IMES DISCUSSION PAPER SERIESTechnological Innovation and Banking Industry/Monetary Policy:
Forum on the Development of Electronic Payment Technologies
and Its Implications for Monetary Policy
ReportDiscussion Paper No. 2001-E-3

INSTITUTE FOR MONETARY AND ECONOMIC STUDIESBANK OF JAPAN
C.P.O BOX 203 TOKYO
100-8630 JAPANNOTE:IMES Discussion Paper Series is circulated inorder to stimulate discussion and comments. Views
expressed in Discussion Paper Series are those of
authors and do not necessarily reflect those of the
Bank of Japan or the Institute for Monetary andEconomic Studies.

“Technological Innovation and Banking Industry/Monetary Policy:
Forum on the Development of Electronic Payment Technologies and Its
Implications for Monetary Policy ”
ReportExecutive Summary
1. Preface
The Bank of Japan established the “Forum on the Development of Electronic Payment
Technologies and Its Implications for Monetary Policy” in December 1997 to examine
the influence of the development of electronic payment technologies including“electronic money” on monetary policy.

The Forum released the Interim Report in

May 1999. Subsequent to the release of the Interim Report, the Forum expanded thescope of its examinations to the Information Technology (IT) Revolution in general,
including electronic payment technologies, and the Forum’s name was changed to“Technological Innovation and Banking Industry/Monetary Policy:

Forum on theDevelopment of Electronic Payment Technologies and Its Implications for Monetary
Policy.”The Forum held active discussions regarding the changes to the financial andeconomic structures prompted by the IT Revolution and its effect on monetary policy,
based on papers prepared by experts from academia and by the Forum’s Secretariat(refer to Attachment 1 for a list of the Forum’s members, and to Attachment 2 for an
outline of the reports presented in each meeting).

This Report summarizes the main

points that were clarified during the Forum’s subsequent discussions, based on theInterim Report.
2. Essence of the IT Revolution
The distinctive characteristics of the present IT Revolution, as exemplified by the rapid
development of computer technologies and the Internet, may be summarized as follows:
Q the integration of information processing and telecommunications technologies; R
the consequent acceleration of the speed of information processing and transmission,
reduction of information processing costs, and increase of the geographical distanceover which information can be transmitted (globalization); and S the astounding speed

This is the English-language version of the Japanese Report, which was originally published inJapanese on Nov. 9, 2000.
i

at which information technologies are spreading among the public.
The IT Revolution has increased the efficiency of the information processing
used in goods and services production processes.

As a result, it has facilitated pricereductions for existing goods and services as well as the production of new goods andservices that was practically impossible in the past.

Moreover, the reduction in

information transmission costs utilizing networks has greatly decreased the costs of
information collection (search costs), and increased the potential for enterprises to findnew trading partners that offer more advantageous terms of trade.
On the other hand, the increase in the volume of information brought about by
the reduction in information transmission costs is not expected to eliminate theasymmetry of information (the imbalance of information between the buyers and sellersof goods and services). It is not yet clear whether the increase in the volume of
information will make an additional social burden, but if this is the case, frameworks tolessen the burden (such as credible information intermediaries) will become necessary.
The merits of the IT Revolution, such as improved production efficiency andreduced search costs, have the potential to radically change the conventionalsocioeconomic structure.

To begin with, the increase in capacity for information

processing and transmission and the reduction of their costs will render existing
technologies outdated, and make it easy for enterprises to rapidly enhance theircompetitiveness with the introduction of the latest technologies.

Furthermore, thereduction of search costs utilizing networks is expected to greatly influence the ways
businesses are implemented (changes in trading partners and in enterprise management
methods).
3.

Development of Electronic Commerce, Changes in Trading Patterns and Price

Setting Mechanisms, and Influence on Monetary Policy
The integration of computers and telecommunications networks has facilitatedelectronic commerce over the Internet, and E-commerce is rapidly expanding. First ofall, in terms of business transactions, the development of E-commerce has facilitateddirect transactions between producers and consumers.

Some assert that thisphenomenon will result in the elimination of the distribution sector, and of intercorporate keiretsu/subcontractor transactions.

In terms of price setting, others havenoted that the simplification of distribution sector promotes price reductions, facilitates
frequent price revisions, and may lead toward the emergence of a so-called “perfectmarket” without any “market friction” whatsoever.
Examining these points, E-commerce is indeed changing transaction patterns.
ii

It increases direct transactions between producers and consumers, and for certain
intermediate goods, trading is now transcending the conventional business-to-business
transaction framework, such as inter-corporate keiretsu/subcontractor transactions, andtaking place on a global scale.

Nevertheless, E-commerce can not resolve the so-called “agency problem” for direct transactions just as under conventional transactions,so the role of the intermediation business will likely remain important. The emergenceof a vast number of intermediation sites on the Internet suggests that the intermediation
business will continue to play an important role, even with the spread of E-commerce.
Among business-to-business transactions, the merits of Internet transactions related tothe production of finished goods that require a large number of customized parts andclose communication between parts suppliers and assembly manufacturers are relatively
small.

However, there is a strong likelihood that the trading of general-purpose

intermediate goods with a wide range of applications to many finished goods will takeplace on a global scale and transcend the framework of inter-corporate keiretsu
transactions.
Turning to price setting, price levels on the E-commerce markets are lower thanthose on conventional markets, and price revisions are being conducted more frequently,
in small steps.

However, in the E-commerce markets, the Law of One Price does nothold because of the so-called “lemon problem” (the problem whereby buyers have risks
to purchase inferior-quality products [“lemons”] due to the imbalance in productinformation between buyers and sellers), the switching costs incurred when changing
the sites where buyers purchase goods, suppliers’ price discrimination in favor ofcertain customers, etc.
As for the influence of the spread of E-commerce on monetary policy,
particularly from the perspective of changes in price setting, first it is generally believedthat the central bank should accept the reduction in price levels from the spread of Ecommerce as this is interpreted as a downward shift of the aggregate supply curve.
Second, because increased price discrimination makes it difficult to compile accurate
price indices using conventional methodologies, the issue of how to maintain andimprove the quality and reliability of price indices will become increasingly important.
Third, the increasing price flexibility resulting from the reduction in menu costs may
reduce the effect of monetary policy on the real economy.

However, there is anotherview that this is no great cause for concern because the strengthening of the market
mechanism through flexible price adjustments will reduce the necessity of monetary
policy itself.

iii

4. Influence of the IT Revolution on the Financial Industry
Even with the IT Revolution, the essential functions of the financial industry – such as
the provision of payment and settlement services, the intermediation of risk (or risktaking), information production, and the provision of liquidity – will remain unchanged.
However, major changes are expected in the specific contents of financial products andservices, and in the financial institutions that provide these products and services.
The IT Revolution has facilitated the provision of derivative products, thedevelopment of securitization, and the emergence of electronic payment and settlementmeans.

Thus, technological innovations have raised the quality of financial products

and services, and dramatically improved the risk-management capabilities of asset
managers.

Moreover, the development such as the Internet has also enabled theprovision of financial services via new delivery channels.
These changes in financial transactions increase the variety of financial products
traded in financial markets, especially through securitization.

In addition, the huge

reductions in information processing and transmission costs have made arbitrage tradingon financial markets much more active, and promoted the development of such trading.
Amid this expansion of financial markets, financial intermediaries are substantiallychanging the contents of their services. One direction is to handle financial productsthat are difficult to standardize and seldom traded on financial markets. For example,
financial intermediaries are moving to improve the efficiency of financial transactions
for lending to small and medium enterprises, which entail high agency costs, byadopting the new method of credit scoring.

Another trend is to transform advanced,

complex financial products into simple ones that are easily understood by consumers
and businesses, and then offer these products as new services.

For example, theprovision of new financial products incorporating derivatives and the expansion of offbalance sheet transactions seem to reflect such development.
Considering these developments, how will financial intermediaries change in the
future under the influence of the IT Revolution?

The financial industry is now

witnessing a wave of mergers and alliances (concentration) based upon the greater
economies of scale prompted by the IT Revolution.

On the other hand, the IT

Revolution is leading to a deterioration of the comparative advantages of banks in
information production, the unbundling of existing financial services, and thedevelopment of the Internet.

These are facilitating the advent of financial institutions

specializing in particular services as well as entry into the financial intermediation
market by firms in different industries (diversification).

The future direction of thisconcentration and diversification in the financial industry is not yet entirely clear, butiv

considering the reduced comparative advantages of banks in information production, thefuture providers of financial intermediation services may not be limited to firms in thepresent financial industry. There is a high probability that firms in other industries will
utilize the fruits of the IT Revolution to provide financial intermediation services.
Additionally, considering that the strong economies of scale from the IT Revolution
may be limited to certain financial services, the present simultaneous trends toward
concentration and diversification may well continue.
Regarding the effect of these financial changes on the monetary policy
transmission mechanism, first the development of domestic financial markets is
expected to increase the speed at which policy interest rates affect short-term and longterm interest rates via more active arbitrage trading.

Meanwhile, in terms ofavailability channels, the effectiveness of monetary policy will probably decline if thegreater variety of fund-raising methods other than bank loans are available and credit
rationing decreases from the development of derivatives. Next, as for the influence ofthe changes in financial intermediaries, the increased competitive pressures from theentry of firms in other industries to the financial intermediation industry may reinforce
the response of lending rates to policy interest rates and thus increase the importance ofinterest rate channels. Conversely, there is a view that if the IT Revolution improvesfinancial institutions’ abilities to monitor their borrowers, the transmission effectthrough changes in corporate collateral value (balance sheet channels) may be reduced.
5. The IT Revolution and Globalization
Since the Internet lessens geographical and spatial restrictions, it will probably makenational borders less important and accelerate the globalization of trade and financialtransactions. Cross-border E-commerce transactions are not yet very popular for the
trade in goods and services, but the reduction in search costs, the dramatic decrease in
the transportation costs for digital goods, the changes in transaction patterns, andenhanced product differentiation are expected to increase cross-border E-commercetransactions and accelerate the tempo of trade growth.

In terms of international

financial transactions, the decrease in information transmission costs has made foreign
financial trading much easier than in the past, increasing the substitutability of domestic
and foreign financial assets. Therefore, the Internet will probably bring about moreinternational portfolio diversification as well as further convergence of domestic andforeign real long-term interest rates.

Additionally, the increase in trade resulting fromthe development of E-commerce may promote currency substitution through the wider
use of the U.S. dollar for the settlement of domestic business-to-business transactions.
v

As for the influence of further globalization on monetary policy, to begin with,the rising dependence on foreign trade is expected to strengthen the transmission effectvia foreign exchange rates.

This implies that interest rate channels, which are closely

related with foreign exchange rates, will become more important.

Moreover, thehigher substitutability of domestic and foreign financial assets may increase theinfluence of interest rates on foreign exchange rates. Nevertheless, it should be notedthat it may become more difficult for policy interest rates and short-term interest rates toinfluence long-term interest rates because of the worldwide convergence of long-term
real interest rates when exchange rate expectations are unchanged.
6. The IT Revolution and Monetary Policy
Central banks conduct their monetary policy under an uncertain environment where
various changes such as exogenous shocks occur continuously and where it is difficult
to grasp the influence of these changes accurately in real time.

The IT Revolution is

expected to change financial and economic frameworks (structures), resulting in
additional uncertainties.

For example, with the IT Revolution, it is becoming

increasingly difficult to grasp potential growth rates and price trends accurately in realtime. Accordingly, central banks must exert every possible effort to grasp the changes
accompanying the IT Revolution promptly and accurately, and to minimize theuncertainty faced in making policy decisions. For these purposes, central banks willneed to raise the level of their capabilities to analyze monetary and economic conditions
and to improve the quality of their economic statistics.
As for the influence of the IT Revolution on the effects of monetary policy andthe monetary policy transmission mechanism, there is a strong likelihood that thedevelopment of electronic payment technologies and the emergence of new financial
products will structurally and unstably decrease the demand for the monetary base.

Tolessen fluctuations in the real economy in this situation, it is desirable for central banks
to adopt interest rate stabilization policies. As almost all nations presently adopt shortterm interest rates as their operational targets, the reduced demand for the monetarybase is not expected to exert a significant influence on the present frameworks formoney market operations.

Also, even if the demand for the monetary base does

decrease, since central banks are monopolistic suppliers of the monetary base, in
principle there seems to be no reason why central banks will lose the controllability ofshort-term interest rates.
Regarding the influence of the IT Revolution on the monetary policy
transmission mechanism, Q the effects of monetary policy via interest rates and foreignviexchange rates will likely become stronger, while R the effects of monetary policy via
funds availability (or balance sheets) will likely diminish.
The IT Revolution will not only change the relative importance of monetary
policy transmission channels, but there is also some possibility that it may reduce thenecessity and the effectiveness of monetary policy itself due to the reduction in menu
costs, the development of electronic money, and the increased domestic use of the U.S.
dollar for settlement purposes.

Nevertheless, taking information asymmetry into

account, for the time being it is not realistic to believe that all transactions will be
conducted over the Internet or that pricing will become completely flexible.
Moreover, there is a low likelihood that the U.S. dollar will be used for all domestictransactions.

Thus, for the foreseeable future, monetary policy will remain bothnecessary and effective, even though the necessity and effectiveness of monetary policy
may decline somewhat.
7.

Conclusions
The Forum made every effort to grasp the effects of the IT Revolution on acomprehensive basis, but it was not possible to cover every possible aspect.
that require further examination include:

IssuesQ the best practices for communication

between central banks and other market participants when information is exchanged ona real-time basis; R the effects of the increased speed and globalization of financialtransactions on the stability of financial markets; and S the influence of the IT
Revolution on financial market stability, and the appropriate prudential policies tomaintain financial market stability.

vii

Attachment 1
Members of “Technological Innovation and Banking Industry/Monetary Policy:
Forum on the Development of Electronic Payment Technologies and Its Implicationsfor Monetary Policy”{From the 9th Meeting of the Forum}
Chairman

Ryuichiro Tachi

Members

Kazumi Asako
Kazuhito Ikeo
Motoshige Itoh
Mitsuru Iwamura
Hideki Kanda
Yukinobu Kitamura
Kazuharu Kiyono
Masahiro Kuroda
Yutaka Kosai
Wataru Takahashi

Fumio Hayashi
Akihiko Matsui

Hiroshi Yoshikawa
ObserverKazuo Ueda

Bank of Japan

Yutaka Yamaguchi
Kunio Okina

Professor Emeritus, the University of
Tokyo
Professor, Hitotsubashi University,
Institute of Economic Research
Professor, Keio University, Faculty of
Economics
Professor, the University of Tokyo, Facultyof Economics
Professor, Waseda University, Asia PacificResearch Center
Professor, the University of Tokyo, Facultyof Law
Assistant Professor, Hitotsubashi
University, Institute of Economic Research
Professor, Waseda University, School of
Political Science and Economics
Professor, Keio University, Faculty ofBusiness and Commerce
Chairman, Japan Center for Economic
Research
Professor, Keio University, Faculty of
Economics (former Chief Manager,
Research Division II, Institute for
Monetary and Economic Studies [IMES])
Professor, the University of Tokyo, Facultyof Economics
Assistant Professor, the University ofTokyo, Faculty of Economics, andAssistant Professor, the University ofTsukuba, Institute of Policy and Planning
Sciences
Professor, the University of Tokyo, Facultyof Economics
Member of the Policy Board, the Bank ofJapanDeputy Governor
Director, Institute for Monetary andMichio Ayuse
Kazuhiko IshidaKazuo Monma
Shuhei Aoki

Secretariat

Shigenori Shiratsuka
Mahito Uchida

Takamasa Hisada
Fumikazu Taniguchi

Akira Otani
Takuji Kawamoto

Tomiyuki Kitamura

Economic Studies (IMES)
Chief Manager, Research Division II,
IMES
Senior Economist, International
Department, Financial Markets Department
and IMES
Chief Manager, Policy Research Division,
Policy Planning Office
Chief Manager, Payment System Division,
Financial and Payment System OfficeSenior Economist, IMES
General Manager, Naha Branch (former
Chief Manager, Research Division I,
IMES)
Chief Manager, Research Division I, IMES
Assistant Manager, Information System
Services Department (formerly assigned to
Research Division I and Research Division
II, IMES)
Research Division I, IMES
Human Resources Management
Department (formerly assigned to Research
Division I, IMES)
Research Division I, IMESAttachment 2
Reports presented at each meeting of “Technological Innovation and Banking
Industry/Monetary Policy:

Forum on the Development of Electronic Payment

Technologies and Its Implications for Monetary Policy”
9th meeting
10th meeting

11th meeting
12th meeting
13th meeting
14th meeting
15th meeting

16th meeting
17th meeting
18th meeting
19th meeting

Electronic Money and the Monetary aggregates (Kazuhiko Ishida andTakuji Kawamoto)
Report of the Findings of the Conceptualization Research Group –Implications for the Forum’s Future Deliberations (Masahiro Kuroda,
Tetsuya Inoue [former Senior Economist, Research Division II, IMES]
and Fumikazu Taniguchi)
Technological Innovation and the Banking Industry: Summary fromthe U.S. Experience (Mahito Uchida, Akira Otani and Takuji
Kawamoto)
Monetary Policy when the Base Money Demand is Absolutely Zero
(Fumio Hayashi, Akira Otani and Takuji Kawamoto)E-commerce Present Conditions and Issues: Birth of New
Intermediation Businesses and the Formation of Credibility (Yukinobu
Kitamura, Akira Otani and Takuji Kawamoto)
The IT Revolution and Settlement Currencies (Akihiko Matsui,
Takashi Shimizu [Tokyo University, Graduate School of Economics],
Akira Otani and Takuji Kawamoto)
Information Technologies and Financial Intermediaries (Kazuhito Ikeo
and Takuji Kawamoto)
The Relationship between Technological Innovation and theEconomies of scale in Banking Industry (Mahito Uchida, Akira Otani,and Akira Andou [Research Division I, IMES])The Development of the Internet and Globalization (Takamasa Hisada,
Akira Otani and Takuji Kawamoto)
The Advance of the IT Revolution and Monetary Policy (Takamasa
Hisada, Akira Otani and Takuji Kawamoto)Discussion Points not yet addressed in the Forum (Takamasa Hisadaand Akira Otani)
Draft of Report (Takamasa Hisada, Akira Otani and Tomiyuki
Kitamura)*NOTE: The names inside parentheses are the report authors, and the names in italics
are the names of the presenters.

Table of Contents
1. Preface........................................................................................................................... 1
2. Essence of the IT Revolution........................................................................................ 4(1)Characteristics of the IT Revolution ............................................................................ 4(2)The IT Revolution and Improving Production Efficiency ........................................... 5(3)Merits of Network Usage:

From the Perspective of Increased Information Volume 6(4)Changes in the Socioeconomic Structure from the IT Revolution............................... 9
3. Development of Electronic Commerce, Changes in Trading Patterns and Price Setting
Mechanisms, and Influence on Monetary Policy....................................................... 11(1)Current Conditions of E-commerce ........................................................................... 11(2)Effects from the Expansion of E-commerce .............................................................. 12(3)Expansion of E-commerce, Price Setting Mechanisms, and Monetary Policy.......... 18
4. Influence of the IT Revolution on the Financial Industry........................................... 23(1)Effects of the IT Revolution on Financial Transactions............................................. 23(2)Changes in Financial Markets .................................................................................... 26(3)Changes in the Contents of the Services of Financial Intermediaries........................ 28(4)Future Outlook for the Banking and Financial Intermediation Industries ................. 31(5)Financial Changes and Monetary Policy.................................................................... 39
5. The IT Revolution and Globalization ......................................................................... 44(1)Expansion of Cross-border E-commerce ................................................................... 44(2)Trade Growth from the Expansion of E-commerce ................................................... 46(3)Expansion of International Financial Transactions .................................................... 48(4)Globalization and Monetary Policy............................................................................ 50
6. The IT Revolution and Monetary Policy .................................................................... 52(1)Influence on the Ability of Central Banks to Grasp Financial and Economic
Conditions .................................................................................................................. 53(2)Influence on Monetary Policy and the Monetary Policy Transmission Mechanism . 59
7. Conclusions................................................................................................................. 62(Appendix 1) Regarding the Domestic Co-existence of Multiple Currencies............. 65(Appendix 2) Monetary Policy under Uncertainty ...................................................... 69(Appendix 3)Interest Rate Control when the Outstanding Balance of the Monetary

Base is Zero................................................................................................................ 73
References....................................................................................................................... 75

1. Preface
The Bank of Japan established the “Forum on the Development of Electronic Payment
Technologies and Its Implications for Monetary Policy” in December 1997 to broadly
examine the issues in monetary policy raised by the development of electronic payment
technologies including “electronic money” and the potential policy responses to theseissues from both theoretical and practical perspectives.

