MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission
at Low Inflation:
Some Clues from Japanin the 1990s
Keynote Speech by Allan H. Meltzer

The paper analyzes the performance of the Japanese economy from1985 to 1999. It compares different explanations of slow growthand prolonged recession. Using both bivariate comparisons andstatistical tests, the paper concludes that the maintained growth rate
fell after 1992. Also, the data suggest that the recession early in the
1990s was induced by a decline in money growth. In contrast, therecent recession was induced mainly by a fall in real exports. Failure
to allow the nominal exchange rate to depreciate forced deflationand increased the costs of adjusting to reduced export demand. The
main policy conclusion calls on the Bank of Japan to pursue amore expansive policy to end deflation. This policy would depreciate
the yen, but it would end the deflation that is costly to Japan andits neighbors.
Key words: Economic policy; Money; Deflation; Exchange rates;
Recession

Carnegie Mellon University, and the American Enterprise InstituteThis paper owes a great deal to the assistance of Randolph Stempski at the American
Enterprise Institute.

13

I. Introduction
Compared to its performance from the 1950s through the 1980s or to the U.S.
economy in the 1990s, Japan’s growth rate has been sluggish. Growth declined froman average of 10 percent for the mid-1950s to the early 1970s, to 4 percent for the
1970s and 1980s, to about 1 percent for the 1990s. For the first time since the very
early postwar years, Japan’s growth rate has been below U.S. growth for a protracted
period. The convergence of the economies that had become a stylized fact of the
postwar era has ended, at least temporarily.
Several very different explanations have been offered. One common explanation
cites changes in banks’ willingness to lend as a major cause of sustained sluggishness
of investment. Motonishi and Yoshikawa (1999) present evidence suggesting that this
explanation applies mainly to small firms. They show that the decline in lending
explains only a small part of the slowdown in growth of investment and income.
These authors conclude that real factors are more important than financial factors,
but they do not explain which real factors are most important or why they declined.
I find the argument about banks’ unwillingness to lend puzzling for two
reasons. First, it does not fit well with another common argument about Japanesebanking—that banks went heavily into real estate lending in the 1980s because, after
deregulation, corporate borrowers greatly reduced their reliance on banks. Second,
evidence from many countries suggests that loans, including very risky loans, increase
in weakened financial systems with many insolvent banks. This is the familiar moral
hazard argument.
Both of these arguments suggest that much of the decline in lending reflected
reduced demand for loans. Below, I present some modest evidence that supports
Motonishi and Yoshikawa’s finding that an autonomous shift in banks’ willingness tolend is not a principal factor affecting recovery.
There is no shortage of alternative explanations. Widely discussed explanations
include overvaluation of the yen or the expectation of future appreciation(McKinnon [1999]), a liquidity trap that eliminates the effectiveness of monetary
policy (Krugman [1999]), collapse of the bubble in stock or land prices affecting
investment and housing (many authors), and pessimism about future pensions andjob security (Nakayama [1999]), cited in Motonishi and Yoshikawa [1999]. I consider some of these below. Before doing so, it seems useful to present some basic data
both to show what happened to the economy and to dispel the frequent, mistaken
claim that the economy is in a deep depression, similar to the 1930s depression in the
United States.
Behind the many suggestions about the causes of slow growth and recession lie
different implicit or explicit ideas about the transmission process. For example, those
who suggest that weakness of the financial structure and bank failures are causal mustbelieve that restrictions by banks lowered investment and output. Whatever power
this explanation may have is limited to the last half of the decade, so it is at most apartial explanation.
The liquidity trap explanation can apply, at most, to the last two years. Shortterm interest rates remained above 2 percent until 1995 and did not approach zero or

14 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

fall below the Bank of Japan’s discount rate until 1998. It is easy to prove existence ofa liquidity trap in a model with one interest rate. It is more difficult in a multi-asset
world unless all asset prices reach an equilibrium consistent with the zero short-term
interest rate (Brunner and Meltzer [1968]).
McKinnon (1999) makes a related claim. He argues that Japan cannot depreciate
its exchange rate. He notes that, except for 1980–85, the yen has appreciated against
the U.S. dollar and other currencies. Everyone anticipates long-term yen appreciation, in part because depreciation would arouse the ire of the United States, which
would retaliate by restricting imports from Japan. Since everyone believes theyen cannot depreciate, the Bank of Japan cannot depreciate its currency. With theshort-term rate near zero, depreciation does not offer an alternative channel by whichmonetary expansion could end the recession.
At best, McKinnon’s argument is incomplete. It applies to the nominal exchange
rate, not the relevant, real exchange rate. If everyone believed and acted as McKinnon
assumes, the Bank could deflate to adjust an overvalued real exchange rate. Or, it
could end deflation and depreciate its currency. U.S. threats cannot prevent that.
In fact, the real exchange rate shows no evidence for the 1990s of the persistent
appreciation that McKinnon’s reasoning requires. The real, trade-weighted yen
exchange rate in 1997–98 differs little from the rate in 1985–86 and in many intervening years. The rate fluctuates but shows no evidence of persistent appreciation or
depreciation since the mid-1980s.
Many explanations of the 1990s attribute slow growth to “bursting the bubble.”
Some of these explanations attribute a large role to asset prices—particularly equity,land, and housing prices. I have long held that these prices have an important role in
the transmission process, so I welcome the attention they receive (Brunner andMeltzer [1968], and Meltzer [1995]). I note, however, that housing and land prices
continue to decline, a finding that is more consistent with deflationary policy thanwith a liquidity trap. Asset prices respond endogenously to productivity, policy, andother impulses. I comment briefly on the role of asset prices below.1
The theme of this conference is “The Role of Monetary Policy under Low
Inflation.” Divergent explanations of slow growth and recession based on lending,interest rates, exchange rates, asset prices, or other variables suggest that economists
hold different views about that theme. Japan in the 1990s provides a case study fromwhich we can learn. I begin by presenting some of the principal facts. The datasuggest that the transmission process has several familiar features. I do not attempt acomplete model of the economy. I have limited my inquiries to the modest objectiveof looking for clues about some of the forces at work in Japan during the 1990s.
The data suggest some reasons for slow growth and recession and suggest a rolefor policy. The Bank of Japan is not responsible for choosing the exchange rate and,judging from its discussion and analysis, it does not give much attention to theexchange rate. I conclude that this is a costly oversight that reflects an institutional
constraint that should be removed.
1. Figure 10 of Okina et al. (2001) shows that other countries experienced sizeable reductions in stock market
indexes without having prolonged recessions. Claims that “bursting the bubble” caused slow growth and recession
have to consider why Japan differs in this respect.

