DP2014-12

Exchange Rate A djustment, M onetary
Policy and F iscal Stim ulus in Japanʼs
Escape from the Great Depression
Masahiko SHIBAMOTO
Masato SHIZUMEMarch 19, 2014

Exchange Rate Adjustment, Monetary Policy and Fiscal
Stimulus in Japan’s Escape from the Great Depression
Masahiko Shibamotoa,∗, Masato Shizumeb,†a

Research Institute for Economics and Business Administration, Kobe UniversitybInstitute for Monetary and Economic Studies, Bank of Japan
February 26, 2014∗

Corresponding author: Research Institute for Economics and Business Administration, Kobe University,
2–1, Rokkodai, Nada, Kobe, 657–8501, Japan. E–mail: shibamoto@rieb.kobe-u.ac.jp. Tel/Fax:+81-78-8037008.
†
Institute for Monetary and Ecoomic Studies, Bank of Japan, 2–1–1, Nihonbashi-Hongokucho, Chuo, Tokyo,
103–8660, Japan, E–mail: masato.shizume@boj.or.jp.

Abstract
A veteran ﬁnance minister, Takahashi Korekiyo, brought an early recovery for Japan fromthe Great Depression of the 1930s by prescribing a combination of expansionary ﬁscal,
exchange rate, and monetary policies. To explore the comprehensive transmission mechanism of Takahashi’s macroeconomic policy package, including the expectation channel,
we construct a structural vector auto-regression (S-VAR) model with three state variables(output, price, and the inﬂation expectations) and three policy variables (ﬁscal balance,
exchange rate, and money stock). Our analysis reveals that the exchange rate adjustment
undertaken as an independent policy tool had the strongest eﬀect, and that changes inpeople’s expectations played a signiﬁcant role for escaping from the Great Depression.
During the second half of 1931, in particular, speculation on Japan’s departure from thegold standard and the inﬂation that was likely to follow reversed the existing expectations: instead of expecting deﬂation, people began to expect inﬂation, months ahead of
the actual departure from the gold standard. As a whole, the choice of the level of theexchange rate was crucial for changing people’s expectations as well as promoting exports.
Keywords: Great depression; Japanese economy; Macroeconomic policy; Expectation;
Vector auto-regressive model; Commodity futures
JEL Classification: E52, E63, N15.

1

Introduction

In the wake of the recent global economic turmoil, policymakers and economists around theworld focus on the experiences during the Great Depression in the 1930s to learn lessons
from them. In this respect, the Japanese economy in this period draws renewed attention
as a canonical case of successful policy to bring an early recovery in the midst of the global
depression. After two years of double-digit deﬂation in 1930 and 1931, Japan escaped fromthe deﬂationary trend in 1932. Over the next ﬁve years, it went on to experience robust
economic growth and mild inﬂation, even as depression persisted in many other parts of theworld.1
Korekiyo Takahashi, a veteran ﬁnance minister, brought about an early recovery for Japan,
during his ﬁfth, sixth and seventh terms as ﬁnance mininster, by prescribing a combination of
expansionary exchange rate, ﬁscal, and monetary policies between December 1931 and February 1936. Right after his return as minister, Takahashi moved Japan oﬀ the gold standard todepreciate the yen. Over the next few years, he prescribed ﬁscal stimulus and an easy monetary policy.2 Takahashi’s policy has drawn attention from economic historians, economists,and policymakers from around the world. Ben Bernanke, among others, has spoken highlyof Takahashi’s accomplishments: “Finance Minister Korekiyo Takahashi brilliantly rescued
Japan from the Great Depression through reﬂationary policies in the early 1930s.”3
While most economic historians agree that Takahashi’s policy package stimulated theJapanese economy as a whole, they do not agree on which parts of the package were more
eﬀective and which parts were less eﬀective.4 Some argue that Japan’s early economic recovery
can mainly be credited to the depreciation of the yen.5 Others claim that the key was ﬁscal
stimulus.6 Others still are convinced that the easy monetary policy kick-started the recovery.

1
Patrick, “Economic Muddle.” For an international comparison of economic performance during the early
1930s, see Shizume, “Japanese Economy.”
2
Smethurst, Takahashi Korekiyo, pp.238–267; Nakamura, Economic growth, pp.232–262.
3
Bernanke, Ben, “Some Thoughts on Monetary Policy in Japan,” Remarks by Ben S. Bernanke, Member,
Board of Governors of the Federal Reserve System, before the 60th Anniversary Meeting, Japan Society ofMonetary Economics, Tokyo, Japan, May 31, 2003.
4
Okura-Teranishi and Iwami et al. claim that various factors such as the depreciated yen, deﬁcit spending,and expansionist policy in the Asian Continent contributed to the recovery. Okura and Teranishi, “exchange
rate and economic recovery,” and Iwami, Okazaki and Yoshikawa, “the Great Depression in Japan.”5
Nanto and Takagi, “Korekiyo Takahashi and Japan’s recovery,”; and Takagi, the “ﬂexible exchange rate.”
6Cha, “Did Takahashi Korekiyo Rescue Japan?”1Some emphasize the impact of the Keynesian path in creating eﬀective demand, whereas
others stress the central role of the expectations of price changes in the future.
Observing data in Japan’s interwar period, we notice that Takahashi pursued a policy
package of increasing ﬁscal deﬁcit, depreciating the currency, and expanding the money stockduring his term. We now know little, however, of the dynamics of the policy shifts. Whichparts of the policy package were crucial for Japan’s recovery from the Great Depression?
What kind of policy shift brought about the changes in output? Which parts of the package
were deliberate policy actions and which were reactions to changes in the economy or theinﬂuence of other policy changes?
To disentangle the various possible directions of causality, we need to identify and measure
the exogenous and endogenous components of each macroeconomic variable in a systematicway. A structural vector autoregressive (S-VAR) methodology is useful for this purpose. Cha(2003) introduces a S-VAR analysis to capture the magnitude of respective policy eﬀects inJapan during this period. He uses the S-VAR model with monthly data on world output, thereal eﬀective exchange rate, the real government deﬁcit, high-powered money, the volume ofrailway freight (as a proxy for aggregate real output), and real wages for the period of January
1929 to September 1936 (93 months). He concludes that ﬁscal expansion stands out as the
single most important cause of Japan’s upswing in the early 1930s.
Recent macroeconomic policy debates shed new light on the role of expectations as the
key element when escaping from a severe economic downturn. A number of studies explore
the experience during the Great Depression to derive policy lessons. After the seminal works
by Temin (1989) and Eichengreen (1992), the departure from the gold standard was regarded
crucial for the economic recovery of the 1930s.7 Temin and Wigmore (1990) argue that, in
the United States, a “regime change” associated with the departure from the gold standard
in 1933 was crucial in order to change people’s expectations and behavioral patterns.8 Romer(1992) states that the departure from the gold standard enabled monetary expansion whichbrought recovery.9 Hsieh and Romer (2006) ﬁnd that a large, but short-lived, monetary expansion in 1932 did not raise expectations for devaluation of the dollar because investors had
7

