expectations of economic entities. therefore, while it would not be appropriate to attempt any rigid control of asset prices and exchange rates, the bank will pay due attention to developments in them in managing monetary policy aimed at achieving the objective of price stability. b. monetary policy instruments let me next discuss the instruments of monetary policy under the new bank of japan law. economic textbooks often refer to ( 1 ) the official discount rate, ( 2 ) open market operations, and ( 3 ) reserve requirements as the three major monetary policy instruments. these are in fact the means with which the bank of japan implements monetary policy, and this will remain unchanged under the new law. the revised law, however, incorporates the following changes. first, the new law explicitly stipulates that “ guidelines for money market control through various measures such as buying and selling of bills or bonds ” — that is, the bank ’ s basic policy for open market operations, or in other words, the bank ’ s policy for the guiding of money market rates — are to be decided by the bank of japan ’ s policy board, while in the current law, there is no explicit stipulation concerning such policy. second, while the current law stipulates that determination and altering of reserve requirements must be approved by the minister of finance, the new law abolishes this approval system. with these changes, all three instruments of monetary policy — including official discount rate policy, which is already stipulated by the current law as a matter for decision by the policy board — — will be spelt out explicitly as matters to be decided by the policy board. reserve requirements have been altered less frequently as the means of open market operations developed. i would therefore like to discuss in detail the historical background and the bank ’ s view of official discount rate changes and of the guiding of money market rates, with emphasis on how the bank will utilize these two means of implementing monetary policy. 1. relationship between official discount rate changes and the guiding of money market rates for many years, monetary policy was in most cases implemented in japan by changing the official discount rate. this was because the financial markets were not sufficiently developed and, under these circumstances, deposit interest rates and lending rates were linked to the official discount rate. the situation changed gradually from the 1980s. the financial markets began to grow both in quality and quantity, with massive issuance of government securities and introduction of new financial instruments such as certificates of deposit ( cds ) and commercial paper ( cp ). as a result

a deflationary economy. one possible example was the japanese economy in 1995, when there were concerns about a deflationary spiral. this line of thinking leads to the conclusion that ensuring price stability means maintaining a situation in which firms and households need not be concerned about a continuing rise or fall in prices in the future when planning their investment and consumption. 2. the relationship between price stability and the economy having defined price stability, there may still be questions about the relationship between price stability and other important policy objectives or economic variables. for example, should we not care about the economy and economic growth as long as prices remain stable? what is the relationship between prices and foreign exchange rates or asset prices? first, with regard to the relationship between prices and the economy, it is true that in the short term, it seems as if higher economic growth could be realized if a certain level of price increase were allowed. however, it has recently been proved both theoretically and empirically that this effect will only be temporary. if such a process is repeated, the economy may well fall into an intractable situation of stagflation, in which the economy falls back into a recession but high inflation remains. this was the economic disease that plagued the industrialized countries of europe and the united states from the mid - 1970s to the early 1980s. in the light of that experience, there is a common understanding today that price stability is a precondition for sustainable economic growth. second, how are foreign exchange rates and asset prices to be considered in the context of monetary policy management? they are important factors that require due attention. however, if their stability is made a direct objective of monetary policy, the stability of the domestic economy and of prices in general may be undermined. this is because land prices and exchange rates reflect certain factors which prices in general do not. specifically, land prices incorporate changes in the productivity of land and in the expected rate of return. exchange rates, in the long term, are adjusted by the market mechanism in accordance with the differentials between domestic and overseas inflation rates, or in other words, changes in the purchasing power parities. any attempt to control such factors forcibly through macroeconomic policies will most likely cause distortions in other sectors of the economy. needless to say, fluctuations in exchange rates and asset prices will affect the economy in various ways. it has been a valuable lesson of the bubble economy that significant fluctuations in asset prices may be a sign of some irregularities in economic activity or excessive