15

II. Some Facts and Interpretations
The data in this chapter help to dispel a common assertion, call attention to someapparent regularities, and suggest what needs to be explained. Contrary to frequentcomments, Japan is not in a depression comparable to the Great Depression of the
1930s. Japan’s GDP did not decline by 25 to 30 percent over four years, as in the
United States in 1929–33. The largest decline is 3 percent in 1998, the year in which
many of Japan’s principal customers had deep recessions.
Figure 1 compares GDP growth in the United States for 1930–39 to growth inJapan from 1989 to 1998. U.S. real GDP fell at a 10 to 15 percent annual rate formore than three years before making a strong recovery. Japan’s growth rate is positivein most years, but there is no sign to date of a strong recovery. Including recessions,
growth averaged about 1 percent from 1991 to 1998. This compares to average rates
of growth of about 10 percent from the mid-1950s to the early 1970s and 4 percent
from 1973 to 1990. Some evidence suggests that part of the reduction in growth rate
will persist.
Figure 1 Real Per Capita GDP Growth

15

Percent

10
5
0
–5
–10
–15
–20
1989
(1930)

Japan 1989–98
90
(31)

91
(32)

92
(33)

93
(34)

94
(35)

United States 1930–39
95
(36)

96
(37)

97
(38)

98
(39)

Figure 1 suggests that Japan experienced two distinct declines in the 1990s. One
ended in 1993. A mild recovery followed with rates of GDP growth below the rate ofearlier recoveries. A second, deeper recession began in 1997 and deepened in 1998
and 1999, at the time of the Asian crisis.
One challenge is to explain the two recessions. A second challenge is to explain
why the growth rate has remained comparatively low for a decade. Recession is not
the main answer to the second challenge. Even if we exclude the three years with zeroor negative growth rates of per capita GDP, average growth for 1991 to 1998 rises
only to 2.6 percent, well below previous recoveries.
Figure 2 compares long-term interest rates for the United States in the 1930s
to Japan in the 1990s. Despite the deeper depression in the United States, longterm rates reached a lower level and fell much more in Japan, in part a reflectionof the higher level they reached, in part the influence of the continuing decline

16 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Figure 2 Nominal Long-Term Interest Rates

9
8
7
6
5
4
3
2
1
0

Percent
10-year Treasury bond, Japan,
January 1989–December 1999
Long-term Treasury bond, United States,
January 1929–December 1939

1989 90(1929) (30)

91
(31)

92
(32)

93
(33)

94
(34)

95
(35)

96
(36)

97
(37)

98 99
(38) (39)in many price indexes after 1992. Long-term rates and the term spread rose in
1994, suggesting that near the start of the recovery markets anticipated thatthe recovery would continue. The movement of long-term rates and the term spreadsuggests that the public may have believed that the economy had completed its
adjustment to the bubble. The real rate of interest remained modest after the earlyyears of the decade.
Japan in the 1990s had higher growth and milder recessions than the UnitedStates in the Great Depression. It also had more deflation and lower long-term
interest rates at the end of the decade. Further comparison to the United States in the
1930s finds more differences than similarities. The rest of the data in this section are
for Japan in the 1990s.
Figure 3 compares growth of real, nonresidential investment to GDP growth since1975. The two series generally move together for the entire quarter-century. The
Figure 3 Real Nonresidential Investment Growth and Real GDP Growth, Japan,
1975/I–1998/IV

20

Percent

15
10
5
0
–5
–10
–15
Real nonresidential investment growth

–20
–25
1975

77

79

81

83

85

87

89

Real GDP growth
91

93

95

97

17

synchronous movement continued in the 1990s; qualitatively, the decade does notseem exceptional. However, the duration and amplitude of the rise in investment in
the 1990s are both smaller than in earlier cycles, and the declines are much deeper
and longer. Average investment for the decade is much lower as a consequence.
The preliminary conclusions I draw from Figure 3 are that the two recessions
in the 1990s were deeper than earlier declines and lasted longer. The recovery in
mid-decade was milder. Investment rose less rapidly and did not repeat the rates
of increase sustained in the two previous decades. Slower growth of both real, nonresidential investment and GDP suggests that the 1990s are not a unique period
unrelated to earlier experience. If this inference is correct, it focuses attention on low
investment as a main reason for slower growth.
To pursue this inference, I estimated a simple production equation using quarterly
values of four-quarter moving averages for the period 1975 to 1989. The basic
equation relates output per worker to capital per worker. The estimation uses
logarithmic first differences; growth of GDP per worker depends on investment(growth of capital) per worker. Figure 4 shows out-of-sample differences between
actual and predicted real GDP growth per worker in the 1990s. The equation isshown in the Appendix.
Figure 4 Difference between Actual and Predicted GDP Growth per Worker with
Predicted Growth Based on Per Capita Investment, Japan, 1990/I–1998/IV
Percent
4
3
2
1
0
–1
–2
–3
1990

91

92

93

94

95

96

97

98

Note: Sample period for model 1975/I–1989/IV. Growth rates measured year on year.

