Deflation in Japan

For the past decade, deflation has persisted in Japan. Deflation is the sustained decrease in the average of all prices of goods and services in the economy (Economics Today 2006). Among all the countries since WWII, Japan has been suffering from deflation for the longest time. There have been many attempts in stopping deflation. Then why has Japan been under deflation for such a long time?

Reason for deflation

One reason for the deflation in Japan is the increased goods being imported from China and other Asian Countries. Since Japan imports more goods, the Net Exports (Exports – Imports) has decreased significantly, creating a lower Aggregate Demand (AD) which leads to a recessionary gap; which drops the price level of goods and services and also causes unemployment. It is said that imports from China has accounted for a third of the increase in Japanese imports during 2004-2005 (OECD 2005). Since businesses are selling cheaper goods than when selling domestic goods, the total revenue of the company decreases and therefore in the long-run, the wages will go down as well. Therefore, consumption of goods and services will decline as well. Then, it will result in a decrease in company’s revenue, bringing down the wages again. This process will continue until some action is taken by the government or the FED.

Actions taken to end deflation

Monetary Policy has been used to stop deflation from continuing. Specifically, the Open Market Operations have been used. The Bank of Japan (BOJ) has been trying to increase Money Supply (MS) in order to increase AD. The first step BOJ takes is increasing the prices of Japanese Government Bonds (JGB). By doing this, bond owners will give up their bonds; resulting in the FED buying the JGB (We can see this buy looking at the Bonds Market). After doing this, the FED successfully should have increased the MS, which also brings down the interest rate (Money Supply and Demand Graph). The lowered interest rate will result in an increased Investment (shortened Loan able Funds Market). This is basic operation the BOJ uses in order to cease deflation. Today, the BOJ buys JBG in huge amounts; it increased from 400 million yen to 1.2 trillion yen per month (ECONOMIST.com 2006). The BOJ increased their MS 35 trillion yen between March 2001 and December 2004 (FRBSF 2006).

(Dr. John Rutledge 2006)

The FED also aggressively sells yen and buys dollars to avert appreciation of the yen. By doing this, Japan may be able to stop the price deflation (RIETI 2006). This is because when the price of yen rises, the quantity of Japanese goods will fall. For example, if a T.V. costs 150,000 yen and the US wants to buy 100 of them. In order to buy 100 televisions require 15 million yen. If 1 yen costs 1 cent then it would cost $1500 per T.V. and therefore the US demands 100 of them. However, if the price of yen rises to 1.25 cents, then the price of the TV will be $1875. Then the demand for Japanese T.V. will decrease, leading to a decrease in exports. However, if the price of yen becomes .75 cents, then the price of the TV will become $1125. At this price, the US will demand more T.V. which would lead to an increase in exports. By doing this, there would be an increase in MS and NX (exports – imports) and increasing AD; which would presumably end deflation.

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