Analyzing Japan’s Economic Deflation from 1990-2009

Analysing Japan’s Economic Deflation

ECO 5002/CLD
WG C1
Members:
21F111- Apoorva
21F129- Kiran Pranav S
21F138- Pavan Hebbar
21F155- Soumalya Dutta
21F140- Rishabh Ranjan
21F161- Tanvi Shetty
Analyzing Japan’s Economic Deflation from 1990-2009

Background

Japan’s economic deflation from the year 1990-2009 was a consistent trend for a period of 2
decades that continues to affect the value of the Japanese Yen in the international money
market. While Japan survived the economic crisis of the late 80’s, why it suffered from a
continuous YoY deflation is a matter of analysis.
Deflation can be caused either by positive forces like productivity spurt, technological
developments, globalizations, etc. These forces induce short term deflations and eventually
the economy finds its equilibrium. However, when deflation is caused by negative forces like
falling interest rates, unemployment, etc., it entails significant deflation costs over time. As
we will find out by the end of this paper, Japan’s deflation has majorly been attributed to
negative forces and a number of such forces.
This long stint of deflation in Japan slowed their GDP growth for years and pressurized the
economy to boost its output and expand industrialization to make up for a sluggish growth
rare. However, the country’s aggregate demand was low due to the deflation and boosting
output rates would only affect the output gap, making the situation worse. Japan found
itself in a productivity trap.

The CPI and GDP deflator

CPI stands for Consumer Price Index, which measures the degree to which the prices of a
basket of goods have increased in a given period, relative to a base period.
CPI (t) = Price of basket-t/Price of basket-0)
A positive value in the index is indicative of a positive inflation rate in the economy.
The CPI rate in Japan gives a clear picture of the deflation that it suffered for 2 decades.
Table 1 gives a clear picture of the situation.

Timeline CPI
1990-1995 1.3
1996-2000 0.0
2001-2005 -0.4
2006-2009 0.0
Table 1: Japan’s CPI from 1990-2009
Analyzing Japan’s Economic Deflation from 1990-2009

1.3

0 0
1990-1995 1996-2000 2001-2005 2006-2009

-0.4

Fig-1: Japan’s CPI from 1990-2009

The above table and figure show that the prices of goods in the country had been readily
falling over the years, contributing to the country’s deflation stint.
Another metric to take a look at is the GDP deflator. GDP deflator is the index that measures
the ratio of a country’s nominal GDP and real GDP. If nominal GDP and real GDP values don’t
differ by much, it indicates that the country’s economy has not inflated by much and the value
is closer to 1. A negative value indicates deflation in the economy.
GDP deflator = Nominal GDP/Real GDP
Fig-2 shows the steep decline in the country’s GDP deflator from 1992-2002.

Fig-2: Japan’s price dynamics and GDP deflator – 1992-2002

Analyzing Japan’s Economic Deflation from 1990-2009

The declining value of the GDP deflator from 1992 and the negative figures from 1994 to 2002
shows the extent of the deflation trap that Japan found itself in.

Unemployment
Speaking of deflation in an economy, one must consider the unemployment rates. The
modern Philips Curve suggests that there is always a trade-off between inflation and
unemployment, plotting a downward sloping curve between the two.
Thus, there is an inverse relationship between the two. This prompts one to take a look at
unemployment in Japan during the given time period.
Fig-3 gives a clear picture of the unemployment scenes in Japan from 1991-2009.

Fig-3: Japan’s Unemployment Rates from 1991-2009

Interestingly, going back to the CPI data from 1996-2006, which shows the worst phase of the
deflation in the country, a high spike in the unemployment rates can be observed during the
same time period. Thus, we can assume a direct correlation between the two, thereby making
meaning of the Philips Curve in the context.
Could the government have made any effort to boost employment rates and in turn inflation
rates in the country during this time? At a time when the country’s GDP had been falling due
to the deflation stint, would this have been feasible? This would initiate a discussion on the
fiscal and monetary policies that were adopted in the country during this time period but we
shall delve deeper into that in the later sections.

