Price deflation and consumption: central bank policy and Japan’s economic and financial stagnation

Abstract

In this paper we review the major causes of Japan’s economic and financial stagnation during the past decade, considering in particular how past policies of the Bank of Japan have generated the current deflationary environment. This paper does not attribute Japan’s economic and financial distress entirely to Bank of Japan policy nor does it fail to recognize the shift in policy starting March 2001 when the Bank shifted toward a policy of “quantitative easing” that generated a significant increase in the growth of high powered money by late 2002. The paper argues the Bank’s deflationary policies starting in the mid-1990s up to late 2002 exacerbated the distress and it remains to be seen whether the new policy will reverse deflationary expectations. We consider the economic effects of the deflation, and in particular we argue for a link between expected deflation when nominal interest rates approach their lower bound and a decline in consumption. We find some initial evidence for this hypothesis using both a simple two-period model with a simulation and estimates of consumption functions for both the United States and Japan. Reinflation is thus a necessary, though not a sufficient condition for Japanese economic recovery.