Figure 4 has three distinct periods. First, in 1990–91, actual and predicted GDP
growth are similar. The past relation continues out of sample. Investment rose at anannual rate of 10 percent or more and GDP growth fluctuated around 3.5 percent.
Second, from 1991 to 1997, the equation generally underestimates growth of realGDP. GDP growth per worker falls less in 1991–93 than the past relation to growthof capital per worker. The strength of the expansion in 1996 is greater than
predicted. Third, in 1997–98, the equation overestimates. GDP growth fell morethan predicted in the recession that includes the Asian crisis.

18 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Let me turn now to some possible explanations of these differences. I selected twovariables to represent monetary actions and external events or shocks. Growth of thereal value of the monetary base is the monetary variable. In my (unfinished) work on
the history of the Federal Reserve and elsewhere, I have found that growth of the realmonetary base affected real income growth even in periods with nominal interest
rates close to zero (Meltzer [1999]). To represent external events, I chose growth ofreal exports.
Movements of the two variables are highly suggestive about the differences
between actual and expected real GDP growth in the 1990s. Figure 5 shows monthly
values of annual rates of change in the real value of the monetary base. The consumer
price index converts nominal to real values. Changes in nominal base growth
dominate movements of the series. Four distinct periods are visible.
Figure 5 Year-on-Year Real Base Growth, Japan, 1985/I–1999/IV
Percent
16
14
12
10
8
6
4
2
0
–2
1985

86

87

88

89

90

91

92

93

94

95

96

97

98

First, the base accelerated under exchange rate management following the Plaza
and Louvre agreements of 1985 and 1987. The yen appreciated against the U.S.
dollar and other currencies in 1985–86 under the Plaza Agreement (and before).
The trade-weighted real exchange rate rose 37 percent in five quarters as the U.S.
dollar depreciated. The Louvre Accord in 1987 temporarily ended nominal yen
appreciation; instead of permitting the capital inflow to appreciate the yen, the Bankof Japan, acting under the political agreement, purchased U.S. dollars, raising the
growth of the monetary base. The nominal and real value of Japanese equities soared.
The real value of the Nikkei index rose at 20 to 40 percent annual rates. Investment
and GDP expanded rapidly beginning in 1987 (see Figure 3).
The agreements were partly based on a faulty economic premise and partly on a
possibly correct political premise. Politically, the U.S. current account deficit raised
the possible threat that the U.S. Congress would restrict Japanese, and perhaps other,
imports. The nominal U.S. current account deficit was US$125 billion in 1985 and19rose to US$150 billion in 1986. It has since doubled in nominal value and increased
as a percentage of GDP.
The economic rationale was faulty. The nominal exchange rate has, at most, a
temporary influence on the real value of exports and imports. Nominal depreciationof the U.S. dollar cannot permanently reduce the U.S. current account deficit orJapan’s surplus. The United States continues to have greater investment opportunities
than it can finance with its own saving, so it borrows and sells assets. Japan has arelatively high saving rate, both compared to the United States and compared to its
domestic investment opportunities, so it exports capital and has a trade surplus. Thissymbiotic relation between the United States and Japan continues.
Second, the principal effect of the Plaza and Louvre agreements was to shift
Japanese policy first to appreciation of the yen and then to inflation. The Bank ofJapan was not willing to tolerate the inflation. Monetary policy shifted direction in1991. Real base growth fell to zero from the 6 to 10 percent annual rate of increase
realized in 1988–90. Interest rates rose. The yield curve inverted; the economy went
into recession from 1991 to 1993, and the stock market boom collapsed. The Nikkei
average fell 50 percent from its peak in two years.
Third, in 1992, the period of zero or negative real base growth ended. Realbase growth began to rise gradually until it reached 8 percent in 1996. As shown in
Figure 3, the turning point in the economy was in 1993, a few months after realbase growth began to increase.
Fourth, monetary actions contributed to the start of the recession at the end of
the decade, but they are not the main cause. From 1996 to 1999, annual growth of
the real base fluctuated within two percentage points of 6 percent. There are notable
periods of sharp decline, especially in early 1999 and in 1997, when the government
increased tax rates to reduce the budget deficit. Below, I consider the role ofmonetary policy in this period.
Falling exports are the major shock affecting Japan in the late 1990s. Real exports
fell from a 15 percent annual rate of increase in the spring of 1997 to negative values
a year later. Exports fell for several quarters, an unusual event in postwar Japan. The
decline in real exports follows the collapse of several Asian economies. The export
decline worsened after the Asian recession reached the Republic of Korea, a large purchaser from and supplier to Japan. With the recovery in several Asian economies,
export growth resumed. Figure 6 shows these data.
Falling exports also contributed to the decline in real GDP in 1987. However,export growth did not fall in 1991–92; exports helped to reduce the contractive
effects of monetary policy in this period. Falling export growth may have prolonged
the recession in 1993 after the monetary base started to expand.
While changes in exports contribute to growth and decline, turning points inexport growth typically follow, rather than precede, turning points in growth ofinvestment and real GDP in these years. Real export growth responds both toautonomous or policy induced changes in foreign demand and to changes inJapanese policies affecting the real exchange rate. There are, in addition, changes inJapan’s foreign aid, grants, and loans to developing countries. Often foreign aid
finances exports.

20 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Figure 6 Year-on-Year Growth, Real Total Exports, Japan, 1985/I–1998/IV

20

Percent

15
10
5
0
–5
–10
1985

86

87

88

89

90

91

92

93

94

95

96

97

98

The 1997 recession started early in the year, following the tax increase and asustained decline in growth of the real monetary base.2 Growth of real exports turned
negative in third quarter 1997 and remained negative through most of 1998. The
annual moving average fell from above 15 percent to –6 percent in six quarters.
Figure 7 shows the relation between year-on-year changes in real exports and thereal exchange rate. Changes in the real rate are inverted (yen per foreign currency) inthis figure; a falling line is an appreciation of the yen.
Figure 7 Real Total Export Growth versus Rate of Change of Real Effective
Exchange Rate, Japan, 1976/I–1998/IV
Year-on-year change, percent
50
Real total export growth40

Change in real effective exchange rate

30
20
10
0
–10
–20
–30
–40
1976

78

80

82

84

86

88

90

92

94

96

98

Note: Exchange rate measured as a value of foreign currencies in relation to the yen,in percent.