Temin, Lessons from the great depression; Eichengreen, Golden fetters.
Temin and Wigmore, “the end of one big deﬂation.”
9
Romer, “What ended the great depression?”82

no doubt about the Fed’s commitment to maintaining the gold standard. They argue that
the Fed was not constrained by the gold standard, but that the Fed refrained from a decisive
monetary expansion because it adhered to the gold standard philosophy.10 Eggertsson (2008)
suggests that the elimination of policy dogmas of the gold standard, a balanced budget, and asmall government generated an endogenous shift in expectations about future macroeconomic
policies such that, rather than expecting contractionary macroeconomic policies, people expected expansionary policies, which triggered the recovery from the Great Depression.11 In
Europe, Crafts (2011) claims that the British government changed people’s inﬂation expectations by abandoning the ﬁxed exchange rate, gaining control over its monetary policy, andmaking interest rate reduction possible.12 Berg and Jonung (1999) argue that Sweden in the
1930s was the pioneering case of price level targeting by which the monetary authorities succeeded in turning people’s expectations from deﬂation to inﬂation.13 Straumann and Woitek(2009) challenge the view of Berg and Jonung.14 Strauman and Woitek claim that Swedish
monetary authorities intended to stabilize its exchange rate vis-a-vis the pound-sterling andfollowed British monetary policy both before and after the departure from the gold standard
in 1931. In Japan, some economists argue that Takahashi’s decisive monetary policy rescued
Japan from the Great Depression by reversing people’s expectations from deﬂation to inﬂation.15 However, the transmission mechanism of macroeconomic policy tools including the“expectation channel” has been under-explored so far.
This paper is the ﬁrst attempt to draw an overall picture of the transmission mechanismof macroeconomic policy tools of ﬁscal, exchange rate and monetary policies in a national
economy during the Great Depression, incorporating the role of expectations as well as thepolicy tools. To do so, we construct a S-VAR model with three state variables (output,
price, and inﬂation expectations) and three policy variables (ﬁscal balance, exchange rate,
10

Hsieh and Romer, “Was the Federal Reserve constrained by the gold standard?”
Eggertsson, “Great Expectations and the End of the Depression.”
12
Crafts, “delivering growth while reducing deﬁcits.”
13
Berg and Jonung, “pioneering price-level targeting.”
14
Straumann and Woitek, “a pioneer of a new monetary policy?”
15
Iida and Okada, “expected inﬂation.” They estimate inﬂation expectations in the 1920s and 1930s in
Japan using the interest rate model developed by Mishkin (1990) and Cecchetti (1992). With the result of theestimation, they argue that a “two-step regime change” caused shifts in inﬂation expectations and contributed
to an early recovery during Takahashi’s term. They attributed the two-step regime change to British departurefrom the gold standard in September 1931 and the announcement of BOJ’s underwriting of government bonds
in March 1932. However, they do not elucidate the dynamics behind the shifts in inﬂation expectations.
113and money stock).
Several novel features of our analysis set this study apart from the existing litelature. Our
VAR allows us to incorporate the variables underlying the explanations of Japan’s recovery
from the Great Depression into a single empirical model. In this regard, the only precedentfor our analysis is Cha’s S-VAR analysis of macroeconomic policy. We expand and deepen
Cha’s analysis by integrating an inﬂation expectation variable into the model, quantifying
eﬀects of each policy measures, and extending sample period.
First, we incorporate a direct measure of the public’s inﬂation expectations extracted from
commodity future prices into the VAR. This approach helps us identify exogenous movements
in inﬂation expectaions, which in turn allows us to study the role of expectations in thebusiness cycles during the interwar period.
Second, we quantify impacts of the policy measures. We express the impacts on output
using the relevant impulse response functions, which Cha uses, too. In addition, we examine
the historical role of each policy measure employing econometric methodologies such as thehistorical decomposition analysis of past movements in macroeconomic variables and thecounter-factual simulation analysis.
Third, the sample in our analysis is relatively large compared with the samples in previous
studies, which allows us to make more precise estimations.
Our analysis sheds new light on the conduct of macroeconomic policy not only in Japan
during the Great Depression, but also in other parts of the world and/or during diﬀerent
periods. It demonstrates that exchange rate adjustment undertaken as an independent policy
tool played the most important role in recovery from the depression and that expectations
played a pivotal role in dynamics at work. During the second half of 1931, in particular,
speculation on Japan’s departure from the gold standard and the inﬂation likely to follow
reversed expectations: instead of expecting deﬂation, people began to expect inﬂation, months
ahead of the actual departure from the gold standard, which occurred in December of thatyear. Monetary policy was eﬀective, but was not conducted as an independent policy device.
Rather, it accommodated changes in economic conditions and other macroeconomic policy
measures such as exchange rate settings. The eﬀects of ﬁscal policy were limited. As a whole,
the choice of the level of the exchange rate was crucial for changing people’s expectations as
4well as promoting exports and raising domestic prices.
The rest of this paper proceeds as follows. Section 2 describes the econometric methodology and our data. Section 3 presents the empirical results. Section 4 discusses our ﬁndings
in relation to anecdotal evidence and previous studies. Section 5 concludes the paper.

