I.

INTRODUCTION
Today, the application of economic policies appropriately in the
international economic environment now plays a very important role to
enhance the development of the country. The same economic policies, but
depending on each country or each stage, the effect of promoting policies
will be different.
The Lost Decade of Japan is the time after the Japanese asset price
bubble's collapse within the Japanese economy. It happened from 1991 to
2000 and monetary policy of Japanese banks is one major cause of lost
decade of this country
During the 1990s, before the actual economic stagnation racking some
stimulus measures were made to revive the Japanese economy. But, the
economy continues to slow down. Many studies have shown that stimulus
policies of Japan are effective, but low level of effectiveness. And after the
property bubble broke in the years 1990-1991, economic growth in Japan
would go lower. Annual average during the 1990s, total domestic product of
Japan's real gross national product and per capita increased by only 0.5%,
lower than most other advanced industrial countries and the unemployment
rate increased rapidly every year.
Through the analysis of the failures in the application of monetary
policy and fiscal policy of the Japanese government in lost decade, our
group wants to analye the reasons why the Japanese government failed.
It is our pleasure to truly thank the mentor - MSc Hoang Xuan Binh,
who supervised our group. We would like to express our sincere gratitude
MSc Hoang Xuan Binh for his invaluable advice and support.

1
 II. CONTENT
1. Theory apply in recession time
1.1.1. Monetary policy
Now, we will consider the impact of monetary policy on GDP in the
short run under floating exchange rate:
Exp. monetary policy with floating exchange rates (figure 2.1)
LM1
i
LM2
FE1
E1
FE2
i1
i3 E3

i2 E2

IS2
IS1

0 Y1 Y2 Y3 Y

Consider a country that begins with external balance — a triple

intersection of IS, LM, FE shown as point E 1 in Figure 2.1. The country’s
central bank now uses a domestic change to expand the domestic money
supply, MS increases, and lead LM1 curve shifts down to LM2. The direct
domestic effects of this policy change reduce the domestic interest rate from
I1 to I2 and increase real domestic product from Y1 to Y2. The country’s
balance of payments then tends to go into deficit. (The intersection of LM 2
and the original IS1 curve at point E2 is to the right of the initial FE1 curve).
The country’s currency depreciates in the foreign exchange market. As the
country’s price competitiveness improves, exports increase and imports
decrease. Net export increases so the FE 1 curve shifts to FE2 and the IS1
curve shifts to the right to IS2. If the floating exchange rate adjusts to
maintain external balance the economy will be at a triple intersection of all
2
three curves after the exchange rate has adjusted. The new triple intersection
is point E3. Because of the depreciation, real GDP increases even more, to
Y3. So we can conclude that monetary policy is powerful in affecting real
GDP in the short run under floating exchange rates.1
1.1.2. Fiscal policy
Then, we will consider the impact of fiscal policy on GDP under
floating exchange rate (responsive international capital flows and
unresponsive international capital flows).
Expansionary fiscal policy with floating exchange rates
(responsive international capital flows)
i
LM
T2
FE2
0.08
E2
0.075
E0 FE
0.06

IS’

IS
IS2

0 110 125 130 Y

FIGURE 2.2

1
International economics , Thomas A.Pugel (2007, page 586)

3
 Expansionary fiscal policy with floating exchange rates
(Unresponsive international capital flows)

i IS3
FE
FE3
IS’
IS
LM
0.09 E3
T3
0.08
E0
0.06

0 Y
110 130 140

FIGURE 2.3
The effects of fiscal expansion can be pictured using an IS-LM-FE
graph. Figure 2.2 and 2.3 shows the two cases possible. In both cases the
economy begins at the triple intersection E 0. The fiscal expansion directly
shifts the IS curve to IS’. The domestic rate rises from 6 percent to 8 percent,
lead to an increasing number of domestic product from 110 to 130
The two cases differ by whether the country’s overall payments
balance tends to go into surplus or deficit. The Figure 2.2 shows the case of
a tendency to surplus because capital inflow effect is larger. The incipient
payments surplus is shown by the IS’- LM intersection to the left of the FE
curve. DC appreciates, the CA balance worsens, and the FE and IS curves
shift to the left. The new triple intersection is at point E 2. Because of the
currency appreciation, domestic product decreases from 130 to 125.
International crowding out reduces the expansionary thrust of the fiscal
change

