Could Japan Target the Price Level or Inflation - What Happens to Monetary Policy Effectiveness during Disinflation?

Aaron Mehrotra

No ECO2004/02, Economics Working Papers from European University Institute

Abstract: The aim of this paper is to study whether price level or inflation targeting would be appropriate monetary policy regimes for Japan. A necessary condition for such regimes is that the rate of interest remain a positive tool of monetary policy. Using VAR and SVAR approaches, we investigate whether changes in the real ex ante and the nominal interest rate are able to stimulate an economy with a low inflation rate or deflation. Both with perfect foresight and using backward-looking schemes to predict the future price level, monetary policy remains potent even with declining inflation rates. This is confirmed by the stability of the estimated system throughout the examination period. A tax on currency, or ’Gesell money’ would be a possible alternative for Japan in order to lower the zero interest rate floor. We also find that monetary expansion in terms of broad money, broadly defined liquidity and M2+CDs, can bring Japan back to positive inflation rates. This must be supported by a higher interest rate differential between components of broad and narrow money. Moreover, expansion of direct funding in terms of corporate bonds could be beneficial for output growth while the non-performing loans problem in the economy is being tackled. Importantly, these results indicate that monetary policy alone is not able to pull Japan out of deflation and that fiscal measures need to be implemented in unison with monetary policy.

Keywords: disinflation; deflation; price level targeting; inflation targeting (search for similar items in EconPapers)
JEL-codes: E31 E42 (search for similar items in EconPapers)
Date: 2004
New Economics Papers: this item is included in nep-ifn
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