Output Gap
Output Gap of an economy is measured as the difference between the potential output at
full employment level and the actual output produced during a given period of time. As
Analyzing Japan’s Economic Deflation from 1990-2009

indicated by the unemployment levels, the output gap in Japan during the period can be
easily assumed to be high. However, that is contrary to reality. Japan experienced a negative
output gap, which indicates that its supply of goods and services far exceeded the country’s
demands in the economy.
Fig-4 gives a comprehensive picture of the output gap that has been prevailing in Japan.

Fig-4: Output Gap in Japan – 1983-2021

The solid black line indicates the output gap, which has been consistently negative from 1992
and reached its peak negative in 2009. In fact, even today the gap remains negative. As supply
exceeds demand, it pushes the inflation rates down significantly in the economy. However,
this thought process ignores the demand that would be generated due to the falling prices,
thereby pushing the inflation rates higher. In Japan’s case however, deflation has been
constant and stagnant.
Thus, there are more forces at play here other than unemployment and production. The idea
is to find out how the country’s fiscal and monetary policies had reacted to the situation to
bring the economy back to equilibrium.
Analyzing Japan’s Economic Deflation from 1990-2009

MONETARY POLICY
From the beginning of 1997 to the end of 2002 the price level in Japan (measured by GDP
deflator) fell to about 10% resulting in the deflation. The Bank of Japan (BoJ) have the
capability to end deflation by following a right monetary policy.
OJ followed with low or zero interest rate policy and quantitative easing policy and it can be
best understood from the perspective of bubble economy.
Japan has faced 3 recessions from the year 1990. From Feb 1991 to October 1993 japan
faced the first recession. The BOJ has cut down the targeted policy rate for the
uncollateralized call money rate to 2% by 1994.
Though BOJ reduced the policy rate sharply and the government also increased the
spending still these measures were not enough to boost the growth for the incoming period
nor they were successful in controlling the deflation that emerged later in the decade.
In the late 1995, to enter to the first period of low interest rate policy (LIRP), The BOJ
lowered the policy rate to 50 basis points. By then, the four quarter GDP growth rate data
had come and it was above 3% which showed a sign of recovering Japanese economy.
Despite all the growth and very low policy rates, there was an abysmal inflation rate of
0.5%.

ZIRP
By lowering the policy rate, BOJ was moving away from the traditional monetary policy that
were used to curb the crisis. It established a temporary lending facility to support the firm’s
financial activities and also extended commercial paper repo operation from 3 month to 1
year .But these measures did not help bank lending from falling as from the fourth quarter
of 1998 to the second quarter of 2005 the outstanding amount of bank credit fell by 21%.
As after trying all those measures when nothing worked in handling the deflation, The BOJ
lowered its policy rate to zero i.e. the period of zero interest rate policy (ZIRP). At the time,
the Bank decided to continue this easy stance of monetary policy until deflationary concerns
abated. In October 1999, the BOJ began to expand its repo operation that includes 2-year
government securities and outright the purchase of short time government securities.
Analyzing Japan’s Economic Deflation from 1990-2009

By late 1999, GDP growth was consistently positive and it topped to 3% at the end of year
2000 but this doesn’t mitigate the deflation issue as it has been more persistent in the 1999-
2000 period. Despite making the promise to maintain the policy till inflation come, BOJ
exited ZIRP in mid-2000, and again in response to seemingly strong economic recovery it
raised the policy rate to 25 basis points.

QEP

In March 2001, it was again the time when recession hits Japan and prices starts to fall at a
faster rate than before. This time what happened that the Bank of Japan again cuts the
policy rate to 0 but along with it they also introduced quantitative easing policy. QEP works
on 3 measures. The first one was to influence and increase the purchase of long term
Japanese government bond. The second was to maintain the policy until the core consumer
price index stopped falling from y-o-y basis and the third was to change the BOJ’s operating
target to the outstanding current account balances held by financial institution at the BOJ.
The QEP measure of bank of America considerably boosted the balance sheet. Due to this
there was a sharp increase in the beginning of the period. M1 increased by 32 percent
during April 2001 to 2002. But it can’t repeat the growth of M1 in the subsequent period
after April 2002 and the growth of M1 did not extend to broader definition of money and
there was a decline in the growth period of M2 during the QEP period.
BOJ followed QEP till March 2006, and then it discontinued the policy in the context of
sustained solid GDP growth.
Analyzing Japan’s Economic Deflation from 1990-2009

Fiscal Policy:
A fiscal stimulus package was the introduced in 1992 in response to the weakening economy
and this marked the beginning of a series of fiscal stimulus packages. Japan
attempted nine stimulus packages during this decade amounting to 130 trillion yen or
roughly $1.3 trillion.