This Forum, which wascomprised of experts from academia and the Bank of Japan, and observers fromgovernment agency, held active discussions during eight meetings held overapproximately one and a half years.

The Forum then released the Interim Report in

May 1999 summarizing the conclusions of the deliberations up until that time.1
The main conclusion of the Interim Report was “For the foreseeable future,electronic payment technologies will not raise new issues for monetary policy that are
fundamentally different from those raised by previous financial innovations (the adventof MMFs and other new financial products), but in the long run they could substantiallychange the present financial and economic structures.”

The Interim Report also

identified the following as future issues that require further wide-ranging consideration:
how the Information Technology (IT) Revolution in general, including the innovations
in payment technologies, will engender structural changes in the organization of thebanking industry; how globalization will advance by lessening the importance ofnational boundaries; and based on these developments, what changes will appear in theoverall transmission of monetary policy, including the policy goals.
To examine these issues, subsequent to the release of the Interim Report, theForum expanded the scope of its examination to the IT Revolution in general, including
electronic payment technologies, and the Forum’s name was changed to “TechnologicalInnovation and Banking Industry/Monetary Policy:

Forum on the Development ofElectronic Payment Technologies and Its Implications for Monetary Policy.”

The

Forum met additional 11 times to hold further discussions based on papers prepared byexperts from academia and by the Forum’s Secretariat.

This report summarizes themain points that were clarified during the Forum’s subsequent discussions, based on theInterim Report.

The opinions contained do not necessarily represent the official

positions of the Bank of Japan.
As the IT Revolution is still underway, it is difficult to completely predict all of
1“Forum on the Development of Electronic Payment Technologies and Its Implications for
Monetary Policy: Interim Report,” Monetary and Economic Studies, 18(3), Institute for1its ramifications at the present time. Accordingly, the Forum applied economic theory,
giving reference to the changes that are presently being (or have already been) observed,
in an effort to depict the future image that is presently considered most likely to occur.
It need hardly be said that this future image represents just one possibility.

The

Forum’s discussions have indicated that major changes may emerge in financial andeconomic activities and frameworks (structures), including a substantial transformationof the financial industry due to the entry of firms in other industries into financial
intermediation industry, changes in traditional transaction patterns such as intercorporate keiretsu/subcontractor transactions from the expansion of E-commerce, shifts
in the goods and services price setting mechanism, and the accelerated globalization ofboth trade and international financial transactions from the diminishing importance ofnational boundaries prompted by the development of the Internet.

Given thesedevelopments, the Forum expects that it will become even more difficult than it was in
the past to accurately grasp monetary and economic conditions, as well as changes inthe effects of monetary policy and on monetary policy transmission mechanisms.

It

was noted that central banks will now have to conduct monetary policy amid these
uncertainties resulting from the IT Revolution.
The organization of this report is as follows.
Following this Preface, Chapter 2 identifies the distinctive characteristics of the
IT Revolution, and then considers the consequent improvements in production
efficiencies and the merits from utilizing networks, as well as the impact on thesocioeconomic framework.
Chapter 3 examines the potential changes to traditional transaction patterns, suchas inter-corporate keiretsu/subcontractor transactions, from the ongoing expansion of Ecommerce as well as the changes in price setting from the growth of E-commerce, andthen investigates the implications of these changes for monetary policy.
Chapter 4 summarizes the potential changes in the financial industry from the IT
Revolution and presents the future outlook for the industry.

It also examines theinfluence of these changes on the monetary policy transmission mechanism.
Chapter 5 investigates the likelihood of the further globalization of trade andinternational financial transactions from the development of the Internet, as well as theeffects of this globalization on monetary policy.
Chapter 6 comprehensively analyzes the influence of the IT Revolution on
monetary policy based on the possible changes to the monetary and economic structure
Monetary and Economic Studies, Bank of Japan, 1999.
2and the effects on monetary policy presented in Chapters 3-5, giving special
consideration to the uncertainty resulting from the IT Revolution.
Finally, Chapter 7 summarizes the conclusions of this report.

32. Essence of the IT Revolution
The present IT Revolution is exemplified by the rapid development of computer
technologies and the Internet.

Some think that this may be a third industrial revolution

comparable to the first industrial revolution represented by the development of spinningmachinery and the steam engine in the late 18th and early 19th centuries and the second
industrial revolution represented by the development of electricity, the telegraph andtelephone, and railroads in the late 19th century.

Although many of the possible

impacts of the present IT Revolution remain uncertain at the present time, the Forumcame to the conclusion that this revolution is exerting a massive influence on wideranging financial and economic fields, or will likely do so in the future, as explained insubsequent chapters.
This chapter begins by examining why the present IT Revolution has the power
to prompt significant financial and economic changes.

(1) Characteristics of the IT Revolution
The history of the computer essentially began in 1946 with the development of theworld’s first programmable computer (ENIAC).2

The initial trend was toward large

supercomputers, but the invention of the microprocessor by Intel Corporation in 1971
and the subsequent drastic improvements in microprocessor performance became aturning point toward the advance of miniaturization and the development of the
Personal Computer (PC).

While computer prices have continuously declined,

information processing capacities have rapidly increased, as symbolically expressed by
Moore’s Law.3 As shown in Figure 1, the average price of a PC declined from $3,995
in 1984 to $799 in 1998.

Meanwhile, average computer processing capacities as

expressed in Million Instructions Per Second (MIPS) jumped from 8.3 to 266 over thesame period.

Thus, the cost per MIPS dramatically declined from $479 in 1984 to $3

in 1998.
Additionally, the integration of PCs and networks has been advanced by theswitch from a centralized network architecture (similar to telephone networks, whichhave supercomputers at the apex) to a decentralized Local Area Network (LAN)architecture connecting the PCs that serve as network terminals (Figure 2).
2
3

These

ENIAC is an acronym for Electronic Numerical Integrator and Computer.
Moore’s Law states that the number of transistors on a single microprocessor doubles every 18

4developments, coupled with the reduction in information transmission costs and the
network externality4, have promoted the rapid expansion of network scales and a further
extension of the geographical range of network coverage.
Because of this exponential growth in computer performance and the network
externality as typified by the Internet, the present IT Revolution is spreading at an
astounding pace compared with former technological innovations.

For example, in the

United States it took about 50 years from the invention of electricity and the automobile
in the 19th century before 25% of Americans came to enjoy these technologies.

In

contrast, it took only 16 years from the development of the PC to achieve a penetration
rate of 25%, and just 7 years from the development of the Internet until a quarter ofAmericans were on line5 (Figure 3).
Thus, the distinctive characteristics of the present IT Revolution may besummarized as follows:

Q the integration of information processing andtelecommunications technologies; R the consequent acceleration of the speed of
information processing and transmission, reduction of information processing costs, andincrease of the geographical distance over which information can be transmitted(globalization); and S the astounding speed at which information technologies are
spreading among the public.
The IT Revolution has increased the efficiency of the information processing
used in goods and services production processes, and the reduction in informationtransmission costs utilizing networks has resulted in dynamic growth in the volume of
information.

The subsequent sections examine the increased efficiency in production

processes and the merits that are generated by the utilization of networks.

(2) The IT Revolution and Improving Production Efficiency
Through the remarkable increases in information processing and data transmission
performance and major cost reductions, the IT Revolution is increasing the efficiency ofmonths.
4
For example, in a telephone network, the more subscribers increase the more benefits theyreceive because the network can then provide connections to and from a wider range ofsubscribers. However, since the individual subscribers themselves cannot control the overall
number of subscribers, the benefits enjoyed by the individual subscribers are under the
influence of an externality. This is referred to as network externality (Okuno, Suzumura, andNanbu [1993]).
5
Similarly, it took only 13 years from the invention of mobile communications until 25% of
Americans had portable phones.
5the information processing used in goods and services production processes.

Thus,

these technological innovations are Q resulting in quality improvements and pricereductions for existing goods and services, and R enabling the production of new goods
and services that was practically impossible in the past.
Looking at some specific examples, the transfer of conventional financial
services (bank-counter operations and securities brokerage services) to the Internet isfacilitating large price reductions.

Also, as detailed in Chapter 4, the development of

the credit scoring method has systematized credit screening by using computers to
execute works formerly conducted by hand, enabling low-cost credit screening.
Moreover, the commoditization of new financial technologies such as derivatives is adirect result of the increases in computer processing performance.6
In the real economy as well, the accumulation of IT capital stock through active
IT investment and the accompanying labor savings and improved production
efficiencies7 are leading to reductions in the prices of goods and services.

In addition,

the reduction in information transmission costs has enabled a transformation from theformer production system, which was based on projected demand, to production basedon consumer orders whereby goods are provided in accordance with actual consumer
needs.

(3) Merits of Network Usage:
Information Volume

From the Perspective of Increased(Merits of Network Usage)
Because the development of the Internet has greatly reduced data transmission costs, thevolume and variety of information transmitted and received by individual economic
agents has increased beyond comparison with prior levels.

What type of impact does

this increase in the volume and variety of information transmitted have on financial andeconomic activities?
The utilization of networks is vastly decreasing information collection costs(search costs), so it is now possible to investigate a greater number of goods andservices provided by a wider variety of suppliers. This type of increase in the available
choices of trading partners is increasing the potential to find new trading partners that6

See Chapter 4 for a detailed discussion of these points.
See Chapter 6 for a discussion of the improvements in Total Factor Productivity (TFP) at themacroeconomic level from the IT Revolution.
7

6

offer more advantageous terms of trade.8 Consequently, many of the Forum members
hold the opinion that network usage generates merits for the activities of individual
enterprises and consumers by decreasing search costs.9
For example, let us consider the case when a consumer purchases a productwhich will have the same quality from any supplier he chooses (such as a newautomobile, CD or book). The consumer can search via the Internet to instantaneously
determine which sellers are offering the desired item, and easily compare their prices.
This enables the consumer to purchase the item from the source offering the lowest
price.

This example demonstrates that the reduced search costs from network usage

increase social welfare and generate benefits.
(Asymmetry of Information in the Development of Networks)
However, it is also important to consider the issue of asymmetry of information (theimbalance of information between buyers and sellers of goods and services or between
the parties to any other sort of transaction).

The Forum examined this issue,

particularly by deliberating Q whether the increase in the volume of information fromthe IT Revolution will really eliminate the asymmetry of information, and R whether
the decline in data transmission costs will actually result in a social burden, as the lower
transmission costs could make it easy for agents to intentionally distribute biased
information and falsehoods that are advantageous to their own interests.
To begin with, many Forum members believed that the increase in the volume of
information from the IT Revolution will not eliminate the asymmetry of information
itself.
Regarding this point, let us consider the used car market, which is a
representative example of the asymmetry of information, and in particular the case of
selling used cars via the Internet.

Using the Internet, it is now quite simple to obtain avast quantity of information about the used vehicles being handled by a great many
dealers instantaneously, at a negligible cost.

For consumers, this has the merit ofgreatly increasing their selection, which was previously limited to the inventories ofdealers located nearby their homes.

However, under normal circumstances, the8The extent to which this merit can be enjoyed is dependent upon information users’
capabilities to access information. As agents that cannot access information are unable toenjoy this merit (the so-called “digital divide” problem), policy measures will be necessary toresolve this issue.
9
Other merits of network usage include the substantial reduction in transportation costs for
products that can be digitized (such as music). See Chapter 5 for a further discussion
regarding this point.
7

information that is available via the Internet, such as car model, year of manufacture,
mileage driven and price, is almost never sufficient to make a purchasing decision.
This is because it is impossible to grasp the engine condition and other important factors
without actually test-driving the car, and such non-digitized information cannot be
obtained via the Internet.

This example clearly illustrates that the asymmetry of

information will not be completely eradicated even with increased information
volume10.
The Forum reached no unified consensus regarding whether the increase in thevolume of information will make an additional social burden.

Some members notedthat it is becoming easy to link Internet information sources with other Internet
information sources, which makes it easy to confirm the veracity of information, andexpressed the opinion that even under a network environment the percentage of false
information will not necessarily increase.

In contrast, other members expressed theopinion that the IT Revolution will not automatically resolve the incentive to spreadfalse information. And they expressed concerns that the increased information volume
may lead to a greater volume not only of significant information but also of meaninglessand false information because the new technologies make it easy to disseminate suchfalsehoods.

They pointed out that even if the volume of meaningful information(“goods”) increases, the volume of noise and falsehoods (“bads”) will also inevitably
increase, and that it may actually become more difficult than in the past to separate out
the “goods” from the “bads.”

In this case, some sort of framework will be needed tomitigate the burden from the increase in the volume of information.
Let us further examine this point by returning to the prior example of used
vehicle sales via the Internet.

Even if a dealer intentionally transmits biased

information which is advantageous to him, the consumer can easily obtain informationfrom other consumers who have experience in using this dealer, confirm the dealer’s
reputation beforehand, detect any falsehoods, and thus narrow down the candidate
vehicles for purchasing selection.11
On the other hand, dealers might still transmit false information that cannot
easily be detected by consumers (information that exceeds consumers’ judgement
10

According to a survey conducted by the Ministry of International Trade and Industry andAndersen Consulting, Business-to-Consumer (B-to-C) E-commerce accounted forapproximately 25% of the Japanese automobile market in 1999, but this was almost exclusively
new vehicle sales. Reportedly, there are virtually no used car sales transactions taking place online.
11
In this case, because falsehoods can easily be detected, dealers would presumably refrain fromspreading falsehoods that would damage their credibility and reputation.
8

capabilities).

In this case, because consumers believe the information provided by the

dealer is accurate, some “lemons” (poor quality used cars) will remain in the candidate
vehicles. This implies a growing risk that consumers may actually purchase “lemons,”
which constitutes a demerit for consumers.
One way to address this issue would be for third-party institutions with a highlevel of expertise to produce information on dealer credibility on behalf of consumers,
and then provide this information.

This would make it easier for consumers to narrow

down their candidate vehicles and make good selections.

The Forum examined thepotential for mitigating the harms of the asymmetry of information through such
“credible information intermediaries”12 which would produce and transmit information
regarding the veracity of other information.

(4) Changes in the Socioeconomic Structure from the IT Revolution
The prior sections have considered the merits from the IT Revolution in improving
production efficiencies and reducing search costs through network usage.

These

merits have the potential to transform the present socioeconomic framework, and thissection considers the types of changes that may occur.
The increase in information processing and transmission capacities provided by
the IT Revolution are rendering existing technologies outdated, and the reductions in
information processing and transmission costs are also lowering the costs incurred in
adopting new technologies.

Thus, it is becoming easier for comparatively

uncompetitive enterprises and firms in other industries to suddenly enhance theircompetitiveness through the introduction of the latest technologies.13

Consequently,

those enterprises that cannot introduce the latest technologies, for whatever reason, but
continue to use older technologies will find themselves at a comparative disadvantage.
In other words, they will suffer from diminishing corporate value (goodwill).

This

trend is represented by the diminishing relative competitiveness of the banking industry
in the field of information production and by the growing entry of firms in otherindustries into the financial sector, as further described in Chapter 4.

12

See Chapter 3 for a detailed discussion of this issue.
This phenomenon is referred to as “leapfrogging,” and the extremely rapid spread of mobile
telephones in Southeast Asian countries provides a representative example. Initially, mobile
telephones were not widely adopted in the industrialized nations because they already had welldeveloped fixed telephone networks. State-of-the-art mobile technologies rapidly penetrated
Southeast Asian nations precisely because their fixed telephone networks were insufficient.
13

9Coupled with “credible information intermediaries” and the other frameworks
for reducing the burden from the asymmetry of information, the decrease in search costs
utilizing networks described in the previous section expands the choice of trading
partners and increases the likelihood of conducting transactions under moreadvantageous terms.

Moreover, the integration of information processing technologies

and networks, which is one of the distinctive characteristics of the IT Revolution, ischanging the ways in which information is processed and shared, and is likely to greatly
influence the ways businesses are implemented.

This increases the opportunity costs

incurred in maintaining existing business models and transaction patterns, and offers thepotential to change existing management methods and trading frameworks. However,some members of the Forum noted that such changes might not occur if the merits fromnew trading partners and business approaches do not exceed the merits and prerogatives
from the present transaction patterns, etc.14
Then, to what extent will these changes actually occur?

Given the present IT

Revolution, how will the traditional transaction patterns such as inter-corporate
keiretsu/subcontractor transactions change, and what sort of specific transformations
will occur in the financial industry?

The Forum conducted extensive examinations

regarding these questions based on the understanding of the issues outlined above, as
explained in detail in the subsequent chapters.

14

Consequently, if the social structure is highly rigid and vested interests are strong, it will not
be possible to take advantage of the merits from the IT Revolution as described above. Thus,
one future policy issue will be to identify where the rigidities lie and to determine how toeliminate social structural rigidity.
10

3. Development of Electronic Commerce, Changes in Trading Patterns
and Price Setting Mechanisms, and Influence on Monetary Policy
The integration of computers and telecommunications networks, as presented in Chapter
2, has facilitated E-commerce over the Internet15, and the scale of E-commerce israpidly expanding.

The emergence of E-commerce has facilitated direct transactions

between producers and consumers, and some enterprises are beginning to move beyond
the established framework of inter-corporate keiretsu/subcontractor transactions toward
the global procurement of parts.

Accordingly, some assert that the distribution sector

will no longer be necessary (the elimination of middlemen), and that the inter-corporate
keiretsu/subcontractor transactions that have traditionally been one of the salient
characteristics of Japanese business transactions may disappear.

Moreover, others

have noted that as E-commerce may eliminate the distribution sector, it exerts
downward pressure on prices, facilitates frequent price revisions, and may lead toward
the emergence of a so-called “perfect market” without any “market friction” whatsoever.
Will the expansion of E-commerce actually result in these dramatic changes?

And ifso, what will the effects be on monetary policy?
Based on the understanding of the issues outlined above, this chapter reviews thepresent conditions of E-commerce, and examines the potential changes to the existing
patterns of goods and services transactions among economic agents from the expansionof E-commerce.

It also investigates the influence of the expansion of E-commerce on

price setting in terms of Q price levels, R menu costs,16 and S the Law of One Price,and finally considers the implications for monetary policy.

(1) Current Conditions of E-commerce
E-commerce can be broadly divided into two main categories: Business-to-Business(B-to-B) E-commerce and Business-to-Consumer (B-to-C) E-commerce.
The overall scale of E-commerce has been rapidly expanding from the beginning

15

In this Report, “E-commerce” is defined as “commercial transactions (the delivery of goods
or services and the receipt of information or monetary value in relation with the commercial
transfer of goods or services among economic agents) via electronic media utilizing networks,”
following the definition presented by Kitamura, Otani, and Kawamoto (2000).
16
At restaurants, the purchase prices of ingredients such as meat and fish vary from day to day,but rewriting the menu prices on a daily basis would be costly. These types of costs incurredin revising prices are referred to as “menu costs,” and are believed to be one reason for pricerigidity.
11

of the 1990s. According to a survey conducted by the Ministry of International Tradeand Industry and Andersen Consulting (Figure 4), in Japan in 1999 the B-to-C market
scale was approximately ¥336.0 billion, and the B-to-B market scale was approximately¥12 trillion. For comparison, in the U.S. the B-to-C market is on the order of $35.6
billion, the B-to-B market is about $250.0 billion, and the Japanese and U.S. markets
are both projected to grow at annual rate of more than 40%.
B-to-C E-commerce accounts for only a small percentage of final consumption
expenditure (the constituent percentages are projected to reach 1.4% in Japan and 3.2%
in the U.S. in 2003).17

On the other hand, B-to-B E-commerce is projected to have arelatively large impact, accounting for 11.2% of intermediate and final demand in Japanand 19.1% of that in the U.S. in 2003.

