The Enigma of Japan’s Long Recession

Adherents of the real business cycle approach or similar neoclassical and new classical theories follow the deductivist approach of constructing theoretical models from first principles, based on a number of axiomatic assumptions, including perfectly competitive and complete markets, flexible prices and no transaction and information costs. It is then shown that, under such assumptions, unique equilibrium solutions exist. For instance, under such assumptions the markets for factor inputs, such as labour, are in equilibrium and aggregate demand equals aggregate supply. Output therefore always operates at its full employment level in such an imaginary environment. Since this hypothetical situation is already assumed to be optimal, any disturbance or departure from it must by definition be suboptimal. Existence theorems and equilibrium models of this type focus on allocative efficiency within perfectly competitive markets, and are constructed such that any intervention by the government must disturb that efficiency. Since the economy is assumed to always perform optimally, the adherents of such models also assume that there is nothing the government can do in terms of cyclical policy.