Bank of Japan
An Essay on Japan's Monetary Policy
Experience and Lessons
SAKURAI Makoto
Member of the Policy Board
KIMATA Tomonori
Director, Secretariat of the Policy Board
I. Introduction1,2
Japan's monetary policy has been consistently accommodative over the past three
decades. However, especially in times of global economic shocks, there have been cases when
the intended policy effect did not materialize due to differences with macroeconomic policies
in other countries. In what follows, we look back at the spillover effects of monetary policies
abroad and implications for the conduct of monetary policy in Japan.
II. Relationship between Money Demand and Supply and Economic Activity
Monetary policy is carried out by central banks in order to affect the real economy
through private financial institutions as well as financial and capital markets.
In general, monetary policy is effective when the following conditions hold:
(1) The relationship between the monetary base and the money stock is stable (i.e.,
the money multiplier is stable).
(2) The relationship between money demand, which is determined by interest rates,
future growth expectations, etc., and the level of activity in the economy as a whole
is stable (i.e., the money demand function and the investment multiplier are stable).
If (1) is satisfied, the central bank can estimate the level of the monetary base, which
it can directly control, that is necessary to achieve the desired level of economic activity. If
(2) is satisfied, it can estimate the extent of interest rate cuts necessary to stimulate private
sector demand for funds and hence investment.
Looking back at the period from the early 1990s to the present, Japan has
experienced the bursting of the domestic bubble economy, the Asian Financial Crisis and the
financial system crisis in Japan, and the Great Recession caused by the Global Financial
Crisis (GFC), and it is currently experiencing a major depression caused by the novel
coronavirus (COVID-19) pandemic. Although monetary policies in Japan remained
accommodative almost throughout, the economy did not decisively overcome economic
stagnation and deflation. One reason that monetary easing was unable to stimulate sufficient
demand is that the money stock did not rise enough relative to the monetary base (i.e., the
money multiplier fell), due in part to the decline in the functioning of credit intermediation,
especially during the crisis of Japan's financial system in the late 1990s. Furthermore, since
the money demand function became unstable with growth expectations declining as
deflationary sentiment took hold and interest rates approaching the zero lower bound, the
effectiveness of accommodative monetary policies may have declined accordingly. Thus, it
is likely that accommodative monetary policies that would have been quite powerful based
on conventional standards had a much smaller effect than expected. This raises the question
whether the scale of monetary easing was sufficient.
III. Monetary Policy under Globalization
The main objectives of monetary policy can be summarized as (domestic) price
stability and sound development of the national economy, such as maximizing employment
or maintaining an appropriate balance of supply and demand. Central banks conduct
monetary policy to achieve these goals in line with the particular conditions of their domestic
economy.
However, in a globalized world economy, monetary policies in one country are
inevitably affected by the economic conditions and monetary policies of other countries. The
transition from a fixed to a floating exchange rate system in the 1970s and the subsequent
advances in globalization have meant that macroeconomic policies, including monetary
policies, and their effectiveness must be considered within the framework of international
finance (open macroeconomics).
The move to a floating exchange rate system has led to the so-called "trilemma of
international finance," which is summarized in Table 1.
Table 1: The Trilemma of International Finance
Regime Monetary policy International capital flows Exchange rate
Fixed Similar Regulated Fixed
exchange rate
Floating
exchange rate
Similar (due to similar Stable flows Stable
economic trends)
Independent Free flows Variable
The trilemma of international finance refers to the fact that economies cannot
maintain (1) a fixed exchange rate, (2) independent monetary policy, and (3) free international
capital flows all at the same time. One of the three must be relinquished. Giving up (1) results
in a floating exchange rate regime, while giving up (2) results in a fixed exchange rate regime.
Under a floating exchange rate regime, central banks conduct monetary policy
independently based on domestic economic and price conditions. Under independent
monetary policy, the direction of individual economies' monetary policy differs in the short
term depending on their own financial and economic conditions. That said, when the global
economy as a whole is growing steadily, the direction of monetary policy in different
economies tends to become similar, leading to a situation where exchange rate fluctuations
are limited and exchange rates ultimately become close to being fixed. In fact, looking back
over the past 50 years, periods of major economic swings caused by global crises such as the
oil shocks, the bursting of various bubbles, the GFC, and the latest COVID-19 shock, have
alternated with periods of relatively stable economic expansion under an accommodative
financial environment. The former can be described as periods in which monetary policy
tends to differ and the latter as periods in which monetary policy tends to become similar.
Since the transition to a floating exchange rate system, there have been constant
advances in the liberalization of international capital flows. Although, in the short term,
capital flows sometimes have been highly volatile, from a long-term perspective,
international capital flows have been relatively stable and growing steadily. The increasingly
global nature of supply chains (at least until the start of the COVID-19 pandemic) reflects
these free capital flows.
In sum, the period of stable global economic growth can be characterized as one in
which, although economies were able to pursue independent monetary policy and enjoy the