(2) Effects from the Expansion of E-commerce
As E-commerce is projected to expand at an annual rate of over 40%, the expansion ofthis new trading pattern will certainly have some effect on the traditional transaction
framework.

To what extent will the growth of E-commerce actually result in the

breakdown of traditional inter-corporate keiretsu/subcontractor transactions and theelimination of the distribution sector?
In actual commercial transactions, the asymmetry of information poses the socalled “agency problem.”18

To resolve the agency problem, commercial transactions

are presently conducted within the framework comprised of marketplaces, wholesalers
and retailers, and inter-corporate keiretsu/subcontractors.
In this section, we examine the potential changes to transaction patterns from the
expansion of E-commerce, giving due consideration to the agency problem.

17

The purchase prices of durable consumer goods are included in compiling final consumption
expenditure under national income statistics. In principle, however, the purchase of durable
consumer goods is actually a type of investment, and it may be the cost of the service obtained
from such goods that should be counted as consumption expenditure. It should be noted that
calculations of final consumption expenditures adopting this approach might result in different
figures for the scale of the B-to-C E-commerce market.
18
The “agency problem” refers to the problem that arises between the principal (the economic
entity that entrusts certain works) and the agent (the economic entity that actually implements
these works). It means that because the agent’s behavior is not necessarily always consistent
with the principal’s wishes, it becomes necessary to provide some sort of motivation to ensurethat the agent acts in the principal’s best interest. For further detail, see Kurasawa (1989).
12

(Traditional Frameworks for Resolving the Agency Problem)
First, we review the traditional frameworks for resolving the agency problem in somedetail.
Q B-to-C Transactions
The existence of marketplaces where multiple producers gather on a regular basis
represents the first framework for resolving the agency problem in B-to-C transactions.
This framework reduces consumers’ search costs, and the establishment of reputations
through repeated transactions at marketplaces also reduces agency costs.19 At the sametime, marketplaces reduce enterprises’ search costs as firms are spared the costs thatwould otherwise be incurred in searching for consumers one at a time.
Similarly, the existence of wholesalers and retailers also reduces search costs forboth producers and consumers.

These intermediaries accumulate information on

producers and products, and by accumulating expertise they remove poor-quality goods
from their product offerings and thus reduce agency costs.
R B-to-B Transactions
Inter-corporate keiretsu/subcontractor transactions represent the first framework forresolving the agency problem in B-to-B transactions.

Under this system20, parts

manufacturers make appropriate investments to meet the product specifications of theirparent companies, which share information about changes in parts specifications for
new products and quality improvements.

This subcontractor system provides various

merits from long-term trading relationships (in addition to information sharing, theseinclude coordinated activities, financial accommodations and personnel exchanges).
Moreover, because this facilitates appropriate investment by parts manufacturers andbecause the parent companies are “held hostage” as they will lose their public reputation
if they betray subcontractors, there are definite incentives for maintaining long-term
trading relationships.
In the realm of international B-to-B transactions, multinational corporations
function as another mechanism to resolve the agency problem.

The issue of why

multinational corporations exist can be broken down into two main questions:

19

Q why

“Agency costs” are the sum of two kinds of cost. The first are the costs incurred to resolve
the agency problem through the implementation of policies to motivate agents to act in the bestinterests of their principals. The second are the disadvantages suffered by principals comparedwith the case when there is no agency problem, regardless of the implementation of thesepolicies.
20
The following discussion is based on Itoh and Matsui (1989).
13

do single corporations conduct production and sales activities in various nations, and R
why are production and sales activities in various nations conducted by single
corporations, rather than by different entities.

The answer to the first question is

simply that locational factors are important, including the supply of low-wage labor, thelocation of final demand, and the supply of raw materials and other resources.

The

answer to the second question apparently lies in the merits of internalization, that is, inthe merits realized when a single corporate entity conducts the entire production process
and then sells final goods.

Other merits of internalization include the ease oftechnology transfer, avoiding conflicts of interest between upstream and downstream
processes21, and mitigating the asymmetry of information in areas such as the quality ofintermediate goods and market data.
(Changes in Trading Patterns from the Expansion of E-commerce)
Q B-to-C Transactions
The spread of the Internet has greatly reduced consumers’ search costs via the use ofInternet search engines (producers have also benefited from reduced search costs related
to consumer demand surveys, etc.), and thus the volume of direct transactions between
producers and consumers has been increasing.
Nevertheless, in goods and services transactions where the asymmetry of
information is problematic, direct transactions can not resolve the agency problem, sosome kind of framework is needed to settle it.

For example, many flourishingelectronic market malls essentially fulfill the same functions as traditional marketplaces,
and this implies an important role for intermediation businesses in reducing agency
costs (see Box 1).22

21

There is a conflict of interest when the upstream and downstream processes are handled bydifferent enterprises because the upstream firms work to maximize their sales price while thedownstream firms work to minimize their acquisition price, but this conflict is averted when the
upstream and downstream processes are vertically integrated (Krugman and Obstfield [1994]).
Of course, this does not necessarily mean that all transactions should be internalized, asinternalization also has certain demerits such as conflicts of interest among internal corporate
divisions and increasing internal adjustment costs.
22
E-commerce information intermediaries that directly link producers with consumers arepresently sprouting up like mushrooms after a summer rain. The establishment of solid
reputations and brand images will be a decisive factor for these businesses to succeed, so the
key will be how they manage to win credibility. Therefore, most likely, many of thesebusinesses will fail and only a small handful will achieve success.
14

R B-to-B Transactions
Whether enterprises will decide to change their trading partners along with thedevelopment of the Internet will depend on whether or not the merits generated bychanging trading partners and procuring low-priced intermediate goods will surpass the
merits presently realized from inter-corporate keiretsu/subcontractor transactions andfrom internal transactions in multinational corporations.
For many general-purpose intermediate business goods with wide-ranging
applications, such as automobile windshield wipers, steel products and computer parts,
the merits of low-price procurement surpass those generated by information sharing
within keiretsu corporate groups. Consequently, the trading of such parts transcending
the inter-corporate keiretsu/subcontractor and multinational firm framework is now
expanding on a global scale.23
However, the Forum members noted that the merits of Internet E-commerce will
be small for customized product parts that are only used for specific final goods (forexample, for drawings-approved automobile parts24).

This is because there are highcosts in initiating transactions with new suppliers for such parts, resulting from the needto provide detailed information and the necessity of additional capital investment for
production.
Thus, as long as a “closed and integrated production process”25 remains themainstream approach, the conventional transaction framework will likely change only
for certain general-purpose intermediate goods with a wide range of applications tomany finished goods. Nevertheless, if parts procurement via the Internet results inlower finished product prices, if consumers intensify their price orientation, or if thepercentage of goods produced under an “open and modular process”26 increases,

23

For example, in May 2000 the world’s leading electric and electronic appliance manufacturers
announced that they will be jointly establishing an E-commerce market for electronic parts.
24“Drawings-approved parts” refers to parts that are jointly planned by the parent company andits subcontractors right from the design stage, and thus the designs are pre-approved for
production.
25
A “closed and integrated production process” is a process whereby parts are produced inaccordance with the final product specifications with close communication among different inhouse divisions, or between the parts suppliers and the assembly manufacturers. A typicalexample of goods manufactured under this process is sedan-style passenger vehicles. For
further details, see Ministry of Finance (2000).
26
An “open and modular production process” is one wherein the production process is open tovarious suppliers because the functions provided by each part are complete in and of themselves,the connections linking the individual parts are standardized, and modular design is possible.
Typical examples of goods manufactured under this process are trucks and PCs. For further
details, see Ministry of Finance (2000).
15

common parts usage would be advanced and thus the global scale of B-to-B Ecommerce transactions outside the inter-corporate keiretsu/subcontractor framework
could expand.
Box 1: Importance of Credibility and Role of Intermediaries in E-commerce
A variety of E-commerce intermediation sites have been appearing on the Internet.
Why is the intermediation business required under E-commerce, just as for regulartransactions, and what are the specific functions performed by these intermediation
businesses?

This Box introduces the paper regarding these issues presented in the 13th

meeting of the Forum (Kitamura, Otani and Kawamoto [2000]).
(The Asymmetry of Information and the Importance of Credibility)
With E-commerce, consumers must make purchasing decisions without directly viewing
or touching the goods they are buying. Moreover, because the market-entry costs areminimal and poor-quality businesses can initiate Internet operations, there is a highprobability that the “lemon problem” (the problem whereby buyers have risks topurchase inferior-quality products [“lemons”] due to the imbalance in productinformation between buyers and sellers) may occur. Thus, when there is asymmetry of
information and when the pricing mechanism does not completely function,mechanisms to avert market failures (frameworks to secure trading credibility) areneeded.

Possible mechanisms to avert E-commerce market failures include:Q

sellers providing information to consumers by building up their brand image and via
advertising; R third-party organizations, such as government agencies and consumers’groups, providing quality standards and quality assurance; and S the provision of
information by private-sector intermediation businesses (platform businesses).
(Role of Intermediation Businesses)
Kitamura, Otani and Kawamoto (2000) note the following five functions of platformbusinesses, giving reference to Kokuryo (1999).
Q Searching for Trading Partners
By collecting information on behalf of a great number of consumers, intermediation
businesses can reduce the search costs compared with those that would be incurred
when consumers collect information individually.

These intermediation businesses

generate cost savings in the collection of information concerning suppliers and products
16through repeated transactions with various suppliers and by accumulating knowledge
about products that provide the same performance (that is, they make good use of
economies of scale and of scope). Moreover, they can produce information to meet
consumer needs, for example, by providing charts summarizing the prices charged forany given product by various retailers, and thus provide consumers with the lowest
prices.
In addition, intermediation businesses generate cost savings for firms as wellsince it is less expensive for intermediaries to collect important consumer information
all at once compared with the costs that would be incurred when firms gather suchinformation individually, and the intermediation businesses can also produce thisinformation to meet specific corporate needs.
R Providing Credibility (Information)
Even when networks are used to identify potential trading partners, commercial
transactions cannot be implemented without credibility regarding delivery dates, qualityof goods, payment, etc.
The intermediation businesses stand in between buyers and sellers andeffectively function as credit intermediaries.

For example, credit card companies canconclude transactions because sellers trust them even though sellers are uncertain about
the buyer’s credibility.
S Evaluating Economic Value
Intermediation businesses select high-quality companies and products and include themin their information lists based on their long experience and specialized knowledge.
By removing firms and products that are subject to consumer complaints,
intermediation businesses can limit their offerings to only high-quality products (andthus eliminate “lemons”).
T Standardizing Transaction Procedures
In conducting transactions with various trading partners over networks, it is desirable tostandardize (to establish protocols for) basic commercial arrangements such as contract
terms, transaction procedures and accounting standards.

While the standardization ofthese systems is often addressed by the government and by organizations forstandardization, standardized procedures may also be studied and disseminated byprivate-sector platform businesses.

17

U Integration of Distribution and Other Functions
The actual conclusion of goods and services transactions requires not only the exchange
of information, but various other functions such as arranging delivery and credit card
payment procedures.

The integration of these functions represents yet another role ofplatform businesses.

(3) Expansion of E-commerce, Price Setting Mechanisms, and Monetary
PolicyThe development of the Internet is reducing search costs, and making it easy for
consumers and firms to find suppliers offering goods and services at the lowest prices.
Accordingly, some note that the Internet effectively makes the constraints of time anddistance less important, and may lead toward the emergence of a so-called “perfectmarket” without any “market friction” whatsoever.
Let us then consider the actual price setting mechanisms under E-commerce.
Specifically, has the expansion of E-commerce Q changed price levels and R facilitatedfrequent price revisions (a decrease in menu costs)?
maintained in Internet E-commerce?

And S is the Law of One PriceAs these issues are related with monetary policy,

this section also incorporates some considerations from the monetary policy
perspective.
(Changes in the Price Setting Mechanism from the Expansion of E-commerce)
Q Reduction in Price Levels
Brynjolfsson and Smith (1999) conducted a survey on the sales prices of books and CDs
in 1998 and 1999 on both the conventional market and the E-commerce market.

They

discovered that on average the prices on the E-commerce market were approximately
16% less than those on the conventional market.

After adjusting for transportation

costs and local sales taxes, they reported that the average prices on the E-commercemarket were 9% less than those on the conventional market for books, and 13% less for
CDs.
R Reduction in Menu Costs
Baily (1998) and Brynjolfsson and Smith (1999) investigate the differential in thefrequency of price revisions on the conventional market and the E-commerce market.
These research papers are based on the idea that prices should be revised at a higher
frequency on the market with lower menu costs, given that both markets are subject to18

exactly the same shocks. Both papers reach the same conclusion that the frequency of
price revisions is overwhelmingly higher on the E-commerce market than onconventional markets.

In particular, Brynjolfsson and Smith (1999) report an

extremely high frequency of small price changes of less than $1 on the E-commercemarket (Figures 5 and 6).

These findings suggest the possibility that price revisions

are conducted on the E-commerce market even in response to small shocks for which
price revisions are not conducted on the conventional market because of the menu costs.
Their research also finds that the minimum price revision for books is 5¢ on the Ecommerce market compared with 35¢ on the conventional market, and that for CDs is amere 1¢ on the E-commerce market compared with $1.00 on the conventional market.
S Failure of Law of One Price in E-commerce
In the real economy, there are differentials in the prices charged for the same products(the difference between the highest price and the lowest price). This is normally
attributed to consumers’ shortage of information regarding prices due to the existence ofgeographical distance and search costs.

Because E-commerce lessens geographicalrestrictions and has greatly reduced search costs, it would be natural to assume that thedifferentials in the prices charged for the same products on the Internet would besmaller than those on the conventional market.
However, Brynjolfsson and Smith (1999) reported that under E-commerce, themaximum price differential for the same books and CDs is 50%, and the average pricedifferential is 33% for books and 25% for CDs. Additionally, Clemons, Hann, and Hitt
(1998), who surveyed the prices of airplane tickets sold via on-line travel agencies,
found a price differential of 20% after making adjustments for the heterogeneity of
products sold, such as the departure and arrival times.

Thus, contrary to general

expectations, the Law of One Price does not hold on the E-commerce market, even forhomogeneous goods that cannot cause a “lemon problem.”
The Forum identified the following four background factors as to why the Lawof One Price is invalid in E-commerce.
The first factor is the credibility of the suppliers and their products.

A largenumber of consumers apparently feel that they cannot trust sites offering the lowest
prices, and only conduct transactions with sites they can trust to avert a potential “lemon
problem.”
The second factor noted was the non-anonymity in E-commerce transactions.
In E-commerce (especially B-to-C), consumers must disclose their names, addresses,
credit card numbers and other private information in order to purchase goods and19

services. Once consumers have registered such private information on a given site, ifthey subsequently find another site offering lower-priced products, they must incur theswitching costs of registering the same information once again in order to makepurchases from that site.

When the amount of the price differential is less than theseswitching costs, consumers may refrain from changing suppliers, and this may accountfor a certain price differential among sites.
The third factor is the ease of suppliers’ price discrimination in E-commerce infavor of certain customers, which is tantamount to a “Law of a Different Price for Each
Consumer.” For example, an airline ticket sales company site offers two types of
options to consumers:

the first is a channel whereby the tickets are sold at fixed prices

set by the sales company, and the second is a channel whereby the tickets may bepurchased at lower prices through on-line negotiations with the sales company.

In thiscase, the Internet sales company makes a discrimination between those consumers whowant to purchase fixed-price tickets without conducting negotiations and those whowant to purchase their tickets at lower prices, even though this requires negotiations,and offers different pricing to each category of consumers.27
The fourth factor is the possibility that the Law of One Price, which isartificially held by suppliers’ activity, is losing validity because of a decline in theirmonopoly power.

In the real economy, uniform prices are artificially set for certain

goods not as a consequence of arbitrage transactions, but rather by autonomous
practices based on monopoly power, such as the private setting of fixed resale prices inJapan. On the Internet, however, monopoly power is declining from the ease of newmarket entry and other factors, so there is a potential that the Law of One Price based onsuch autonomous practices may cease to function.
(Influence on Monetary Policy)
First, the reduction in price levels from the spread of E-commerce28 is interpreted as adownward shift of the aggregate supply curve from the simplification of distribution.
Thus, it is generally believed that the central bank should accept, to some extent, the27

If prices are considered in a broader manner as the total of the monetary value of goods, theconsumer’s choice of supplier and the ancillary services related to purchasing (such as delivery
and the necessity of price negotiations), prices for the same product differ among individual
consumers. Therefore, this ease of price discrimination means that the “Law of a Different
Price for Each Consumer” is easily maintained on the Internet.
28
While, as noted above, the scale of E-commerce itself is still relatively small, throughcompetition the reduction of prices on the E-commerce market may exert downward pressure on
the prices charged through conventional sales channels.
20

reduction in price levels from the spread of E-commerce.

In the real economy,

however, because various shocks occur continuously it is difficult to distinguish supply
shocks from demand shocks.

The cost-price relationship (the mark-up ratio) may

provide one useful criterion for distinguishing between these two types of shocks.
Specifically, when dividing mark-up ratio movements into time trends and cyclicalfluctuations, one might be able to interpret the time trends mainly as supply side factors
and the cyclical fluctuations mainly as demand side factors.

Although it is extremely

difficult to conduct such analyses in real time, the ability to accurately grasp the data
could provide additional information for making policy decisions.
Second, coupled with the greater ease of price discrimination, the reduction in
price levels from the expansion of E-commerce may influence the compilation of priceindices. For example, if the revision of price indices becomes belated amid the rapid
expansion of E-commerce and items sold over the Internet remain excluded from pricesurveys, the upward bias of price indices may become an increasingly serious problem.
Additionally, when price index measurement error increases it may become extremely
difficult to determine whether observed price movements reflect supply shocks, demand
shocks, or measurement error.29

What is more, if the trend toward multiple prices forthe same goods advances from further price discrimination and the price movements ofitems presently used as representative items for individual product categories come todiffer from the price movements of the other items in these categories, this would pose amajor problem for the usefulness of price indices as indicators.

In any event, how tomaintain and improve the quality and reliability of price indices will become
increasingly important.
Third, the reduction in menu costs on the Internet may have an important
influence on the effectiveness of monetary policy.

Specifically, in the long run, whenreal GDP is constant at full employment, the money supply and price levels areproportionally related with each other.

Thus, the real money supply may become

constant and changes in money supply would no longer have any effect on the real
economy (in other words, this would result in a dichotomy between money and the real
economy).

Regardless of this, in the short run monetary policy still remains effective

since central banks can change the real money supply because of the price rigidity
caused by menu costs and other factors, and thus influence the real economy.
However, if the expansion of E-commerce is drastically reducing menu costs to
one-tenth or even one-one hundredth of prior levels and price flexibility is increasing,29

See Chapter 6 for a discussion of this type of statistical uncertainty.
21

then a dichotomy between money and the real economy may easily appear even in the
short run, and the influence of monetary policy on the real economy might diminish.
On the other hand, some Forum members expressed the opinion that this is no
great cause for concern because the reduction in menu costs implies a reinforcement of
the market mechanism, and leads to a diminishing necessity for monetary policy itself.
Additionally, because price rigidity also derives from the rigidity of nominal
wages under employment contracts, it is premature to judge that the necessity oreffectiveness of monetary policy will decrease solely due to a reduction in strictly
defined menu costs.

