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Japanese Monetary Policy, 1991–2001 Bennett T. McCallum D uring recent years, Japanese monetary policy has been the topic of a great deal of discussion, commentary, and debate. This is not only because of the great practical importance of the long-lasting slump of the world’s second largest national economy, but also because the situation in Japan has raised interesting issues concerning some fundamental topics in monetary theory. Accordingly, this paper considers issues relating to recent and
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   Japanese Monetary Policy,1991–2001 Bennett T. McCallum D uring recent years, Japanese monetary policy has been the topic of agreat deal of discussion, commentary, and debate. This is not onlybecause of the great practical importance of the long-lasting slumpof the world’s second largest national economy, but also because the situationin Japan has raised interesting issues concerning some fundamental topics inmonetary theory. Accordingly, this paper considers issues relating to recentand prospective policy measures of the Bank of Japan (BOJ).It is hard to avoid the impression that Bank of Japan (BOJ) policy hasbeen overly restrictive for approximately a decade. That statement does notimply that Japan’s poor economic performance during the 1990s was entirelyor even primarily attributable to monetary policy, for structural flaws havealso been very important. 1 It does suggest, however, that Japanese economicperformance would have been less undesirable if BOJ policy had been lessrestrictive. In the pages that follow, I will attempt to support the foregoingclaim, discuss the difficulty faced by the BOJ because of the zero lower boundon nominal interest rates, and illustrate this difficulty with a small quantitativestudy. ThenIwilltakeupsomeofthenonstandardpolicyapproachesthathavebeen proposed and will argue that the most promising of these would entailrapid monetary base growth effected largely through purchases of foreign H. J. Heinz Professor of Economics, Carnegie Mellon University, and Visiting Scholar, FederalReserve Bank of Richmond. This paper has been prepared for the Federal Reserve Bank of Richmond. It is in part based upon position papers presented at meetings of the ShadowOpen Market Committee held in Washington, D.C., in April and October of 2001. For usefulcomments, the author is indebted to Marvin Goodfriend, Bob Hetzel, Tom Humphrey, AllanMeltzer, Edward Nelson, Roy Webb, and John Weinberg. The views expressed in this articleare not necessarily those of the Federal Reserve Bank of Richmond or the Federal ReserveSystem. 1 Major banking-system difficulties are widely recognized, and in addition it is likely thatthe growth rate of “potential” or “natural-rate” output has fallen from the level of the 1970s and1980s. But the severity of the bank-solvency problem has been increased by the deflation of the past several years, and it is almost certainly the case that actual output has fallen far belowpotential. Federal Reserve Bank of Richmond  Economic Quarterly  Volume 89/1 Winter 2003  1  2 Federal Reserve Bank of Richmond Economic Quarterlyexchange. Such a strategy has faced two major objections, however, so muchof the paper is devoted to counterarguments to these objections. The firstobjectionisbasedonlegalprovisionsoftheBankofJapanLawandthesecondon the concern that such actions would constitute a “beggar-thy-neighbor”policy that would reduce Japanese demand for imports. It is argued thatneither of these objections is appropriate. With respect to the former, it issuggested that the BOJ Law, as written, includes conflicting provisions andthat foreign exchange purchases for the purpose of monetary control could beconducted if the BOJ were to request permission of the government. In thisregard, the intimate connection between monetary and exchange-rate policiesis emphasized. With respect to the beggar-thy-neighbor issue, it is arguedthat in fact an expansionary monetary policy of the type recommended wouldincrease net Japanese imports. In this regard, a major portion of the paperis devoted to a quantitative analysis of the trade-balance effects of a policyof the recommended type. The analysis is carried out in the context of adynamic optimizing model of an open economy, which is exposited in somedetail. Policy simulation exercises conducted with this model represent amajor feature of the paper. 1. HAS BANK OF JAPAN POLICY BEENTIGHT? That BOJ policy has been quite tight—low interest rates notwithstanding—is suggested by the most prominent and widely-respected guideline for theconduct of monetary policy, i.e., the policy rule developed by John Taylor(1993a). The Taylor rule can be expressed as R t   =  3  +  p at   +  0 . 