- All Best Essays, Term Papers and Book Report

Japans Monetary Policy

Essay by   •  July 2, 2013  •  Research Paper  •  2,866 Words (12 Pages)  •  1,476 Views

Essay Preview: Japans Monetary Policy

Report this essay
Page 1 of 12

Many observers naturally draw parallels between the U.S situation at present and that experienced by Japan in the mid - 1990s, when the Bank of Japan reduced interest rates to very low levels and the economy was faced the sharp decline in inflation and later turned out to be a protracted deflationary slump.(Alan page 3)

1) Deregulation of Japanese Banks:

Not only the Japanese banks are allowed to buy corporate stocks, but also they could lend money to those who would buy stocks. During later 1980s, Japanese Banks lent more with less regard for quality of the borrower and supervision of bank loans on the purpose of stimulating economy. People can borrow money easily with low interest rate at that moment. This caused the later banking system collapse with asset price bubble burst discussed in the latter parts.

2) Monetary policy during 1986 ~ 1987 result in asset price bubble:

After Japanese government signed Plaza Accord, the Japanese yen was appreciated dramatically. In order to resist this bad influence on exports and spur the economy, Japanese government decreased discount rate by 5 times from 5% to 2.5%. At the meantime, due to excessive credit easing and increasing value of Japanese yen, a large amount of money flow into the real estate and stock market. After the asset prices increased, investors using these valuable assets as collaterals to lend more money from the bank and put back into stock and real estate market which result in huge asset price bubble. From mid - 1980s to early 1990s, The Nikkei stock market index soared close to the 40,000 level, having risen almost 500 percent for the decade. Japanese stocks sold at more than 60 times earnings, more than 200 times dividends. The boom in real estate prices was even more dramatic. By 1990, the total value of all Japanese property was estimated at nearly $20 trillion - equal to more than 20 percent of the entire world's wealth and about double the total value of the world's stock markets. (Burton page 9)

3) Financial System collapse in early 1990s:

The Bank of Japan began increasing interest rates in 1989 due in part to concerns over the bubble that result in an economic hard landing. At that moment, the major collaterals of bank loans are houses and stocks. After the asset-price bubble burst, the price of these asset collaterals was dramatically decreasing which caused a large amount of bad loans (or non-performing loans). These bad loans quickly shrink the Bank's Capital funds. In order to meet the requirement of capital adequacy ratio by Basel Accord, the banks had to sell the corporate stocks. However, when the corporation had demand for borrowing funds, the banks had no ways but let those corporations went into bankruptcy, thereby facing a further deteriorating scale of bad loans in banks. This eventually caused the financial system collapse along with very weak banking system. This is the main reason why monetary policies had less effect on getting the economy out of deflation during the lost decade.

Figure 1 shows the Japanese economy since 1990 (CPI inflation, the nominal interest rate, and the output gap). Looking on the Output Gap chart, which shows a positive number (called an inflationary gap, and it indicates the economy possibly creating inflation) from 1990 to 1993, but the number is declining and reached the zero in 1993. And the number remained negative (Recessionary gap, possibly signifying deflation) until 2006. From the CPI inflation chart, we see flowing the collapse of the asset price bubble in early 1990; Japanese growth steadily deteriorated through the first half of the 1990s, rebounded briefly at mid-decade, but has been generally weak since then. Consumer price inflation followed the economy downward, falling below zero in 1995. In the nominal interest rate chart, in response to the weak economy, Japanese short-term interest rates were lowered nearly to zero by late 1995 and have stayed close to zero ever since. However, with prices declining, real interest rates have remained positive, restraining growth. (Alan page 3)

What policy was the Bank of Japan following, what "exceptional mistakes" did it make, how quickly the policymaker respond to sharp declines in inflation, and the deflation, what, if anything, could it have done to shorten the "Lost Decade", and did monetary policy in Japan prolong the "Lost Decade"? This paper addresses these questions by analyzing the monetary policy Bank of Japan made.

II. Discount Rate Policy

In 1989, the Bank of Japan replaced the easing monetary policy that had lasted for a decade and started monetary contraction. Bank of Japan's goal was to maintain price stability and as well as to create continuous growth based on domestic demand. The Bank of Japan raised the discount rate five times, reaching a level of 6% in a year. The Bank of Japan wanted to maintain price stability by preventing a rise in inflationary expectations, this pricked the financial bubble.

The stock market in Japan collapsed, resulting in a decline in real estate prices. Following the decrease in prices, the Japanese economy slowed down and weakness in the banking system began. The decline in prices reduced investment and consumption spending, and generated a non-performing loan and borrower problem. Monetary policy during this period was changed several times, starting with a reduction in discount rate.

In the early 1990's, the official discount rate was one of the primary instruments used to conduct the monetary policy. With signs of weakness in the economy and downward movement in the asset prices, the Bank of Japan began to lower interest rates in July 1991 with a 50 point decrease in official discount rate. An expansionary policy was started in July of 1991 when the official discount rate was dropped from 6 to 5.5%. Over the next 4 years the economy continued to decline, the Bank of Japan reduced the official discount rate eight more times until it stood at 0.5 percent in September 1995.

The Bank of Japan continued too long with tight monetary policy, not shifting aggressively enough to monetary easing after 1993, when the policy changed. The Bank of Japan not only imposed tight monetary policy in the early 1990s, but it also failed to prevent disinflation from becoming deflation. When the Bank of Japan finally acted, it focused on decreasing nominal interest rates but did not realize that the decline in prices had increased the real rate of interest.

Fisher equation: real interest rate = nominal rate - expected inflation.

The lowering of the interest rate sent wrong signals to entrepreneurs that the structure of production did not need to be shortened. This served



Download as:   txt (17.6 Kb)   pdf (190 Kb)   docx (15.6 Kb)  
Continue for 11 more pages »
Only available on
Citation Generator

(2013, 07). Japans Monetary Policy. Retrieved 07, 2013, from

"Japans Monetary Policy" 07 2013. 2013. 07 2013 <>.

"Japans Monetary Policy.", 07 2013. Web. 07 2013. <>.

"Japans Monetary Policy." 07, 2013. Accessed 07, 2013.