22

4. Influence of the IT Revolution on the Financial Industry
How will financial products and services change from the IT Revolution, and whatchanges will occur in financial markets, and in the banks and other financial
intermediaries that provide these products and services?

Even with the IT Revolution,

the essential functions of the financial industry – such as Q the provision of payment
and settlement services, R the intermediation of risk (or risk taking), S information
production (the screening and monitoring of borrowers), and T the provision ofliquidity – will remain unchanged.30 However, major changes are expected in thecontents of financial products and services, and in the financial institutions that provide
these products and services. Moreover, these changes may influence the transmission
mechanism and effects of monetary policy.
This chapter examines Q the influence of the IT Revolution on financialtransactions, R the consequent changes in financial markets, S the changes in thecontents of the services of financial intermediaries, T the future outlook for thefinancial intermediation industry, especially for the banking industry, and U theconsequent changes in the monetary policy transmission mechanism, giving reference tothe experience in the United States, which is a front runner in the IT Revolution.

(1) Effects of the IT Revolution on Financial Transactions
As presented in Chapter 2, the present IT Revolution may be characterized by the
integration of information processing and telecommunications technologies; theconsequent acceleration of the speed of information processing and transmission,
reduction of information processing costs, and increase of the geographical distanceover which information can be transmitted (globalization); and the astounding speed atwhich information technologies are spreading among the public.
are greatly changing financial transactions.

These developments

The changes that are presently being

observed may be summarized as follows.
(Development of Advanced Financial Products and Services)First, coupled with the development of financial engineering, the phenomenal
improvements in information processing speed and cost performance are facilitating thepractical application of various technologies whose theoretical bases had already been30

See Cecchetti (1999) regarding this point.
23

established, but which previously could not be applied to actual financial transactions
because the required computation times were too long and the costs too high.

Theseinnovations have also enabled the unbundling of existing integrated financial functions
and the recombination of their constituent parts into new forms as illustrated, forexample, by the combination of variable interest rate loans and interest rate swaps,
which provides an equivalent financial function to fixed interest rate loans. As a result,
it is now possible to offer new financial products and services that make full use ofadvanced information technologies, as demonstrated by the dramatic growth in recent
years of derivatives (such as options and futures) trading, the development of
securitization, and the practical use of electronic money and other electronic payment
and settlement technologies analyzed in the Forum’s Interim Report.

What is more,

the compilation of customer databases and the improvement of their quality have madeit possible to offer highly detailed and differentiated financial services to eachindividual customer.
Development of Derivative Products
It is most significant that the increase in information processing capacity from the IT
Revolution has provided banks and other finance market participants with the means
to actualize the fruits of recent finance theory (even complicated estimations, such as
numerical calculations of payoff functions utilizing the Monte Carlo simulation
method, can be easily conducted using low-priced hardware and software).
Derivatives trading has been rapidly expanding, especially since the 1980s, due to thenecessity of responding to fluctuations in interest and foreign exchange rates.
According to the Bank for International Settlements (BIS), the worldwide notionalamount of OTC derivatives had reached $81.5 trillion at the end of July 1999.31
Securitization
Financial products must be standardized for them to be traded on financial markets.
Recent IT Revolution has made it possible to present the risks and returns of financial
products that previously could not be calculated in practice due to their extreme
complexity (that is, to accurately calculate the probability of future cash flows and topresent the calculation results to investors).

In addition, technologies are also being

developed to compose new financial products that have more suitable risk-return
characteristics for market trading by pooling together multiple items with different
31

See BIS (2000) regarding this point.
24

risk-return characteristics.

As a result of these various innovations, thesecuritization of financial products has clearly been further developed.32

Cases inpoint include the rapid growth of Mortgage-Backed Securities (MBS) in the UnitedStates, and the securitization of credit card and automobile loans.
Electronic Money and other Electronic Payment and Settlement Means
Along with the development of electronic payment and settlement technologies,
many attempts to develop and actualize the practical use of electronic money andother electronic payment and settlement means have been made in nations throughout
the world.

In Japan as well, debit card payment services are beginning to be offeredby many financial institutions.
(Improvement of Risk Management Capabilities)
Second, together with the development of financial engineering, the IT Revolution isdramatically improving the risk-management capabilities of asset managers.
Examples include the quantification of portfolio risk such as price volatility risk throughValue at Risk (VaR), the identification of the risk factors that influence portfolios, andthe calculation of the correlations among these various risk factors.

Thus, investment

trust, pension fund, hedge fund and other asset managers can now adjust thecomposition of their portfolios to optimize the risks and returns.

This improvement inrisk-management capabilities is also supporting the demand for new, advanced financial
products and services (as reviewed above).
(Changes to Financial Service Delivery Channels)
Third, new network infrastructure such as the Internet is being constructed, enabling theprovision of financial services via these new delivery channels.33

In the past, because

financial services were highly dependent on physical service bases such as bankbranches, the provision of such services was greatly restricted by geographicallimitations.

With the reduction of information transmission costs and the dramaticdevelopment of information processing technologies, however, the provision of bankservices is no longer dependent upon bank’s branch networks, as evidenced by the
recent alliances between banks and convenience stores in Japan. Furthermore, the32

See Chapter 3 of Crane et al. (1995) regarding this point.
Unique delivery channels are already appearing in Japan, such as terminals for the payment ofpublic utility fees at convenience stores.
33

25

increased utilization of networks, such as Internet banking34 and Internet finance35 (forexample, public offerings of shares via the Internet), is facilitating the provision offinancial services via delivery channels that transcends physical and geographicallimitations.
Internet Banking
The provision of Internet banking services is becoming more active not only by banks
but also by firms in other industries that are entering the financial services industry.
This is because utilizing the Internet permits a major reduction in banking operation
costs, such as those incurred in checking deposit balances and transferring funds
among different accounts.

According to a survey conducted by the U.S. consulting

firm Booz-Allen & Hamilton Inc., the estimated costs per transaction are about 1¢ forInternet banking compared with $1 or more when conducted by bank branchpersonnel36 (Figure 7).

Thus, Internet banking is making it possible to provide

existing bank services at a lower cost than in the past, and also facilitating theprovision of new services. For example, some U.S. banks are not only providing Bto-B E-commerce payment and settlement services, but also providing enterprises
with additional information, such as information associated with the procurement anddistribution of goods and services among firms.

(2) Changes in Financial Markets
As explained above, the IT Revolution is changing the content of financial goods andservices to more advanced and convenient ones.

Combined with revisions to the legal,

taxation and disclosure systems for financial markets and other market infrastructure
improvements, these changes increase the variety of financial products traded infinancial markets.

Meanwhile, the rise in the speed of information processing andtransmission and the reduction of costs are promoting more active arbitrage trading
34

The physical security of networks is an essential prerequisite to the development of Internet
banking. Naturally, measures will have to be implemented to maintain network safety andcurtail operational risk from the standpoint of maintaining and fostering the prudent credit order.
35
Regarding Internet finance, see Box 5 of the Forum on the Development of Electronic
Payment Technologies and Its Implications for Monetary Policy: Interim Report (May 1999).
36
These are average variable costs. Because the initial investment amounts for Internet
banking are relatively high, the average costs under Internet banking do not compare favorablywith those incurred under conventional means of providing financial services unless the numberof accounts reaches a certain level. Some point out that at least one million accounts are
required for Internet banking to generate profits.
26

among financial products.37(Increased Variety of Tradable Financial Products in Financial Markets by the
Securitization)
As mentioned in the previous section, securitization increases the variety of thefinancial products traded in financial markets.

Nowadays, financial markets are nolonger only the venue where small number of highly rated companies raise funds, butalso function as the venue for the trading of various financial products.

In the U.S.,

many small and medium enterprises and low rated firms actively raise funds in capital
markets such as NASDAQ and the junk bond markets. On the other hand, thesechanges are not so conspicuous in Japan since funds raised through financial institutions
have accounted for the majority of the flow of funds.

However, many derivatives arebeing developed and their trading volume is increasing dramatically.

In addition, thesecuritization of bank loans is being developed as banks try to regain financial
soundness.
(Increased Arbitrage Trading)
While the huge reductions in information processing and transmission costs from the IT
Revolution have enabled electronic brokering and Internet stock trading, these are also
promoting more active arbitrage trading in financial markets.

The development of

futures and options markets and the improved risk-management capabilities of asset
managers are moving in the direction of more active arbitrage trading.

Of course,

arbitrage trading is nothing new, but the dramatic decrease in information processing
and transmission costs in recent years is one factor contributing to significant growth inarbitrage activities.

This more active arbitrage trading is promoting greater market

liquidity and increasing the quality of market prices as indicators.

37

With the spectacular improvements in information processing and transmission speeds fromthe IT Revolution, market prices are coming to instantaneously reflect various exogenous
shocks (or information about such shocks). Additionally, the dramatic reduction in information
processing and transmission costs and the globalization of networks has enabled 24-hour-a-day
trading via overseas markets. See Chapter 5 for a discussion of how this enhanced
globalization of financial transactions is affecting the substitutability of domestic and foreign
financial assets and the domestic and foreign interest rate differential.
27

(3) Changes in the Contents of the Services of Financial Intermediaries(Financial Intermediaries and Changes in Financial Transactions/Financial
Markets)
As explained in the previous section, the IT Revolution is expanding trading in financial
markets, and this trend is greatly changing the contents of the services of financial
intermediaries.
To begin with, let us consider the reason why financial intermediaries exist
through a comparison with the role of financial markets.

While financial markets areappropriate for the trading of standardized financial products, financial intermediaries
can provide customized financial products and services that are difficult to standardize.
As considered in Chapter 2, if the IT Revolution cannot resolve the problem of theasymmetry of information, financial transactions with the asymmetry of information
will still entail costs in examining the creditworthiness of transaction partners before
contracts, monitoring the partners and transactions after the contracts are signed, as wellas enforcing the partners to fulfill the contracts when the transactions are completed.
Thus financial intermediaries will continue to provide great value from their expertise in
the screening and monitoring of financial transactions (information production). For
example, because the agency costs accompanying the asymmetry of information are
particularly high for lending to small and medium enterprises, such financialtransactions represent a typical example of financial products that are not suited for
trading on markets.

Banks and other financial intermediaries are improving theirefficiency in conducting such financial transactions through adopting the new method ofcredit scoring, which has been made possible by the IT Revolution.
Credit Scoring
In the past, many of the credit screening works for loans to small and medium
enterprises have been conducted by hand based on the unique know-how of eachindividual bank.

In recent years, however, some banks are adopting the new methodof credit scoring (see Box 2 for an outline of the credit scoring model) to calculateborrowers’ credit risk based on financial statements and other credit information andthen actually providing loans utilizing the results of the credit scoring model.

Byadopting the credit scoring method, the costs incurred in credit screening for loans arebeing markedly reduced.
In particular, larger banks are becoming more active in using this new method
and providing loans to small and medium enterprises.

This trend is particularly

conspicuous in the United States. For example, in the San Francisco region, even28

after adjusting for the influence from bank mergers, the total amount of loans ofunder $100,000 provided to small and medium enterprises by larger banks has been
sharply increasing (Figure 8).
This trend has been somewhat belated in Japan, as the data required todevelop the credit scoring model had not been collected or processed.

Recently,

however, a corporation was founded to collect financial data on small and medium
enterprises38, and some financial institutions are moving to newly develop theirmodels based on the data obtained.
Moreover, the IT Revolution and the development of financial engineering have enabled
the provision of advanced, complex financial products and services, and financial
intermediaries are believed to be providing information about these advanced, complex
products and services and also transforming them into financial products and services
that are easily understood by consumers and businesses (Allen and Santomero [1998]).
Theoretically, if diverse risks in financial products are unbundled and reallocated, thisshould increase the welfare of economic agents.

However, the costs incurred byconsumers and businesses to understand the nature and properties of such financial
products accurately as required for financial products trading (participation costs)39 will
actually increase,40 so without a framework to reduce these costs, consumers andbusinesses will not be able to fully enjoy the merits of the advanced financial products
and services from the IT Revolution.41

In response to this issue, banks have been

38

Japan Risk Data Bank Inc. was founded in April 2000, primarily by system consulting
companies. To date, 22 financial institutions, including 19 banks, have announced theirintentions to provide capital to Japan Risk Data Bank Inc.
39
The concept of “participation costs” was introduced by Allen and Santomero (1998), and acomparison with financial transaction costs such as commissions may be useful forunderstanding this concept. While “participation costs” are the internal costs incurred byindividual economic agents in the process of gaining an understanding of the nature of financial
products, financial transaction costs are the external costs incurred when individual economic
agents conduct financial transactions with other economic agents.
40
Allen and Santomero (1998) argue that participation costs under the IT Revolution are
increasing, and that the essential feature of financial institutions is to decrease theseparticipation costs. As examples demonstrating how participation costs are increasing underthe IT Revolution, the authors note that: Q almost all of the participants in derivatives markets,
which continue to rapidly expand, are financial institutions, with very few households or firms(final consumers) participating; and R while there is an ongoing trend toward a reduction in
trading costs such as brokerage fees, the number of shares owned directly by individuals isdecreasing while the number of shares owned indirectly by individuals through mutual funds
and pension funds is rapidly increasing.
41
It is not inconceivable that the participation costs may fail to decrease if financial
intermediaries disseminate inappropriate information, in which case the participation costs may
29

actively providing new financial products such as those incorporating derivatives, andrapidly expanding their off-balance sheet transactions.
Expansion of Off-balance Sheet Transactions
Banks, especially those in the United States, are actively pursuing highly profitableoff-balance sheet operations such as derivatives trading and servicer businesses
through the securitization of loan credits (proxy lending and collection businesses) inplace of traditional banking businesses (such as making loans to firms, etc. andfunding them by issuing demand deposits and other deposits).42

In Japan, reflecting

the fact that the demand for bank deposits remains strongly entrenched, the weight oftraditional banking businesses is relatively high compared with that in the U.S., but
this situation is gradually changing.

These increased off-balance sheet activities area result of banks’ efforts to increase profits while controlling their own risk, andbanks are beginning to transform advanced, complex financial products into easily
understandable ones and to provide consumers and businesses with these financial
products (responding to participation costs).

Box 2: Outline of the Credit Scoring Model“Credit scoring” is the statistical method used to evaluate the credit risk of loan
applicants.

This method produces “scores” from the various attributes of individuals

and the financial data of businesses applying for loans, and then generates a total scoreexpressing the creditworthiness of loan applicants.

The total score is then used as acriteria for making credit decisions (in actual practice, banks set a “cut-off score” as thelending criteria, and provide credit to applicants whose scores exceed this minimum
standard). The credit scoring model has long been used for credit card loans and otherconsumer financing.

But the dramatic improvements in information processing

capabilities from the IT Revolution and the increase in computer memory capacity havefacilitated the construction of the databases required for further model development, andexceed the merits provided by higher-level financial transactions. This would pose the same
issues examined in Chapter 2 regarding the necessity of credible information intermediaries tolessen the social burden from the increase in the volume of information.
42
As detailed below, banks are said to achieve certain synergy effects from simultaneously
conducting deposit and lending businesses. For an explanation of this point see, for example,
Chapter 2 of Freixas and Rochet (1997).
30

the credit scoring model has recently become widely used for lending to small andmedium enterprises.
Specifically, the process of constructing a credit scoring model comprises thethree steps of Q selecting effective attribute data for the credit screening, R setting“classes” for each attribute, and S assigning scores for each class.

These steps are

conducted by the optimization method. (The following tables show an example of themodel).
Attribute: Liquidity Ratio
Class
Score
100% or more
30
50-100%2025-50%
10
Less than 25%
5
Attribute: Cash and Deposits / Total Assets
Class
Score
10.0% or more
50
5.0-10%35
2.5-5.0%
20
Less than 2.5%
10

Attribute data commonly adopted in the credit scoring models includes:

Q corporate

financial indices (divergence from the industry average ratio of pre-tax profits to total
assets, liquidity ratio, etc.); R personal data regarding corporate representative directors(age, net holding assets, etc.); S corporate credit data provided by credit monitoringfirms (key negative information, number of days elapsed on overdue payments, etc.);
and T personal credit data provided by credit monitoring firms (number of credit
inquiries over the past six months, etc.).

(4) Future Outlook for the Banking and Financial Intermediation Industries
The previous section pointed out that the contents of the services of banks and otherfinancial intermediaries are changing under the IT Revolution, and financial
intermediaries will continue to play significant roles given the existence of theasymmetry of information and participation costs.

What, then, is the potential

influence of the IT Revolution on the organizational forms (institutional aspects) of
31

financial intermediaries?

The Forum members noted several possibilities, as outlined

below.
(Concentration of Financial Intermediaries)
To begin with, because the IT Revolution offers the potential to achieve greater
economies of scale in certain financial transactions, mergers and alliances among
financial institutions may become more active, resulting in a greater concentration offinancial intermediaries.

In fact, the number of bank mergers and alliances has been

increasing worldwide since the late 1980s, and in Japan mega-banks have also been
appearing recently through mergers among large banks.

It is said that the greater

economies of scale prompted by the IT Revolution represent one factor behind thismovement toward the establishment of mega-banks.
However, even if the economies of scale are increasing from the IT Revolution,
this may not significantly influence all of the services conducted by financial
intermediaries.

Rather, strong effects may be limited to certain financial services suchas payment and settlement services (see Box 3 regarding this point). Additionally, thewave of bank mergers in recent years is apparently being prompted by a wide variety offactors including: Q responding to the geographical expansion of markets from theremovals of restrictions on interstate banking in the United States and the integration of
the European Union; R trying to maintain a presence in various markets underglobalization; S efficient risk diversification via mergers; and T responding to theworsening profitability of existing banking services caused by the intensifiedcompetition from the entry into the financial intermediation market by firms in different
industries.43,44(Diversification of Financial Intermediaries)
The second point is that the IT Revolution may be reducing the barriers to market entry
into the financial intermediation business.

The IT revolution may be Q deteriorating

the comparative advantages of banks in information production (see Box 4 regarding

43

Some also note the incentive to pursue scale under “too-big-to-fail” policies and the privateinterests of bank managers as additional factors that may be contributing to the merger trend.
44
The Forum members generally agreed that because the economy of scale from the IT
Revolution differ for each banking service field, there is no need for traditional banks which
provide all possible banking services, like Japanese banks, to expand their scale while providing
the same services. Some members also expressed the opinion that the costs of post-merger
internal adjustments may be higher at Japanese banks than at banks in the U.S. and Europe due
to slow restructuring.
32

this point), R facilitating the provision of new financial products and services and theunbundling of existing financial functions so that certain financial institutions may beable to specialize in the provision of particular services, and S promoting theconstruction of network infrastructure such as the Internet (and thus greatly diminishing
the significance of bank branches in providing banking services).

All of these factors

are facilitating the advent of financial institutions specializing in particular services aswell as new entry into the financial intermediation market by firms in different
industries (diversification).45

In the U.S. one information industry firm founded a

subsidiary on the Internet which conducts credit screenings for loans using the credit
scoring model on behalf of financial institutions.
representative example of this trend.

This case may be considered as a

In Japan, firms in distribution industry and IT-

related firms are also moving to enter the financial intermediation business via theInternet.

Given these developments, the Japanese government is trying to improve theenvironment for non-financial firms to enter the financial intermediation business.

For

example, the Financial Services Agency and the Financial Reconstruction Commission
issued “Measures for Licensing for and Supervision of New Types of Banks(Operational Guidelines).” on August 3rd, 2000.
(Future Outlook for Financial Intermediaries)
The future direction of this concentration (trends to mega-banks) and diversification(specialization in certain financial services; market entry of firms from other industries)of the financial intermediation business is not yet entirely clear.