Small financial institutions, housing loan companies and credit unions failed in 1995. Though
the banking problem was worsening day by day, no serious policy was introduced to address
the issue. Unfortunately the public was not informed of the magnitude of the problem or a
coming crisis as the Ministry of Finance managed to hide it from them. Since the politicians
and general public were not alarmed, the suggestions for fiscal injections to recapitalize
banks was ignored. Many economists called for introducing prompt corrective action and
fiscal stimulus if necessary. But fiscal intervention was politically difficult.
Wealth redistribution that happened because of the deflation affects the fiscal position of
the Japanese government. Japan being one of the largest borrowers with fixed interest rate
has been issuing long term government bonds on a regular basis with fixed exchange rates.
Unexpected deflation led to increased debt burden in real terms for the Japanese
government. Adding to this, since the tax brackets are inflation adjusted, the deflation
meant that the government had less tax revenues too.

Aggressive fiscal policy backed by aggressive monetary expansion could function as a strong
weapon to fight deflation. Though the Bank of japan has partially provided such a
framework by maintaining a near 0 short term interest rate for close to 10 years, the fiscal
policy by the government however has not made full use of this environment which is
clearly evident by the sharp slump in public investments since 1996.
The increase in consumption tax and the repeal of income tax rate cut in April 1997 was a
big fiscal policy mistake by Japanese government.
Analyzing Japan’s Economic Deflation from 1990-2009

Impact on wages:
Aggregate demand-induced deflation generally raises unemployment when nominal wages
are rigid downwards. With sticky wages, price declines cause real wages to increase, profit
margins to reduce, and unemployment to increase. Because of rigidities in wages, an
economy facing a demand shortage would have to undergo a larger adjustment in output
and employment under deflation than it would generally under an inflation of comparable
magnitude.
Figure 8 shows different values of real wage developments during the past decade in Japan.
During the 1980s, real wages in Japan grew by close to 15% in an environment of economic
growth and stable price. However, during the post-bubble years, as growth slowed down
and price pressures cooled down, real wages did not adjust by the same amount. It can be
clearly observed that wages started to adjust in real terms from 1998 onwards, but not at a
very brisk pace. Despite nominal wage rates begun to decline because of prolonged
deflation, real wages were still at about (or above) the levels prevailing at the peak of the
bubble around 1990. Examining Japanese longitudinal labour market data, the researchers
found that nominal wage change distributions to be statistically skewed to the right, which
indicates downward wage rigidity.
Analyzing Japan’s Economic Deflation from 1990-2009

References
Boj.or.jp. Available at: <https://www.boj.or.jp/en/research/research_data/gap/gap.pdf>
[Accessed 9 January 2022].
Macrotrends.net. 2022. Japan Unemployment Rate 1991-2022. [online] Available at:
<https://www.macrotrends.net/countries/JPN/japan/unemployment-rate> [Accessed 9
January 2022].
2022. Japan Deflation IMF Report. [online] Available at:
<https://www.imf.org/en/Publications/WP/Issues/2020/11/08/Twenty-Years-of-
Unconventional-Monetary-Policies-Lessons-and-Way-Forward-for-the-Bank-of-49765>
[Accessed 9 January 2022].
Nishizaki, K., Sekine, T. and Ueno, Y., 2014. Chronic Deflation in Japan. Asian Economic Policy
Review, 9(1), pp.20-39.
Dornbusch, R., Fischer, S. and Startz, R., n.d. Macroeconomics.
Japan’s deflation, problems in the financial system and monetary policy by Naohiko Baba,
Shinichi Nishioka, Nobuyuki Oda, Masaaki Shirakawa, Kazuo Ueda and Hiroshi Ugai