5 (p at   −  2 )  +  0 . 5 (y t   − ¯ y t  ),  (1)where  R  is the call rate,  p at   is the average inflation rate (GDP deflator) overthe previous four quarters, y is real GDP and  ¯ y  is its potential value. 2 A chartcontrasting Taylor-rule prescriptions for the overnight call rate 3 with actualvalues of this rate over the years 1972–1998 appeared in a recent paper inthis journal (McCallum, 2000b) to which the reader is referred for variousdetails. 4 That comparison is reproduced in the top half of Figure 1. There itis clear that the actual value exceeded the setting prescribed by Taylor’s ruleduring almost every quarter beginning with 1993Q1 and continuing through1998Q4. Of course, the negative values called for by the rule are not feasible, 2 Here the long-run average real rate of interest is taken to be 3 percent per annum (p.a.)and the inflation target rate to be 2 percent. Some versions of the rule use other values for theseand for the coefficients attached to the target variables. 3 The (uncollateralized) overnight call rate was the BOJ’s operating target or instrument vari-able through the period of the 1990s. The procedure was changed in March 2001. 4 The most important of these, of course, is the measurement of “potential” output—whichhas been especially problematic for Japan in recent years. Its reliance on this inherently difficultconcept is one weakness of the Taylor rule.  B. T. McCallum: Japanese Monetary Policy 3 Figure 1 Policy Rule Indications but that does not alter the fact that Taylor’s policy guideline has called forgreater monetary ease through this period.An alternative rule involving management of the monetary base has beenpromoted in several of my papers (e.g., McCallum 1988, 1993, 2000b). It canbe written as b t   =  5  −  v at   +  0 . 5 ( 5  −  x t  − 1 ),  (2)  4 Federal Reserve Bank of Richmond Economic Quarterlywhere  b  and  x  are logs of the monetary base and nominal GDP, while  v at   isthe average rate of base velocity growth over the previous four years. Here5 is the target value for nominal GDP growth, obtained from a 2 percentinflation target and a 3 percent assumed long-run average growth rate for realGDP.This rule is much less prominent thanTaylor’s, primarily because actualcentral banks focus upon interest rates, not monetary base growth rates, indesigning their policy actions. Especially in an environment with near-zerocall rates, however, its prescriptions may be of interest. In any event, theactual and rule (2) settings for base growth rates are shown in the lower panelof Figure 1. 5 There the indication is that actual BOJ policy has been too tightvirtually all of the time since the middle of 1990! 6 Increased base money growth rates have been recommended for severalyears by Mr. Nobuyuki Nakahara, a member of the BOJ’s Monetary PolicyBoard (MPB). 7 But until the change that was announced at the MPB meetingon March 19, 2001, the BOJ’s position was that additional base growth wouldhavenostimulativeeffectsinceshort-termnominalinterestrateswereclosetozero. With such low rates, base money and short-term government securities(bills) become almost perfect substitutes, so purchases of the latter by theBOJ have no effect on asset markets and consequently none on the economy,according to the BOJ view. That position will be discussed in the next twosections. 2. THE BANK OF JAPAN’S DIFFICULTY Over the period 1999–2001, commentary in influential nonacademic publica-tions including the  Economist  , the  Financial Times , and the  Wall Street Jour-nal  became increasingly critical of the BOJ for not providing more monetarystimulus to aggregate demand in Japan. The plots presented in the previoussection also suggest that more stimulus is needed and has been needed foryears, but nevertheless I believe that much of the press commentary has failedto recognize the difficulty of the problem that has faced the BOJ. It is not just stubbornness that has prevented the BOJ from providing such stimulus,for the nature of monetary policy actions is sharply different when short-terminterest rates are effectively equal to zero. It is not true that there has been“nothing more that the BOJ can do,” but what needs to be done is differentthan in normal conditions and the policy actions are more difficult to design. 5 The plot is reproduced from the same source as before, which provides details. 6 Some early indication that BOJ policy was too tight during 1990–92 appears in McCallum(1993, 35–36). Also see McCallum and Hargraves (1995). 7 Mr. Nakahara’s term as an MPB member ended in April 2002. The MPB currently includesMr. Shin Nakahara, who is not related to Mr. Nobuyuki Nakahara.
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