Nevertheless, many of

the Forum members expressed the opinion that as the comparative advantages of banks
in information production may decline under the IT Revolution, the future providers offinancial intermediation services may not be limited to firms in the present financial
industry, and that there is a high probability that firms in other industries will utilize thefruits of the IT Revolution to provide financial intermediation services. Additionally,
considering that the strong economies of scale from the IT Revolution may be limited tocertain financial services such as payment and settlement services, the Forum memberssuggested that while concentration may continue in such fields, diversification may

45

Of course, when economies of scope can be realized by providing multiple financial services,the provision of multiple services by individual financial institutions results in cost savings
merits. To date, however, no clear consensus has been obtained regarding such economies ofscope in the provision of multiple financial services (such as combining lending with CP
underwriting or off-balance sheet transactions), as some empirical research has confirmed sucheconomies of scope and other empirical research has disproved them.
33

concurrently advance in other fields (specialization in certain services and outsourcingof others).

In other words, the Forum members indicated that the two simultaneous

trends toward concentration and diversification may well continue. Considering thislikelihood, sufficient consideration must be given to the potential for major changes in
the financial intermediation business (see Box 5 regarding this point).

Box 3: The IT Revolution and the Economies of Scale in the Banking Industry
The IT Revolution is apparently resulting in remarkable cost reductions by using
computers to systematize operations that have traditionally been conducted by hand.
For this reason, banks have been making huge IT-related investments in recent years,
but does the actual data verify that this IT-related investment is generating costreduction merits for banks through greater economies of scale?
This Box introduces the latest empirical analyses regarding the economies ofscale in banking operations overall, beginning with a discussion of the economies ofscale in payment and settlement services, for which a great deal of research has alreadybeen accumulated, based on the paper presented in the 15th meeting of the Forum(Uchida, Otani and Kawamoto [2000]).
(Economies of Scale in Payment and Settlement Services)
The provision of payment and settlement services requires back-office works for dataprocessing. Personnel expenses, data processing costs, and the telecommunications
costs for data transmissions among various offices and sites comprise a large portion of
the back-office works costs. Therefore, if data transmission costs among sites decrease
and the increase in computer data processing capabilities results in remarkableeconomies of scale, then merits would be generated through the integration of multiple
sites or of multiple banks’ payment and settlement services.
The Federal Reserve Board (FRB) has conducted empirical analyses on theeconomies of scale for payment and settlement services, including check processing(interbank settlement of check transactions), automated clearinghouse (ACH) services(interbank value-dated electronic funds transfers) and Fedwire service (real-time grosssettlement for federal funds transactions and for U.S. Treasury bond and governmentrelated debt transactions).
Bauer and Ferrier (1996) found that among these three payment and settlement
services, there is no scale economy merit for check processing, which is mostly34

conducted through paper-based processing and is thus the most difficult to be influenced
by the IT Revolution.

In contrast, significant economies of scale may be achieved for

ACH and Fedwire services, which are conducted electronically.

For ACH services,

Bauer and Ferrier (1996) found that the elasticity of the total costs to the number oftransactions handled is 0.5 (that is that an increase of 1.0% in the number of transactions
handled results in a cost increase of approximately 0.5%).

Similarly, Hancock,

Humphrey and Wilcox (1999) found that the elasticity of the total costs to the number oftransactions handled for Fedwire service is also 0.5.
Accordingly, considering that there are high economies of scale for thosepayment processes (ACH and Fedwire services) that most easily benefit from the meritsof the IT Revolution, there is a strong probability that the recent IT Revolution is
generating growing economies of scale in payment and settlement processes overall.
(Economies of Scale in Banking Operations Overall)
While banks conduct certain operations, such as the screening and monitoring of largelot loans and debt collection, for which it is difficult to realize benefits from the IT
Revolution, banking operations also include fields (such as payment and settlement
services) which can definitely benefit from the scale economy merits provided by the IT
Revolution.

Given this situation, how is the optimum scale changing for banking

operations overall?
Under the initial research conducted from the late 1980s through the early 1990s(utilizing data from the 1980s), a consensus was achieved that the average variable costfunction to total bank assets is a relatively gradual U-shaped curve, that the scale forminimizing average variable costs is a small to medium scale with total assets of $100
million to $10.0 billion, and that greater scales result in an increase in average variable
costs (in diseconomies of scale).
Subsequently, utilizing data from 1990 through 1995, Berger and Mester (1997)
estimated that banks’ average variable costs are minimized when the scale of total assets
is $10.0 to $25.0 billion.

Their conclusion implies that the optimum scale of banks

increased in the 1990s, reflecting the greater economies of scale.

Box 4:

Changes to the Specialty of Banks

Banks are said to be special in that they efficiently produce information and provide

35liquidity by simultaneously providing payment and financial intermediation services.
How is the specialty of banks changing under the IT Revolution?

This Boxthintroduces the paper regarding this issue presented in the 11 meeting of the Forum(Uchida, Otani and Kawamoto [2000]).
(What is the Specialty of Banks?)
Q Information ProductionMore frequent monitoring must be conducted in cases where the problem of theasymmetry of information is serious and financial statements and other financial data
are not so credible, such as in lending to small and medium enterprises.

In this regard,banks can grasp corporate behavior more accurately than other funds providers bymonitoring changes in cash flow because they provide enterprises with payment andsettlement services.

Accordingly, it has generally been accepted that banks enjoy

comparative advantages in financial intermediation to borrowers with high agency costs
such as small and medium enterprises.
R Liquidity Provision
The standard theory is that even if depositors’ liquidity demand is uncertain, banks canafford to maintain just a portion of their deposits as payment reserves because thepercentage of depositors actually requesting repayment becomes more stable as the total
number of depositors increases. Accordingly, it is said that banks can provide liquidity(bank deposits) and also acquire fixed assets (lending).
(Changes to the Specialty of Banks From the IT Revolution)
Q Deterioration of Banks’ Comparative Advantages in Information Production
As a result of the IT Revolution, even firms other than banks can now conduct credit
screening without payment account information by using the credit scoring model.
Especially in the United States, which is a front runner in this field, Internet firms arebeing founded which utilize the credit scoring model to conduct credit screenings andmake lending decisions on behalf of banks. Moreover, there may be ways other thancorporate cash flow analyses that provide an accurate grasp of corporate behavior.
(For example, Higano [1999] claims that information regarding goods distribution, suchas raw materials and equipment purchasing data and product sales data, has anequivalent value to cash flow data. And he also states that firms which have access tosuch purchasing and distribution data can engage in information production.)
Thus, banks’ comparative advantages in information production (for credit
36screening and monitoring) may decline.
R The Effect of the IT Revolution on the Provision of Liquidity
Sufficiently persuasive conclusions have yet to be reached regarding the influence of the
IT Revolution on the provision of liquidity by banks. On the one hand, under theincrease in direct financing resulting from the IT Revolution (especially the increase in
CP and other highly-liquid short-term financial assets), some assert that not only bankdeposits but also MMFs are somehow meeting the economic demand for assets withgood ratings and high liquidity, and institutions providing MMFs may come to play thecentral role in the provision of liquidity (Gorton and Pennacchi [1990]).

In response,

others argue that, for example, if the ratings of bank deposits are high because of
deposit insurance systems, individuals and enterprises may prefer bank deposits fortheir liquid assets, and therefore it is difficult to predict that MMFs will come to play
the central role in the provision of liquidity (Kashyap and Stein [1994]).
Regardless of the liquidity issue, at the very least, the IT Revolution does havethe potential to diminish banks’ comparative advantages in information production.

Box 5:

Changes in the Management of Financial Intermediaries under the IT

Revolution
What is the potential influence of the IT Revolution on the organizational forms offinancial intermediaries?

This box introduces the paper regarding this issue (Ikeo[2000]) presented in the 15th meeting of the Forum, which regards the increase in thevolume of information (discussed in Chapter 2) as the provision of more detailed
information on a more frequent basis and examines the possible effects on financial
institutions.
(Influence from More Highly Detailed Information)
The trend toward more highly detailed information has enabled financial institutions torecognize distinctions among different customer segments that could not be
distinguished in the past, and thus provide a more precise response to each customer
segment.

Conversely, if the customers themselves also become aware of these

distinctions, they may no longer accept banks’ conventional offerings of uniform
products and services.

If financial institutions take a differentiated response based on37customer segment characteristics, internal conflicts of interest may arise among thedifferent departments responsible for individual customer segments, so it might be thecase that all operations should be conducted under a single organization. However,this response entails the risk that the organization as a whole may lose the ability tomake optimal decisions.

Thus it would be most beneficial for the organizational

structure, which responds to each customer segment, to be divided as much as possible
by individual function, and to thus increase the independence of each organizationalunit.
On the other hand, when organizations are divided into small, independent units,
the economies of scale may be lost. Nevertheless, economies of scale are actuallyrealized for back-office operations in particular and it is difficult to believe that strong
economies of scale can be realized for customer-interface operations.

Thus, greater

efficiencies may be achieved by small organizational units for some operations, and bylarge organizational units for others.

This may be the reason for the simultaneous

trends toward both concentration and diversification in the organizational structure offinancial institutions.
(Influence of More Frequent Information)
With the provision of information on a more frequent basis, because activities anddecisions must be changed at distinctively shorter intervals, there is a pressing need to
expedite decision making and to facilitate the reallocation of management resources (sothat decisions can be implemented promptly).
A centralized decision-making system (with a hierarchical pyramid structure)
may be expected to accurately transmit all the necessary information and to realize highperformance in the mutual coordination among departments, provided that the
information processing capabilities at the top of the structure are of a high level.
However, large-scale organizations may not accurately transmit information because of
the conflicts of interest among departments, and there are also physical limitations to
the information processing capabilities at the top of the structure.

Meanwhile, adecentralized decision-making system (with delegation of authority) may be superior interms of information transmission and information processing at the individual unit
level, but may have low performance in the mutual coordination among departments.
Thus, a “capsulized” organizational structure which combines the merits fromthe centralized and decentralized systems may be required to expedite decision making
and to facilitate the reallocation of management resources.

Under this system, theorganizational structure is arranged so that the mutual dependencies among the38

individual units (capsules) are not that high, and each unit (capsule) retains a high levelof autonomy.

While the decision-making authority concerning the roles and functionsof the individual units is delegated to these units, the decision-making authority
concerning the mutual coordination among the capsules is retained by a holding
company or some other centralized organization.

This structure may provide a meansof responding to the provision of information on a more frequent basis.

(5) Financial Changes and Monetary Policy
This section examines the effect of the financial changes described above (changes infinancial transactions, in financial markets, and in the financial intermediation business)on monetary policy from the perspective of its transmission mechanism.
(Influence of Changes in Financial Markets)
Q Interest Rate Channels
The dramatic reductions in information processing and transmission costs and theimprovement in risk-management capabilities from the development of derivatives andother new markets (that is, the simplification of the transfer of risk from economic
agents that wish to avert risk to economic agents that are willing to take risk) areresulting in more active arbitrage trading among financial assets with various term
structures on domestic financial markets. As a result, the transmission speed at whichchanges in policy interest rates affect short-term and long-term interest rates is believed
to be increasing.

Thus, the IT Revolution is apparently raising the effectiveness ofinterest rate channels.46,47

46

For example, Fernald, Keane and Mosser (1994) examine the influence of securitization on
the monetary policy transmission mechanism using mortgage-backed securities as an example.
Arbitrage transactions are normally conducted between mortgage-backed securities andgovernment bonds, which have approximately the same terms. When monetary tightening
decreases the pace at which mortgages are repaid and increases the interest rates charged on
mortgage-backed securities, long-term government bond interest rates also rise via arbitrage
trading. Fernald, Keane and Mosser demonstrate that the growth in the trading of mortgagebacked securities and in arbitrage trading is increasing the response of long-term interest rates toshort-term interest rates.
47
The improvement in risk-management capabilities from the development of derivatives andother markets is not reducing the extent of exogenous shocks themselves. However, the more
appropriate risk diversification within the economy may be lessening the influence of interest
rate changes on the spending of economic agents (see BIS [1994]), so further analyses of thisissue will be needed.
39

R Availability Channels
In addition to interest rate channels, the monetary policy transmission mechanism
includes availability channels, which are the route whereby firms and other agents canborrow funds from banks.

These channels depend on the idea that because the bonds

traded on financial markets are not complete substitutes for bank loans, decreases inborrowings from banks cannot always be covered by fund raising from financial
markets.48
If the development of securitization and the growth of financial market
transactions under the IT Revolution increase fund raising methods other than bankloans (the substitutability of bank loans and bonds increases), the effectiveness ofavailability channels will probably decline.49
Another important point is the influence of derivatives on credit rationing.50
The conventional understanding is that credit rationing appears on bank lending markets
because of the existence of the asymmetry of information (the fact that lenders can notgrasp borrowers’ creditworthiness perfectly), and that the supply and demand are notbalanced by interest rates.51

Nevertheless, when firms raise funds from markets, theattachment of derivatives to the securities increases the amount of information available
about these firms.

Additionally, when lenders identify specific types of risk and use

derivatives to hedge such risk, it becomes possible for them to reduce the risk
48

By assuming this incomplete substitutability, it becomes possible to explain that shifts in the
supply-demand function of bank loans can influence real GDP and interest rates independent ofchange in money supply.
49
Assume the substitutability between bonds such as CPs and bank loans is strengthening inrecent years because of the IT Revolution. Then, the demand curve for bank loans should
become more elastic to interest rates, that is the curve should become more flat, and the shift ofthe supply curve should result in larger changes in the loan volume. From this perspective,
Becketti and Morris (1992) conduct empirical analyses to confirm whether a flattening of theloan demand curve in the United States actually occurred during the post-war era. They showthat the amount of decrease in the volume of loans resulting from a permanent increase in theFederal Funds Rate of 1% (an upward shift of the loan supply curve) doubled from the mid1970s to the early 1980s. And they claim that the curve flattened further from the early 1980s,
when financial technological innovation rapidly advanced. These empirical findings are
consistent with the conjecture that the substitutability between bank loans and bonds isstrengthening and that the importance of availability channels is diminishing with financial
technological innovation.
50
When credit rationing exists on lending markets, the importance of availability channels
definitely strengthens, but it is important to note that credit rationing is not a necessary
condition for the existence of availability channels.
51
For example, when the interest rates on risk-free assets rise due to monetary tightening,
because of adverse selection (corporations about to borrow at higher interest rates pose higher
credit risks), banks shift their assets from loans to lower-risk bonds and some firms are unable
to borrow from banks. See Stiglitz and Weiss (1981) regarding this issue.
40accompanying an increase in lending, and this should reduce the likelihood of credit
rationing on bank lending markets (BIS [1994]).

This sort of possible reduction incredit rationing caused by derivatives may also decrease the effectiveness of monetary
policy availability channels.
(Influence of Changes in Financial Intermediaries)
As for the influence of changes in financial intermediaries on monetary policy, the firstissue is how the concentration and diversification of financial intermediaries willchange the monetary policy transmission mechanism.

The second main issue is how

the improvements in financial intermediaries’ monitoring technologies resulting fromthe IT Revolution may influence the monetary policy transmission mechanism.
Q Influence of the Concentration and Diversification of Financial Intermediaries
To begin with, let us consider the influence of the concentration and diversification offinancial intermediaries, specifically the trend toward mega-banks and the entry into thefinancial intermediation market by firms in different industries.

Will the increase inmega-banks make the market more oligopolistic and have an adverse effect on thesetting of loan interest rates? Alternatively, will the increased market entry by firms in
different industries heighten competitive pressures, and thus have the opposite effect?52
According to the most orthodox microeconomics, when the market becomes moreoligopolistic, interest rate competition pressures decrease and profit margins expand.
This may lead to concerns of a slower response and a decreased extent in how lending
rates reflect changes in policy interest rates.53,54

Conversely, when competitive

pressures intensify from new market entries, the response of lending rates to policy
interest rates may actually strengthen.
Then which scenario is more likely to occur:stronger competitive pressures?

further oligopolization or

Reviewing the conditions in foreign countries wherebank mergers have occurred, the research does not demonstrate that bank mergers have52

While the changes in financial intermediaries may also influence the demand side, this
discussion assumes that the demand side remains constant.
53
Additionally, if the market share of a specific bank increases in a given financial asset market,
this could obstruct arbitrage trading and prevent the effective functioning of interest rate
arbitrage.
54
For example, export industries in an oligopolistic market may refrain from changing theirexport prices as denominated in local currencies, regardless of exchange rate changes, topreserve market share. Thus, in some cases the above argument may not apply even when amarket changes from a monopoly to an oligopoly.
41

resulted in higher profit margins.55

Some empirical research has also found a higher

transmission effect of changes in short-term interest rates on lending rates amid theincrease in bank mergers.

Thus, to date a reduction in the effectiveness of interest ratechannels from oligopolization has not been observed.56

In Japan, IT related firms have

only just expressed their intentions to enter the banking business.

Considering thatthese plans will move on to the implementation stage and that an increasing number offirms in different industries will also enter the financial intermediation market, thecompetitive pressures are projected to increase.

If this is the case, we should think thatthe effectiveness of interest rate channels would strengthen.

Nevertheless, it ispossible that during the process whereby the competitive pressures increase, therelationships between short-term interest rates and lending and deposit rates may
become unstable, and the extent of the effect of monetary policy on final demand maychange substantially.

Therefore, it should be noted that the implementation ofmonetary policy may become more difficult.
R Influence of the Improvement of Monitoring Technologies
Corporate lending by financial institutions is dependent upon corporations’ net assets.
Simply stated, when corporations have large net assets, their collateral value is also high,making it easy for financial institutions to provide large loans (smaller credits areoffered to corporations with lesser net assets).57

Monetary policy influences banklending indirectly through its effect on corporations’ net assets, and these transmission
effects are referred to as balance sheet channels (which are one type of availability
channels).

The extent of the effect via balance sheet channels is dependent uponfinancial institutions’ monitoring capabilities.

When the monitoring capabilities are

low, because the financial institutions have a limited understanding of corporations’conditions, the scale of the corporations’ collateral value may greatly influence the loan
decision-making process.

But when financial institutions can improve their55

See Braun et al. (1999) regarding this point.
While no consensus has yet emerged as to why bank mergers have failed to result in higher
profit margins, one Forum member expressed the opinion that this may be due to influencesfrom the expansion of international markets and the intensification of competition from therelaxation of U.S. interstate banking regulations, the integration of the European Union, andglobalization.
57
Behind this mechanism lies the moral hazard issue from the asymmetry of information.
Assuming limited liability, when a corporation’s net assets are small, the owners’ losses are
relatively small even when projects fail. In this case, the incentive to invest in high-risk
projects increases, and the moral hazard worsens. Consequently, financial institutions restrict
their lending to such corporations. Regarding this point, see Bernanke and Gertler (1995).
56

42

monitoring ability using the fruits of the IT Revolution, this reduces corporations’agency costs as well as the influence of the amount of the collateral value on banklending. Consequently, some Forum members expressed the opinion that the influenceof monetary policy via balance sheet channels may decrease under the IT Revolution.

43

5. The IT Revolution and Globalization
Since the Internet lessens geographical and spatial restrictions, it has the potential to
make national borders less important and to increase cross-border E-commercetransactions. Thus, the IT Revolution may further accelerate the tempo of trade growth.
In terms of financial transactions, the IT Revolution may increase the substitutability ofdomestic and foreign financial assets and promote currency substitution (ordollarization).

This chapter examines the globalization58 from the development of theInternet in terms of both trade and financial transactions, as well as the influence of
these developments on monetary policy.

(1) Expansion of Cross-border E-commerce
Reviewing the trends in cross-border E-commerce, for B-to-C transactions, it is difficult
to grasp the overall conditions because of insufficient statistics. But, according toOECD (1998), approximately 6% of U.S. software exports are presently sold via theInternet, and approximately one-third of the export sales of firms that are most actively
engaged in E-commerce are generated via the Internet (Figure 9).