2. From a peak of 8.74 percent in June 1996, the growth rate of the real base fell in April 1997. The quarterly
average shows a smaller drop.

21

The figure shows no uniform pattern over the period. In 1979, 1986–87, and1994, export growth fell as the yen appreciated. In 1976–77, 1991, and 1998, export
growth moved opposite to the exchange rate; appreciation accompanied risingexports and conversely.
Let me sum up these preliminary findings. I find that real GDP growth is closely
related to growth of real nonresidential investment. The data suggest that the 1990s
were not very different from earlier periods in this regard. Two principal differences
are that recessions in the 1990s were deeper and longer than in previous decades and,on average, the maintained growth rate of real GDP declined.
Two factors—one monetary, one real—appear to have had a major role in the tworecessions and possibly the slower growth of non-recession years in the 1990s. The
monetary explanation seems most important for the beginning and end of theso-called bubble period. Large changes in nominal and real base growth preceded theeconomic boom of the late 1980s and the recession in the early 1990s. A declineof more than 20 percent in real export growth was a main factor deepening andprolonging the recession at the end of the decade. Recovery in export growth in 1999
and 2000 helped to end the recession.
Of the two factors, the monetary factor has a straightforward interpretation. The
Bank of Japan, acting under Ministry of Finance direction, was too slow to raiseinterest rates and lower base growth in the late 1980s, and it tightened too much in
the early 1990s. At the end of the decade, the Bank followed a gradual policy ofmonetary expansion but did not prevent deflation. Influenced for a time by the
Ministry of Finance, the Bank moderated or prevented yen depreciation and at times
permitted appreciation.
Real export growth responds to domestic and foreign influences. The recessionthat started early in 1997 would likely have remained brief and mild if the Asian
economies had continued to grow. Recessions in the countries of principal Asiancustomers lowered real GDP growth. Policy permitted investment to fall sharply
at the same time. To move the analysis forward, we need to go beyond the binary
comparisons shown in the figures.

III. Growth of Real Investment, Real Exchange Rate, and Real
Balances
This chapter uses some of the relations in the previous chapter to study how the growthof real investment and the real exchange rate respond to policy actions and othervariables. Since investment and income change together, it is convenient to work withgrowth of real, nonresidential investment as a measure of economic fluctuations. Unlessotherwise noted, all variables are quarterly observations measured as relative rates ofchange from the previous year and expressed as annual rates of change.
Table 1 shows two estimates of an equation relating growth of real investment to
the growth in real long-term interest rate on government bonds, real GDP, and the real
trade-weighted exchange rate. The first set of estimates uses overlapping four-quarter
moving averages. The second uses only the four-quarter moving average for the fourth

22 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Table 1 Real Nonresidential Investment in Japan, 1975–98

Constant
Real long rate
Real GDP
Real GDPt –1
Real exchange rate
Real exchange rate t –1
AR (1)
R2 /DW

Quarterly

Fourth quarter

–1.13

–3.84

–0.42

–1.26

–0.54

–1.43

–1.64

–2.24

1.61

3.45

6.51

6.14

0.66

1.20

2.78

2.17

–0.02

–0.06

–0.73

–0.82

0.02

0.00

0.81

0.03

0.90

0.48

18.01

2.67

0.90/1.44

0.88/1.88

Note: All variables are annual growth rates of real values. t -statistics are below the coefficients.

quarter. Since the variables are all measured as year-to-year annual rates of change,
there is considerable serial correlation in the error terms in the full set of estimates.
The coefficient on the AR(1) correction suggests the extent of serial correlation. The
estimates for the fourth quarter give less weight to the AR(1) correction.
The fourth-quarter estimates suggest that growth of investment is elastic withrespect to the rate of change of long-term interest rates. Both sets of estimatessuggest strong response to GDP growth, as suggested by Figure 3. The dramaticchanges in the real exchange rate have neither a large nor a reliable effect, given
growth of interest rates and GDP. The findings for investment growth are consistent
with a neoclassical framework and the standard transmission process.
Changes in the monetary base are linked to the economy through a number ofchannels. An increase in the base lowers the short-term interest rate, depreciates theexchange rate, and changes expectation about future prices and spending. The sizeof the responses depends critically on the anticipations held in the market before thechange occurs and, therefore, on the central bank’s transparency and credibility. In
principle, the central bank’s actions may be fully anticipated; in practice, there is
uncertainty at least about timing. In Japan, investors must take account also of the
Ministry of Finance’s control of the exchange rate. The Ministry and the Bank
may have different objectives, so that policy shifts between inflation and exchange
rate targets.
The Bank of Japan was not fully independent during the 1990s. If the Bank’s
decisions to change interest rates and growth of the monetary base resulted in morechange in the exchange rate than the Ministry would accept, the Ministry told the
Bank to control the exchange rate. Revision of the Bank of Japan Law to increase theBank’s independence left the Ministry responsible for exchange rate policy.
For current purposes, the importance of this arrangement is its effect on the23market’s belief about the Bank’s actions. The Bank may have been committed to
end deflation, but it could be effective only if its actions were consistent with
the Ministry’s exchange rate target or target zone. When the two objectives wereinconsistent, the Bank had to yield to the Ministry.
Table 2 presents evidence that the rise or fall of the real exchange rate depends onthe difference between growth of Japan’s monetary base and the U.S. monetary base.
Both bases are in real terms, deflated by respective consumer price indexes. Ideally,
growth of the trade-weighted monetary base should replace the U.S. monetary base.
Many of Japan’s principal trading partners had exchange rates pegged to the U.S.
dollar during much of the period considered, however.
Table 2 Percent Changes in the Real Exchange Rate in Japan, 1979–98
All observations