4
 The Figure 2.3 shows the case of a tendency to deficit, because the
aggregate- demand effect is larger – the IS’-LM intersection is to the right of
the initial FE curve. The country’s currency depreciates, the current account
balance improves, and the FE and IS curves shift to the right. The new triple
intersection is at point E3. Because of the currency depreciation, domestic
product rises to 140 rather than 130
=>> Fiscal policy is more effective when international capital flows is
less responsive to interest rate.
2. Lost decade
2.1. Background
The so-called Japanese “bubble economy” marked high economic
growth. The 1973 period of high growth illustrated an average real growth
rate of GDP/capita of close to 10 percent. It was also a time where there
was near-zero inflation rate. The period of 1973-1991 shows moderate
growth of around 4 percent. As we know, 1981 marked the highest real GDP
growth rate of 6.4 percent. The second half of the ‘80s signifies this
moderate growth and it is from 1985-1991 that is coined the bubble
economy, showing high growth expectations, high asset price levels and
rapid credit expansion. In comparison, the data clearly shows a sudden drop
in GDP growth rates after 1990 from 5.5 percent to 2.9 percent the following
year and approximately 0.5 percent the year after, leading to -1.9 percent in
1998.

5
 GDP GROWTH RATES OF JAPAN

1987-1997 Nikkei Shimbun and Japan Research Quarterly, Spring 1997 and
Winter 1996/1997; OECD. Main Economic Indicator, 6/2000/MOF.

At the same time, Japan had lower inflation rate. That of it was always
lower than that of the other country and value of yen fluctuated erratically.

THE INLATION RATE OF SOME COUNTRIES ON THE WORLD

Unit: %

Source: IMF, World Economic Outlook, September 2003

6
 EXCHANE RATE JAPAN YEN TO USA DOLLA

Source: IMF, International Financial Statistics

Thirdly, real estate, stocks market slumped. Land price increased

sharply in the last 80’s decade then felt suddenly in the early 90s (the Nikkei
from 39,000 in 1989 at 15,000 points also have dived in late 1990). This has
created a crisis shock in land and business property, it also leaded to the
crisis of the banking system to the almost certain loss of bank solvency.
Bankruptcy wave of Japanese financial institutions have to climax in late
1997. By February 1998, the losses of Japanese banks cost 27,000 billion
yen (207.6 billion U.S. dollars). The rate of budget deficit is the highest level
in the G7 (5.4% of GDP). Numerous companies and large corporations in
Japan went bankrupt.

7
 BANKRUPTED STATEMENT IN JAPAN

Unit: Thousand of companies

20 16
18 14
16
12
14 Companies
12 10

10 8
8 6 Debt
6
4 Trillion yen
4
2 2

0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999

Resource: MOF, Main Economic Indicators of Japan, 6/2000

Finally, As of June 1998, the number of unemployed reached almost 3

million people, amazing effects loss rate up to 4.1%, the highest level in 40
years

THE UNEMPLOYED RATE IN JAPAN

( Unit: %)

8
2.2. Japanese’s policies
2.2.1. Monetary policy
To rescue the economy from recession, Japan began to apply the
Expansionary Monetary policy by lowering the discount interest rate. From
1991 to 1995, step by step, the discount interest rate was decreased from 6%
to 0.5%. In June of 1991, the discount interest rate fell from 6% to 4.25%. In
September of 1993, the interest continued going down to 1.75% and it was
only 0.5% in 2 years later – September 1995. During 1998 – 1999, Center
bank injected money supply to the major bank by using various tools for
monetary operations including nationalizing Long Term Credit Bank and
Nippon Credit Bank. In 1999, Center Bank implement the Zero base interest
rate policy with the nominal interest rate was maintained at Zero. This Policy
led the discount interest rate decrease to 0.1% in 2001. Even the lowering
interest rate in lost decade very strong but the target of increasing the Money
Supply was collapsed.
2.2.2. Fiscal policy

Since the asset-price bubble happened in 1990, the Japanese

government had repeatedly launched some expansionary fiscal policies to

9
boost the economy. The government spending from fiscal year 1992 to 1996
amounted to more than 65 trillion yen: half of that used to stimulate public
works, such as construction and infrastructure, and 20 percent of it took the
form of tax cuts. Despite these economic measures, Japanese economic
growth had been stagnant for more than 6 years, except for 1996, when the
Japanese economy grew by approximately 3 percent.

