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A ‘Second-Best’ Rationale to Deflationary Monetary Policy in Japan

  • Tom Cargill

    ()

    (Department of Economics, University of Nevada, Reno)

  • Federico Guerrero

    ()

    (Department of Economics, University of Nevada, Reno)

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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File URL: http://www.business.unr.edu/econ/wp/papers/UNRECONWP06009.pdf
File Function: First version, 2006
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Paper provided by University of Nevada, Reno, Department of Economics & University of Nevada, Reno , Department of Resource Economics in its series Working Papers with number 06-009.

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Length: 22 pages
Date of creation: Dec 2006
Date of revision:
Handle: RePEc:unr:wpaper:06-009
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  1. Takatoshi Ito, 2004. "Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting?," NBER Working Papers 10818, National Bureau of Economic Research, Inc.
  2. Thomas F. Cargill & Michael M. Hutchison & Takatoshi Ito, 2001. "Financial Policy and Central Banking in Japan," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262032856, June.
  3. Kenneth N. Kuttner & Adam S. Posen, 2003. "The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy," Working Paper Series WP03-10, Peterson Institute for International Economics.
  4. Cargill, Thomas F. & Parker, Elliott, 2004. "Price deflation, money demand, and monetary policy discontinuity: a comparative view of Japan, China, and the United States," The North American Journal of Economics and Finance, Elsevier, vol. 15(1), pages 125-147, March.
  5. Thomas F. Cargill, 2005. "Is the Bank of Japan's Financial Structure an Obstacle to Policy?," IMF Staff Papers, Palgrave Macmillan, vol. 52(2), pages 311-334, September.
  6. Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35, March.
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