Fourth quarter only

(1)

(2)

(3)

Constant

3.85 (0.98)

2.46 (0.82)

4.13 (1.08)

Diff. in base growth (t )1.25 (2.95)

1.04 (1.97)

1.93 (2.55)

Diff. in base growth (t –1)

1.19 (2.78)

0.71 (0.98)

0.24 (0.33)

Diff. in real GDP growth (t )0.13 (0.25)–0.04 (0.06)–0.58 (0.58)

Diff. in real GDP growth (t –1)

0.20 (0.41)

0.68 (1.12)–0.37 (0.37)

Diff. in change in real interest rate

–0.34 (0.53)

0.49 (0.98)

0.81 (1.11)

AR (1)

0.82 (10.21)

0.68 (8.18)

0.26 (0.88)

R2 /DW

0.78/ 1.69

0.63/ 1.87

0.47/ 1.85

Notes: 1. All variables are quarterly values of year-to-year percentage changes. Differences are taken
relative to the United States. t -statistics are in parentheses.
2. With respect to diff. in change in real interest rate, column (1) uses short-term rates; columns(2) and (3) use long-term rates. Columns (1) and (2) use overlapping four-quarter moving
averages. Column (3) uses fourth-quarter annual moving averages only.

The results in Table 2 suggest that increases and decreases in the growth of Japan’s
monetary base, relative to growth of the U.S. monetary base, have relatively large,
persistent effects on the rate of change of the exchange rate. Holding differences ininterest rates and output constant, the rate of depreciation increases when theJapanese real base accelerates relative to the U.S. real base.
The table reports responses to differences in rates of change of short-term interest
rates in column (1) and long-term rates in columns (2) and (3). Responses to acceleration of the domestic interest rates relative to U.S. rates are not significant. This
result may be due to neglect of simultaneity, or use of U.S. interest rates to proxyfor world rates, or failure to distinguish anticipated and unanticipated changes.
The data suggest that the relative growth rate of the base adequately summarizes theinformation in monetary action and that acceleration or deceleration of the base isunanticipated to a considerable extent at least as to timing.
Table 2 also relates rates of change of the trade-weighted real exchange rate todifferences in rates of GDP growth between Japan and the United States. Properly,
multi-country averages should replace U.S. rates of change on the right side of theestimation. An index of real growth for Japan’s trading partners might strengthen theeffect of differences in real growth rates.

24 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

A major issue in Japan at the end of the 1990s concerns the effect of monetary
policy when the short-term interest rate is close to zero. A broader issue, raised in thetheme of the conference, is how monetary policy works in a period of low inflation
or deflation. The evidence in Table 2 suggests that monetary actions affect theexchange rate. Table 3 considers whether changes in the exchange rate affect thedemand for money and, by inference, other variables.3
Table 3 Growth of Demand for Base Money in Japan, 1979–98
All observations

Fourth quarter only

Constant

5.27 (3.04)

5.58 (3.12)

7.53 (3.84)

Short rate

–0.32 (1.32)–0.28 (1.24)–0.84 (2.12)

Real GDP

0.37 (2.22)

0.35 (2.29)

0.65 (1.78)–0.10 (4.25)–0.09 (1.36)

Nominal exchange rate
AR (1)

0.87 (14.91)

0.89 (16.54)

0.51 (2.01)

R2 /DW

0.82/ 1.46

0.86/ 1.79

0.58/ 1.64

Note: All variables are quarterly values of annual rates of change. t -statistics are in parentheses.

As shown in the table, I estimated the equation with and without the rate ofchange of the nominal exchange rate. Not shown are similar estimates with changes
in long-term rates in place of changes in short-term rates. The interest rate variable
reaches the customary 5 percent significance level using annual rate of change for the
fourth quarter only. Growth of the nominal exchange rate has a coefficient of about–0.1. On average, increased exchange rate appreciation increases growth of thedemand for money, and conversely. Taken together, tables 2 and 3 suggest thatthe exchange is relatively elastic in response to the base, but the demand for baseis relatively inelastic with respect to the exchange rate. This is consistent with therelatively large observed changes in the exchange rate.
The data suggest that a 10 percent greater depreciation of the nominal tradeweighted yen reduces growth in demand for real base by about 1 percent on average.
Annual changes in the exchange rate of 10 to 20 percent in both directions are notunusual. Large-scale appreciation of the yen in 1985–86 increased growth of thedemand for real base money; large-scale depreciation in 1978, 1989–90, and 1996
reduced growth of demand for real yen balances. The Sakakibara policy of appreciating the yen in 1998, after it had fallen, increased the demand for money.
The findings in this chapter contribute to an understanding of the transmission ofmonetary policy in Japan. The exchange rate appears to be an important variable in
the transmission of monetary and other changes. The results suggest monetary action
is not adequately summarized by changes in a short-term interest rate. Investment
depends on the long-term rate. Real base growth affects growth of the real exchange
rate, given real interest rates, and changes in the nominal exchange rate affect growthof the demand for base money.

