A ‘Second-Best’ Rationale to Deflationary Monetary Policy in Japan
The Bank of Japan permitted a ten-year period of deflation (1995-2005) which appears to have ended in 2006. The deflation, as well as the preceding disinflation, adversely affected the financial and real sectors of the economy that in turn, made it difficult to recover from the collapse of asset prices in 1990 and 1991. Various ad hoc explanations have been offered to account for the deflation period. This paper offers a second-best explanation based on a two-player policy game between the Bank of Japan and the banking system in which the banking system relies on an accommodative policy of forgiveness and forbearance by the Ministry of Finance to deal with weak balance sheets. The paper does not explicitly model the Ministry of Finance preference function but incorporates the Bank of Japan’s perceived willingness of the Ministry to accommodate the banking system in the Bank’s reaction function. The model suggests that in the context of established deflationary expectations and large amounts of debt, the Bank of Japan explicitly regarded the level of debt as exceeding the socially optimal level, that Ministry of Finance forgiveness and forbearance contributed to this excess, and lacking an instrument to reverse deflationary expectations, the Bank of Japan employed deflation as a disciplining instrument to limit real debt.
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