2

Econometric Methodology and Data

This section describes our econometric methodology and our data to explore the transmission
mechanism of Takahashi’s ﬁscal, exchange rate, and monetary policies, including the expectation channel, and estimates the magnitude of the eﬀects of these policies. To this end, we
extract measures of the expected inﬂation from commodity futures prices and use the VAR
model to distinguish between the causes and eﬀects of the movements of the macroeconomic
variables, including inﬂation expectations.

2.1

Inﬂation expectations for commodity futures prices

Regarding the public’s expectations of inﬂation/deﬂation, we follow Hamilton’s notion that
commodity futures prices contain some information about people’s expectations of inﬂation/deﬂation.16 Let fit (j) denote the futures price of commodity i for the j-period-ahead.
Following Hamilton (1987), we use the 1-month futures price fit (1) as the spot price andfit (j) as the j − 1-month futures price of commodity i. The expected inﬂation for the j − 1e , isperiod-ahead anticipated by futures market participants for commodity i at period t, πitmeasured as follows:e
πit= 100(log(fit (j)) − log(fit (1))).

(1)

We collect data on the four commodity futures prices of cotton yarn (1-month futures,
7-month futures, January 1920–December 1936), raw cotton (1-month futures, 7-month futures, January 1927–December 1936), rice (1-month futures, 3-month futures, January 1920–
December 1936), and silk (1-month futures, 5-month futures, December 1923–December 1936).
While the commodity futures data contain some idiosyncratic noise, commodity futures
prices contain substantial elements of the general inﬂation expectations within the economy.
16

Hamilton, “deﬂation during the Great Depression.”5

By using commodity futures prices as direct measures of inﬂation expectations, we gain independent information on inﬂation expectations that is helpful for identifying their exogenous
shocks and examining the role of inﬂation expectations in the economy.

2.2

VAR speciﬁcation

To analyze the dynamic relationship among macroeconomic variables, we construct the following 6-variable S-VAR model consisting of the following variables: output (yt ), price (pt ),e ), a ﬁscal policy measure (g ), the exchange rate
expected inﬂation of the commodity i (πitt(et ), and money (mt ):B(L)Xt = b0 + ϵt ,(2)′

e , g , e , m ) , b is a six-by-one constant vector, B(L) = B − B L −where Xt = (yt , pt , πit
t t
t
0
0
1

· · · − Bp Lp is a pth order lag polynomial of a six-by-six coeﬃcient matrix Bj (j = 1, · · · , p)′(the diagonal elements of B0 are equal to 1), and ϵt = (ϵyt , ϵpt , ϵπie t , ϵgt , ϵet , ϵmt ) is a six-byone vector of serially uncorrelated structural disturbances with a mean zero and a covariancematrix Σϵ .
In our VAR model, we place macroeconomic variables before policy instrument variables.
This ordering assumes that policymakers are aware of the current macroeconomic variables
when they set the policy instruments, but that the macroeconomic variables will only respond to a policy shock with one lag. This ordering is essentially the same as that employedby Christiano et al. (1999). We put ﬁscal policy ﬁrst, among the policy variables, as thegovernment determined its ﬁscal policy independently from the other policies in the period
in question. We put the exchange rate second and leave the money stock last, as monetary
policy was thought to be conducted in a manner accommodating to the other policies duringthat period.17
The structural model above can be described in the following reduced-form VAR:

A(L)Xt = a0 + ut ,(3)

where a0 is a six-by-one constant vector, A(L) = I −A1 L−· · ·−Ap Lp is a pth order lag polyno17

Changes in the order of variables do not qualitatively alter the regression results.

6

′

mial of a six-by-six coeﬃcient matrix Aj (j = 1, · · · , p), and ut = (uyt , upt , uπie t , ugt , uet , umt )is a six-by-one vector of serially uncorrelated structural disturbances with a mean zero and acovariance matrix Σu . Here, a Cholesky decomposition of the reduced-form covariance matrix
Σu is used to orthogonalize the reduced-form innovations.

2.3

Data

yt is output measured by the volume of railway freight; pt is the wholesale price index (WPI);e is inﬂation expectations derived from commodity futures prices; g is the real ﬁscal balance
πittmeasured by changes in the ﬁnancial assets and liabilities of the government, and deﬂated by
the WPI; et is the eﬀective exchange rate calculated from the export-weighted average valueof the US dollar, British pound sterling, French franc, and Chinese (Shanghai) tael against
the yen; and mt is the money stock measured by cash in circulation.
The volume of railway freight is taken as the measure of output, as this is the mostreliable data for the full-sample period from January 1920 through December 1936. Several
other industrial production indexes (IIPs) are available for subsample periods, and we have
conﬁrmed that the railway freight data moves in tandem with them.
The real ﬁscal balance is calculated by taking the diﬀerence between the net balance ofthe central government at the end of a month and the net balance at the end of the previous
month and then deﬂating it by the WPI.18 On the liability side, we use the overall government
liabilities, including long-term and short-term government securities and borrowings from thecentral bank. On the asset side, we use government deposits to the central bank. These steps,
taken together, allow us to count all of the activities of the central government.
The eﬀective exchange rate of the yen is used as a weighted average of exchange rates
against the US dollar, the British pound-sterling, the French franc, and the Chinese (Shanghai)tael. The weight of Japanese exports to respective countries and their colonies is used (the1917 weight).19 Japanese exports to those regions account for 89 percent of the total Japanese
18

Deﬂating the ﬁscal variables by the Consumer Price Index (CPI) does not alter the empirical results
qualitatively though CPI series is available only from January 1922.
19
We conﬁrmed the robustness of the main empirical results reported below by using several alternative
exchange rate measures: (i) the eﬀective exchange rate of the yen calculated by the 1917 weight for the period
from January 1920 to December 1931 and by the 1936 weight for the period from January 1932 to February
1936, (ii) yen-dollar exchange rate, and (iii) yen-pound-sterling exchange rate.