3. The short-term rate is available in the data source only from the fourth quarter of 1979.

25

IV. Other Parts of the Story
Preceding pages suggest some possible ways in which cyclical and other changes
in Japan during the low inflation or deflation of the 1990s affected growth ofinvestment, output, and the demand for money. This chapter briefly considers
two questions. Is there a basis to conclude that the maintained rate of real GDP
growth slowed in the 1990s? What role did fiscal actions and variables such as stock
prices, housing prices, and bank lending take? I have not attempted a full analysisof these variables but have limited my comments to suggestions for further analysis.
Japan is the second-largest economy in the world. It competes with the largest
economy (and others) in third countries and in home markets. Figure 8 shows oneof the principal factors affecting that competition. In the 1990s, the index of unit
labor costs fell in the United States relative to Japan. The slope of the change appears
modest after 1993, but the only evidence of possible reversal is in 1999, and that
evidence is tenuous.
Figure 8 Ratio of Indices of Unit Labor Costs, United States versus Japan,
1985/I–1999/IV

120

1985 = 100

100
80
60
40
20
0
1985 86

87

88

89

90

91

92

93

94

95

96

97

98

99

The data show that, on a 1985 base, relative cost changes moved in favor of Japanby 9 percent in the 1980s and early 1990s. The relative cost advantage disappeared in
1992. By mid-1993, the United States had increased its (relative) cost advantage by 5
to 6 percent and in 1998 by more than 10 percent. The nominal exchange rate did
not depreciate to offset the change in costs. This evidence suggests that the terms oftrade became less favorable to Japan.
A likely reason is that, after a long period of slow growth and adjustment, theU.S. economy changed in the 1990s. New technologies, response to deregulationthat began in the 1970s, and the shift of the labor force from old to new and lessregulated industries raised U.S. productivity growth. Japan has been slower to makethat transition. Rising productivity and slow growth of real and nominal wages in the
United States shifted the competitive advantage toward the United States.

26 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Reduction in real wage growth slows growth of unit labor costs. Figure 9 shows thathourly real wage growth in Japan remained below 3 percent after 1992. If bonuses areincluded, the decline is greater, and the change in real compensation turns negative in
1998–99. Falling nominal and real wages appear to be a deflationary response to slower
relative productivity growth and deflationary monetary policy.
Figure 9 Real Wage Growth, Japan, 1985/I–1998/IV

7

Percent

6
5
4
3
2
1
0
–1
1985

86

87

88

89

90

91

92

93

94

95

96

97

98

Many discussions of the Japanese economy in the 1990s focus on the fall in banklending. The argument is that the unwillingness of banks to lend retarded growth of
spending and GDP.
This argument is incomplete. Japan is an open economy with a fluctuatingexchange rate. Capital flows vary over a wide range. Large Japanese corporations canborrow abroad, and they do. Borrowing abroad declined in the 1990s suggesting thatthe decline in lending reflected reduced demand to borrow. Consumption lending bybanks has been relatively small, or nonexistent, during most of the postwar era.
Further, Japanese households have maintained a high saving rate throughout the
decade. Lending gives less support to consumption spending in Japan than in the
United States. Studies of investment by small firms show, at most, a small effect oflending on investment expenditure, as noted in the introduction (Motonishi and
Yoshikawa [1999]).
Reported loan losses by Japanese banks reached 5 percent of GDP. A large partof the financial system is insolvent. Some suggest that delay in closing or merging
insolvent banks slowed lending and delayed recovery. This is an unusual argument.
The more common argument is that insolvent banks lend actively and make riskyloans, responding to the moral hazard inherent in de facto or de jure deposit insurance
protection and negative net worth.
For these reasons, I am skeptical that reluctance to lend was a powerful factor inJapan’s slow growth and recession. The basic data give little support. Figure 10 showsthat growth of lending can either lead or lag growth of real GDP. In 1997–99, lending growth lagged behind GDP growth. This suggests that, with a lag, borrowers

27

Figure 10 Growth in Real Loans and Discounts versus Real GDP Growth, Japan,
1975/I–1998/IV
Growth rates measured year on year, percent
20
Growth in real loans and discounts

Real GDP growth

15

10

5

0

–5
1975

77

79

81

83

85

87

89

91

93

95

97

became less willing to borrow when income declined. The figure also suggests that
there is not much relation between growth of lending and output after the middle ofthe decade. Lending growth remained close to zero during the economic recovery in
1995–97. The binary comparison cannot rule out a marginal affect of lending on
output, but it shows no evidence of this channel.
To test the lending effect, I added growth of the real value of loans and discounts
to the investment equation shown in Table 1. The coefficient on loans is negativeand not significant. The Appendix shows the estimate. This finding could change ina more complete analysis that separates the presumed positive effect of lending
growth on investment growth from the effect of expected income or GDP growth onlending growth.
Some economists claim Japan is in a liquidity trap. With the short-term interest
rate close to zero, they claim, monetary action is powerless to change the price levelor economic activity. This claim implies that central bank purchases of long-term
debt, equities, foreign exchange, or other assets would have no effect on nominal
GDP, investment, or other variables of interest.
In a static model of a closed economy with only three types of assets—money,
bonds, and capital—the model solves for one relative price, typically the interest rateon bonds or bills. If this price cannot be reduced—for example, below zero—increases in money do not affect the economy by changing interest rates. The realbalance effect on spending is small, so real balance or wealth effects on spending
introduce only a minor qualification.
I have argued that the liquidity trap proposition depends on the assumption that
all asset prices have fully adjusted to the zero rate of interest.4 No one in the economy
4. Notably in Brunner and Meltzer (1968) and Meltzer (1999).

