Kazumasa Iwata: The role of money and monetary policy in Japan
Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Fourth
ECB Central Banking Conference, "The role of money: money and monetary policy in the twenty-first
century", Frankfurt am Main, 10 November 2006.
* * *
Introduction
The role of money in implementing monetary policy is one of the most controversial issues in Japan.
Although the importance of the role of money in the transmission mechanism of monetary policy
cannot be denied, there exists a wide divergence in views on the impact of changes in monetary
aggregates on economic activity and prices among academics and policy makers. This is particularly
true when faced of the zero bound on nominal interest rates in combating deflation.
In evaluating the role of money, I would like to take up three episodes in post-war Japan; namely,
(1) the oil price hikes from the mid-1970s to early 1980s,
(2) the emergence and bursting of the asset price bubble from the mid-1980s to early 1990s,
(3) the experience of persistent deflation under the zero interest rate and the quantitative easing
policy covering from the mid-1990s to March 2006.
First episode: oil price hikes and the money supply-oriented monetary policy
In the first episode, the rapid acceleration of money supply growth amid expansionary fiscal policy
after 1971 induced rampant inflation. In spring of 1973, Japan moved to the flexible exchange rate
system to mitigate the tradeoff between the free international capital flows and the control of the
money supply. Yet, the first oil price hike in late 1973 exacerbated the already strong inflationary
pressures.
The Bank of Japan succeeded in overcoming the rampant inflation and its stagflationary impact arising
from the two oil price hikes by monitoring the money supply (M2+CDs) carefully. After the mid-1970s,
the money supply growth was held down steadily, while the volatility of money supply changes
diminished significantly. Corresponding to the gradual deceleration of money supply growth, the
inflation rate subsided remarkably (Chart 1).
In 1982, Milton Friedman described Japan's monetary policy in the 1970s as "less monetarist in
rhetoric, yet far more monetarist in practice than the policies followed by the United States and Great
Britain."
Despite the praise of Friedman, Japan's money supply-oriented monetary policy cannot be regarded
as "monetary targeting policy". In 1975, the Bank of Japan employed monetary aggregates as one of
the important information variables, yet it eschewed attaining the reference value of the monetary
growth target (Bank of Japan (1975)).
Instead, from 1978 the Bank of Japan began to announce a quarterly forecast for money supply
growth, yet the forecast was different from the "intermediate target growth rate" announced by the
Federal Reserve or the M3 reference target rate by the ECB.1 The forecast was close to the actual
outcome, yet money supply reaccelerated and diverted from the trend nominal GDP growth after the
mid-1980s in the wake of financial deregulation and innovation.
To conclude, the first episode reconfirms the lesson that the control of money supply (which was
restored under the flexible exchange rate system) played an essential role in containing the rampant
inflation prevailing in the early 1970s.
Second episode: asset price bubbles and the real money gap
Let me turn to the second episode. Lax monetary policy after the mid-1980s was evidenced by the
sustained deviation of actual real money stock from the equilibrium real money stock. Given the
positive "real money gap", asset price bubbles emerged in the equity and real estate markets while
general price stability was maintained (Chart 2).2 Once land prices started to move up, the augmented
collateral value of land triggered the rapid expansion of bank credit through the "financial accelerator
mechanism" or the "credit cycle" on the imperfect financial market.3 On the other hand, price stability
was reinforced by the yen appreciation after the Plaza Accord in 1985 in spite of the accelerating
money supply.4
Plentiful market liquidity facilitated the active management of risk portfolios through relaxing the
liquidity constraint and affected the willingness of investors to take more risks, leading to the reduction
in risk and term premia.
From the second episode, we can draw the lesson that a positive "real money gap" can cause the
asset price bubbles through the "financial accelerator mechanism" and the reduction in risk and term
premia, precisely because price stability is maintained.
Third episode: deflation and the quantitative easing policy
Turning to the third episode, after the bubble burst in the early 1990s, the required adjustment to the
balance sheets of both the corporate and banking sectors tended to significantly lower the natural
interest rate and reduce the potential growth rate from about 5% to about 1% in the mid-1990s.5 It is
not difficult to gauge the consequence from the Wicksellian process perspective: deflation began to
prevail as the natural interest rate became significantly lower than the real market interest rate.
After the "zero interest rate policy" from February 1999 to August 2000, the "quantitative easing policy"
was initiated in March 2001. The quantitative easing policy set bank reserves as an operating target
and reconfirmed the commitment to continue the virtual zero interest rate policy until the core CPI
growth rate stands above zero in a stable manner.6
The perceived emergence of the "liquidity trap" under the zero short-term interest rate seemed to
undermine the effectiveness of the quantity-oriented monetary policy, as the interest rate elasticity of
demand for money became close to infinity at the zero short-term interest rate.7
Moreover, the linkage between monetary aggregates and income or prices has largely disappeared
since 1997, mainly reflecting the increase in precautionary demand for money due to financial
instability and nonperforming assets on the banks' balance sheets.8
2
Gerlach and Svensson (2002) compared the usefulness of the "real money gap" (which can be decomposed into the "GDP
gap" and the "velocity gap") as an information variable with the GDP gap. They thus noted that the deviation of actual
monetary growth from the "unconditional" monetary growth target is likely to be a misleading indicator of risks to the price
stability because of the tradeoff between the price stability and monetary growth target stability: in their view the
Bundesbank actually gave priority to price stability rather than monetary target stability when the tradeoff between the
"unconditional" money growth target and the inflation target becomes serious.
