Japan: A Modern example of Deflation in an economy

Submitted By:
Shubhi Nagar

What is Deflation?
Deflation is a general decline in prices in an economy due to lack of money or credit supply or a decline in government, personal or investment spending. A persistent decline in prices in an economy can cause it to fall into a vicious deflationary spiral due to liquidity trap, causing severe harm to the health of the economy.

Deflationary cycle In Japan

Japan has been facing a stagnant economy since the1990s and been caught into a deflationary spiral since then. Japans economy grew at a minimal rate of 1% on average during the 19922002 which is also called the lost decade .

Japans Deflation did the most damage to the financial sector and the Industries relying on domestic demand.(e.g. Services, Agriculture etc.)
Demand for loans was brought down because the real rate of interest rose due to deflation. Even with nominal interest rate 0%, deflation causes the real interest rate to be positive.

An increase in the real interest rate enriched the creditors but impoverished the debtors. Thus the purchasing power shifts from debtors to creditors.
Increased real interest rate also discourages planned investments and leads to a reduction in national income.

Deflation is also associated with currency appreciation. Imports become less expensive while for a strong currency. Domestic producers are forced to match up with the low prices that countries like China offer and further reduces prices in the country.

Causes of Deflation In Japan

The Deflation cycle started when the Bank of Japan raised the interest rates causing asset bubble to burst which had been building up since the mid 1980s. The real estate and stock prices were greatly inflated before the bubble burst. (The stock price index and the land price index quadrupled from 1983 to 1989. The stock prices index (Nikkei 225) rose from 10,000 yen at the end of 1983 to near 40,000 at the end of 1989. ) The asset bubble had caused the assets to be overvalued and as the asset bubble burst, prices started falling. The stock price index declined by one-third from the end of 1989, the peak, to the end of 1990. Stock prices continued to decline and the index lost 60 percent of the peak level by the summer of 1992. Land prices started to decline in 1991.Declining asset prices hit the banking sector severely. Slow policy responses to the nonperforming loan problem caused the banking crisis of 199798, and the financial sector weakened. The NPLs tied up the much needed capital for investments and growth. The Bank of Japan was unable to stop the inflation rate from turning negative, despite its various efforts. Deflationary expectations have kept the economy in a liquidity trap as aggregate demand lowered and prices kept falling. Japans situation is more complicated due to its demographics which aggravate deflation. (An aging population which tends to consumes less)

Monetary Policies Adopted by the Bank of Japan

Policies Adopted by the BOJ to combat deflation
In April 1999, the BOJ to maintain a zero interest rate until deflationary concerns are dispelled the so-called zero interest rate policy (ZIRP). The economy then recovered and grew at 3.3% between 1999 and 2000. ZIRP was abandoned in August 2000. The economy, however, went into a serious recession again led by worldwide declines in the demand for high-tech goods. The Bank of Japan also tried Quantitative easing (QE) from 2001 to 2006. It flooded financial institutions with excess money supply to promote private lending, leaving them with excess reserves to lessen the risk of liquidity shortage.

Possible solutions for Japan to come out of the deflationary cycle

If the BOJ puts up an inflationary target and hence making inflationary expectations in the market which will help break the cycle. Firms need to spur domestic demand by unleashing the latent spending power of the elderly who have vast savings ($18 trillion ) Tapping demand in the health care, nursing and tourism sectors to tap the purchasing power of the aging population of Japan..