policies continued to underpin the economy since the 1990s. in the meantime, while the need for drastic structural reform was pointed out many times, in reality the reform did not progress except for deregulation in some areas. it could be one reason for the downtrend in japan ’ s economic growth rate since the 1990s that structural reform, which was essentially necessary in strengthening growth potential, did not progress smoothly. low growth and deflation such downtrend in growth potential is also one reason for japan ’ s long - standing problem of deflation. if the downtrend in the economic growth rate becomes protracted, people will become unable to have confidence in or expectations for future growth. as i mentioned earlier, concern over future growth shrinks people ’ s current spending. if that results in a decline in the actual growth rate, it forms a vicious cycle of once again lowering people ’ s future growth expectations. such structural vicious cycle will induce a chronic demand shortage. when there is a lack of demand compared with the supply of goods and services, normally, prices will fall. since the second half of the 1990s, japan ’ s economy experienced a downturn three times triggered by the financial system crisis, the bursting of the it bubble, and the lehman shock. whenever japan was faced with a substantial decline in the economy, the aforementioned vicious cycle was strongly recognized, and, even in the ensuing economic recovery phase japan repeatedly encountered the situation in which growth expectations did not sufficiently rise and it could not escape from a demand shortage. the result was a protracted deflationary trend. output gap and a mismatch between demand and supply according to an estimate by the cabinet office, the current annualized output gap is about 15 trillion yen. as it was estimated to be about 40 trillion yen immediately after the lehman shock, the gap has narrowed considerably but has remained substantial. in that regard, some point out that if economic activity is stimulated by fiscal or monetary policy to create a demand of 15 trillion yen, the output gap will be filled and japan ’ s economy can immediately overcome deflation. it is not that simple. the output gap in numerical terms is the difference between the size of demand for the existing goods and services and the existing production capacity to supply those goods and services. however, in reality, people ’ s demand itself has been changing due to structural changes in society, including aging. if the supply side has not been able to sufficiently meet such new demand, then it might not merely be

a need for a financial diplomacy strategy, and ( 5 ) it should take due account of international political and security issues. these principles, notably the second principle, seem to be different from the exchange rate targeting proposal. prof. mccallum regards the separation by government of exchange rate policy and monetary policy as an anachronism, because of the linkage of exchange rate and interest rates within the general equilibrium framework. 17. second, we should put emphasis on the need to deal with the euphoria brought about by higher expected growth and the sharp drop in " finance premium " during the bubble period. the increasing collateral value compressed the finance premium for real estate and corporate borrowing. the aggressive risk - taking was facilitated by financial deregulation and the higher expected growth rate under price stability, in part due to mistaken perceptions of future technological progress ( figure 7 ). 18. today, we see a similar problem with low term - and risk premia, which constitute one of the causes of the " conundrum of global low long - term interest rates ". we observe that the real long - term interest rate among major advanced economies has tended recently to converge at around 2 % ( figure 8 ). given the low term - and risk premia across various financial markets, the low real long - term rate implies that any country which has higher expected growth rate, significantly above 2 %, is liable to register the acceleration of asset prices. 9 19. third, it may be useful to extract a signal or guide to future price developments from asset price changes by examining the factors and the sources of asset bubbles, to the extent that there exist various distortions and imperfections in financial markets. although it may be desirable to have an intertemporal cost of living index, this might not help us in the near future. it is possible instead to show the likely consequence of deviation of asset price from the historical trend or the simulated fundamental price based on models. it is interesting to note that the oecd ( 2005, 2006 ) identified the deviation of the actual rent - to - price ratio from the fundamental ratio based on the long - term historical average ratio, employing the inverse of user cost as a proxy to the price - to - rent ratio, as the user cost equates the expected cost of owning a house with the cost of renting. further, the oecd estimated the nearing of a peak to real house prices, if interest rates were to rise further. 20. fourth