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Could Japan Target the Price Level or Inflation - What Happens to Monetary Policy Effectiveness during Disinflation?

The aim of this paper is to study whether price level or inflation targeting would be appropriate monetary policy regimes for Japan. A necessary condition for such regimes is that the rate of interest remain a positive tool of monetary policy. Using VAR and SVAR approaches, we investigate whether changes in the real ex ante and the nominal interest rate are able to stimulate an economy with a low inflation rate or deflation. Both with perfect foresight and using backward-looking schemes to predict the future price level, monetary policy remains potent even with declining inflation rates. This is confirmed by the stability of the estimated system throughout the examination period. A tax on currency, or ’Gesell money’ would be a possible alternative for Japan in order to lower the zero interest rate floor. We also find that monetary expansion in terms of broad money, broadly defined liquidity and M2+CDs, can bring Japan back to positive inflation rates. This must be supported by a higher interest rate differential between components of broad and narrow money. Moreover, expansion of direct funding in terms of corporate bonds could be beneficial for output growth while the non-performing loans problem in the economy is being tackled. Importantly, these results indicate that monetary policy alone is not able to pull Japan out of deflation and that fiscal measures need to be implemented in unison with monetary policy.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2004/02.

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Date of creation: 2004
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Handle: RePEc:eui:euiwps:eco2004/02
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  1. Simon Gilchrist & Ben S. Bernanke & Mark Gertler, 1994. "The financial accelerator and the flight to quality," Finance and Economics Discussion Series 94-18, Board of Governors of the Federal Reserve System (U.S.).
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  11. Willem H. Buiter & Nikolaos Panigirtzoglou, 2003. "Overcoming the zero bound on nominal interest rates with negative interest on currency: gesell's solution," Economic Journal, Royal Economic Society, vol. 113(490), pages 723-746, October.
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  13. H. Lütkepohl & P. Saikkonen, 1997. "Testing for the Cointegrating Rank of a VAR Process with a Time Trend," SFB 373 Discussion Papers 1997,79, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
  14. Kasa, Ken & Popper, Helen, 1997. "Monetary Policy in Japan: A Structural VAR Analysis," Journal of the Japanese and International Economies, Elsevier, vol. 11(3), pages 275-295, September.
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  21. repec:sae:niesru:v:174:y::i:1:p:68-79 is not listed on IDEAS
  22. Shinobu Nakagawa & Kazuo Oshima, 2000. "Does a Decrease in the Real Interest Rate Actually Stimulate Personal Consumption? - An Empirical Study -," Bank of Japan Working Paper Series Research and Statistics D, Bank of Japan.
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