7

exports in 1917. The United States, Great Britain, and France returned to and departed fromthe gold standard at diﬀerent times during sample period, while China stayed on the silver
standard until its currency reform of November 1935.
We use the commodity price inﬂation expectations derived in eq. (1). Our VAR analysis
employs cotton yarn, the commodity with the most readily available data, as the benchmark
result. We also conﬁrm the robustness of the main empirical results reported below by using
other commodity futures data.20
The frequency of our data is monthly, and the sample period is from January 1920 to
December 1936 (204 months). All of the variables are transformed into the logarithmic form
and multiplied by 100, except for the real ﬁscal balance (which takes a negative value attimes). We estimate the VAR in levels because it yields consistent estimates even if eachvariable is nonstationary.21 The lag length is set to four in the reduced-form VAR estimation,
which is suﬃcient to capture the system dynamics and ensure no serial correlation in theresiduals.22

3

Empirical Results

This section presents the empirical results based on the VAR framework just described. We
oﬀer four sets of results: (i) a time series of identiﬁed structural shocks, namely, real output,
price, expected inﬂation, ﬁscal, exchange rate, and monetary shocks, (ii) impulse responses,(iii) counterfactual simulations about the eﬀects of the expected inﬂation shocks, and (iv)historical decompositions of macroeconomic variables that are explained by the structural
shocks.

20

Checking by the X-12-ARIMA method, we conﬁrm that commodity futures data contain no seasonality.
See Hamilton (1994) pp. 651–653.
22
We perform a modiﬁed likelihood ratio test proposed by Sims (1980) to check whether taking four lags
is suﬃcient. The null of four lags is tested against the alternative of six lags or eight lags. The chi-squarestatistics indicate that the null hypothesis is not rejected by conventional signiﬁcance levels for any of the models
considered. We also perform the multivariate Lagrange multiplier (LM) test for residual serial correlation for
up to the {1, · · · , 13}th order. See Johansen (1995), p. 22 for the formula for the LM statistic. The LM
statistics for each order indicate that the null hypothesis of no serial correlation is not rejected by asymptotic
signiﬁcance levels.
21

8

3.1

Identiﬁed structural shocks

Figure 1 displays the six time series of structural shocks: output shocks, price shocks, expectation shocks, ﬁscal shocks, exchange rate shocks, and monetary shocks. The estimatedtime series of the structural shocks identiﬁed from the VAR model tend to be noisy, since
all of them are by construction serially uncorrelated. Although we employ all the regressions
with raw data, we report the moving average of the shock for the previous 11 months in Figure 1 for ease of visual interpretation. The eight vertical lines denote major events, namely,
the Great Kanto Earthquake (September 1923), the outbreak of the Showa Financial Crisis(March 1927), the NY Stock Exchange crash (October 1929), the Japanese return to the gold
standard (January 1930), the British departure from the gold standard (September 1931), theJapanese departure from the gold standard (December 1931), the start of government bondunderwriting by the Bank of Japan (BOJ) (November 1932), and the US departure from thegold standard (April 1933). The shocks we have extracted from our VAR system are independent from the structural shocks on other variables. The shocks on ﬁscal, exchange rate, andmonetary variables are independent policy shocks not induced as responses to ﬂuctuations inother variables. Meanwhile, the shocks on output, price, and expected inﬂation are exogenous
shocks that cannot be accounted for by contemporaneous ﬂuctuations in other variables. As
our model includes expected inﬂation components, we identify price shocks as unexpected
shocks that can be treated independently from expected inﬂation shocks.
The shocks shown in the panel are largely consistent with the anecdotal evidence. In theupper left panel of Figure 1, we see two major troughs representing unexpected output shocks,
one after the Great Kanto Earthquake in 1923 and one after the Japanese return to the gold
standard in 1930. Each is followed by a recovery in output.
In the upper right panel, we see major troughs in unexpected price shocks during thepost-world-war-I deﬂationary period of 1920 and during the de-jure gold standard period of
1930–31, each followed by an upward swing, and a third trough after the US departure fromthe gold standard in 1933.
In the middle left panel, we see growing deﬂation expectations before and during Japan’s
return to the gold standard in 1930–31, and an upswing in inﬂation expectations approxi-

9mately when Japan departs from the gold standard at the end of 1931.
In the middle right panel, we see persistent contractionary ﬁscal policy shocks during thesecond half of the 1920s. Contrary to the conventional arguments, the ﬁscal policy shocks
during the ﬁrst half of Takahashi’s term during 1931–36 shows no signiﬁcant upswing independent from the shocks on other variables. We will come back to this point later in thispaper.
In the lower left panel, we see major independent shocks leading to a weaker yen after the
British return to the gold standard in April 1925, followed by an upswing in shocks towards
a stronger yen after the British departure from the gold standard in September 1931. Thisis followed by a new round of shocks towards a dramatically weaker yen after the Japanese
departure from the gold standard in December 1931.
In the lower right panel, we see major contractionary shocks in monetary aggregates before
the outbreak of the Showa Financial Crisis in 1927, followed by sudden stimulative shocks
just after the crisis. The monetary aggregates show small shocks as an independent policy
variable during the de-jure gold standard period of 1930–31 and Takahashi’s subsequent term.