benefits of free capital flows, the monetary policies they pursued ultimately were very similar.
This can be interpreted as a situation in which, despite a floating exchange rate system,
exchange rates were generally stable (without any institutional constraints to fix exchange
rates). In fact, a glance at recent exchange rates shows that, while they may have fluctuated
in the short term due to temporary fluctuations in capital flows, they have been stable in the
long run. The fact that monetary policies in major economies have become increasingly
similar may have contributed to this.
It should be noted, however, that the expression "similar monetary policies" here
does not simply refer to a shared policy stance in the direction of monetary easing. The reason
is that differences across major economies in the strength of accommodative monetary
policies, especially in response to a global crisis, can have economic spillover effects through
the exchange rate. That is, even if countries adopt similar accommodative monetary policies
in response to a major global economic shock, the relative strength of the policy responses
will have repercussions. For instance, a country with relatively weak monetary easing will
experience upward pressure on its currency, and if this country is highly dependent on
external demand, the currency appreciation will put downward pressure on the economy
through a decline in exports. In the following, we look back at Japan's economy and monetary
policy since the 1990s.
IV. Japan's Economy and Monetary Policy Regime Changes since the 1990s
Over the past three decades, Japan's economy has experienced major economic
fluctuations and prolonged economic stagnation. In the early 1990s, Japan experienced the
bursting of the domestic asset bubble, followed by the Asian Financial Crisis of 1997, which
occurred outside of Japan but coincided with a crisis in Japan's financial system. The result
of these shocks was a prolonged period of economic stagnation. Economic stagnation
accompanied by deflation continued thereafter. However, after the strengthening of monetary
easing in 2013, the economy started to recover at a moderate pace and improved to the point
where it was no longer experiencing deflation. With domestic growth remaining sluggish,
Japanese firms continued to actively invest overseas, building increasingly global supply
chains.
Looking back at Japan's monetary policy over the past three decades, while the Bank
of Japan (BOJ) has almost consistently pursued a policy of monetary easing since the bursting
of the bubble, the strength of monetary easing has varied considerably over time. In addition,
there have been major changes in the environment, including changes in the main policy
instruments and in the effectiveness of monetary policy as a result of monetary policies
pursued in other economies. In the following, we will focus on these "regime changes" in
monetary policy and look back at Japan's accommodative monetary policy.
Looking back at Japan's monetary policy since the 1990s, three major regime
changes can be identified, all of which occurred in response to the global recession triggered
by the GFC.
2008-2012 (Regime 1): Unintentional Regime Change
The first, unintentional regime change was triggered by the GFC in 2008, and the
regime can be thought to have continued through the second half of 2012. Although the BOJ
strengthened its accommodative monetary policy in response to the GFC, the extent of easing
was much smaller than the quantitative monetary easing of the United States, which was
facing a crisis of its financial system.3 Thus, although both Japan and the United States
implemented monetary easing policies, there was a substantial difference in scale, as seen,
for example, in terms of the balance sheets of the BOJ and the Federal Reserve (Fed). As a
result, the yen appreciated against the U.S. dollar, which, coupled with the evaporation of
global demand, led to weak exports, slow domestic growth, and deflationary tendencies.
Figure 1 shows changes in the relative size of the Fed's and BOJ's balance sheets,
which serve as a proxy for the monetary base, from the end of 2007 onward. The period from
2008 to 2012 is denoted by the blue circle near the vertical axis. By the end of 2012, the Fed's
assets had expanded about 3.3-fold, while the BOJ's assets had grown only about 1.4-fold.
The rapid appreciation of the yen in the period from 2008 to 2012 can thus be regarded as the
result of diverging monetary policies in the two economies. Even though the direction of
monetary policy -- toward easing -- was the same in Japan and the United States, their
magnitude differed greatly, leading to substantial changes in the exchange rate. This period
can be regarded as an unintended regime change caused by the Fed's massive monetary policy
accommodation.
Figure 1: Relative Developments in the Fed's and BOJ's Balance Sheets (Total Assets, Log
Scale)
Fed's total assets (end of 2007 = 1)
Regime 3
8
2020
2016
Regime 2
2014
2015
2017
2013
4 2010
2019
2012
2018
2011
2009
2
2008
Regime 1
2007
1
1 2 4 8
BOJ's total assets (end of 2007 = 1)
Figure 2: Exchange Rate
yen/U.S. dollar
130
Regime 2
Regime 3
Regime 1
120
110
100
90
80
70
05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
CY
2013-2016 (Regime 2): Substantial Monetary Policy Regime Change to Catch Up with the
United States
The introduction of Quantitative and Qualitative Monetary Easing (QQE) by the
BOJ in 2013 represents a significant monetary policy regime change. The BOJ embarked on
an expansionary policy, which closed the gap vis-à-vis U.S. monetary easing that arose in
Regime 1. With the quantitative easing (QE) introduced in Japan in Regime 2 much larger in
scale than previous easing measures, the process of closing the gap was more or less
completed by the second half of 2016. Further, this regime was widely regarded as a major
change that encompassed economic policy overall, consisting of a framework for policy
cooperation between the government and the BOJ.
The closing of the gap meant that, by the end of 2016, the BOJ's balance sheet had
expanded to the same extent vis-à-vis the level in 2007 as the Fed's balance sheet, as shown
in Figure 1. In hindsight, it can be argued that QE had reached a point where some of its