3
Kiyotaki and Moore (1997) developed the "credit cycle" theory, on the assumption of the financial constraint to borrow on the
imperfect financial market. Regarding the emergence of the asset price bubble, the explanation based on the "Pigou cycle"
of boom-bust of industrial fluctuation is plausible: the expectation on the strong technological progress stimulates the
investment boom, although the expectation is not realized ultimately (Pigou (1926), Christiano and Fujiwara (2006)).
4
Aside from the well-maintained price stability, we can mention factors which might work to delay the timing of tightening of
monetary policy as follows: the need for international cooperation at the time of the October crash in 1987 with Japan as the
largest creditor country as well as tax reforms to introduce the consumption tax in 1988-89, in addition to the apprehension
of the consequences of the rapid yen appreciation on economic activity. Ikeo (2006) put emphasis on the absence of
corporate governance due to the joy ride of "developmentalism" and the eroded role of the "main bank" as delegated
monitor in explaining the excessive credit provision by banks.
5
On the cause of lower potential growth in the 1990s, Prescott and Hayashi (2002) focused on the importance of the negative
supply shock arising from the shortening of labor hours.
6
Yet, this did not imply that "nominal income targeting" by using the monetary base as an operating instrument was adopted.
7
The "vector-error-corrections model" confirmed the breakdown of the long-run cointegrating relation between money supply
and income or prices, although the cointegration linkage still exists with respect to the total fundraising by moneyholders and
economic activity (Bank of Japan (2003)). Miyao (2005) also confirmed the disappearance of the predictive content of
M2+CDs in the late 1990s by carrying out cointegration analysis.
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Yet the unstable demand for money as well as the zero bound on policy interest rate do not imply that
money has no role to play in the transmission mechanism of monetary policy.
Citing the experience of Japan's quantitative easing policy, Governor Mervyn King (2002) questioned
whether the excess supply of money under the zero interest rate policy would lead to the potency or
impotency of monetary policy.9
At the panel discussion of the Jackson Hall Conference in 2005, I gave my answer to this question:
under the quantitative easing policy the extent of the zero interest rate was widened to cover the
oneyear maturity in tandem with the increasing amount of reserve target from 5 trillion yen to 30-35 trillion
yen.
I argued that ample provision of liquidity contributed to preventing the economy from falling into a
deflationary spiral. Besides, the additional injection of liquidity into the market complemented the
commitment about the future path of the policy interest rate, thereby strengthening the "policy duration
effect".
Furthermore, at the satiation level of money holdings, a fiscal policy aimed at achieving a zero primary
balance by FY2011, combined with the positive rate of increase in the monetary base, contradicts the
existence of the "deflation trap", due to the violation of the transversality condition (Iwata (2005)).
The effect of liquidity injection can be interpreted in two ways. First, I recall that Fisher Black (1995)
reformulated the role of interest rates as an option, assuming that the equilibrium shadow interest rate,
or the natural interest rate, can become negative. Yet, individual investors can safely avoid negative
interest rates by holding currency at zero interest rate. Thus, the observed zero interest rate can be
regarded as a call option on the equilibrium shadow interest rate.
Black argued that the long-term interest rate will remain positive under the "liquidity trap" in the
presence of a zero bound on nominal short rates, because of the more-than-usual term premiums and
the expectation of future development of the short-term interest rate at zero embedded in the
longterm interest rate.
The commitment on the duration of the zero interest rate policy suggests that the shadow interest rate
will be negative, as long as deflation is expected to persist into the future; the longer the duration of
the zero nominal interest rate, the larger the size of negative interest rate.10
Accordingly, while the additional liquidity injection strengthened the commitment on the duration of the
zero interest rate policy, it was supposed to result in more currency holdings (Chart 3).
Secondly, we can add a new insight into the role of money; money provides a liquidity service which is
not identical to the service provided by government bonds.
If we reformulate the utility function to include not only money but also bonds of various maturities
(money and bonds in utility function), the zero short-term interest rate is not equivalent to the zero
marginal utility of money, because there remains the arbitrage relationships with the longer maturity
bonds with positive interest rates (Iwamura, Shiratsuka and Watanabe (2006)). As long as the
marginal utility of money remains positive, the "satiation of money holdings" will not emerge even
though the zero bound on short-term interest rates appears in the economy.
In this case, the increase of real money balance can affect the market interest rates, pushing down the
forward rate relative to the future rate. As a result, the spread between the forward and the future rate
has never closed under the quantitative easing policy (Chart 4, 5).11
From the third episode, we can draw the following two lessons.