As some firms that

conduct E-commerce do not make international transactions, the overall scale of crossborder B-to-C E-commerce is believed to be relatively small at present.
Turning to B-to-B E-commerce, although some firms are moving to procureparts from overseas via the Internet, the vast majority of parts procured via the Internet
are those of domestic inter-corporate keiretsu/subcontractors.

Additionally, mosttransactions in the electronic B-to-B markets are also among domestic firms.

Thus, itappears that overall the majority of B-to-B E-commerce is composed of domestictransactions.
Possible reasons why cross-border E-commerce transactions are not yet very
popular include the lemon problem and other concerns regarding the safety of Ecommerce transactions, as well as the home bias toward domestic goods (the national
borders effect59), which is similar to that in conventional trade.
58

While there is presently no definitive definition of “globalization,” this report follows Okina,
Shirakawa and Shiratsuka (1999) in defining globalization as the condition whereby the hurdles
presented by national borders decrease and whereby individual national markets, such as thosefor goods and financial transactions, are unified into a single market. (On the other hand, a“borderless economy” refers to the condition whereby globalization has further advanced andthe existence of national borders has become meaningless).
59
MacCallum (1995) estimates the goods transactions within and between the United States and
44

The reasons for this home bias, which divides markets, apparently include:Q

foreign exchange rate fluctuations; R educational, cultural, political, social, andemotional linkages based on families, transportation and telecommunications networks,etc.; S tax systems and other economic systems such as the existence (or nonexistence) of inter-corporate keiretsu/subcontractor transactions; T the greater
uncertainty and the higher likelihood of agency problems in cross-border transactions
than in domestic transactions; and U the higher search costs in foreign countries.
Among these factors, while the foreign exchange rate fluctuations and theestablished bonds based on locality and kinship will not change from the IT Revolution,
the development of the Internet is greatly reducing the search costs for foreign products.
Additionally, as noted in Chapter 3, the advent of Internet electronic markets may havean influence on domestic inter-corporate keiretsu/subcontractor transactions and othertrading patterns.
Moreover, the Internet is dramatically reducing the transportation costs for
digital goods (Figure 10), facilitating the low-cost delivery of digital goods at distantlocations.
Consequently, while the development of the Internet cannot completely
eliminate the home bias toward domestic goods (result in a completely borderless
economy), it is likely to reduce the extent of the home bias.60 Considering these points,
Canada for cities in both countries, utilizing the gravity equation. His findings indicate thatwhen the sizes (GDP) and distances are the same, the volume of domestic trade is 22 times
bigger than that of cross-border trade. These findings demonstrate that national borders remain
important even for the trade between the United States and Canada, two nations which share asimilar culture, language and systems and which are said to have one of the smallest national
borders effects on earth. Thus the findings imply that national borders are even more
important for cross-border trade between other countries. Similarly, Engel and Rogers (1996)
estimate tradable good prices in U.S. and Canadian cities based on the understanding that the
Law of One Price does not hold due to the distance among cities (a proxy for the transport cost)and because of national borders (using a dummy variable whose value is 1 when both cities arein the same country, and 0 when the cities are in different countries). Specifically, they
estimate the differential from the Law of One Price utilizing these factors. Their findings showthat the differential from Purchasing Power Parity (PPP) in the United States and Canada is not
only due to the distances among cities, but that the existence of national borders also has a large
influence, equivalent to a distance of 2,500 to 23,000 miles.
60
The United States and international organizations such as OECD are proposing various
measures to increase cross-border E-commerce from the perspective of ensuring the security of
E-commerce, and harmonizing tax and other economic and legal systems internationally. For
example, in July 1997 the U.S. government issued a report entitled “Framework for Global
Electronic Commerce” which presented proposals for the role of government in thedevelopment of E-commerce, and in 1997 the OECD issued a report entitled “Electronic
Commerce Opportunities and Challenges for Government” which advocated government
measures for the development of E-commerce. Such efforts are also likely to work toward45

there is a high probability that the volume of cross-border E-commerce transactions will
increase in the future.61
The following section examines whether the increase of cross-border Ecommerce may result in an autonomous and endogenous increase in the degree of
dependence upon foreign trade.

(2) Trade Growth from the Expansion of E-commerce
If existing foreign trade is simply conducted on the Internet, its impact on the macroeconomy will not be all that great, but if E-commerce induces new cross-bordertransactions, this may significantly raise the tempo of trade growth and have a great
influence on domestic economies.

Accordingly, this section examines themacroeconomic effects from the expansion of E-commerce, particularly focusing on thequestion of whether E-commerce will induce new cross-border transactions.
(B-to-C Transactions)
The development of the Internet is not only reducing search costs, but also greatly
decreasing the transportation costs for goods which can be digitized (software, music,
etc.; see Figure 10).

Consequently, the Internet is projected to increase the tradevolume of such goods and to transform services that were formerly nontradable goods
into tradable goods, and thus induce new trade.
Furthermore, since the development of the Internet is facilitating surveys of
consumer needs by producers, it will advance product differentiation to better match
consumer demand and increase intra-industry trade.
For products that cannot be digitized, the development of the Internet is reducing
the search costs, consequently increasing product imports from foreign firms whosevery existence the purchasers were formerly unaware of, and is thus expected to resultin a demand shift from domestic products to foreign products. Nevertheless, as thedevelopment of the Internet will not affect the transportation costs of products thatcannot be digitized, its major effects in inducing an expansion of cross-border B-to-Ctransactions are expected to primarily arise from growth in the trade in digital goods andservices and from greater product differentiation.
increasing the volume of cross-border E-commerce and mitigating the home bias.
61
One Forum member expressed the opinion that the volume of B-to-B Internet transactions
may not increase until an open and modular production process becomes more popular than aclosed and integrated production process.
46

(B-to-B Transactions)
As for B-to-B transactions, the reduction in transportation costs from the developmentof the Internet is expected to induce an expansion in the trade of intermediate goods andservices which can be digitized (IT services such as the data and application services
required for production activities).62
Turning to the trading of existing intermediate goods, as noted above, businesses
are highly likely to continue purchasing customized parts via domestic inter-corporate
keiretsu/subcontractor transactions.

There is, however, a possibility that businesses

may move toward shifting their procurement of common-use parts with wide-ranging
applications from domestic inter-corporate keiretsu/subcontractor parts manufacturers toforeign parts manufacturers, and this may increase the trade in intermediate goods.
(Will the Expansion of E-Commerce Increase the Overall Volume of Trade?)
As explained above, B-to-C E-commerce is expected to directly increase the volume oftrade by increasing the trade of digital goods and services and through greater productdifferentiation.

On the other hand, theoretically the increase in the trade ofintermediate goods and services under B-to-B E-commerce could either increase or
decrease the trade of finished goods because the increase in the imports of intermediate
goods may increase the domestic production of finished goods and thus decrease thetrade in finished goods.
However, empirical research indicates that the increase in the trade ofintermediate goods is actually promoting an increase in the trade of finished goods andthus increasing the overall volume of trade.63

Additionally, considering the trend

toward a greater division of labor in the international supply of intermediate goods andservices, the increase in the trade of intermediate goods and services from the expansionof cross-border B-to-B E-commerce is highly likely to result in an increase in theoverall volume of world trade (an increase in the degree of dependence upon foreign
trade in each nation).64

62

In the United States, Application Service Providers (ASPs), which are businesses that provide
customers with IT services such as application services from remote locations, are becoming
very active, and the scale of the ASP market is projected to reach $2.0 billion by 2003.
63
For example, see Hummels, Rapoport and Yi (1998).
64
According to economic geography theory, the location of production sites is determined by atrade-off between the transportation costs from production locations to final consumers andother producers, and the economies of scale or the positive externalities from the agglomerationof production factors and from information sharing. Thus, when the transportation costs are47

Thus, the expansion of E-commerce is expected to accelerate the tempo of trade
growth overall.

(3) Expansion of International Financial Transactions(Advance of Asset Substitution)
In the real world, international portfolio diversification is not progressing to the levelprojected in economic theory, and a strong preference for domestic financial assets isobserved. This phenomenon is referred to as the home bias (in portfolio investment).65
The reasons for this home bias are said to include:

Q the existence of nontradable

goods (while domestic investors hold equities of both foreign and domestic tradable
goods firms in order to diversify risk internationally, they don’t need to hold equities offoreign nontradable goods firms, and thus they have an incentive to hold more domestic
equities than foreign equities); R the limited merits from international portfolio
diversification66; and S the existence of factors obstructing investors’ optimizing
behavior (foreign-exchange risk, systemic and social factors, the asymmetry of
information, etc.).
As the expansion of E-commerce is expected to turn services and other formerly
nontradable goods into tradable goods, for risk diversification, foreign investors may
then have an incentive to hold equities of domestic firms producing what were formerly
nontradable goods.

Consequently, the influence of factor Q above will decline.

Moreover, if the reduction in data transmission costs and the emergence ofintermediaries accompanying the development of the Internet make foreign financialtransactions easier than in the past, the factors obstructing investors’ cross-borderhigh, production sites are concentrated nearby final consumers and intermediate goods
providers. Therefore, when transportation costs are sharply reduced, actual production sites
tend to be dispersed. Because the advent of the Internet is greatly reducing the shipping costs
for data and other digital goods, firms’ locational strategies are changing, and this is apparently
permitting the development of corporate production and sales systems on a global scale. As
for the effects of the increase in direct investment accompanying the dispersion of corporate
production locations on trade, trade theory offers two mutually contradictory conclusions. The
first is that the volume of trade increases (that is, factor mobility is a complement of trade).
The second is that the volume of trade decreases (that is, factor mobility is a substitute of trade).
The empirical research has not reached definitive conclusions on these issues, but recent
research (such as Collins, O’Rourke and Williamson [1997] and Goldberg and Klein [1997])
confirms a complementary relationship. For a detailed consideration, see Otani, Kawamotoand Hisada (2001b).
65
The following discussion is based on Shiratsuka and Nakamura (1998).
66
Some studies show that the potential merits from international portfolio diversification are on

48

optimizing behavior may weaken. As a result, the development of the Internet has thepotential to mitigate home bias.
(Convergence of Long-term Real Interest Rates)
Along with the increased capital flows and financial services transactions in recent
years, international interest-rate arbitrage trading is becoming more active.

But realinterest rates are not completely converging internationally, even long-term interest
rates which are most likely to be arbitraged, because of expectations of foreignexchange rate fluctuations, risk premiums, the asymmetry of information (the relative
ease of obtaining information related to domestic securities as opposed to foreign
securities, etc.), and certain factors obstructing investors from optimizing theirinvestments, such as taxation systems.

Among these factors, the problem of theasymmetry of information in particular may be diminished by the reduction in datatransmission costs and the emergence of information intermediaries (such as those
providing financial services).

Consequently, we must consider the possibility of a stillcloser convergence of long-term real interest rates.
(Potential for Currency Substitution)
The conventional understanding is that currency substitution normally progresses when
there is a great decline in the credibility of a national currency, such as during periods ofhyperinflation. Nevertheless, the growth of trade from the expansion of E-commerce
may also directly advance currency substitution.
Following the revisions made to Japan’s Foreign Exchange Act in April 1998,
settlements using on-hand U.S. dollars are beginning to increase among trading
companies, manufacturers, and other firms engaged in foreign trade.

If most foreign

trade continues to be settled in U.S. dollars in the future, with the growth of trade
resulting from the expansion of cross-border E-commerce, the amount of firms’ onhand dollar funds and of the dollar funds required for settlement may both increase.

If

the weight of such dollar settlements surpasses a certain level, the use of the dollar forthe settlement of B-to-B transactions (dollarization) may then accelerate.
For B-to-C commerce as well, since the Internet has facilitated instantaneousand low-cost deposits in overseas banks, the dollar holdings of consumers may rise andthe use of the dollar for payments may increase as well.

However, considering that thescale of B-to-B transactions is much larger than that of B-to-C transactions, a more
the order of merely 0.5% of permanent income. For example, see Lewis (1996).
49

likely scenario is that dollarization will advance mainly for B-to-B transactions.67(Competition among Financial Markets)
The competition among financial markets is nothing new.

There have been many

examples where financial transactions that were formerly conducted on domestic
financial markets were relocated to foreign markets with fewer regulations and lower
tax rates, such as the development of Euro markets under regulation Q68 in the UnitedStates in the 1970s and the increase of bond issues by domestic firms on foreign
markets.
The development of the Internet is dramatically reducing data transmission costs
and greatly curtailing the expenses incurred in conducting financial transactions. Thus,
the possibility that financial transactions in domestic markets may be relocated toforeign markets from slight differences in regulations and tax systems is rising to an
unprecedented level.69

To avert this, efforts toward the international harmonization ofregulations and tax systems are becoming even more important than in the past.

(4) Globalization and Monetary Policy
This section examines the developments described above, specifically the increase in
the degree of dependence upon foreign trade, asset substitution, convergence of realinterest rates and currency substitution, from the perspective of the monetary policy
transmission mechanism.
(Influence of the Increase in the Degree of Dependence upon Foreign Trade)
Because the degree of dependence upon foreign trade is increasing from globalizationand the influence of the balance of trade (foreign demand) on the business cycle is
growing, foreign exchange rates are believed to be becoming more important in themonetary policy transmission mechanism.70

Assuming uncovered interest-rate parity,

the expectations of foreign exchange rate changes are equal to the sum of thedifferential between domestic and foreign interest rates and the risk premium, so this67

See Appendix 1 for a discussion of how an equilibrium may be established under the coexistence of two different currencies in one country.
68
Regulation Q set upper limits on savings and time deposit interest rates.
69
Recently, in conjunction with the growing demand for pan-European stock trading from theintroduction of the common currency the euro, the competition among European securities
markets has been intensifying, resulting in a wave of mergers and alliances.
70
Mishkin (1995) also emphasizes this point.
50

implies that interest rate channels will become even more important.
(Influence of Asset Substitution and the Convergence of Long-term Real Interest
Rates)
If, as discussed above, the IT Revolution is mitigating the home bias and increasing thesubstitutability of domestic and foreign financial assets, the differential between
domestic and foreign real interest rates may come to have a great influence on realexchange rates via more active capital transfers (in other words, the importance ofinterest rate channels will increase). On the other hand, the substitutability of domestic
and foreign financial assets may advance further, resulting in greater pressure for theworldwide convergence of long-term real interest rates when expected changes of
exchange rates are unchanged. Thus, it is important to note that under these conditions
it may become more difficult for policy interest rates and short-term interest rates toinfluence long-term interest rates.
(Influence of Currency Substitution)
Turning to the influence of currency substitution71, to begin with, under a partial
advance of dollarization, central banks will not lose the controllability of short-term
interest rates denominated in domestic currencies. However, in this situation, since a
portion of domestic transactions will be conducted in dollars, the influence of domestic
monetary policy will decline proportionately.

Additionally, the advance ofdollarization will likely make the compilation of monetary aggregates statistics evenmore difficult.

Even if monetary aggregate statistics can be accurately compiled, therelationship of monetary aggregates with the real economy or prices may become
unstable.

In the case of a complete dollarization, domestic monetary policy would be

both unnecessary and ineffective.72

71

It is also noteworthy that the advance of dollarization will also decrease the central bank’s
seigniorage revenue. But the discussion here is limited to the effectiveness of monetary policy.
72
This point is made clear by the fact that the monetary policy decision-making authority wastransferred from each nation’s central bank to the European Central Bank by the introduction of
the common currency, the euro.
51

6. The IT Revolution and Monetary Policy
Central banks conduct their monetary policy under an uncertain environment where
various changes such as exogenous shocks (e.g. oil shock), economic structural changes
and systemic changes occur continuously, and in which it is difficult to grasp theinfluence of these events accurately in real time. As described in the previous chapters,
the ongoing IT Revolution is expected to change financial and economic frameworks(structures), and this may well advance at a pace exceeding all expectations.
Consequently, the IT Revolution will bring new uncertainties to the world within whichcentral banks implement monetary policy.
Various research is being conducted regarding the best approach to monetary
policy implementation under such uncertainty.73

One influential argument is that a

conservative and gradual implementation of monetary policy is desirable.

For

example, suppose that although the effect of monetary policy on the real economy isactually strengthening, the central bank judges that it is weakening or unchanged, andimplements a major policy change.
economy.

This change could cause major damage to theOn the other hand, some warn that a conservative and gradual

implementation of monetary policy could easily result in policy changes that are “toolittle and too late.”

They believe that when there is a high level of uncertainty,

monetary policy should be changed as flexibly as possible, and then promptly changed
back if the desired results are not achieved.

Thus, at the present time, no firm

consensus has yet been reached regarding the appropriate approach to monetary policy
implementation under uncertainty.74
Accordingly, this chapter examines the difficulties posed by the IT Revolution
for the implementation of monetary policy, notes the increasing difficulty central banks
will face in grasping economic conditions, and considers appropriate countermeasures.
This chapter also reviews and summarizes the influence of the IT Revolution on theeffects of monetary policy and the monetary policy transmission mechanism, as
examined in the previous chapters.

73

See Appendix 2 for a detailed explanation of this point.
The Forum also discussed whether the implementation of monetary policy under uncertainty
should be based on rules or on discretion. Some Forum members expressed the opinion that a
rule-based monetary policy framework is necessary to set a nominal anchor precisely because of
the uncertainty. Nevertheless, no consensus was reached regarding whether the framework
should be based on rules or on discretionary policy, or whether a discretionary policy is actuallyinevitable under such circumstances.
74

52

(1) Influence on the Ability of Central Banks to Grasp Financial andEconomic Conditions
Because the IT Revolution is increasing the volume of information as explained in
Chapter 2, it is also increasing the volume of information that central banks can utilize
in conducting monetary policy.
Nevertheless, the IT Revolution inevitably makes it increasingly difficult for
central banks to accurately grasp the real economic and price conditions that are thebasis for policy decisions. This section considers these issues in some detail, and notes
the necessity of decreasing this uncertainty.
(Accurately Grasping Potential Growth Rates)
The IT Revolution is expected to raise Total Factor Productivity (TFP) via labor savings,
more efficient inventory control75, and the synergy effect76 in industries that use thegoods produced by new technologies as inputs. However, actual estimations failed toshow a rise in TFP in the U.S. economy for a long time (the so-called “productivity
paradox”).

While various hypotheses have been proposed to explain this paradox (seeBox 6), recently some empirical analyses have appeared confirming that the IT
Revolution has in fact raised TFP, and opinions for a rise in TFP are becoming dominant.
For example, the annual report of the U.S. Council of Economic Advisors (CEA)
released in February 2000 very positively evaluates the rise in TFP from the IT
Revolution.

It shows that the annual increase in labor productivity since 1995 is

1.47% higher than the long-term trend77 (Figure 11). Moreover it clearly demonstrates
that, during the current economic expansion, the growth rate of productivity has actually
been accelerating as the expansion continues even though the normal pattern is to leveloff during the latter half of economic expansion phases (Figure 12).
Although IT-related investment in the U.S. increased from the early 1990s, therise in TFP has only recently been confirmed.

It is extremely important for central

banks to accurately grasp macroeconomic productivity and potential growth rates in realtime for the implementation of monetary policy, but as demonstrated by the U.S.
experience, this is also extremely difficult.

In fact, one study claims that the failures of75

For example, firms can now easily trade their excess inventories via Internet electronic
marketplaces (such as MetalSite), and this should reduce the appropriate inventory-sales ratios.
76
This synergy effect is dependent upon the extent to which the market mechanism functions ineach market, such as the level of labor market mobility.
77
This can be broken down into 0.47% from the increase in capital stock under active IT
investment, 0.23% from the rise of TFP in the computer sector, and 0.77% from TFP increases
in other sectors.
53

U.S. monetary policy in the 1970s resulted from excessive monetary easing, which was
implemented without recognizing the decrease in the potential growth rate from the oilshock and other factors at that time.78(Accurately Grasping Price Conditions)
The IT Revolution is also making it more difficult for central banks to accurately grasp
price conditions, which are an important basis for making policy decisions.
To begin with, when prices decline under the advance of the IT Revolution, it isnecessary to distinguish between the effect of a demand shock and that of a supply
shock from the IT Revolution.

