With of the AD curve from AD1 to

Topic: EconomicsConsumer Science
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Last updated: September 27, 2019

 Witha slow and stable inflation target of 2% and an aim to “kickstart Japan’seconomic growth”  the Bank of Japan(BoJ )has decided to implement an unconventional monetary policy with interestrates below the zero level bound to curb the highly stagnated deflationaryspiral. Deflation is a sustained fall in the general price levels. In such acase, it is argued that an expansionary monetary policy which seeks toinfluence aggregate demand by lowering interest rates would likely get theeconomy out of the deflationary trap. However, various attempts by BoJ has notled to this, and forced it to implement a monetary policy with negativeinterest rates.         Interestingly, the government wants to reduce theinterest rates by maintaining its open market operations or  “bond buying more or less in line withthe current pace.” Instead it seeks to achieve this by buying fewer longterm bonds to increase money supply of Japanese yen from Sm1 to Sm2.This would lead to a fall in the interest rate from 0 (assuming the interestrate was at lower bound) to –0.1%.

The nominal interest rates are inverselyproportional to the quantity of investment. When the interest rate was at 0%the quantity of Japanese yen invested was i1 and when the interestrate decreased to –0.1% the quantity of JPY invested increased to i2.Low interest rates make borrowing easier for various economic sectors thusdriving demand for loans.  Though thenegative interest rates would stimulate investment in the economy it would havea different effect on depositors. It would mean that the depositors would haveto pay to  save money and receive a smallor no amount of interest in return.

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This is highly unlikely to happen and wouldhave an indirect effect of dampening savings which are leakages in the economy.The direct and indirect effect of negative interest rates results in the shiftof the AD curve from AD1 to AD2 while bringing the economy back to thepotential output Yp from the deflationary output Ydef.  Nevertheless,this policy might do more harm than good to Japan’s economy as households andfirms may stop depositing their money in banks which is the crucial source offunding i.e. loans. This would perhaps even trigger a bank run which is thesituation that occurs when a large number of customers of a bank or financialinstitutions withdraw the deposits simultaneously. In addition, the movementfrom output Ydef to Yp doesn’t happen without time lagsgiven that there is negative “inflation expectations” which furtheradds to negative business and consumer confidence.

If firms and consumers arepessimistic about the future, they might avoid taking loans and might evenreduce investment. Additionally in such a severe recession, the commercialbanks in Japan would be highly concerned that the negative rates would squeezetheir profit margin between their lending and deposit rates and might make themeven less willing to lend. Also, they would be highly unlikely to increasetheir lending to facilitate household investment as they might fear that theborrowers might be unable to repay their loans let alone interest.

This wouldcontradict the BoJ’s attempts to increase investment and get the economy out ofthe deflation. Therefore,the nominal negative interest rates would be highly ineffective given that thesuccess of commercial banks is at stake. Moreover, despite the low nominalrates the real interest rates could still be high enough such that it does notstimulate enough investment and would require a greater rate cut.

Instead thegovernment can use fiscal policy to get the economy out of a deflationary trap.It is a highly effective policy not only due to its ability to curb recessionbut also due to its ability of effecting supply side factors in the long term.However, it is still subjected to time lags and political constraints with anadditional problem of crowding out.  In acase of deflation where expansionary fiscal or monetary policy is notsufficient enough to stimulate a recovery, the government and the BoJ could tryand resort to quantitive easing (Maley et.

al, 2011) which is printing money toencourage spending. Nevertheless, this money supply is financed by deficitspending which would create a burden on government budget. However, there is nosubstitute to a policy mix of both monetary and fiscal policy with an aim ofgetting Japan to Yp and methods like quantitive easing should bejust seen as compliments but never substitutes to these major policies. 

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