3.2

Measuring the eﬀects of structural shocks

Figure 2 displays all estimated impulse responses to a one-standard-deviation shock to eachvariable. The ﬁrst to sixth rows represent the dynamic responses of the six variables to an
output shock, a price shock, an expected inﬂation shock, a ﬁscal shock, an exchange rate
shock, and a monetary shock, respectively. The solid lines in each plot indicate the estimatedresponses and the shade areas denote the 1.64 standard error band (90% conﬁdence interval)
calculated using 10000 bootstrap samples.
Here, we will ﬁrst turn to the impulse responses to exchange rate shocks, shown in the ﬁfth
row of Figure 2. In the chart on the far left, the real output moves to the bottom 1 year afteran exchange rate shock (appreciation in the exchange rate), with statistical signiﬁcance, thenrises back to a steady-state level. Goods prices also respond negatively to the exchange rate
shock, though the standard error band appears to be relatively wide. These results suggestthat exchange rate shocks independently had strong inﬂuences on the real economy during theinterwar period. We also note that the rise in the exchange rate is followed by a decline in the10money stock. This indicates that the monetary authority endogenously responded to the yen
appreciation by decreasing the money stock, a move that was tantamount to accommodating
the money supply in response to the exchange rate change. We also note a downward trend
in the ﬁscal deﬁcit in response to the exchange rate appreciation. This implies that the
government also considered the exchange rate when setting its ﬁscal policy. Overall, these
responses to the exchange rate shock reﬂect the open nature of the Japanese economy during
the interwar period.
The charts in the bottom row of Figure 2 plot the impulse responses to a monetary shock.
A monetary shock (an exogenous increase in the money stock) is followed by a depreciation of
the yen, indicating that an upward adjustment of the money stock by the monetary authority
pushes the yen value down. The shock, in turn, raises real output and prices, which implies
that the aggressive monetary expansions had substantial impacts on the real economy bystimulating the aggregate demand. On the other hand, as we observe in the fourth row of
Figure 2, ﬁscal policy shocks have limited impacts on real output and prices, which is incontrast with Cha’s ﬁnding.
The expectation shocks (exogenous changes in the expected inﬂation) have persistent andstatistically signiﬁcant impacts on the output and prices. The peak comes about one and ahalf years after the initial shocks, and is long-lived. This implies that the expectation shocks
identiﬁed in our VAR model played an important role over the business cycle during theinterwar period. We also note that the shock leads to a rise in the ﬁscal deﬁcit, a depreciationin the exchange rate, and a rise in the money stock. This suggests that shocks contain forwardlooking information reﬂective of market expectations or forecasts of future macroeconomic
events such as ﬁscal expansion, depreciation of the yen, and monetary expansion.
Real output shocks, which are often interpreted as productivity/technology shocks in theliterature, have signiﬁcant impacts on real output but limited impacts on prices. Price shocks(unexpected changes in aggregate prices) have signiﬁcant eﬀects on prices. These shocks havelarge eﬀects when they strike, and the eﬀects are rapidly transmitted.

11

3.3

The “expectation channel” of macroeconomic policy eﬀects

Here, we examine macroeconomic policy eﬀects through inﬂation expectations. When people
anticipate shifts in ﬁscal, exchange rate, and/or monetary policies, people alter their inﬂation
expectations ahead of actual changes in the macroeconomic policies. Our VAR model identiﬁes such changes in the inﬂation expectations as exogenous shocks, independent from othermacroeconomic shocks, followed by endogenous shifts in ﬁscal, exchange rate, and monetary
policy variables. We refer to the eﬀects of the macroeconomic policies that occur throughinﬂation expectations as occurring through the “expectation channel.”Then, to what extent does the expectation channel work on output? We test the signiﬁcance of the expectation channel of three measures of macroeconomic policy; ﬁscal, exchange
rate, and monetary policies in our VAR framework. Speciﬁcally, we employ a counter-factual
simulation analysis introduced by Bernanke et al. (1997) and Sims and Zha (2006) in our
VAR model. The analysis will enable us to disentangle the endogenous components of future
macroeconomic policy actions from the total eﬀects of expectation shocks on output.
Figure 3 compares impulse responses for output in the absence of endogenous reactionsof macroeconomic policy measures with the baseline result. The solid line without symbols
is the baseline result with the estimated ﬁscal, exchange rate, and monetary policy reactions
in our benchmark model. The solid line with stars (∗) is the result if the policymakers holdﬁscal policy unresponsive to other variables, the solid line with pluses (+) is the one if thepolicymakers hold exchange rate policy unresponsive, the solid line with circles (◦) is the one
if the policymakers hold monetary policy unresponsive, and the solid line with squares (□) isthe one if the policymakers hold all the macroeconomic policies unresponsive. The diﬀerence
between the baseline result and the result in absence of each policy response indicates amagnitude of the eﬀect of the policy through the expectation channel.
As seen in Figure 3, the absence of exchange rate and monetary policy responses results inthe limited rise in output compared to the benchmark, whereas the absence of a ﬁscal policy
response yields almost the same result as the benchmark. These results imply that the expectation channel has signiﬁcant impacts on output in the case of exchange rate and monetary
policies, but has little eﬀect in the case of ﬁscal policy. The absence of all policy responses

12results in a quite small rise in output, which suggests that other expectation components
unrelated to the macroeconomic policy actions have limited eﬀects on output.

3.4

Source of the economic recovery

The next part of this study, the historical decomposition analysis, examines how our modelinterprets history. Figure 4 decomposes the real output series into six components that are
respectively explained by six types of structural shock: the output shock, unexpected priceshock, expected inﬂation shock, ﬁscal shock, exchange rate shock, and the monetary shock.
All the series are displayed as deviations from the linear trend. The solid line shows thedecomposed series and the dotted line indicates the estimated series before the decomposition.
In the upper-left chart in Figure 4, we ﬁnd that, while real output shocks explain a largepart of the ﬂuctuations in output during the second half of the 1920s, in contrast, during
the early 1930s, most of the ﬂuctuations were due to factors other than the exogenous real
output shocks. The lower-left chart shows that exchange rate shocks had signiﬁcant impacts
on real output throughout the sample period, especially on the upswing in real output in
1932–34. We also ﬁnd that the changes in the expected and unexpected inﬂation explain alarge part of the fall and rise in output in the early 1930s, which indicates that these shocks
had some impact on real output. Monetary shocks had signiﬁcant impacts on real output, but
the eﬀect diﬀered on each occasion: the shocks contributed to a downturn in output before
the Financial Crisis in 1927, followed by an upswing just afterwards, then they counteracted
the sharp decline of output in 1931. Monetary shocks had limited impact during the recovery
of 1932–33. Fiscal policy shocks had no eﬀect on the real output, which suggests that changes
in the ﬁscal balance played virtually no role as an independent policy tool during the recoveryof the early 1930s.
From the trough in October 1931 to the peak in May 1934, output rises by 39 percentage
points around the trend, of which exchange rate shocks contribute 17 percentage points, exogenous changes in expected inﬂation 9 percentage points, unexpected price shocks 5 percentage
points, unexpected output shocks 4 percentage points, monetary shocks 2 percentage points,
and ﬁscal policy shocks 2 percentage point. These results conﬁrm the relative importance ofthe depreciation of the yen and the expectation channel.
13