objectives had been achieved. The economy was close to full employment and inflation as of
the second half of 2016 had become -- and remained -- positive. The negative spillovers from
monetary policies abroad during Regime 1 had disappeared by then.
However, although inflation remained positive from 2016 onward, it did not
accelerate, and the link between QE and inflation appears to have become less clear. The
reason is that the link between the monetary base and the money stock as well as the link
between output and the demand for money became less stable. In addition, tightening in the
labor market due to sustained moderate economic growth led to an increase in labor-saving
capital investment, which allowed firms to respond to upward pressures on labor costs
without passing on rising costs to sales prices, resulting in weak inflation.
A possible interpretation of these developments is as follows. Thanks to the
prolonged demand-side support through monetary policy, the economy neared full
employment; at the same time, this brought about changes on the supply side -- such as labor-
saving capital investment -- that counteracted upward pressure on prices, resulting in sluggish
inflation. However, despite such developments in prices, it seems fair to say that monetary
easing policies during this period did have a certain effect.
2016-2019 (Regime 3): Regime Change to Yield Curve Control
The next regime change, from the second half of 2016 onward, was a switch in the
nature of monetary easing from QE to monetary easing via the control of interest rates through
yield curve control (YCC). During this period, (1) Japan's economy was close to full
employment, (2) it experienced positive inflation, and (3) on the international front, there
were no longer major differences in monetary policies across economies. These conditions
allowed Japan to achieve the monetary easing effects necessary to sustain a moderate
economic expansion by implementing monetary easing of a scale comparable to that of other
central banks.
Since monetary easing through YCC is conducted mainly by controlling interest
rates, YCC has the advantage that there is no crowding-out of fiscal stimulus measures,
making it possible to maximize the effects of policy cooperation with fiscal policy. On the
other hand, keeping interest rates at a low level has the side effect that it may impede the
functioning of financial intermediation by reducing financial institutions' profitability through
the narrowing of lending margins (i.e., there may be a so-called "reversal interest rate" effect,
where the impact of low interest rates is reversed). Therefore, it is important for central banks
to conduct monetary policy while taking its impact on the financial system into account.
Looking back on the period since the introduction of YCC, Japan's economy has
continued to expand at a moderate pace, which implies that, at the least, the necessary degree
of monetary easing was maintained. Meanwhile, fluctuations in the U.S. dollar-yen exchange
rate during this period remained within a narrow range. In other words, the direction and scale
of monetary policies in the major economies have been quite similar, leading to a situation
close to the fixed exchange rate regime shown in Table 1. What is critically important is to
understand that the fact that this situation came about is not a coincidence but is the result of
the similarity of monetary policies of major economies.
Meanwhile, in most major economies, the expected acceleration in inflation so far
has not occurred. Given the increasingly complex mechanisms underlying general inflation,
in order to avoid sudden market swings and achieve a gradual expansion of economic activity
on a global basis, it seems desirable to prioritize full employment and avoid deflation (i.e.,
maintain a positive rate of inflation). This means that, even if the expected rise in inflation
does not materialize, central banks should avoid implementing aggressive policy measures in
the short run and instead respond gradually over time.
V. The COVID-19 Crisis and Its Policy Implication
Japan's long experience with monetary easing, and in particular the three different
regimes just described, provides important lessons. The experience of the 2008-2012 period
suggests that monetary policy should be flexible, bold, and responsive to external shocks.
Moreover, the experience of the two policy regimes between 2013 and 2019 shows that, by
applying the lessons of international macroeconomics, the BOJ was able to flexibly adjust
monetary policy, taking into account the domestic implications of overseas monetary policies.
The current global spread of COVID-19 has brought about a global depression, and
it is difficult to predict future developments. That said, faced with a crisis of global scale, all
major economies have implemented large-scale economic measures, reflecting the experience
of the Great Depression of the 1930s and the Great Recession caused by the GFC in 2008.
What is noteworthy about the current response is that policy coordination between
governments and central banks in major economies and close cooperation among major
central banks, such as the expansion of U.S. dollar funds-supplying operations, have been
established quickly and are functioning effectively. As a result, despite some temporary
swings, exchange rates between the major economies have remained stable.
The challenges currently facing Japan's economy are of a similar scale as those
facing other major economies, but so are Japan's policy responses. Based on the experience
of the GFC, the BOJ has used all possible tools at its disposal. It will need to continue to
cooperate closely with the government and other central banks to implement flexible and bold
policies in a timely and appropriate manner.
Appendix: Theoretical Background Model
This appendix presents a two-country model describing the interdependence of
monetary policy in the two countries. In the model, central banks choose the extent of
monetary creation to achieve their inflation target taking into account spillover effects of the
monetary policy of the other central bank.
The following notation is used:
M and M*: the monetary base at home (Japan) and abroad (United States). Hereafter, the
asterisk denotes variables referring to the United States.
   
