profits due to lower import costs that, in turn, were caused by a rapid appreciation of yen after the Plaza Accord; and (iv) lower oil prices in the international markets.<sup>2</sup> With these four supportive elements, the Japanese economy expanded during this period at an average rate of 5 percent a year. This period was also characterized by a strong growth in plant and equipment investment. With the fear of a rapidly shrinking pool of domestic labor due to the much-publicized aging of the population, the expansion soon hit a resource shortage, manifested in low unemployment and an extraordinarily active recruitrnent of new college graduates. However, the economic overheating, which normally results in visible wage increases and inflation in goods and service prices, instead produced an explosive increase in the prices of stock assets.

An economic theory that prescribes the normal relationship between investments and asset prices (equity prices) gives us a useful guide for viewing asset prices as business cycle indicators. That is, if a market is efficient, the equity price should precisely reflect future earnings created by corporate investments. A deviation in asset price from an investment earning ratio - Tobin's q (average q) - is considered a noise that, in turn, results from market inefficiency and/or expectation (bubble) elements. Ogawa (1994a), after analyzing this relationship by measuring movements in average q and marginal q during this bubble period, found that there was significant noise during the period and that it was related to the values of land assets owned by corporate sectors.

The movements in asset prices during this period had two components: one reflected an improvement in economic fundamentals, and the other represented the bubble elements. Improvements in economic fundamentals were particularly visible in a rapid expansion in corporate profits (fundamental to equity prices) and in demand for office space in major cities -Tokyo, in particular (fundamental to land prices). These key improvements in fundamentals were, in turn, supported by low interest rates and strong growth in money stock (see Figures 5 and 6). The discount rate was lowered from 5 percent in January 1986 to 2.5 percent in February 1987, and was kept at this low level until May 1989. The bubble elements were formed by rising asset prices, which, in turn, drew speculative investments in equities and land purchases in search of capital gains. Capital gains on equity/land reached about 490 trillion yen, worth over 140 percent of GNP in 1987 (see Table 1). During the four years from 1986 to 1989, capital gains on land and stock assets surpassed gross domestic output produced during the same period by more than 17 percent! Low interest rates and abundant liquidity worked as leverage to expand speculative investments in stock assets. This speculative money game permeated all private economic agents in the financial, nonfinancial corporate, and household sectors. Throughout this period, financial institutions increased their asset holdings in equities and land through direct investments and loans to real estate developers. In 1987, the growth of loans to real estate developers was twice as high as that of total loans.<sup>3</sup> Since Japan's financial institutions use land as collateral for their loans, the rising land values provided a push to create credit through both demand and supply-side factors. BIS regulations, by allowing financial institutions to count 45 percent of their unrealized gains as capital base, relieved ceilings for loan creation. As a result, bank loans continued to grow at around 12 2 During 1985, the ratio of the value of fuel imports to nominal GNP fell by about 3 percentage points.

3 For a more detailed account of this issue, see Research Bureau, Economic Planning Agency, _State of the Japanese Economy-Review and Issues of the Japanese Economy in 1995,_ December 1995.

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