Many studies argue that Takahashi rescued the Japanese economy from the Great Depression through a package of macroeconomic stimulus measures combining ﬁscal, exchange rate,
and monetary policies. Our results reveal that the depreciation of the yen and changes ininﬂation expectations contributed to production growth after Japan departed from the gold
standard in December 1931, whereas monetary and ﬁscal policies had very limited eﬀects inthe early stage of the recovery.
According to our analyses, policymakers shaped some of their policy measures in responseto economic conditions and other policy shifts in a systematic fashion, while undertaking
other policy actions independently. To elaborate this point, Figures 5, 6, and 7 plot historicaldecompositions of ﬂuctuations in the ﬁscal balance, exchange rate, and money stock, respectively, into components attributed to structural shocks in output, price, inﬂation expectations,ﬁscal balance, the exchange rate, and money stock.
Figure 5 shows a historical decomposition of ﬂuctuations in the ﬁscal balance. Fiscal policy
shocks apparently accounted for most of the ﬁscal balance movements over time. Periodically,
however, we observe deviations from the independent movements of the ﬁscal balance. These
deviations can be largely explained by the expectation shocks and the exchange rate shocks.
Later, we will look more deeply into the background of these deviations.
Figure 6 shows the historical decomposition of exchange rate ﬂuctuations. The component
explained by the exchange rate shocks rapidly fell in December 1931, indicating that theexchange rate shocks accounted for a large part of the exchange rate depreciation at thattime. Inﬂation-expectation shocks and unexpected price shocks also turn out to be importantfactors in explaining the large hump in the exchange rate when Japan returned to and thendeparted from the gold standard. Speciﬁcally, the upward swing in inﬂation expectations
from September 1931, when Britain departed from the gold standard, explains a substantial
part of the yen depreciation over the ensuing months.
Figure 7 plots the historical decomposition of ﬂuctuations in the money stock. The independent monetary shocks apparently explain a substantial part of the ﬂuctuations in moneystock throughout the sample period. As it turns out, these shocks are the sole factor explaining
the upward spike in the money stock during the Showa Financial Crisis of 1927. Meanwhile,
unexpected output and price shocks, the inﬂation-expectation shocks, and the exchange rate14

shocks contributed to the large swings in money stock in the early 1930s. These results suggestthat the policy actions by the BOJ during the Great Depression and the Takahashi period
may be emblematic not of an active, exogenous monetary policy, but of an accommodative,
endogenous series of policy responses to changes in economic conditions, such as the exchange
rate and inﬂation expectations, as well as exogenous output and price movements.
Finally, we conduct the counterfactual simulations of our VAR model in which we explore
what would have happened to output in the absence of the macroeconomic policy actions.
Figure 8 shows the results, focusing on the behavior of real output from September 1931
to February 1936. The solid line without symbols shows the historical path of the output.
We call it the baseline scenario. The solid line with stars (∗) shows the ﬁctitious path of theoutput assuming that the ﬁscal balance was ﬁxed at the initial value through the entire sample
period, that is, it assumes no exogenous ﬁscal policy shocks and no endogenous ﬁscal policy
responses to ﬂuctuations of other variables. The solid line with pluses (+) shows the scenario
assuming that the exchange rate was ﬁxed at the initial value through the entire sample
period, that is, assuming no exogenous exchange rate shocks and no endogenous exchange
rate responses to ﬂuctuations of other variables. The solid line with circles (◦) shows the
scenario assuming that the money stock was ﬁxed at the initial value through the entire
sample period, that is, assuming no exogenous monetary policy shocks and no endogenous
monetary policy responses to ﬂuctuations of other variables. Each of the scenarios eliminates
the exogenous policy component and the endogenous policy component of the eﬀect of theother shocks. The solid line with squares (□) shows the scenario assuming that all the policy
variables were ﬁxed at the initial value through the entire sample period, that is, it assumes
there are no exogenous policy shocks and no endogenous policy responses to ﬂuctuations ofvariables in the system. The last scenario leaves only the eﬀects of the exogenous shocks
in output, price and inﬂation expectations on output. The diﬀerence between the baseline
scenario and the scenario without any policy shocks and responses implies the overall policy
eﬀects, including exogenous shocks and endogenous responses.
Exchange rate shocks and/or responses substantially explain the low level of output in
1932, the vigorous recovery in 1933, and the high output levels achieved during 1934 andafterwards. Apparently, this is the result of the delayed eﬀects of the appreciation of the yen
15

in 1931 and the subsequent depreciation in 1932. Monetary policy shocks and/or responses
explain a large part of the enduring high level of output in 1934 and 1935. During this period,
exogenous monetary policy shocks had limited eﬀects on output (Figure 4), and monetary
policy accommodated the depreciation of the yen (Figure 7). This indicates that conducting
easy monetary policy in accordance with the depreciation of the yen, not as an independent
policy action, supported the high level of output. Fiscal policy played only a marginal role.

4

Discussion

Our results show that, on the one hand, the depreciation of the yen and the consequent changes
in inﬂation expectations had dominant eﬀects on the macroeconomy when Japan escaped fromthe Great Depression of the early 1930s. In the wake of Britain’s departure from the gold
standard, speculation on Japan’s departure from the gold standard precipitated a drasticchange in inﬂation expectations months ahead of its actual departure.
Our ﬁndings indicate that exchange rate movements played a pivotal role in the increases
in output and prices during the economic recovery in the early 1930s. This is consistent with
Nanto and Takagi (1985) and Takagi (1989). They characterize Japan at that time as a small
open economy and emphasize the impact of price movements induced by overseas eventsand exchange rate ﬂuctuations. In a sense, we explore the underlying mechanism of theirargument, taking into account the role of expectations and the dynamics of policy formation.
As the Japanese economy depended heavily on overseas markets, in terms of both trade andﬁnance, Japanese market participants and policymakers took overseas events and exchange
rate settings into account in making their decisions.
In the course of events, expectations related to the future exchange rate and monetary
policy actions were the main channel resulting in the output increase in the early 1930s.
In particular, the Japanese economic recovery in 1932-33 was initiated by changing the expectations of market participants from deﬂation to inﬂation. This occurred as a result of
anticipations that Japanese policymakers would depart from the gold standard following the
British departure and alter the exchange rate and monetary policies.
In the initial stage of recovery in 1932-33, monetary policy played a limited role, in con-16

