bank prevented japan ’ s economy from falling into a 1930s - style deflationary spiral of sharply falling prices and economic contraction. however, none of these monetary policy measures were sufficiently strong to overcome deflation. why was this the case? to understand the reasons, we should start with the mechanisms through which monetary easing affects the economy. a key concept in this context is the so - called “ natural rate of interest, ” which is the real interest rate at which the economy neither accelerates nor decelerates. monetary easing aims to push real interest rates in financial markets below the natural rate of interest through a lowering of the policy rate and / or increase in the supply of funds in order to stimulate economic activities such as business fixed investment and housing investment. this is the main channel through which monetary easing seeks to boost economic activity. although the determinants of the natural rate of interest are the subject of considerable debate, it is widely thought that the potential growth rate of the economy plays a major role. the conceptual framework i just outlined allows you to easily see that japan ’ s monetary policy under deflation faced two major challenges. the first was that real interest rates remained high. nominal short - term interest rates – the policy tool of traditional monetary policy – already were close to 0 percent after the introduction of the zero interest rate policy in 1999. this means that short - term interest rates already faced the so - called “ zero lower bound ” in the sense that nominal interest rates cannot be lowered below 0 percent. at the same time, with the economy stuck in a deflationary equilibrium, inflation expectations remained low. as a result, real interest rates – that is, nominal interest rates minus inflation expectations – remained high. the second major challenge that made it more difficult to overcome deflation is the decline in the natural rate of interest reflecting a deceleration in japan ’ s growth potential. with the benefit of hindsight, we know that deflation has coincided with a decline in the productive population as a result of rapid population aging, reducing japan ’ s growth potential. another factor contributing to the deceleration in growth potential was sluggish capital accumulation reflecting the prolonged deflation. specifically, while japan ’ s potential growth rate in the early 1990s was around 3 – 4 percent, it subsequently followed a declining trend and recently has been under 1 percent ( chart 4 ). given that, as mentioned, the potential growth rate likely is a key determinant of the natural rate of interest, it is

low inflation, and there is concern that they might fall into japanese - style deflation. fortunately, the end of deflation in japan is in sight as a result of the bold monetary policy measures called “ quantitative and qualitative monetary easing, ” or qqe for short, we launched three years ago. today, i will discuss how japan, as the “ front runner ” of deflation, has fought against deflation and is overcoming it. while doing so, i will also explain the theoretical background to the evolution of what is called unconventional monetary policy. i. what is deflation? the harm of moderate yet persistent deflation what is deflation? for those living in the united states, which has enjoyed moderate inflation for an extended period of time, this might not be immediately obvious, so let me start with this point. deflation refers to a situation where prices decline persistently. if prices of individual goods and services fall thanks to innovation and improved productivity, this is of course a good thing. a good example is the gradual price decline in pcs and smartphones. however, the bis central bankers ’ speeches deflation i am talking about refers to a situation in which the prices of a broad range of goods and services decline, and consequently, prices as a whole drop. in most countries, including the united states, general prices are measured in terms of consumer price indices, which are the weighted averages of baskets of goods and services purchased by consumers. put very simply, deflation can be understood as a continuous decline in consumer prices. what happens to the economy if prices as a whole decline continuously ( chart 1 )? looking at the overall economy, suppliers of goods and services will see a decrease in sales and profits, and firms with declining profits typically start to lay off employees or restrain their wages. employees that have been laid off or whose wages have declined experience a fall in their income and restrain their spending due to uncertainty about their future. such restraint in spending leads to a further decline in the sale of goods and services, resulting in harsher competition among firms. firms therefore lower prices in order to compete, leading to a further decline in their sales and profits. this simple outline shows that once deflation starts, it perpetuates itself, so that the economy falls into a bad “ equilibrium, in which economic activity is shrinking. ” japan has been struggling with deflation for a decade and a half, triggered by the collapse of the asset bubble of the late 1980s / early