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Monday, July 15, 2002


Japan still remains something of a mystery to most economists. Of course in some sense they are their own worst enemies, because they seem to stubbornly refuse to accept that Japan's population dynamics could have anything to do with what's happening. However this makes the danger of a mysterious Japan type slide seem even more ever-present. If you don't understand the problem, then of course the risk can seem even greater. My personal feeling is that the US economy, having benefited from the low wage dynamics offered by a steady stream of immigration during the 1990's, and with a fertility rate around 1.8 or 1.9 shouldn't be too preoccupied about a Japan style malaise. However the dangers of importing deflation via the twin pincers of outsourcing from China and falling unit costs of information are real enough, and it's a good sign that papers like this one are appearing.

Abstract: This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving intoa phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the
general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus–both monetary and fiscal–should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.
Source: Federal Reserve Board International Finance Discussion Papers

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