  ,  ≡   ,
   
e: exchange rate (an increase in e implies a depreciation of the yen), P: price level, p: inflation
rate, π: inflation target, Y: real GDP, y: GDP growth, and m: excess monetary creation, which
is   .
Based on the money demand function and purchasing power parity, the long-run
exchange rate can then be expressed as follows:
M/P  kY, ∗/∗  ∗∗,


  ∗∗

e    ∙
∗
∗ ∗ 

∗∗

̂     ∗    ∗    ∗    ∗    ∗

Thus, the exchange rate is expressed as a decreasing function of monetary expansion
in the United States and an increasing function of monetary expansion in Japan.
The two countries try to achieve their inflation targets by adjusting their monetary
bases. We assume that under price rigidities, there is a short-run negative spillover effect as a
result of monetary policy interdependence, the so-called "beggar-thy-neighbor effect of
monetary policy."
The optimization functions are:
Minm  γm  ∗   for Japan, and
Min∗  γ∗  m  ∗ for the United States
where γ is a positive coefficient (of less than 1) representing the spillover effect.
Solving these yields the first order conditions:
1  γm  γ∗  π  0 for Japan, and
1  γ∗  γm  ∗  0 for the United States.
These optimal monetary policy reactions can be expressed on the scatter plot as
below. The 45-degree line is the set of monetary bases that yield the same exchange rate.
Points above and to the left of the line correspond to an appreciation of the yen, while those
below and to the right correspond to a depreciation.
Figure A.1: Analytical Framework
Under flexible exchange rates, each country can
essentially choose its best point.
m* (U.S.)
Japan's Reaction Curve (RC)
U.S. Reaction Curve
 ∗
P
∗   
1   1  
0
m (Japan)
Using this framework, it is possible to depict the monetary policy reactions of the
BOJ and the Fed after the GFC. The QE by the Fed would be represented by an upward shift
of the reaction curve for the United States, while QQE by the BOJ would be represented by
a shift to the right of the reaction curve for Japan.
Figure A.2: Central Bank Reactions in Regimes 1 and 2
RC (Japan) at the
RC (Japan) at the
m* (U.S.)
QQE
end of Regime 2
end of Regime 1
by the BOJ
RC (U.S.) after the GFC
Yen
P'
appreciation
P*
RC (U.S.) before the GFC
QE by
the Fed
The points of intersection denote
P
the different regime changes:
P...End of 2007
P*...Beginning of 2013
P'...Around 2016
m (Japan)
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