In addition, to quantitatively measure price declines

from a supply shock, it is necessary to grasp the extent of the downward shift of theaggregate supply curve from the IT Revolution.

In actual practice, this estimation is

likely to be exceedingly difficult as it requires an accurate grasp of the productivity
increases from the IT Revolution and other factors such as the changes in the level ofmonopoly concentration in each market. Moreover, there are concerns that the priceindices may have an upward bias if the new products developed under the IT Revolution
and E-commerce transactions cannot be promptly incorporated.

What is more, if thetrend toward multiple prices for the same goods advances and the price movements ofitems presently used as representative items for individual product categories come todiffer from the price movements of the other items in these categories, this would pose amajor problem for the usefulness of price indices as indicators.
While it is always difficult to accurately grasp price conditions, the IT
Revolution is highly likely to make this task even more difficult.
(Necessity of Responding to Uncertainty)
As noted above, it may become increasingly difficult to accurately grasp potential
growth rates and price conditions under the development of IT Revolution.
Considering that an accurate understanding of monetary and economic conditions is amajor premise for the implementation of monetary policy, central banks must exert
every possible effort to grasp the changes accompanying the IT Revolution promptly
and accurately, and to minimize the uncertainty faced in making policy decisions aswith other exogenous shocks.

In other words, to make more accurate judgments

regarding macroeconomic conditions under the advance of the IT Revolution, central
banks will need to raise the level of their analyses on monetary and economic78

See Orphanides (1999) regarding this point.
54

conditions and to improve their research abilities.

Additionally, from the perspectiveof accurately grasping monetary and economic conditions, central banks will also needto improve the quality of their economic statistics.

For example, there is a highprobability that the reliability of certain monetary aggregate indices will decline withthe development of financial and payment technologies. Therefore it will become
necessary to review the definition and the financial assets covered by existing monetary
aggregate statistics with appropriate timing (see Box 7 for the history of the redefinitionof the monetary aggregates in the U.S. based on the advent of new financial products,
and the stance that should be taken toward the compilation of monetary aggregate
statistics in the future).

The various approaches toward compiling new statistics of E-

commerce, which has recently been notably expanding, and toward maintaining andimproving the reliability of price statistics (mitigating the upward bias, etc.) may also be
important issues.

Box 6: Several Hypotheses Explaining the Productivity Paradox
The debate regarding the productivity paradox may be broadly classified into three main
approaches:

the historical lag hypothesis, the measurement error hypothesis, anddynamic TFP estimation.

This Box introduces the paper regarding this issue presentedth

in the 17 meeting of the Forum (Otani, Kawamoto and Hisada [2001a]).
Q Historical Lag Hypothesis
According to David (1990), while the electric power motor was invented around 1880,
it was not until 1913-1929 that this invention contributed to boosting the productivity of
the U.S. manufacturing industry.

This implies that there was a 30-40 year time lag

between the invention and the increase in TFP.

Applying this time lag to thedevelopment of the computer, the 1980s and 1990s represent a gestation period and therises in TFP should become manifest from now on.
Similarly, Kitamura (1997) reviews Japanese economic history and notes thatthe electric power, telephone, broadcasting and railroad technologies that gradually
spread from the end of the 19th century only resulted in full-scale productivity increases
with the revolution in application technologies after the Second World War.
generally takes an affirmative stance toward the lag hypothesis.

55

KitamuraR Measurement Error Hypothesis
Nordhaus [1997] argues that although the advent of new high-performance goods
reduces the cost to enjoy the same service or utility as in the past, price indices ingeneral do not fully reflect the effects of these goods.

He states that the U.S.

Consumer Price Index (CPI) has an average annual upward bias of 1.2% because it fails
to fully reflect quality improvements.

And he also says that such quality adjustments

would raise the 10 % increase of U.S. real wages from 1959 to 1995 (on a cumulativebase) to a 70% increase, and would also boost the U.S. TFP increase rate during thissame period from 0.6% to 1.8%.

Thus, Nordhaus argues that TFP increases may beunderestimated because price indices do not properly reflect quality improvements.
S Dynamic TFP Estimation
According to Kuroda and Nomura (1997), traditionally the majority of capital stock has
comprised buildings and civil engineering related capital goods, but in recent years theconstituent percentage of such goods has been declining while that of electrical andgeneral machinery has been rising.

The IT Revolution represents a technologicaladvance in capital goods, especially in electronic equipment, and this should be making
the capital goods in each industrial sector more efficient through changes in quality andcomposition.

On the other hand, capital stock as a factor of production is theaccumulation of past investments, and reflects the technological levels when theseinvestments were made.

Thus, in order to measure current productivity, it becomes

necessary to retroactively evaluate the efficiency of the old capital stock. Additionally,
the IT Revolution is changing the mutual dependence relationships among industries,
and this factor must also be taken into consideration in measuring productivity.

Basedon this understanding, the concept of “dynamic TFP” is a means of measuring a nation’s
production efficiency from a dynamic perspective. Applying this concept, Kuroda andNomura (1997) calculate that Japan’s annual productivity increase rate averaged 3.32%
from 1985 through 1990, and this greatly surpasses the figure calculated under thenormal approach (1.65%).

They conclude that the productivity paradox is no longer

observed when dynamic TFP estimation is adopted.

56

Box 7: Changes of the Definition of Monetary Aggregates from the Advent of
New Financial Products
How is the advent of new financial products influencing monetary aggregate statistics,
and what should central banks do to maintain the usefulness of monetary aggregate
statistics?

This Box introduces the paper regarding these issues presented in the 9th

meeting of the Forum (Ishida and Kawamoto [2000]), which reviews the influence of
the advent of new financial products on existing monetary aggregate statistics in the
U.S. as well as the implications for the compilation of monetary aggregate statistics.
Q NOW Accounts
In the U.S., savings banks (savings and loan associations, mutual savings banks andcredit unions) were legally prohibited from issuing demand deposits that can bewithdrawn by check (checking accounts), but they successfully circumvented thislegislation through the development of Negotiable Order of Withdrawal (NOW)
accounts. NOW accounts provide similar functions to checks, but are not considered
to be checks under the law.

As a result, there was a huge shift of funds from demand

deposits, which legally cannot bear interest, to NOW accounts.

In response to thisdevelopment, NOW accounts were added to M1 from November 1978, and to M1B(current M1) from February 1980.
R ATS Accounts
Commercial banks were prohibited from issuing interest-bearing demand deposits bylaw, but they developed Automatic Transfer from Savings (ATS) accounts to counter theshift of funds to NOW accounts.

Under ATS, whenever funds are required for

payment, the required amount is automatically transferred from interest-bearing savings
accounts to demand deposits.

This development rendered the distinction between ATS

accounts and demand deposits meaningless in terms of monetary aggregate statistics, so
ATS accounts were added to M1 from February 1980.
S MMMFs
Money Market Mutual Funds (MMMFs), which are investment trusts that primarily
invest in short-term public and corporate bonds, first appeared in 1971.

From the late1970s, under Regulation Q, with the high-interest policies implemented by Federal
Reserve Board Chairman Paul Volcker and the improved settlement functions for these
instruments, the outstanding balance of funds in MMMFs rapidly increased as funds
57were transferred from savings accounts and small time deposits.

In response, MMMFs

for individual investors were added to M2 from February 1980.
T MMDAs
Banks developed Money Market Deposit Accounts (MMDAs), which are investment
trusts managed directly by banks, to respond to the shift of funds from their deposits to
MMMFs.

MMDAs are covered by the Federal Deposit Insurance and permit bothwithdrawals at bank branch counters and the use of checks, so a large volume of funds
were transferred from MMMFs and other instruments to MMDAs.

Consequently, theMMDA category was added to M2 from January 1983.
U The Rapid Increase in Bond and Stock Mutual Funds and “Missing M2”
From the early 1990s, with the improved settlement functions for mutual funds (thefunds transfer services linking mutual funds with demand deposit accounts at affiliatedbanks), there was a shift of funds from time deposits, which are a component of M2, tobond and stock mutual funds. As a result, the rate of increase in M2 remained at a low
level, despite repeated monetary easing.
In response to this situation, many FRB economists began to compile broadly
defined monetary aggregate statistics, and numerous empirical analyses were conducted
to examine the stability of the relationship between these monetary aggregates and real
economic indices.

But they did not show clear empirical results which would lead to

specific statistical revisions.
These five examples demonstrate how the FRB has sequentially expanded the coverageof monetary aggregate statistics whenever new financial products with high settlement
functions are developed, to seek monetary aggregates definitions that provide thegreatest empirical usefulness for the relationship with the target variables, such as
nominal GDP and prices.
Accordingly, if the future advance of the IT Revolution results in thedevelopment of new financial products, it may well be necessary to pursue the type oftrial-and-error approach adopted by the FRB for the compilation of monetary aggregate
statistics.

58

(2) Influence on Monetary Policy and the Monetary Policy Transmission
Mechanism
Next, this section reviews the influence of the IT Revolution on the effects of monetary
policy and the monetary policy transmission mechanism.
(Control of Short-term Interest Rates by Central Banks)
There is a strong likelihood that the development of electronic payment technologies
including “electronic money” and the advent of new financial products from the IT
Revolution will structurally and unstably decrease the demand for the monetary base,similar to the effects from the spread of MMFs and credit cards in the past.

To lessen

real GDP fluctuations when the demand for money becomes unstable, it is considereddesirable for central banks to adopt interest rate stabilization policies (Poole [1970]).
In actuality, as almost all nations including Japan presently adopt short-term interest
rates as their operational targets, the reduced demand for money is not expected to exert
a significant influence on the present frameworks for money market operations.
Also, even if the demand for the monetary base does decrease, since central
banks are monopolistic suppliers of the monetary base, in principle there is no reason
why central banks will lose the controllability of short-term interest rates.79
Of course, if the further development of electronic payment and settlement
technologies results in a long-term decline in the demand for the monetary base, theinfluence of the short-term interest rates controlled by central banks on financial
markets and the overall economy may well decline. Nevertheless, at present the daily
settlement volume is more than 100 trillion yen with a monetary base of several trillion
yen, and even if settlement efficiencies improve further from the IT Revolution and themonetary base decreases to several hundred billion yen, it is difficult to believe that the
influence of short-term interest rates will weaken.

On the contrary, considering that adecline in the demand for the monetary base implies the further development offinancial markets, the effects of the transmission mechanism via short-term interest rates
may actually increase.80(Influence on Monetary Policy and the Monetary Policy Transmission Mechanism)
Chapter 3 and the subsequent chapters examine how the monetary policy transmission
79

Are central banks still able to control short-term interest rates when financial and payment
technologies advance further and the outstanding balance of the monetary base falls to zero?
See Appendix 3 for a conceptual experiment concerning this point.
80
See Chapter 4 regarding this point.
59

mechanism may change from the changes in financial transactions and financial
intermediaries, and from globalization. Here, we present a brief summary of these
considerations (Figure 13).
Q The reductions in information processing and transmission costs and theimprovement in risk-management capabilities are resulting in more active arbitrage
trading, and thus the transmission speed of interest rate changes in the financial
markets is believed to be increased.

On the other hand, the effectiveness ofavailability channels may decline from the greater variety of fund raising methods
other than bank loans due to the growth of financial markets, and from the decreasein credit rationing resulting from the development of derivatives.
R The entry into the financial intermediation industry by firms in different industries
may increase the effectiveness of interest rate channels as the increased competitive
pressures reinforce the response of lending rates to policy interest rates.

On theother hand, some believe that the influence of monetary policy via balance sheet
channels (the effect on bank lending through changes in firms’ collateral value) may
decrease under the IT Revolution if financial institutions’ monitoring capabilities
improve.
S The rising degree of dependence on foreign trade due to globalization is expected toincrease the effect of monetary policy via foreign exchange rate channels.

This

also implies that the effectiveness of interest rate channels may increase via theinfluence on foreign exchange rates.

If the substitutability of domestic and foreign

assets strengthens from the IT Revolution, the influence of interest rates on foreignexchange rates may increase.

But it is important to note that it may become moredifficult for policy interest rates and short-term interest rates to influence long-term
interest rates with the greater pressure for the worldwide convergence of long-term
real interest rates when the expected change of exchange rates is assumed to beunchanged.
Judging from the results of the considerations summarized above, the conclusions
regarding the influence of the IT Revolution on the monetary policy transmission
mechanism are as follows:

Q the effects of monetary policy via interest rates andforeign exchange rates will likely become stronger, while R the effects of monetary
policy via funds availability (or balance sheets) will likely diminish.
In addition, the IT Revolution will not only change the relative importanceamong the channels through which monetary policy exerts its influence on the economy,
but there is also some possibility that the IT Revolution may reduce the necessity and60the effectiveness of monetary policy.

Specifically, as noted in Chapter 3, the reduction

in menu costs from E-commerce implies the possible emergence of economic
conditions wherein monetary policy itself will become unnecessary. Moreover, thedevelopment of electronic money as a generally accepted settlement currency and theadvance of dollarization (as discussed in Chapter 5) will reduce the necessity andeffectiveness of domestic monetary policy.

Nevertheless, taking the asymmetry of

information into account, it is not realistic to believe that all transactions will be
conducted over the Internet or that pricing will become completely flexible.
Additionally, a complete dollarization remains highly unlikely provided that thecredibility of domestic currencies is not completely lost from hyperinflation. Thus, forthe foreseeable future, monetary policy will remain both necessary and effective, eventhough the necessity and effectiveness of monetary policy may decline somewhat.

61

7. Conclusions
The Forum held comprehensive and active discussions regarding how the IT Revolution
may change financial and economic activities and frameworks (structures), how the
implementation of monetary policy may be influenced by these changes, and how
central banks should respond. As noted at the beginning of this report, because the IT
Revolution is still underway, it is impossible to completely predict exactly how its
influence will come out or the extent of its impact at the present time.

It is importantto recognize the risk of overestimating the impact of the IT Revolution as well as that offailing to predict its ramifications.

Nevertheless, in order to prepare for the future, wemust grasp the potential of the IT Revolution and its likely effects from the broadest
possible perspective as a type of conceptual experiment.
The Forum’s conclusions may be summarized as follows.
Q The IT Revolution may lead to major changes in financial and economic activities
and frameworks (structures), which are the object of monetary policy, includingchanges in financial transactions and the financial industry, changes in theframework of goods and services transactions, and further globalization. Moreover,the changes brought about by the IT Revolution may well advance at a paceexceeding all expectations.
R Considering that an accurate understanding of monetary and economic conditions isa major premise for the appropriate implementation of monetary policy, central
banks must exert every possible effort to grasp the changes accompanying the IT
Revolution promptly and accurately, and to minimize the uncertainty faced in
making policy judgments as with other exogenous shocks.

From this perspective,

central banks will need to raise the level of their analytical capabilities and to further
improve the quality of their economic statistics.
S As for the influence of the IT Revolution on the effects of monetary policy and its
transmission mechanism, the IT Revolution may change the relative importanceamong the routes whereby monetary policy affects the economy, for example it may
make interest rate channels more effective.

Nevertheless, for the foreseeable future,monetary policy will remain both necessary and effective.
As explained at the beginning of Chapter 6, it is important to note here that the various
problems posed by uncertainty are not unique to the IT Revolution. Nevertheless, as
the IT Revolution may have a major influence on every aspect of financial andeconomic activities, including their fundamental frameworks, the resulting uncertainty
62

will likely be wide-ranging and multifaceted.
The Forum endeavored to grasp the effects of the IT Revolution on acomprehensive basis, but it was not possible to cover every possible aspect.
For example, the IT revolution has made it possible to acquire a great volume of
information in real time, for this information to be promptly reflected in market prices,and for central banks to also disseminate information in real time.

Thus, finding thebest practices for central banks to communicate with other market participants when
information is exchanged on a real-time basis may be considered as one important issue
that requires further examination.
It might also prove valuable to conduct more in-depth examinations regarding
the effects of the increased speed and globalization of financial transactions on thestability of financial markets.

This report has focused on increased financialtransactions from the perspective of their impact on the financial industry.

But itwould also be desirable to conduct further studies on how speedy financialtransactions81 may influence the volatility of interest rates, foreign exchange rates andstock prices, and on how the herding behavior of investors and the exogenous shocks
from foreign countries may influence domestic markets.82
Another important issue is the potential influences of the IT Revolution on
financial system stability, and the appropriate prudential policies to respond to suchinfluences. As introduced in this report, while the IT Revolution is prompting thefurther development of financial markets, it is also resulting in the simultaneous
advance of greater diversification and concentration in the financial intermediationindustry, with diversification from the market entry by firms in different industries andconcentration through bank mergers (the creation of mega-banks).

These changes inmarkets and the financial intermediation industry will also have a great influence on thestability of the financial system and on the policies to achieve this stability (such as
81

While the IT Revolution facilities financial transactions in increments of a few hours or
minutes, the spread of E-commerce may also be increasing the demand for such speedytransactions. The shortening of transaction periods may increase the number of financialtransaction errors. Thus, in an effort to achieve the ideal combination of the benefits and risksof speedy financial transactions, it may become necessary to reconsider the optimal basis period
for the calculation of interest, which has traditionally been conducted on a daily basis. The
preparation of markets in which such short-term financial transactions are conducted may also
be important for the conduct of open market operations.
82
Regarding this point, one Forum member noted that as the influence of foreign exchange rates
on domestic economies will strengthen from the increase of trade, it may become easier forforeign shocks, such as policy mistakes in foreign countries which can cause financial crises, toexert a harmful influence on domestic economies. The member stated that therefore policies toavert such circumstances may come to represent an important issue.
63

safety nets, supervision of financial institutions, and regulations).
While these areas lie outside of the scope of this report, they are considered to beimportant issues that require further examination in the future.

64

(Appendix 1)

Regarding the Domestic Co-existence of Multiple
Currencies

While dollarization may progress along with globalization, is it really possible formultiple currencies to be circulated within a single nation as settlement currencies?
The paper regarding this issue presented in the 14th meeting of the Forum (Matsui andShimizu [2000]) utilizes a model with a microeconomic foundation and demonstrates
that there is an equilibrium where multiple currencies are simultaneously circulated as
settlement currencies. This Appendix introduces a summary of this paper.
The paper first constructs a model with a microeconomic foundation for the caseof a single currency, and then expands this model to multiple currencies.
(Case of a Single Currency)
Q Basic Framework of the Model
The basic framework of the model is as follows.

Assume that there are K types ofgoods, and that these goods are perishable and indivisible.

In contrast, unlike thegoods, the currency (fiat money) is non-perishable and divisible (the total nominal stockof fiat money is expressed as M).

This economy is populated by a continuum of

infinitely lived agents with unit mass, and there are K types of agents.

While an agentof type k produces a good k+1, which an agent of type k+1 wants to consume, an agentof type k-1 produces a good k, which an agent of type k wants to consume.

When anagent of type k consumes one unit of good k, he obtains utility u. (These transactions
cannot be achieved through barter and are always conducted with fiat money. In
addition an agent cannot simultaneously buy and sell goods.)(Purchase and Sale Relationships in the Case of Three Types of Agents)

Sale

1

2

Purchase

3

The purchases and sales by each agent must be conducted in marketplaces.

65

There are

countably many marketplaces, and each marketplace has two sides, Side A and Side B(transactions can only take place between agents located on opposite sides).
R Transaction Steps
The transactions among agents are implemented through the following steps.

First, theagents decide which marketplace to visit, and then decide which side of it (Side A orSide B) to enter (Stage 1).

