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, the oil price hikes from the mid - 1970s to early 1980s, the emergence and bursting of the asset price bubble from the mid - 1980s to early 1990s, 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

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 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