2.3. Reasons

2.3.1. Liquidity trap

There are different ways of explaining why the monetary policy
Japanese government applied failed to rescue the economy. However in this
assignment, we only focus on the demand side, Keynes’s followers.
According to Paul Krugman, a Nobel 2008 prize economist, the second giant
economy in the world fell in the “liquidity trap”. He stated: “Japan is in the
dreaded "liquidity trap", in which monetary policy becomes ineffective
because you can't push interest rates below zero”
The definition of Liquidity trap is as follows:
“The Liquidity trap is a Keynesian idea. When expected returns from
investments in securities or real plant and equipment are low, investment
falls; a recession begins, and cash holdings in banks rise. People and
businesses then continue to hold cash because they expect spending and
investment to be low. This is a self-fulfilling trap.”

10
 “Should the regulatory committee try to stimulate the economy by
increasing the money supply, there would be no effect on interest rates as
people do not need to be encouraged to hold additional cash”
In year 1937, Hicks introduced the IS-LM model, which we
mentioned in the first part of the content, explained the possible efficiency of
using monetary policy under depression periods of an economy. Thus, from
then on, for a long time, macroeconomists have a persistent idea of how
theory a liquidity trap is and never expected it’s practically possibility.

NO
MONEY
IN THE
BANK

LOWER NO
PRICE LOANS

LOWER NO
DEMAND PRODUCTION

NO
INCOME

11
 To make the complicated theory and its application simple, we build
up a graph above to explain the “liquidity trap” effect in Japan.
In 1991, a real estate bubble that collapsed, leaving banks holding
trillions of yen in loans that were virtually worthless. Prodded into action,
the government injected 1.8 trillion yen into Japan’s main banks. But the
injections — too small, poorly planned and based on little understanding of
the extent of the banking sector’s woes — failed to stem the growing crisis.
Not as the IS-LM model explains how the monetary policy works, the rescue
package launched by the Japanese government were too small to make an
impact. Although the interest rate was lower to nearly-zero, major Banks
were still in lack of money, led to no more loans fueled into the economy.
The reason was explained by Paul Krugman as follows:
“Under what conditions will a liquidity trap occur? One possibility is
that Price today is high compared with equilibrium price - that people expect
deflation, so that even a zero nominal rate is a high real rate. The other
possibility, however, is that even if prices are expected to be stable, income
is high compared with the future - or to put it differently, peoples' expected
future real income is low compared with the amount of consumption needed
to use today's capacity. In that case, to persuade people to spend enough now
may require a negative real interest rate, and with downwardly inflexible
prices that may not be possible.
Or to put it yet another way, one that is closer to the language of
applied macroeconomics: if people have low expectations about their future
incomes, then even with a zero interest rate they may want to save more than
the economy can absorb. (In this case, of course, the economy cannot absorb
any savings). And in that case, no matter what the central bank does with the

12
current money supply, it cannot reflate the economy sufficiently to restore
full employment”.
And when all the producers couldn’t access any loan, consequently
production wouldn’t be raised. Accordingly, the income of Japanese people
was lower. Besides, it’s a characteristic of the Japanese of high saving rate.
Thus, when a high saving people met a lower income situation there should
be lower demand. Lower demand led to lower price and made the Japan
economy fell into higher deflation.

2.3.2. The fail of the Japanese local government.

For the period from 1992 to 1996, real government spending was
merely 21 trillion yen in public works. This was about two-thirds of the
officially announced public works spending during the period. A closer look
reveals that the local governments, not the central government, failed to
spend announced the fiscal spending. In addition, there is evidence that
much of the public work was geared toward projects of dubious significance.

The most interesting result from the above analysis is that while the
central government spent as much as it said it would (about 25 trillion yen
for 1992 to 1996), the local governments spent much less than the central
government projected (about 10 trillion yen less). In fact, the local
governments spent 3.7 trillion yen less than their initial budget during 1992-
96). That is, the local governments not only failed to spend the
supplementary budget (6 trillion excluding the local governments' share of
joint projects), but also spent less than their initial plans indicated. The
cumulative effect is that the local governments reduced capital spending by

13
about 10 trillion yen from the initially planned spending for 1992-96.
Indeed, this 10 trillion yen was equal to the difference between the officially
announced increase in public works and the actual increase. According to
the government-announced economic measures, public works spending
should have increased by 31 trillion yen. The balance sheet shows that the
spending increased by only 21 trillion yen.

2.3.3. The ineffectiveness of public investment.

Another reason for this ineffective policy is that the quality of public works
was low. Obviously, the quality of public investment declined so its impacts
declined as well. In Japan, the Economic Planning Agency (EPA)
determined that public investment increased by 15 percent from 1992 to
1993, while GDP only grew by 1 percent. Besides, this occurred because
private investment in the same period was also significantly lower because
of the burst of the economic bubbles. By estimating the impact of public
investment stock on productivity on private capital, the results indicate that
public investment stock is not relevant in determining the productivity of
private capital over this period. This implies that spillover from public
capital investment has been negligible.

