately linear, the exchange rate effect of partial current account adjustment
can be gauged by prorating the calculated effect of complete adjustment.
A central relationship in the model is that linking real exchange rate changes tochanges in terms of trade and in relative nontradables prices. It can be approximatedby the expression:
log q =  ( + * − 1)log  + (1 −  )log (PN*/PN ).
Home’s percent relative real depreciation depends on the difference between theForeign and Home rate of tradables price inflation (with weight  ) and the difference
between the Foreign and Home rate of nontradables price inflation (with weight 1 −  ),both measured in the same currency. In turn, because of the asymmetry in international
preferences over tradables, which is equal numerically to  + * − 1 (and therefore iszero in the uniform-preferences case of  = * = 1/2), Foreign’s tradables price inflation
relative to Home’s is an increasing function of the percentage improvement log  inthe Foreign terms of trade against Home.

III. Numerical Assessment of Rebalancing Global
Current Accounts
One can potentially do many alternative experiments within the preceding framework.
For example, as already discussed, just letting CA go to zero gives a pure relative
demand-driven current account reduction (that is, rebalancing of current accounts
because U.S. aggregate demand falls while foreign aggregate demand rises). And, as
we have also already alluded, one can simulate any accompanying effects of relative
productivity shocks by varying Home and Foreign relative output at the same time as
we let the current account go to zero.

33

In our calibration, we assume that, for Japan, PHYH /(PHYH + PNYN ) ≈ 0.2; so that asurplus-to-tradables ratio of CA /PHYH = 0.035/0.2 = 0.175 approximates the country’s
current external surplus. According to the Ministry of Finance, Japan’s net external
assets at the end of 2004 were ¥185.8 trillion, the difference between gross foreign
assets of ¥433.9 trillion and gross liabilities to foreigners of ¥248.1 trillion. I therefore
take initial net Japanese foreign assets (in yen), F, divided by the yen value of traded
goods output, PHYH , to be 1.85, and assume a nominal rate of return of 5 percent per
year on net foreign assets.5 I set relative output levels in Japan and the rest of the world
so that the U.S. dollar value of tradables produced by Japan is around 12 percent of
global dollar sales of tradables.
Regarding preference weights, I take  = 0.2 and  = 0.8. To reflect both the restof the world’s bias toward its own tradables and Japan’s weight in world productionof tradables, I set * = 0.975.6 I investigate several possible values of substitution
elasticities. Between different regions’ tradables, I consider values of  equal to 2 or 3.
These are high relative to the numbers suggested by econometric studies of macro
data, but for reasons discussed in Obstfeld and Rogoff (2005b), these values seem
more reasonable than the estimated values of 1 or below prevalent in the literature
on national-level trade equations. In any case, lower elasticities would imply sharper
terms of trade and real exchange rate movements. For the traded-nontraded elasticity
, I entertain values of  = 1 or 2.
A final issue concerns the relationship between the real exchange rates that appear
in the model and nominal rates. To make this translation, we must add an assumption
about monetary policy. The simplest one is that central banks target CPI inflation
rates in which case, under flexible prices, log  = log q.
Table 1 answers the question: what happens if a relative demand shock suddenly
eliminates the current account surplus of Japan (which therefore drops from 3.5
percent of GDP to zero)? In this initial set of experiments, I do not allow outputs
to vary, nor do I account for the potential effect of the exchange rate in revaluing
Japanese external assets and liabilities.
Under the lowest-elasticity scenario in the table (the first row), the yen appreciates
in real terms by 37.5 percent—more than 10 percentage points for every percentage
point of GDP in current account adjustment. Higher values of  do not affectthe terms of trade change in this simulation, but they do reduce the needed extent ofTable 1 Japan’s Return to External Balance, Simplest Case

1
2
1
2


2
2
3
3

Increase in terms of trade (percent)
24.2
24.2
14.6
14.6

Real yen appreciation (percent)
37.5
26.7
28.5
18.6

5. As will become clear below, within reasonable limits, this last choice implies very little by way of numericalconsequences.
6. Obstfeld and Rogoff (2005a) set the corresponding parameter to 0.925 in a two-region model in which Home is
the United States.

34 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Implications for the Yen of Japanese Current Account Adjustment

