Japanese Monetary Policy, 1991-2001

(ProQuest Information and Learning: ... denotes formula omitted) During recent years, Japanese monetary policy has been the topic of a great deal of discussion, commentary, and debate. This is not only because of the great practical importance of the long-lasting slump of the world's second largest national economy, but also because the situation in Japan has raised interesting issues concerning some fundamental topics in monetary theory. Accordingly, this paper considers issues relating to recent and prospective policy measures of the Bank of Japan (BOJ). It is hard to avoid the impression that Bank of Japan (BOJ) policy has been overly restrictive for approximately a decade. That statement does not imply that Japan's poor economic performance during the 1990s was entirely or even primarily attributable to monetary policy, for structural flaws have also been very important.1 It does suggest, however, that Japanese economic performance would have been less undesirable if BOJ policy had been less restrictive. In the pages that follow, I will attempt to support the foregoing claim, discuss the difficulty faced by the BOJ because of the zero lower bound on nominal interest rates, and illustrate this difficulty with a small quantitative study. Then I will take up some of the nonstandard policy approaches that have been proposed and will argue that the most promising of these would entail rapid monetary base growth effected largely through purchases of foreign exchange. Such a strategy has faced two major objections, however, so much of the paper is devoted to counterarguments to these objections. The first objection is based on legal provisions of the Bank of Japan Law and the second on the concern that such actions would constitute a "beggar-thy-neighbor" policy that would reduce Japanese demand for imports. It is argued that neither of these objections is appropriate. With respect to the former, it is suggested that the BOJ Law, as written, includes conflicting provisions and that foreign exchange purchases for the purpose of monetary control could be conducted if the BOJ were to request permission of the government. In this regard, the intimate connection between monetary and exchange-rate policies is emphasized. With respect to the beggar-thy-neighbor issue, it is argued that in fact an expansionary monetary policy of the type recommended would increase net Japanese imports. In this regard, a major portion of the paper is devoted to a quantitative analysis of the trade-balance effects of a policy of the recommended type. The analysis is carried out in the context of a dynamic optimizing model of an open economy, which is exposited in some detail. Policy simulation exercises conducted with this model represent a major feature of the paper. 1. HAS BANK OF JAPAN POLICY BEEN TIGHT? That BOJ policy has been quite tight-low interest rates notwithstanding-- is suggested by the most prominent and widely-respected guideline for the conduct of monetary policy, i.e., the policy rule developed by John Taylor (1993a). The Taylor rule can be expressed as IMAGE FORMULA8IMAGE FORMULA12IMAGE FORMULA13 2. THE BANK OF JAPAN'S DIFFICULTY Over the period 1999-2001, commentary in influential nonacademic publications including the Economist, the Financial Times, and the Wall Street Journal became increasingly critical of the BOJ for not providing more monetary stimulus to aggregate demand in Japan. The plots presented in the previous section also suggest that more stimulus is needed and has been needed for years, but nevertheless I believe that much of the press commentary has failed to recognize the difficulty of the problem that has faced the BOJ. It is not just stubbornness that has prevented the BOJ from providing such stimulus, for the nature of monetary policy actions is sharply different when short-term interest rates are effectively equal to zero. …