(Selection of Side A or Side B)

A

B

………

A

B

………

Then, when the agents visit each marketplace, random matchings are made between
agents on Side A and agents on Side B (Stage 2).

When these random matchings pairan agent of type k with an agent of type k+183, because the agent of type k produces agood k+1, which the agent of type k+1 wants to consume, the agent of type k acts as aseller and the agent of type k+1 acts as a buyer.

If the number of buyers exceeds thenumber of sellers, the number of buyers that exceeds the number of sellers are unable toconduct transactions.

Thus, it is assumed that rationing occurs when there is an

imbalance in the number of agents on both sides (Stage 3).

When the buyers andsellers meet, if the seller’s offer price Ps is below the buyer’s bid price Pb then thetransaction is consummated at price Ps (Stage 4).

83

Of course, transactions are not conducted when the matching pairs an agent of type k with anagent of types other than k+1.
66

(Matching Process)Transaction Conducted

A

B
Transaction not Conducted

S Definition of Equilibrium
Each type of agent acts after determining his strategy for selecting marketplaces, and forsetting the offer prices for the goods the agent produces when the agent acts as a seller
and the bid prices when the agent acts as a buyer, under the constraint of the fiat moneystock the agent holds. Here, the condition whereby the strategies of each type of agent,
under the fiat money stock the agent holds, remain unchanged is referred to as astationary equilibrium.

Any strategies other than those selected by each agent under

this stationary equilibrium will not generate greater utility than that derived under thestationary equilibrium.
T Existence of Equilibria
While countless stationary equilibria are possible under this model, here we consider astationary equilibrium in which every good is traded at price p.
The total real stock of fiat money, M/p, is expressed as m.

Let us consider thecase where the number of agents holding p units of fiat money is exactly m and thepercentage of agents holding zero fiat money is 1-m.

For example, assume that thetype k agents that hold p units of fiat money adopt a strategy to stand on Side B ofmarketplace k, to act as buyers, and to present a bid price of p. Meanwhile, assume
that the type k agents that hold no fiat money adopt a strategy to stand on Side A ofmarketplace k+1, to act as sellers, and to present an offer price of p84.
84

In this case, if m

Here we assume symmetrical strategies whereby type k agents that hold p units of fiat money
adopt a strategy to stand on Side B of marketplace k, to act as buyers, and to present a bid priceof p , and type k agents that hold no fiat money adopt a strategy to stand on Side A of67

is 1 or less (if p ≥ M ), although rationing may take place based on the size of m85,
there is no merit to be gained by any of the agents from changing their strategies.
Consequently, this case is a stationary equilibrium, and thus a stationary equilibrium
exists under this model setting.
(Case of Multiple Currencies)
The above single currency model is now expanded to cover multiple currencies.
Assume that there are two types of currencies, Currency 0 and Currency 0*, and that themarketplaces where transactions may be conducted using each type of currency are
different.
Let us consider the case when every good is traded at the same prices p and p*.
Here, the total nominal stock of fiat money is M and M*, and the total real stock of fiatmoney is expressed as m=M/p and as m*=M*/p*. Additionally, n percentage of agents
use Currency 0 and n*=1-n* percentage of agents use Currency 0*.

In this case, if thelikelihood of concluding a transaction is exactly the same using Currency 0 or Currency
0*, there is no incentive for the agents using Currency 0 to start using Currency 0*(similarly, there is no incentive for the agents using Currency 0* to start using Currency
0).

Thus, in this case, a situation in which two currencies co-exists becomes anequilibrium.
This equilibrium requires that the ratio of agents that are holding currency 0 toagents that utilize Currency 0 must be equal to the ratio of agents that are holding
m m*
=
).
n n*

The reason why

this is a condition for equilibrium can be explained as follows.

For example, if

currency 0* to agents that utilize Currency 0* (that is,

1 m m*> >, then using either currency there will be fewer buyers than sellers, so a
2 n n*

rationing of sellers will occur.

However, because for sellers the likelihood of rationing

will decrease when using Currency 0*, n* will decrease and n will increase.
movement will continue until

This

m m*
=
holds and the equilibrium will then ben n*established under this condition.

marketplace k+1, to act as sellers, and to present an offer price of p .
85
For example, when m=1/2, because the number of sellers and buyers is the same on all
marketplaces, rationing will not occur. However, when m<1/2, because the number of buyers
is less than the number of sellers, a rationing of sellers will occur.
68

(Appendix 2) Monetary Policy under Uncertainty
How should monetary policy be conducted under “uncertainty”?

Otani, Kawamotoand Hisada (2001a) identify three types of uncertainty – parameter uncertainty (whenpolicymakers cannot accurately grasp the influence of changes of a given variable onothers), economic data uncertainty (when policymakers cannot accurately grasp real
economic conditions), and model uncertainty (when policymakers cannot accurately
judge macroeconomic structures) – and discuss the conduct of monetary policy undereach type of uncertainty.

This Appendix first introduces the case where there is only

additive uncertainty (when there is no parameter, economic data or model uncertainty,
but when random shocks, that policymakers cannot grasp, directly influence economic
variables in an additive manner) as a benchmark, and then introduces a discussion
regarding the conduct of monetary policy under these three types of uncertainty.
Q Additive Uncertainty and Certainty Equivalence
The analysis begins with the case where there is only additive uncertainty.

The model

is comprised of the following two equations;

π t +1 = aπ t + y t +1
y t +1 = −bit + ε t +1

(0 < a < 1)(b > 1)(1)(2)

where π is the inflation rate, y the GDP gap, and i the nominal short-term interest
rate.

Equation (1) is the Phillips curve and Equation (2) is the IS curve.86

The term

ε expresses the so-called additive shock and it is a random variable with an expectedvalue of 0 and a variance of σ ε2 .
The reduced form for inflation rate is obtained by substituting Equation (2) into
Equation (1), as shown in Equation (3).
π t +1 = aπ t − bit + ε t +1

(3)

Let’s assume that the central bank moves nominal interest rates to achieve
inflation rate targets.

In other words, the central bank implements its monetary policy

to minimize the expected value of the square of the deviation of the inflation rate fromthe target under the constraints of Equation (3). For simplification, we assume that the86

Equation (2) assumes that the nominal short-term interest rate influences the GDP gap, but itis the real short-term interest rate that should actually be viewed as influencing the GDP gap, so
the equation should properly be yt +1 = −b(it − π t ) + ε t +1 . Nevertheless, the following discussion
follows Batini, Martin and Salmon (1999) in adopting Equation (2) from the perspective ofmodel simplification. For a discussion of this formulation of the IS curve, see Svensson(1997).
69

inflation rate target is zero.
The following “optimal” policy reaction function is obtained by solving thisminimization problem.
it =

a
πt
b

(4)

This function is exactly the same as the solution to the model in which Equation (2) has
no uncertainty (that is, the term ε t +1 does not exist).
This is the ‘Certainty Equivalence Principle’ previously demonstrated by Theil,
and it shows that the optimal policy reaction function when there is only additive
uncertainty takes exactly the same form as the optimal policy reaction function when
there is no uncertainty.

In other words, there is no need to take uncertainty into

consideration for the optimal monetary policy under only additive uncertainty.
R Parameter Uncertainty
A representative example of parameter uncertainty is when the central bank cannot
accurately know the value of b in Equation (3) and there is uncertainty regarding theextent to which changes in the interest rate change the GDP gap and the inflation rate.
How should the central bank implement monetary policy under such conditions?
Let’s assume that even though the central bank does not know the exact valuesof parameters a and b in Equation (3), it does know that they are random variables
which have independent normal distributions with means of a and b and variances ofσ a2 and σ b2 .87 In this case, the desirable policy reaction function may be expressed asshown in Equation (5) from the first order conditions for the minimization problem.

it =

ab
2

b + σ b2πt(5)While this expression is somewhat more complicated than Equation (4), it basicallydemonstrates that when the uncertainty of the inflation rate reaction to monetary policy
increases (that is, when σ b2 expands), the optimal change of interest rates in response
to inflation becomes smaller. This is the Brainard Conservatism Principle as expressed
in Blinder (1998), which states that when there is uncertainty regarding the multipliereffect in policy, policymakers should adopt a conservative stance toward policy
implementation.
87

The Brainard Conservatism Principle does not necessarily hold true when there are correlated
relationships among the parameters.
70

When the central bank conducts its monetary policy in accordance with
Equation (5), the inflation rate (in the next period)88 does not converge with the target(which is 0) during the period, so during the next period as well the monetary policy
must respond to the remaining influence from the initial shock.

This provides thegrounds for adopting gradualism as the ideal policy approach when there is parameter
uncertainty.
S Economic Data Uncertainty
The next issue is how the central bank should implement monetary policy when it
cannot accurately grasp the true economic conditions due to measurement error, thetime lag and revisions of economic statistics, and the existence of economic variables,such as potential GDP, that cannot be measured directly.
Chow (1977) argues that when this type of uncertainty is treated as “additive
error,” it does not influence the optimal policy reaction function.

Let us consider thisbased on the above model. Assume that the central bank makes policy decisions not inaccordance with Equation (2), but rather in accordance with the following Equation (2’)
yˆ t +1 = −bit + ε t +1 + η ty+1

(b > 1)(2’)

where ŷ is the estimated value of the GDP gap and η y expresses the measurement
error between the real GDP gap and the estimated value.

In this case, the central bankcannot distinguish between the additive error ε t +1 examined in Q and the measurement
error η ty+1 . Nevertheless, under Equations (1) and (2’), the optimal policy reaction
function remains Equation (4), just as in the case considered in Q.

Thus, under thisexample, the existence of GDP gap measurement error does not have any influence on
the optimal policy reaction function. This is the case which Chow’s claim applies to.
Nevertheless, this conclusion will not always hold true. Especially, it is known
that when there are multiple additive uncertainties that require different policy
responses, measurement error requires a more conservative policy reaction (Aoki[1999]). For example, when the measured value of the inflation rate increases, it is notclear whether this reflects a supply shock, a demand shock, or simply measurement
error.

Here, we assume that the central bank’s objectives are not only to maintain thetarget interest rate but also to maintain the stability of real GDP.

In this case, thecentral bank may make a major policy mistake by substantially increasing interest rates
88

Under the model settings, changes in the nominal short-term interest rate in this period
influence the inflation rate in the next period.
71

if the central bank believes that the increase in the inflation rate is completely due to ademand shock although it is actually because of measurement error.

Accordingly, themonetary policy reaction function should be more conservative than that under the casewhen there is no measurement error.
T Model Uncertainty
The above cases all assume that the central bank has an accurate grasp of themacroeconomic structure, yet it goes without saying that the real economy isexceedingly complex, and it may be more realistic to assume that the central bank does
not accurately understand the economic structure.

Moreover, if the IT Revolution is

actually changing the economic structure itself, the model uncertainty will increase.
Then what type of monetary policy implementation is desirable under model
uncertainty?

One approach is to adopt monetary policy that achieves the best

performance from among numerous practical models (which is robust monetary policy).
We first consider the paper by Sargent (1999) as one example of research on
such robust policy.

Sargent compares various policy reactions in terms of the best

possible results under the worst possible cases (the “min-max principle”) by conducting
simulations. He reaches the conclusion that an aggressive policy stance is the mostrobust.89 Hansen and Sargent (2000) utilize various types of dynamic macroeconomic
models, and conclude that an aggressive policy response is desirable. On the other
hand, Taylor (1998) compares policy performance under both aggressive andconservative monetary policy and arrives at different conclusions, which indicate that
there is no specific policy style that is superior in all cases.

Thus, the research on thisissue has only just begun, and no clear academic consensus has yet been reached.
In summary, the stance toward the conduct of monetary policy differs greatly
depending upon how uncertainty is understood, and no clear consensus has emerged
regarding the conduct of monetary policy under model uncertainty.

89

Macklem (2000) interprets the conclusions of Sargent (1999) intuitively as implying that
aggressive policy changes are necessary as a type of insurance to prepare for the worst possible
situation.
72

(Appendix 3) Interest Rate Control when the Outstanding Balance ofthe Monetary Base is ZeroIn the real economy, the demand for the monetary base is undergoing a long-term
decline, reflecting reductions in required reserve ratios (for example, the required
reserve ratio in Canada has been reduced to zero), improvements in the security andefficiency of payment and settlement systems, greater depth and liquidity in short-term
government securities markets, and the development of electronic payment technologies
such as debit card and credit card transactions.
This Appendix introduces the paper presented by Forum member Hayashi in theth12meeting of the Forum (Hayashi, Otani and Kawamoto [1999]).

The paper

examines, as a type of conceptual experiment, whether central banks can actuallycontrol short-term interest rates under the circumstances where there is no reserve
requirement and the outstanding balance of the monetary base has declined to zero dueto the advance of the IT Revolution.90,91 One important point here is that when themonetary base declines to zero this means that the aggregate interbank monetary basedeclines to zero, and does not imply that the monetary base demand of each individualbank for settlement and other purposes declines to zero.
The analysis assumes that private banks all have accounts at the central bank,and that the final settlements for interbank transactions are all conducted via theseaccounts.92

When the central bank does not supply or absorb any funds in theinterbank market (and if there are no banknotes or Treasury Funds), for every bank witha credit balance on the central bank account, there must be another bank with a debit
balance.

Thus the settlements will all be completed as long as the debtor banks canborrow from creditor banks the reserves they need to close their positions at the end of
the day. However, when the central bank absorbs funds on the interbank market, theaggregate debit balance will exceed the aggregate credit balance93, so the banks that are
unable to borrow the necessary funds will be unable to complete their settlements, and90

Of course, each bank’s demand for monetary base on a stock basis will be positive, and will
not decline to zero, if the interest rates charged by the central bank for funds supply at the end of
the day are too high or if the market participants do not believe that at the end of the day theamount of funds supplied by the central bank will equal the amount of funds absorbed.
91
The discussion presented here is based upon Hayashi, Otani and Kawamoto (1999), thediscussions in the 12th meeting of the Forum, and Henckel, Ize and Kovanen (1999).
92
This appendix assumes that the outstanding balance for each bank must not be negative.
93
Only the central bank can artificially create an imbalance between the aggregate funds
shortage and the aggregate excess funds supply.
73

thus they will have to receive credit from the central bank.
In this situation, private brokers would offer interest rates that differ from thoseoffered by the central bank, match debits with credits, and the central bank might lose
the controllability of interest rates.
never occur.

In actual practice, however, this situation will

This is because as long as the central bank retains its status as themonopoly supplier of the monetary base, the central bank will be able to conduct
unlimited intervention in the interbank market, and thus the short-term interest rates
among private banks will not be able to deviate from the rates announced by the central
bank.94

94

Naturally, the private-sector brokers would offer different interest rates to each bankconsidering the credit risk of each bank borrowing funds. Even in this case, however, themarket interest rates would still be based on the interest rates announced by the central bank, but
adjusted for each individual bank’s credit risk.
74

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80

(Figure 1)
Changes in PC Prices and Processing Capacities
1984

1997

1998

Price

$3,995

$999

$799

MIPS

8.3

166

266

Cost/MIPS

$479

$6

$3

Source: Kumasaka (1999); Federal Reserve Bank of Dallas (1997).
Note: MIPS = Million Instructions Per Second.

(Figure 2)
Network Architecturea) Intelligent Network (Telephone)

Telephone Exchange

Terminal

Terminal

Terminalb) Stupid Network (Internet)

LAN

LAN
routerrouterrouter

LAN
Source:Ikeda (1999).

Terminal

(Figure 3)
Number of Years until Inventions are Used by 25% of the Population
Invention

Date of Invention

Electricity

1873

Number of Years to
Achieve 25% Penetration
45

Telephone

1876

35

Automobile

1886

55

PC

1975

16

Internet

1991

7

Source: Kumasaka (1999); Federal Reserve Bank of Dallas (1996).

(Figure 4)a) B-to-C E-commerce Market Scale(Unit: ¥ trillion)

25
21.32

Japan
20

U.S.
15.36

15
10.69

10
5

7.11
4.39

4.27
2.25
0.06

0.37

2.69

1.53

0.77

6.66

0
1998

1999

2000

2001

2002

2003

2004

b) B-to-B E-commerce Market Scale(Unit: ¥ trillion)

180
160

165

Japan

140
120

U.S.
117

100
80

79
68
50

60
40
20
0

20
9

1998

30

45
29

12

19

1999

2000

2001

2002

2003

Source: Ministry of International Trade and Industry; Andersen
Consulting.

(Figure 5)
Histogram of Book Price Changes(Number of Price Changes)(Price Change Amounts - $US)

Source:Brynjolfsson and Smith (1999).

(Figure 6)
Histogram of CD Price Changes(Number of Price Changes)(Price Change Amounts - $US)

Source:Brynjolfsson and Smith (1999).

(Figure 7)
Cost Per Banking Transaction(Researched by Booz-Allen & Hamilton Inc.)
($US)
1.2

1.07

1
0.8
0.52

0.6
0.4
0.2

0.27
0.015

0

Internet Banking

Source:ATM

Telephone

Bank Branch

U.S. Department of Commerce (1999); Booz-Allen and
Hamilton, Inc.

(Figure 8)
Growth in Petty Loans Provided in the California Region(June 1995 ~ June 1996)(year-to-year % change)

30
20

Large Banks

10

Others0-10Less than $100,000

Source:$100,000-$250,000

Levonian (1997).

$250,000-$1,000,000

(Figure 9)
International Trade of Selected E-Commerce Firms, 1997
Company

Segment

CDnow
Music Boulevard
AmazonBarns & Nobel
FastParts
Virtual Dreams
Dell
1-800-Flowers
Sabre
E*Trade

Music
Music
Books
Books
Electronic Components
Pornography
Computers
Flowers
TravelConsumer Brokerage

Source: OECD (1999).

Online Revenues
as % of Total
100
100
100
0.50
100
100
Almost 50
10
67.30
63

International Revenues
as % of Total
35
33
26
30
30
25
20
15-20
17.50
2.80

(Figure 10)
E-Commerce Impact on Various Distribution Costs(US$ per Transaction)

Traditional System
Telephone-basedInternet-based
Savings (%)

Source: OECD (1999).

AirlineTickets

Banking

Bill
Payment

8.0

1.08
0.54
0.13
89

2.22-3.32

Term Life
Insurance
Policies
400-700

0.65-1.10
71-67

200-350
50

1.00
87

SoftwareDistribution
15.00
5.00
0.20-0.50
97-99

(Figure 11)
Labor Productivity in U.S. (Nonfarm Business Sector)
Labor productivity tended upward at an average annual rate of 1.4 percent from 1973 to 1995.
It then accelerated to a 2.9 percent clip over the past 4 years.
Index: 1992=100 (ratio scale)
2.9 percent average growth 1995 to 1999
Actual

1.4 percent average
growth 1973 to 1995

Note:

Productivity is the average of income- and product-side measures.

1999 is inferred from the first three quarters.

Source: Council of Economic Advisors (2000).

Productivity for(Figure 12)
Growth in Nonfarm Business Sector Output per Hour During Expansions
in the U.S.
Productivity growth has fallen over time during previous long expansions but has risen
during the current one.
Average annual percent changeFirst two years
Years 3 and 4
Years 5 and 6
Years 7 and above

Note:

The final column shows growth from 1997 through the third quarter of 1999.

Source: Council of Economic Advisors (2000).

(Figure 13)
Changes in the Monetary Policy Transmission Mechanism Under the IT
Revolution.

Development of financial
and capital markets
Changes in financial
intermediaries
Expansion in the volume of
trade
Asset substitution
Reduction of the differential
between domestic andforeign real interest rates

Interest Rate Channel¡

Availability Channel
X

¡

X

¡

_

?

_

Influence on foreign exchange: ¡Convergence of domestic andforeign interest rates: X

Note: ¡ represents an increase in effectiveness and X represents a decrease ineffectiveness.