real appreciation by reducing the equilibrating increase in the price of Japanese
nontradables relative to tradables. At the same time, an increase in the international
trade elasticity reduces the terms of trade improvement sharply, but has a smaller
proportional effect on the extent of necessary real appreciation, which remains atnearly 30 percent in the  = 1 case. In the highest elasticity case (last row of Table 1),
the terms of trade increase is 14.6 percent and the real appreciation 18.6 percent—numbers that seem somewhat too small, in light of past experiences, to be plausible.
Recent contributions by Tille (2003), Gourinchas and Rey (2006), and Lane andMilesi-Ferretti (2004) have stressed that effects of asset price changes, and especiallyexchange rate changes, on net international positions. The simulations reported inTable 2 take account of the composition of Japan’s internationally leveraged portfolio,
and allow for the revaluation effects of exchange rates as global current accounts
unexpectedly return to balance. The assumption underlying the simulations is that
all of Japan’s external liabilities are denominated in yen, whereas (as suggested by
the IMF’s Coordinated Portfolio Investment Survey for 2001) 75 percent of Japan’s
external assets are denominated in non-yen currencies. The implication for the net
position is quantitatively significant. If the yen suddenly appreciates uniformly against
external currencies by, say, 10 percent, the implied wealth transfer to foreigners willbe 7.5 percent of the gross foreign asset stock of ¥433.9 trillion, which is equal toapproximately 6.5 percent of a year’s Japanese GDP! This number should be kept inmind in evaluating the exchange rate changes reported below.
Table 2 shows that accounting for the revaluation of the net international position
reduces the degrees of terms of trade and real currency appreciation for Japan, but
leaves both quite large. This is true even in the first row, where the implied wealthtransfer to foreigners—assuming no prior adjustment of interest rates in anticipationof the exchange rate change—is nearly 40 percent of initial net external assets. The
reason for this somewhat limited impact on relative price change is basic: unlessratios of gross assets and liabilities to GDP are truly huge, only a large exchange ratechange can result in a sizable reduction in national wealth.
The equilibrium result does, however, accord with intuition. Because yen appreciation reduces national wealth, Japanese consumption is dampened relative to foreign
consumption, resulting in a smaller terms of trade gain and a smaller increase in therelative price of nontradables. As a result, the implied real appreciation is smaller, too.
Qualitatively, the changes line up as in Table 1, but are somewhat muted.
One interesting aspect in the comparison of Tables 1 and 2 is that, in Table 2, theterms of trade change differs across different values of . Why the difference? In
Table 2, a change in  changes the degree of nominal and real appreciation, which
Table 2 Japan’s Return to External Balance, with Asset Revaluation

1
2
1
2


2
2
3
3

Increase in terms of trade (percent)
18.8
19.7
12.2
12.7

Real yen appreciation (percent)
29.6
21.8
24.0
16.2

35

alters net foreign wealth. Because the net foreign wealth level feeds directly into themarkets for tradables—a smaller level of net foreign wealth implies that a smaller
trade deficit is consistent with the current account balance—the international termsof trade are now affected. Table 2 shows that a bigger yen appreciation, and hence a
bigger reduction in net foreign wealth, is accompanied by a smaller terms of trade
improvement (although once again, the quantitative differences are small).
So far, I have analyzed a situation in which Japan moves from a situation of internal balance and external surplus to one of external as well as internal balance. It could
be argued, however, that Japan remains in the grip of deflationary pressures, so that its
position is one of external surplus and deflation. In such cases, as is well known fromthe textbook “four zones of economic discomfort” diagram, internal and externalbalance could, conceivably, be attained without any exchange rate adjustments.
Because the present model is strictly speaking one with full employment, it isdifficult to address this possibility directly. Consider, though, the following indirect
approach. A situation with deflationary pressure could be construed as one in which
the relative price of nontradables is too high to balance supply with demand, so thata deflation in nontradables prices would occur absent other changes in the economy.
In that case, an increase in Japanese spending could simply remove the downward
pressure on nontradables prices, rather than actually raising them. One way of
mimicking such downward pressure is to suppose that, just as the Japanese current
account moves to balance, the supply of nontradables rises. Realistically in light of theJapanese economy’s current position, this supply increase could reflect an end to the
disguised unemployment in the nontradable sector, whereby currently employed but
nonproductive workers actually begin to produce valuable outputs.
Table 3 (which accounts for the revaluation of the net foreign asset position) takes
up this possibility. The simulations it reports assume that as the current accountsurplus disappears, output in the nontradable sector rises by a substantial 10 percent.
Even with this large increase in nontradables output, however, a real appreciation of
the yen is still implied, although its magnitude is considerably dampened. In the low
elasticity case of the first row, for example, a 23.3 percent yen appreciation is still
implied, as compared to 29.6 percent in the corresponding row of Table 2.
Table 3 Japan’s Return to External Balance, with Expansion in Nontradable Output

1
2
1
2


2
2
3
3

Increase in terms of trade (percent)
19.4
19.9
12.6
12.9

Real yen appreciation (percent)
23.3
19.1
17.6
13.4

36 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006

Implications for the Yen of Japanese Current Account Adjustment

IV. Caveats and Conclusions
This paper has analyzed the exchange rate and terms of trade implications of a
rapid adjustment to balance of Japan’s current account, presently running at asurplus of about 3.5 percent of GDP. With moderately low elasticities (albeit easily
within the range of standard empirical estimates), the effect on the yen could be areal appreciation of 30 percent, even accounting for the possible effect of an
unexpected appreciation in reducing Japan’s substantial net foreign wealth. The
analytical framework is a two-region global equilibrium model with nontraded anddifferentiated traded goods.
Insofar as the model used abstracts from factor mobility between and especiallywithin countries, the model overstates the real appreciation that would occur were
adjustment to be gradual and anticipated. However, the model also disallows nominal
rigidities and deviations from the law of one price in international markets, forexample, those associated with international firms’ ability to price to market. Thosefeatures certainly lead the model to understate the impact of a sudden current accountsurplus reduction. To fully analyze the short-run dynamics, a more detailed model
fully specifying international asset market linkages would have to be spelled out.
It is in that context that financial market factors, which have been much discussed
in assessing the sustainability of external imbalances, would have their greatest
influence. The present form of the model shows, however, that imperfections in goods
markets are sufficient to generate large swings in international relative prices evenwhen explicit sticky price and pricing-to-market frictions are absent.

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37

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38 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2006