financial surplus, or become a net saver. to make up for the shortage in aggregate demand brought about by the changes in the corporate sector, the government raised funds by issuing large amounts of japanese government bonds ( jgbs ) and increased fiscal spending such as public works. meanwhile, in the banking sector, deposits increased substantially while lending decreased as a result of the financial surplus in the corporate sector. the banking sector, in turn, invested these surplus funds in jgbs. thus, under japan ’ s deflationary environment, a peculiar flow of funds established itself, in which the corporate sector has a bis central bankers ’ speeches financial surplus, the government sector has a financial deficit, and the banking sector expands its investment in jgbs ( chart 2 ). another problem of moderate yet persistent deflation is that, as the belief becomes entrenched that prices will not rise but continue to steadily decline, real interest rates remain high, hampering the effectiveness of monetary policy. let me elaborate a bit on this point. in terms of both lending and deposit interest rates, what matters for economic activity is not the nominal interest rate, but the real interest rate, or the interest rate adjusted by the outlook for inflation. for instance, if the nominal interest rate is 3 percent per annum and prices are expected to rise by 2 percent, the real interest rate is 1 percent. on the other hand, if the nominal interest rate is again 3 percent, but prices are expected to fall by 1 percent, the real interest rate is 4 percent. obviously, financial conditions are more accommodative in the former than the latter case. if people start to think that prices will steadily decline – in the economics jargon, “ inflation expectations ” fall into negative territory – real interest rates will remain high compared to nominal interest rates. these considerations illustrate how moderate yet persistent deflation is like a harmful chronic disease. it not only stymies the dynamism of the economy but also weakens the effectiveness of monetary policy. ii. the evolution of monetary policy : what is “ unconventional monetary policy ”? given the insidious effects of such deflation, you may be wondering how the bank of japan responded. naturally, the bank did not merely stand by. although the bank ’ s monetary policy measures were often criticized – especially abroad – as being “ too little, too late, ” the bank did in fact adopt a variety of unconventional monetary policy measures from the late 1990s onward ( chart 3

fall in crude oil prices. under these circumstances, inflation expectations declined, as the adaptive mechanism has been playing a relatively large role in the formation of inflation expectations in japan. taking this into consideration, the bank decided to adopt a commitment that allows inflation to overshoot the price stability target so as to strengthen the forward - looking mechanism in the formation of inflation expectations, enhance the credibility of achieving the price stability target among the public, and raise inflation expectations in a more forceful manner. as for the future conduct of monetary policy, the bank will continue with qqe with yield curve control, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. currently, the momentum toward achieving the price stability target is being maintained, and the year - on - year rate of change in the cpi is expected to increase toward 2 percent. nevertheless, the momentum is not yet sufficiently firm, and we are only halfway to achieving the price stability target. some market participants, taking account of a rise in interest rates overseas, argue that the bank might consider raising the target level of the long - term interest rate in the near future, but considering the current developments in economic activity and prices as well as financial conditions, i believe that it is important that the bank continue to steadily pursue powerful monetary easing under qqe with yield curve control. iv. challenges for japan's economy i would now like to express my thoughts regarding the current situation of japan's economy from a longer - term perspective. in order to achieve the bank's price stability target in a stable manner, one of the necessary requirements is to raise the potential growth rate, which indicates the " basal metabolism " of an economy. japan's economy has achieved growth through the process of securing resources and making full use of them, as well as developing high - quality products and services and providing them to markets. through this process, japan has contributed to global economic growth as well. i believe it is possible to further expand japan's growth and contribution to global economic growth in various areas. we should continue with proactive efforts to increase japan's growth potential, rather than being overly pessimistic about structural changes such as the population decline. to secure and make use of resources, measures have been taken in the public sector, for example, to tackle the problem of the population decline - - such as support for childcare and for women and the elderly to become part of the