Preventing Deflation: Lessons from Japan's Experience in the 1990s

64 Pages Posted: 21 Jul 2003

See all articles by Alan G. Ahearne

Alan G. Ahearne

National University of Ireland, Galway (NUIG) - Department of Economics

Joseph Gagnon

Peterson Institute

Jane Haltmaier

Board of Governors of the Federal Reserve System

Steven B. Kamin

Board of Governors of the Federal Reserve System

Christopher J. Erceg

Board of Governors of the Federal Reserve System

Jon Faust

Board of Governors of the Federal Reserve - Division of International Finance; Johns Hopkins University

Luca Guerrieri

Federal Reserve Board - Trade and Financial Studies

Jennifer E. Roush

Federal Reserve Board - Division of Monetary Affairs

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section

Nathan Sheets

Federal Reserve Board

Jonathan H. Wright

Johns Hopkins University - Department of Economics

Date Written: June 2002

Abstract

This paper examines Japan's experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities? failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

Keywords: Monetary policy, Taylor rule, fiscal policy

JEL Classification: E52, E63

Suggested Citation

Ahearne, Alan G. and Gagnon, Joseph and Haltmaier, Jane and Kamin, Steven B. and Erceg, Christopher J. and Faust, Jon and Guerrieri, Luca and Roush, Jennifer E. and Rogers, John H. and Sheets, Nathan and Wright, Jonathan H., Preventing Deflation: Lessons from Japan's Experience in the 1990s (June 2002). FRB International Finance Discussion Paper No. 729. Available at SSRN: https://ssrn.com/abstract=318700 or http://dx.doi.org/10.2139/ssrn.318700

Alan G. Ahearne

National University of Ireland, Galway (NUIG) - Department of Economics ( email )

Newcastle Road
Galway
Ireland

Joseph Gagnon

Peterson Institute ( email )

1750 Massachusetts Avenue, NW
Washington, DC 20036
United States

HOME PAGE: http://www.piie.com

Jane Haltmaier

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2374 (Phone)
202-736-5638 (Fax)

Steven B. Kamin (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-3339 (Phone)
202-736-5638 (Fax)

Christopher J. Erceg

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2575 (Phone)
202-736-5638 (Fax)

Jon Faust

Board of Governors of the Federal Reserve - Division of International Finance ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2328 (Phone)
202-736-5638 (Fax)

Johns Hopkins University

Baltimore, MD 20036-1984
United States

Luca Guerrieri

Federal Reserve Board - Trade and Financial Studies ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2550 (Phone)

Jennifer E. Roush

Federal Reserve Board - Division of Monetary Affairs ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2897 (Phone)
202-263-4850 (Fax)

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2873 (Phone)
202-736-5638 (Fax)

Nathan Sheets

Federal Reserve Board ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-3819 (Phone)
202-736-5638 (Fax)

Jonathan H. Wright

Johns Hopkins University - Department of Economics ( email )

3400 Charles Street
Baltimore, MD 21218-2685
United States

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