Evaluating Japanese Monetary Policy under the Non-negativity Constraint on Nominal Short-term Interest Rates

In this paper, we propose a new method for identifying monetary policy shocks under the non-negativity constraint on nominal short-term interest rates and use it to estimate the impact of monetary policy on the Japanese economy since the bursting of the asset bubble. Our method boasts three distinctive features. The first is the use of intermediate variables that describe aspects of the transmission mechanism of monetary policy. We use these to create a monetary policy proxy, which is able to approximate the policy stance of the monetary authority for a whole range of different policy measures. Second, we identify monetary policy shocks by imposing sign restrictions on the impulse response functions of the monetary policy proxy and nominal exchange rate to monetary policy shocks. Thirdly, we use the Markov chain Monte Carlo method to estimate the date of any structural change in the transmission mechanism of monetary policy. We show empirically that the effects of monetary policy on prices and output weakened in the 1990s. The decline in the impact of Japanese monetary policy is partly attributable to the non-negativity constraint on nominal short-term interest rates as well as to stagnant financial intermediation due to non-performing loans in the banking sector. Our analysis, however, identifies two further obstacles to monetary policy that were still more significant. First, households and entrepreneurs suffering from balance-sheet problems-the other side of the non-performing loan problem-were hesitant about aggressively expanding consumption and investment even amid ultra-loose monetary conditions. Second, the propagation mechanism in the private sector, through which economic activity prompts further economic activity, failed to function properly.