2004 Reports

Monetary policy in Japan: Problems and solutions

Ito, Takatoshi; Mishkin, Frederic S.

The Japanese economy has been underperforming for more than a decade. The average growth rate of real GDP over the past 12 years has been just above 1 percent, and the nominal GDP has been shrinking since 1997 due to inflation. Nominal GDP for 2003 is 4 percent below what it was in 1997. In order to stimulate the stagnant economy, the government has cut taxes and increased expenditures. As a result the government debt/GDP ratio has risen to 150 percent, an unprecedented level for an advanced country in peacetime. The CPI has been declining since 1998, while the GDP deflator has been declining since 1995. Stock prices and land prices have been declining for the decade, with the Nikkei 225 index going down in the Spring of 2003 to a low below 8,000, one-fifth of the peak at the end of 1989. There is no doubt that the economy is in deflation. Important questions about the deflation are how much deflation is due to demand factors and how much to supply factors; and whether deflation is a result of stagnant economy or a cause of the stagnation. The conduct of monetary policy by the Bank of Japan in the deflationary environment has been a source of the controversy for the last several years. Inflation or deflation is in the long-run, ultimately a monetary phenomenon. In theory, when the growth rate is below potential and the prices are dropping, monetary policy should be eased without hesitation. This paper will review theoretical and practical issues surrounding the controversy. It will argue that although a recovery of the Japanese economy appears to be underway since 2003, additional monetary policy steps to exit deflation are necessary for the Japanese economy to reach its full potential. The paper is organized as follows. The first section will raise the issues on monetary policy during the deflationary period, 1998-2003. The second section will discuss possible solutions to the deflationary environment in Japan and make recommendations for monetary policy. A final section contains concluding remarks.