2.3.4. The mistake in tax shared policy

Japan's biggest policy mistake came in 1997 when the government

raised its consumption tax from 3 to 5 percent. The aim was to help
compensate for the large run-up in Japanese debt that resulted from the
series of unproductive fiscal stimulus packages expended largely on wasteful
public works projects. This led to the big fall in expenditures and the

14
deflation in 1998. As a result, the Japanese economy became worse at that
time.

2.3.5. Others

Besides the failure in applying fiscal and monetary policy, Japan

economy had to face with various difficulties that leaded to the lost decade:
declining birth rate and ageing population, too much regulation and
competition from new emerge economies
 Declining birth rate and Ageing Population:
The percentage of the younger age population in Japan (0-14 years) has
been shrinking since 1982. In 2008, the younger age population amounted to
17.18 million, accounting for 13.5 percent of the total population, the lowest
level on record since the Population Estimates began. The working-age
population (15-64 years) totaled 82.30 million, continuing its decline since
1996. In share terms, it accounted for 64.5 percent of the entire population.
As a result, the ratio of the dependent population (the sum of the elderly and
younger age population divided by the working-age population) was 55.2
percent. In terms of their proportion of the total population, the elderly have
surpassed the younger age group since 1997.

In recent years, if there is no large influx of young migrant workers into

these sector workers into the manufacturing industry, the unrelenting
pressure of demographic change will in due course melt away Japan’s
technological foundation. This is obviously a big problem because
manufacturing remains the most productive sector of the economy and main
earner of foreign exchange.

 Over-regulation

15
This is a growth barrier for some sectors, they are: construction, agriculture,
transportation and communications. A typical example for this situation is
construction industry for setting up process; it was inefficient and high-cost
construction. An article in the Japanese newspaper Nihon Keizai Shimbun of
8 March 1999 had written:

Japan’s public works budget is on the order of ¥34 trillion per year. This is
equivalents to the sum total of all the public works ordered by the other
leading industrialized nations combines. This makes Japan a construction
giant of monstrous proportions. What is even more outrageous is that most
of the workers orders placed by local government bodies, which account for
70% of all public works, are knowingly given to local firms that have no
construction capabilities whatever. These orders are then passed up to the
leading general contractors, just as they are. The local firms do nothing
productive, but they pocketed a tidy profit. Even under the current recession,
there are still a vast number of such highly profitable “paper” contractors,
jostling about under the surface.

 New emerge economies

In 1990s in Asia, many countries got significant growth and became new
emerge economies. They had learned so well from Japanese that they are
churning out many if not all the goods that had once brought accolade to
Japan.

III. CONCLUSION
In conclusion, theory is not always as it is and thus, applying theory
into specific occasion requires flexibility of government. The case of Japan

16
provides a precious lesson for the limitations of monetary and fiscal stimuli
to deal with recession of an advanced industrial economy in the context of
globalization.
Japan experienced a lost decade including economic stagnation, a long
spell of deflation and an increase in bad debt. But after series of
expansionary monetary and fiscal policies to stimulate demand, Japanese
government did not solve the problems. While government expenditure
spent towards to the pointless public works, fiscal policy mainly relied on
general tax reduction instead of focusing on social security net and reducing
consumption tax. Meanwhile, monetary policy proved unreasonable. Bank
of Japan was criticized the delay in easing monetary policy (lower interest
rates) and then, when interest rates were reduced, falling rates were not
enough, even Bank of Japan was on rush for raising interest rates when
economy was showing the sign of recovery.
Consequently, flexible combination between fiscal policy and
monetary policy is essential to cope with problems raised from modern
economy. Any country which wants to reach success in imposing reasonable
policies needs to consider it own internal problems first.

17
References
1. Paul Prugman 1998, Japan’s trap, 28/08/2010,
http://web.mit.edu/krugman/www/japtrap.html
2. Siam-Heng, Michael 2009, Insights from Japan’s “lost decade”,
29/08/2010, http://www.eai.nus.edu.sg/EWP154.pdf
3. Liquidity trap, 28/08/2010,
http://economics.about.com/od/termsbeginningwithl/g/liquidity_trap.htm
4. Liquidity trap, 27/07/2010,
http://www.investopedia.com/terms/l/liquiditytrap.asp

18