Inflation would take some form such as external shock to change Japanese group behaviour. It had already happened which to prevent rising interest rate. However, low interest rate meant that companies can get cheap credit to keep going. There was no pressure for them to make higher profit and reform.
2. Use macroeconomic theory to explain the cause of deflation in Japan. Do you think deflation is good for an economy? Explain.
Deflation usually is defined as falling average prices. According to macroeconomic theory, it should be considered that changing the money supply can affect prices because of changing overall volume of spending. Less money supply means less spending which also means lower prices. However, according to the figure 1, during the deflation period which was from 1990 to 2001, Bank of Japan reduced the discount rate and kept it in the low level. Therefore, there was not a contraction of money supply which caused deflation.
Figure 1
Discount Rate of the Bank of Japan from 1990 to 2001
Source: Deflation and Japan Revisited, 2005
Base on macroeconomic theory, there is a formula which is P=D / S.
P: prices
D: aggregate demand
S: supply of goods
In this formula, it is easy to understand that decreasing D and increasing S will both reduce the prices level, which will cause deflation.
According to Johnsson’s (2005) argument that aggregate demand relies on the GDR (Gross Domestic Revenue), as we can see in figure 2, the GDR rose every year during the period except in 1993, 1998, 1999 and 2001 which means the aggregate demand rose.
Figure 2
Percentage change in GDR
Source: Deflation and Japan Revisited, 2005
Therefore, the cause of deflation in Japan was the rising of supply in the most years. What is more, the cause in 1993, 1998, 1999 and 2001 was the falling of aggregate demand.
There may be other cause which was Irrational Expectations. Japan suffered serious inflation before the deflation period. In post-bubble deflation years, ordinary Japanese was still afraid of inflation. Their risk-averse performance made the economic situation in a bad circle.
Deflation is not a benefit or a disadvantage for an economic by itself. However, in this case which happened in Japan, deflation is a benefit for the economy of Japan. In deflation period, the prices level was low. It is a benefit for export. Someone argued that deflation lower sales revenue and profits which also lower the GDP. However, there is no sense to compare the GDP and sales revenue in deflation period whit which in inflation period. In my opinion, Japan’s economy just regressed from inflation.
3. What sort of monetary policy was the Japanese Central Bank (BOJ) following to solve the deflation problem? Do you think that the Japanese Central Bank was successful in solving the problem?
Lowering the interest rate was the monetary policy that Japanese Central Bank following to solve the deflation problem. Considering the theoretical argument, lowering the interest rate will increase consumption and investment. What is more, lowering the interest rate will also reduce the demand of domestic currency. It will force the domestic currency to depreciate that is a benefit to export.
As we know,
GDP= C (consumption) +I (investment) + G (government spending) + NX (net exports)
This will increase aggregate demand, which will make the AD curve shift to the right to increase the price lever to solve the deflation problem.
It is hard to consider that Japanese Central Bank was successful in solving the problem. However, it is a effective way to prevent the deflation going to be worse. As we can see in the figure 3 which was presented in the article, Japan’s consumer prices increased a little bit every year since 2002 which means the deflation was controlled.
Figure 3
Source: Statistics Bureau; Cabinet Offices; CLSA Asia-Pacific Markets
4. Deflation has boosted the Japanese exports on the one hand and on the other hand the Japanese Central Bank has kept interest rate low to solve the deflation problem — what impact do these two effects have on the Japanese foreign exchange market.
On economic theory, Japanese exports increase because of deflation. Deflation will lower the prices level which will also lower the Japanese exports prices. It will bring a benefit to Japan’s exports which is the lower the price is the more demand for Japanese exports there will be. Thus the demand of Japanese Yen will increase because foreign countries will purchase much more Japanese Yen to import Japanese product. Therefore, Yen would appreciate.
On the other hand, when the Japanese Central Bank has kept interest rate low to solve the deflation problem, according to the law of demand and supply, the demand for Japanese would decrease then the value of the Japanese Yen will decrease.
5. In the third paragraph of the second page of this article the author has argued that, because of deflation, “company profits are now falling...” and “consumers are also showing signs of belt-tightening” –Use the relevant microeconomic theories to analyze such behaviour.
As we know the price will fall in the deflation period. Companies will reduce the quantity of production supply because of lower price. The sales of companies will also fall because the falling prices and the falling quantity. However, the costs can not fall faster than prices. The reason is that even though we ignore the cost of goods there will still be the costs as depreciation of fixed assets and cost of good sold. Therefore, the costs decrease slowly than prices do.
As we know, Profit= (Price - cost)*quantity
Considered on what we discussed before (Price fall, cost fall less then price, quantity fall), then we get that the profit of company must fall.
On the other hand, wages also fall because of deflation. Consumers earn less than before which will reduce the spending. That is the reason why consumers are also showing signs of belt-tightening.
Reference list
Johnsson, R 2005, ‘Deflation and Japan Revisited’, THE QUARTERLY JOURNAL OF AUSTRIAN ECONOMICS, VOL. 8, NO. 1, pp. 15-29, retrieved 28 September 2008 < http://mises.org/journals/qjae/pdf/qjae8_1_2.pdf >
