Monetary Policy Framework and "Insurance Against Deflation"

Naoko Hara, Takeshi Kimura and Kunio Okina
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Kunio Okina: Chuo University

No 08-E-6, Bank of Japan Working Paper Series from Bank of Japan

Abstract: Using the FRB/Global model on Japanese monetary policy in the early 1990s, Ahearne et al. (2002) argued that deflation could have been avoided in Japan if the BOJ had lowered short-term interest rates by a further 250 basis points at any time between 1991 and early-1995 as "insurance against deflation." That study raised interesting questions on how the central bank could offer "insurance against deflation" when the inflation rate is close to zero. However, the simulation by Ahearne et al. (2002) has some drawbacks: it assumes the central bank's commitment to permanent downward shift of the policy reaction function when policymakers are not sure what would happen, which is neither feasible nor credible. In this paper, we show alternative policy frameworks of "insurance against deflation" that can be feasible and credible even under uncertainty. The simulation using the Japanese Economic Model (JEM), a large-scale macroeconomic model of the Research and Statistics Department of the Bank of Japan, suggests that what is important is not large cuts in interest rates at an early stage; rather, the central bank would commit to cut interest rates aggressively in the future, if the risk of deflation increases.

Keywords: Asset Price; Collapse of Bubbles; Insurance Against Deflation; Monetary Policy; JEM (Japanese Economic Model) (search for similar items in EconPapers)
Date: 2008-07
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Citations: View citations in EconPapers (3)

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