First, the large option-like value of nominal interest rates at zero, or close to zero under persistent
deflationary expectations stimulates the incentive to hold currency. At the same time, the injection of
liquidity complemented and reinforced the policy duration effect of the zero interest rate policy, serving
to flatten the yield curve (Ichiue and Ueno (2006)).
Secondly, in contrast, if money provides better liquidity services than government bonds, then the
increase in real money balance affects the market interest rates, independently of the expectation
channel arising from the commitment on the duration of expansionary monetary policy.
New framework for the conduct of monetary policy
In early March 2006 the Bank of Japan introduced a "new framework for the conduct of monetary
policy" when it ended five years of quantitative easing policy. The "understanding of medium- to
longterm price stability" provided "common knowledge" to the market participants.12
Further, the new framework introduced two perspectives on examining economic activity and prices;
the first perspective is examining, as regards economic activity and prices one to two years in the
future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth under
price stability. In the second perspective, we identify the potential risks beyond the forecast period. For
instance, excessive investment induced by sustained expansionary monetary policy may give rise to
undesirable wide fluctuations of economic activity.
The second perspective is designed to cope with the situation where the probability of the event is low,
yet the damage to the economy could be quite large if it materializes. This second perspective
corresponds to the risk management approach to monetary policy of Greenspan or the "mini-max
approach to monetary policy management under Knightian uncertainty".
We have observed the upward revision of the potential growth rate under the circumstances of low
real long-term interest rates on the global market. Recent developments in monetary aggregates
suggest a return to the equilibrium trend, after the sustained upward deviation from the equilibrium
trend under the zero interest rate and the quantitative easing policy.
Given the lessons from the second episode, we should cautiously watch the developments in money
and credit, and examine the policy implications of changes in monetary and credit aggregates, as the
role of money is more subtle and far-reaching as suggested by the option-like value of currency
holdings and liquidity effect under the quantitative easing policy.
References
[1] Black, F. (1995) "Interest Rates as Options," Journal of Finance, 50.
[2] Bank of Japan (1975) "On the Importance of Money Supply in Japan" (in Japanese), Bank of Japan
Research Papers, July 1975.
[3] Bank of Japan (2003) "The Role of the Money Stock in Conducting Monetary Policy," Bank of
Japan Quarterly Bulletin, May 2003.
[4] Christiano, L., and Fujiwara, I. (2006) "Bubble, Excess Investment, Shorter Work Hours and the
Lost Decade" (in Japanese), Bank of Japan Working Paper Series, No. 06-J-08.
[5] Friedman, M. (1985) "Monetarist in Rhetoric and in Practice," in Monetary Policy in Our Times, eds.
Ando, A., Eguchi, E., Farmer, R., and Suzuki, Y., MIT Press.
[6] Gerlach, S., and Svensson, E.O. (2002) "Money and Inflation in the Euro Area: A Case for
Monetary Indicators?" CEFP Discussion Paper, No. 3392.
[7] Hayashi, F., and Prescott, E.C. (2002) "The 1990s in Japan: A Lost Decade," Review of Economic
Dynamics, Vol. 5, 1.
[8] Ichiue, H., and Ueno, Y. (2006) "Monetary Policy and the Yield Curve at the Zero Interest: The
Macro-Finance Model of Interest Rates as Options," Bank of Japan Working Paper Series,
No. 06-E-16.
[9] Ikeo, K. (2006) "The Joy Ride and Self-protection of Developmentalism: Financial System and the
Heisei Economy" (in Japanese), NTT Publication.
[10] Iwamura, M., Shiratsuka, S., and Watanabe, T. (2006) "Massive Money Injection in an Economy
with Broad Liquidity Services: The Japanese Experience 2001-2006," paper presented at the Japan
Project Meeting organized by the NBER conference in Tokyo.
[11] Iwata, K. (2005) "The Role of Price Stability Anchor in Extricating Japan from Deflation," speech at
the Jackson Hall Conference, August 2005.
[12] Kimura, T., Kobayashi, H., Muranaga, J., and Ugai, H. (2002) "The Effect of Quantitative Monetary
Easing at Zero Interest Rates," IMES Discussion Paper Series, No. 2002-E-22.
[13] Kimura, T., and Small, D. (2006) "Quantitative Monetary Easing and Risk in Financial Asset
Market," The B.E. Journals in Macroeconomics, Vol. 16, Issue 1.
[14] King, M. (2002) "No, Money, No Inflation: the Role of Money in the Economy," The Quarterly
Bulletin of the Bank of England, Summer 2002.
[15] Kiyotaki, N., and Moore, J. (1997) "Credit Cycles," Journal of Political Economy, Vol. 105, No. 2.
[16] Kocherlakota, N. (1998) "Money is Memory," Journal of Economic Theory, 81.
[17] Miyao, R. (2005) "Use of the Money Supply in the Conduct of Japan's Monetary Policy:
Reexamining the Time-Series Evidence," The Japanese Economic Review, Vol. 56, No. 2.
[18] Neuman, M.J.M. (2003) "The European Central Bank's First Pillar Reassessed."
[19] Pigou, A. (1926) "Industrial Fluctuations."
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