trast to the argument of Iida and Okada (2004). They state that the announcement of the
BOJ’s underwriting of government bonds in March 1932 changed people’s expectations fromdeﬂation to inﬂation and gave a big push to the economic recovery, taking this as an indication of a drastic change in monetary policy. However, our historical decomposition analysis
reveals that an upward swing in output in 1932 was not the result of monetary easing caused
by underwriting of government bonds, but largely the consequence of the depreciation of
the yen and changes in expectations associated with the depreciation (Figure 4). Monetary
policy largely accommodated other policies such as exchange rate settings rather than being
conducted as an independent policy tool (Figure 7).
In a small open economy, monetary autonomy was not available for stabilizing the domestic
economy, and the choice of the exchange rate was crucial because a “regime change” wasbrought largely through depreciation of the currency. Shizume (2002) applies Taylor rule
analysis to interwar Japan and ﬁnds that Japan’s monetary policy was not conducted in acountercyclical manner not only before but also after the departure from the gold standard.23
Fukai Eigo, Takahashi’s primary policy advisor, recalled that the authorities welcomed anorderly depreciation of the yen, but that they conducted an accommodative monetary policy
rather than a proactive one in fear of a spiral of excess inﬂation and currency devaluation.24
This was also the case in Sweden, as reported by Straumann and Woitek (2009), who argue
that Swedish monetary policy was devoted to exchange rate stability rather than domestic
price stability in the 1930s.25 .
Our arguments are consistent with the anecdotal evidence. Market participants anticipated that Britain’s departure from the gold standard would force Japan to follow. From
September to November 1931, the Monthly Report from the Tokyo Stock Exchange (TSE)
repeatedly stated that, in the wake of Britain’s departure from the gold standard, market participants expected Japan to follow suit and once again place an embargo on gold exports.26
In the same vein, the BOJ reported, in October 1931, that Britain’s departure from thegold standard revived speculations on a Japanese departure among investors in London and23

Shizume, “Economic developments and monetary policy responses,” pp. 104-105.
Fukai, “Reﬂections on seventy years,” pp.266-267; pp.274-275. Fukai was the Deputy Governor of the Bankof Japan (1928-35) and the Governor of the Bank (1935-37).
25
Straumann and Woitek, “a pioneer of a new monetary policy?,” pp. 276-277.
26
TSE Monthly Report, September 1931, October 1931, and November 1931.
24

17

Continental Europe.27
The Japanese government considered the exchange rate when setting its ﬁscal policy, too.
Japan suspended the yen from the gold standard in September 1917, 5 days after the UnitedStates had done so. Then, during the 1920s, Japan sought to return to the gold standard
as a primary policy goal. Incidents such as the Great Kanto Earthquake of September 1923
and the Showa Financial Crisis in the spring of 1927 delayed the government’s ﬁnal decision.
Finally, in July 1929, the Hamaguchi Cabinet of the Minseito Party published a manifesto,
placing Japan’s return to the gold standard at the very top. In the ensuing months, they
let the yen appreciate to the level of the pre-war parity and pushed forward ﬁscal austerity
measures. They succeeded in reinstating the yen to the gold standard in January 1930, but
this lasted for only about two years. When the opposing Seiyu Kai Party came into powerin December 1931, Takahashi declared that Japan would depart from the gold standard andembark on a phase of a ﬁscal expansion.28 These episodes illustrate the nature of ﬁscal policy
during the 1920s and early 1930s, a period deeply inﬂuenced by exchange rate policy.
The statistics on gross national product endorse the export-led nature of economic recovery
in the early 1930s (Table 1). The Japanese economy grew by 35 percent during Takahashi’s
years in power during 1932–36. Exports contributed 15 percentage points to this growth, withpersonal consumption contributing 12 percentage points, private investments 7 percentage
points, government expenditure 5 percentage points, with imports subtracting 5 percentage
points. Exports were the only component that grew over the ﬁve consecutive years.
Our results are inconsistent with those of Cha, who concludes that ﬁscal expansion became
the leading source of recovery during Takahashi’s term. In a sense, we expand Cha’s econometric analysis on the eﬀect of Takahashi’s policy package during the early 1930s by extending
the sample period from 93 months to 204 months, and, more signiﬁcantly, by including prices
and inﬂation expectations in the analysis.
From what sources do the diﬀerences between our results and those of Cha (2003) emerge?
If the diﬀerences stem from the inclusion of price dynamics and the role of inﬂation expectations, we will obtain the same results as Cha by running the S-VAR model without variables
27

The Report to the Semiannual Meeting of Executives and Branch Managers, October 13, 1931, BOJ
Archives No. 3942.
28
Shizume, “Sustainability of Public Debt: Evidence from Japan before the Second World War”.

18

Table 1: Growth rates of the components of real GNP during 1932–36.
Year
C
G
I
EX IM EX-IM GNP
1932-1.2 2.8 -1.0 3.1
0.7
3.8
4.4
1933
5.2
1.5 1.7
1.1
0.7
1.8
10.1
1934
4.7 -0.9 2.7
5.1 -2.7
2.3
8.7
1935
-0.1 0.7 1.8
3.6 -0.7
2.9
5.4
1936
1.8
0.4 0.9
0.6 -1.5-0.9
2.2
1932-36 11.9 4.7 7.2 15.4 -4.6
10.8
34.6
Notes: The table shows the contributions to the percentage change in real gross national
product in the previous year from consumption (C), government purchases (G), investment(I), the value of exports (EX), the value of imports (IM), net exports (EX−IM), and real
GNP (GNP). All data are taken from Ohkawa et al. (1974).
representing price and inﬂation expectations.
Here, we employ a S-VAR model with four variables, namely, output, real ﬁscal balance,
the eﬀective exchange rate, and money stock, omitting wholesale price and inﬂation expectations. As the left upper and lower panel of Figure 9 shows, this formula provides a result
qualitatively similar to Cha’s, with a strong ﬁscal policy eﬀect on output. In other words,
the price and inﬂation expectations variables drastically alter Cha’s interpretation. In contrast, our benchmark results show that ﬁscal policy had only a limited eﬀect on the output
throughout Takahashi’s term in the early 1930s. This implies that the exclusion of priceand/or inﬂation expectation variables led to an overestimation of the ﬁscal policy eﬀect.
The most notable diﬀerence between the benchmark model and the model excluding priceand inﬂation expectation variables is in the identiﬁcation of ﬁscal shocks in 1932-33, the initialstage of Takahashi’s term. As we see in the right upper panel of Figure 9, the benchmark
model shows little upward swing in ﬁscal shocks during this period, while the model excluding
price and inﬂation expectation variables shows a big spike in ‘exogenous’ ﬁscal shocks. The
benchmark model tells us that, when Takahashi pushed up ﬁscal spending, depreciation of
the yen boosted the Japanese economy through the “expectation channel” and a subsequent
increase in real demand. Omission of price and inﬂation expectation variables in the model
neglects the crucial channel in interpreting policy eﬀects and misidentiﬁes it as an eﬀect of adiscretionary ﬁscal policy.
Then, why was ﬁscal policy not eﬀective in Japan during the early 1930s? One hypothesisis the changing nature of ﬁscal spending in this period. In the period of 1932-36, the ratio of
19