28 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

is willing to change their mix of current and future consumption or current andfuture production in response to an increase in money achieved by purchasing someasset or assets. The central bank cannot raise any asset price by buying more of that
asset in exchange for money.
Evidence from deflations in 1937–38 or 1948 in the United States does notsupport the liquidity trap. Instead, the data suggest that, with deflationary monetary
policy and the short-term rate close to zero, the price level continued to fall. The
fall was similar to the fall in 1920–21 under deflationary monetary policy witha non-zero interest rate (Meltzer [1999]). Falling prices increase the value of realbalances, producing a small direct effect on spending. A much larger effect comesthrough changes in the relative prices of assets and output, in long-term real interest
rates, and the exchange rate. All that is required for these effects to operate is that
all asset markets are not fully adjusted to the zero interest rate. Evidence frommany studies supports the claim that the term structure, uncovered interest parity, orbond and equity markets do not satisfy the condition that information is always andeverywhere fully exploited.5
During the recession at the end of the decade, the Japanese government engaged
in expansive fiscal policy. Fiscal policy shifted from the goal of closing the budget
deficit, or providing a surplus, to a policy of promoting recovery by public investment and consumption spending. The spending policy leaves Japan with a relatively
large stock of outstanding debt and a large unfunded liability for future pensions andhealth care. The longer-term effect of the policy on growth and capital formation has
been the subject of considerable discussion.
A puzzling feature of the heavy reliance on continued fiscal expansion is therelatively small response of GDP. The reported government deficit has moved fromclose to balance in 1990 to more than 10 percent of nominal GDP in 1999. The
decline is steady, except for the small reversal following the 1997 tax increase.
Data from the family income and expenditure survey show that the average
propensity to consume fell as the deficit to GDP ratio rose. I can offer two, noncompeting explanations. One is Ricardian equivalence. The public does notdistinguish between personal and public debt; as the public debt rises, saving rises.
This process may have been at work, but I suggest another.
A growing segment of the population is approaching retirement. This postwar
generation saved at a comparatively high rate for its retirement and invested in
housing and equities. The 40 to 50 percent decline in equity prices from the stock
market peak, and the similar decline in prices of housing and other assets, lowered
the wealth of this generation. The public has been told repeatedly about theimportance of budget surpluses to provide for the pensions and health care thatthe government promised. Instead, the government ran very large deficits.
As public debt mounted, the risk increased that the government would have torenege partially on its pension and health care promises. The public responded byincreasing saving relative to GDP, offsetting part of the effect of fiscal stimulus.
5. McCallum (2000) develops this argument rigorously for the exchange rate on the assumption that uncovered
interest parity does not hold at every point.

29

Believing their pensions were threatened, households tried to restore personal wealth.
The more they responded this way, the smaller the effect of fiscal expansion on GDP.
The government’s response was to further increase the fiscal deficit absolutely and asa percentage of GDP.
Further, much of the fiscal stimulus took the form of public works with low
contribution to productivity and high maintenance cost. A rational person could not
believe that today’s government spending would yield higher future incomes thatwould pay the unfunded liabilities for pensions and health care or service the debt.
Perhaps tax cuts that helped the public to restore its desired wealth position would
have helped the public to achieve its goal and, thus, slow the increase in the savingrate. Deregulation that increased efficiency and productivity would have had apositive effect also. If correct, the conjectures would relate fiscal actions and asset
prices to saving and consumption in this period.

V. Conclusion: The Transmission Process at Low Inflation
During most of the 1990s, the measured rate of change in the GDP deflator
remained below a 2 percent annual rate. For much of the period after 1994, thedeflator fell modestly on average. By 1998, all short-term interest rates were
0.5 percent or lower. Although there were additional reductions to zero, the central
bank’s ability to reduce short-term rates meaningfully ended.
If the transmission of monetary impulses depends on first changing short-term
interest rates, monetary expansion would have no effect in the circumstances of Japanin the late 1990s. Although it is often useful to think of monetary actions as working
through a single interest rate, this is a property of the models we use, not an empirically verified proposition about Japan or any other economy at a zero or near zerointerest rate and perhaps elsewhere. The available evidence suggests that relations
such as the pure expectations theory of the term structure, uncovered interest parity,
the effect of interest rates on stock prices, and of changes in reproduction costs equal
to changes in asset prices do not hold always and everywhere. Prices determined in
active markets adjust most rapidly, other prices more slowly. All price and asset
adjustments are part of the transmission process by which monetary (and other)
impulses respond to current and anticipated future actions of the monetary authority.
Based on my preliminary examination of evidence from Japan in the 1990s, twotypes of change occurred. The maintained growth rate slowed. Japan’s cost of production rose relative to U.S. production costs. To restore the 1980s growth rate required
either increased productivity growth, real currency depreciation, or deflation. Japan’s
policy makers, by choice or accident, chose deflation over currency depreciation.
Growth of the real and nominal monetary base remained positive after 1993, butmonetary growth was not high enough to avoid deflation as a means of adjusting
asset prices and the real exchange rate.
In a deflationary environment, households and businesses increase real cash
balances to earn the return from deflation. Japan in 1996–97 illustrates thatoutcome. Real balances rose absolutely and relative to income and output. The real,

30 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

trade-weighted exchange rate depreciated, and real GDP recovered at rates of 4 to
6 percent year on year. The expansion ended in a mistaken fiscal action followed bycollapse of export growth as several Asian economies went into deep recession andthe world economy slowed. Monetary growth was a supporting force on average but
was insufficient to prevent real and nominal exchange rate appreciation in 1998, todepreciate the exchange rate in 1999, or to satisfy the increased demand for basemoney as the risk of financial failures rose.
I suggest that exchange rate policy is the main reason that monetary policy has
been deflationary. The Bank does not control exchange rate policy; the Ministry of
Finance has that responsibility. The data show that if the Bank increases money
growth relative to U.S. money growth, exchange rate depreciation increases. During
most of the 1990s, the Ministry of Finance did not permit sustained depreciation of
the nominal yen/U.S. dollar exchange rate. Growth of the monetary base had tosatisfy the exchange rate constraint. The public understood the constraint onmonetary expansion. The Bank’s fault was to ignore, at least publicly, the constraint
on its actions and, later in the decade, to oppose purchases of foreign exchange.
Monetary policy cannot generally achieve two goals, an exchange rate band andprice stability. The exchange rate goal imposed deflation on Japan. Prices had to fallenough to reduce real wages, the real exchange rate, and other real variables. Withmonetary expansion limited by exchange rate policy, deflation enabled the public tosatisfy its increased demand for money, the latter induced in part by financial fragility
and banking failures, in part by the return from deflation.
I draw four policy implications. First, the government and Bank should decide
on a single goal for monetary policy, either control the exchange rate or the rate of
inflation. Monetary policy can achieve either goal at low social cost, but it cannot
generally reach both goals. Either goal is preferable to the current policy of shifting
without warning from one to the other.
Second, increased money growth after the middle of the decade would have raised
the actual and expected price level. Asset prices would have increased instead of
falling. Rising real estate and stock prices would have increased the asset values
underlying bank loans, thereby reducing losses to banks, improving banks’ balance
sheets, and reducing the demand for real money balances. Stable or rising real estate
prices would have stopped the decline in households’ wealth and changed the
expectation that housing and other assets would be cheaper in the future, thereby
increasing demand for these assets.
Third, an adaptive rule for growth of the monetary base would have responded
sooner to deflation, to the slower average rate of real growth and to the increased
demand for money per unit of income. Even if not rigidly followed, the rule, or
policy guide, would have led the Bank to respond sooner and more effectively tothe deflation and recession that followed the decline in exports in 1997–98.
Fourth, an adaptive policy rule for price stability meets the objective expressedin the Bank of Japan Law. At a zero short-term interest rate, the Bank should buy
foreign exchange to expand monetary growth until deflation ends. The Ministry of
Finance should accept the currency depreciation or appreciation needed to meet theBank’s objective of zero or low inflation.

