Japan's Deflation, Problems in the Financial System, and Monetary Policy

This paper offers three analyses of Japan's macroeconomic experience during the post-1990 period. First, we analyze various facets of deflation during the period, arguing that the deflation of general prices has by no means been a major factor for the stagnating economy. In contrast, the deflation of asset prices was closely related to the economic difficulty of the period. In particular, the negative shocks generated by sharp declines in asset prices in the early 1990s have been propagated and amplified by their interaction with the deterioration in the condition of the financial system. Some statistical evidence supports this view. Second, we analyze the effects of monetary policy adopted by the Bank of Japan (BOJ) to fight deflation since the late 1990s. Given that short-term interest rates were already nearly zero in the mid-1990s, policy measures have focused on creating monetary easing effects beyond those created by zero interest rates alone. We show that the zero interest rate policy, which includes a commitment to maintain a zero interest rate for a longer period than that suggested by a baseline monetary policy rule, has produced strong effects on expected future short-term interest rates and thus the entire yield curve. Third, we argue that the BOJ has successfully prevented a repetition of the 1997-98 type liquidity crisis by directing market operations at addressing the financial-sector problems. These operations have taken the form of containing risk and liquidity premiums, particularly in the money market, through proactive provision of liquidity as well as the BOJ's own risk- taking activity.