ﬁscal spending to gross national products (GNP) increased to 10.8 percent from 9.0 percent in
the previous decade of 1922-31. However, military expenditures including overseas campaign
in the Asian Continent increased by more than two percent points from 3.2 percent to 5.4
percent, while other expenditures decreased from 5.7 percent to 5.4 percent.29 Smethurst(2007) shows that the military was the primary beneﬁciary while rural relief program got onlya small portion of the pie.30 As Japanese army and navy heavily depended on the overseas
weapons and fuel, and as military expenditures for overseas campaigns leaked to the AsianContinent, the ﬁscal multiplier of the military spending was smaller than civil spending.31

5Concluding Remarks

We draw an overall picture of the transmission mechanism of macroeconomic policy toolsof ﬁscal, exchange rate and monetary policies in Japan during the Great Depression in the
1930s, incorporating the role of expectations as well as all the policy tools. Our S-VAR
analysis reveals that exchange rate adjustment undertaken as an independent policy tool
played the most important role in recovery from the depression, and that inﬂation expectations
played a pivotal role in the dynamics at work. During the second half of 1931, in particular,
speculation on Japan’s departure from the gold standard and the inﬂation likely to follow
reversed expectations: instead of expecting deﬂation, people began to expect inﬂation, months
ahead of the actual departure from the gold standard, which occurred in December of thatyear. Monetary policy was eﬀective, but was not conducted as an independent policy device.
Rather, it accommodated changes in economic conditions and other macroeconomic policy
measures such as exchange rate settings. The eﬀects of ﬁscal policy were limited. As a whole,
the choice of the level of the exchange rate was crucial for escaping from the Great Depression,by changing people’s expectations as well as promoting exports and raising domestic prices.
People already had expected a “regime change” and recovery months ahead of Takahashi’s
return to power; what Takahashi did was to realize the outcome in a prompt and orderly

29

Shizume, “Sustainability of Public Debt,” p. 1117.
Smethurst, Takahashi Korekiyo, pp. 263–264.
31
Crafts and Mills (2013) show that the ﬁscal multiplier in Britain during the 1930s was signiﬁcantly lessthan one, that was much smaller than previously thought. They argue that British recovery in the initial phase
was brought by leaving the gold standard and the following easy monetary policy rather than ﬁscal stimulus.
30

20

manner as people had expected.
Japan in the 1930s was a canonical case for a small open economy escaping from thesevere global economic downturn. It brought a “regime change” by the departure from thegold standard. People expected the event well ahead of time and changed their behavior inadvance, enhancing policy eﬀects. Our story is consistent with Temin (1989) and Eichengreen(1992), who argue that the departure from the gold standard was crucial for the economic
recovery of the 1930s. Our ﬁndings show new empirical evidence that inﬂation expectations
played a pivotal role in the dynamics at work.

Appendix: Robustness
In this appendix, we reestimate the model under a number of alternative settings to examine
the robustness of the VAR model. First, when we extended the lag length of the VAR fromfour lags to eight lags, the model produced qualitatively similar results with more complex
impulse responses. Next, we reran the VAR using the alternative measures of the commodity
futures price (raw cotton (1-month futures, 7-month futures, January 1927–December 1936),
rice (1-month futures, 3-month futures, January 1920–December 1936), and silk (1-monthfutures, 5-month futures, December 1923–December 1936)) to examine whether the alternative
inﬂation expectation shocks produced impacts on the macroeconomic variables similar to
those observed in the benchmark results. We also included the US output in our regression
to check whether this variable would alter the results. In addition, we reran the VAR using
the consumption price index as a diﬀerent proxy for aggregate prices, and using the index
of industrial production as a proxy for real output. None of these experiments changed thequalitative nature of the results. Finally, we examined the structural stability of our reduced
form dynamic models. Although a statistical test suggests the existence of a structural breakwithin the sample period, we conﬁrmed that our empirical results do not alter even with the
break.32 Following the example from Cha (2003), we set the starting point of the sample in32

We have applied a modiﬁed likelihood ratio test to determine whether the overall parameter values were
unchanged between the two periods before and after a given possible break date. When we set possible breakdates every month for the period from January 1928 to January 1932, the null hypothesis that all the model
parameters are the same is rejected against the alternative of a structural shift. The results suggest that there
was a break sometime between January 1928 and January 1932.

21

January 1929, excluding the period from January 1920 through December 1928, and obtained
a qualitatively same results to the ones with the full sample.

Acknowledgements
We thank Albrecht Ritschl, Hans-Joachim Voth (Editor in Explorations in Economic History),
and two anonymous referees for very useful comments and suggestions. We are also grateful to
Takashi Kamihigashi, Mariko Hatase, Masanao Itoh, seminar participants at Kobe University,
the Bank of Japan, and participants of the Economic History Association’s 71st Annual
Meeting for their helpful discussions and remarks. Shibamoto acknowledges ﬁnancial support
in the form of a Grant-in-Aid from the Japanese Ministry of Education.

22

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