31

The alternative policy is to control the exchange rate. The main difficulty that thispolicy faces is the choice of an appropriate exchange rate anchor. Japan has a chronic
excess of saving over investment. If the exchange rate is not free to respond tochanges in the excess supply of saving, the price level must rise or fall to adjust
the real exchange rate. Influenced partly by pressure from abroad, the Ministry
has insisted on a nominal exchange rate in recent years that requires deflation. The
social cost has taken the form of slow or negative growth, wasteful or unproductive
government expenditure, financial sector weakness, and rising unemployment.
Although the findings that I report require more careful empirical work than I
have attempted, the preliminary results are familiar. The exchange rate responds todifferences in rates of money growth. Investment responds to the long-term interest
rate, and the demand for money responds to both interest rates and exchange rates.
The policy transmission process works through short- and long-term interest rates,
exchange rates, and other relative prices. Expectations of future prices of assets
and output are part of the transmission process also. The estimates suggest that theinterest elasticity of the demand for money is relatively large in Japan. The elasticity
may have increased at low interest rates. Qualitatively, and perhaps quantitatively,
other elements of the transmission process continued to function as before.
Figure 11 shows predicted and actual growth rates of investment. The predictions
are the values generated by the regression estimates shown in Table 1. All the predictedvalues are within sample. The data suggest that the errors did not increase in recent
years. The same is true of the equations for the rate of change of the real exchange ratein Table 2 and the rate of change of the demand for money in Table 3.6
I close by noting two puzzling outcomes. First, the difference in interest rates
between the United States and Japan has persisted for several years. Deflation in
Japan and modest inflation in the United States makes the real difference smaller
than the more widely reported nominal difference. Is the expectation of continued
appreciation the answer? The difference remains to be explained. Second, the standard
prescription is to rely on expansive fiscal policy when the nominal short-term interest
rate is close to zero. Fiscal policy has been highly expansive for more than two years,
but the effect has been modest. I suggested an explanation for Japan based on low
productivity of public investment, demographic changes, and wealth losses. Carefulresearch on this problem would increase understanding of the operation of fiscal
policy as a supplement to monetary policy when market interest rates are low.

6. Copies of the last two figures are available on request.

32 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001

Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s

Figure 11 Actual Investment versus Table 1 Model
Percent
20
15
10
5
0
–5
–10
–15
Actual investment

Model

–20
–25
1977

79

81

83

85

87

89

91

93

95

97

APPENDIX
Estimation of Growth of Output per Worker, 1975–89, Quarterly
Constant
Investment per worker
R2/DW

0.0006 (0.14)
0.27 (4.92)
0.28/ 3.22

Estimation of the Effect of Lending Growth on Investment Growth, 1976/II–1998/IV
Constant
Real long rate
Real GDP
Real GDPt –1
Real exchange rate
Real exchange ratet –1
Real lending
AR(1)
R2/DW

–1.04 (–0.38)–0.48 (–1.42)
1.64 (6.43)
0.66 (2.75)–0.02 (–0.84)
0.02 (0.78)–0.07 (–0.53)
0.90 17.87
0.91/ 1.45

33

References

Brunner, K., and Meltzer, A. H., “Liquidity Traps for Money, Bank Credit and Interest Rates,” Journalof Political Economy, 76, January 1968, pp. 1–37.
Krugman, P., “Deflationary Spirals,” the official Paul Krugman web page, 1999.
McCallum, B. T., “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates,”
NBER Working Paper No. 7677, National Bureau of Economic Research, April 2000.
McKinnon, R. I., “Comments on ‘Monetary Policy under Zero Inflation,’” Monetary and Economic
Studies, 17 (3), Institute for Monetary and Economic Studies, Bank of Japan, December 1999.
Meltzer, A. H., “Monetary, Credit (and Other) Transmission Processes: A Monetarist Perspective,”
Journal of Economic Perspectives, 9, Fall 1995, pp. 49–72.
———, “The Transmission Process,” paper presented at the Bundesbank Conference on the Monetary
Transmission Process: Recent Developments and Lessons for Europe, March 1999.
Motonishi, T., and H. Yoshikawa, “Causes of the Long Stagnation of Japan during the 1990s: Financial
or Real,” NBER Working Paper No. 735, National Bureau of Economic Research, September
1999.
Nakayama, S., “Why Is the Household Saving Rate So High during the 1990s?” cited in T. Motonishi
and H. Yoshikawa, “Causes of the Long Stagnation of Japan during the 1990s: Financial orReal,” NBER Working Paper No. 735, National Bureau of Economic Research, September
1999.
Okina, K., M. Shirakawa, and S. Shiratsuka, “The Asset Price Bubble and Monetary Policy: Japan’s
Experience in the Late 1980s and the Lessons,” Monetary and Economic Studies, 19 (S-1),
Institute for Monetary and Economic Studies, Bank of Japan, 2001, pp. 395–450 (this issue).

34 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/FEBRUARY 2001