Macroeconomics Commentary - Japan's consumer prices fall on weak domestic demand

by stellar00011 (student)

IB Economics – Internal Assessment

Front Cover

Japan's consumer prices fall on weak domestic demand

Japan's consumer prices have fallen for the first time in four months, as weak domestic demand and deflation continue to weigh on growth.

Core consumer prices, which exclude fresh food, slipped 0.1% in October, the statistics bureau said.

One of the reasons for the fall is last year's cigarette tax rise falling out of the calculations.

The strong yen as well as Europe's debt crisis are hurting the growth outlook for the world's third-largest economy.

Yen strength

In March, Japan was hit by a devastating earthquake and tsunami that caused much damage in the north-east of the country.

The government this week passed an emergency budget of $155bn (£100bn) to try to boost domestic demand, however the effects won't be felt for a few months.

"The data underscores the sluggishness of domestic demand, as the economy's recovery has taken a breather because of a delay in reconstruction efforts and global economic slowdown," said Takeshi Minami from Norinchukin Research.

Japan's economy bounced back from recession, triggered by the earthquake and tsunami, in the three months to September.

However, the pace is expected to slow because of the pressure on exporters from the strong yen, as well as the bleak global outlook of growth.

Oil prices

The slowing global economy has caused a decline in crude oil costs. That combined with the yen's appreciation have made energy imports to Japan very cheap.

Gasoline prices at the pumps have dropped 1% since September in Japan.

The yen has advanced 6% against the dollar in the last six months.

Some analysts ...

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Japan's economy bounced back from recession, triggered by the earthquake and tsunami, in the three months to September.

However, the pace is expected to slow because of the pressure on exporters from the strong yen, as well as the bleak global outlook of growth.

Oil prices

The slowing global economy has caused a decline in crude oil costs. That combined with the yen's appreciation have made energy imports to Japan very cheap.

Gasoline prices at the pumps have dropped 1% since September in Japan.

The yen has advanced 6% against the dollar in the last six months.

Some analysts said consumer prices in Japan could further decline as the slowing global economy continues to weigh on the price of oil.

Deflation is a persistent fall in the average price level of prices in the economy. Japan experienced deflation where average level of price fell by 0.1%. The type of deflation in Japan is known as negative deflation which resulted from demand side of economy. A fall in domestic demand caused a decrease in consumer prices level and a decrease in real output.

The fall in domestic demand was due to last year's cigarette tax rise. Government rose cigarette tax to increased government revenue. Cigarette tax charged on producers instead of consumers. Tax increased the costs of production to producers. This shifted the supply curve form S1 to S2 while the demand curve did not change. Cigarette tax depressed the activity of market and placed a wedge. Producers gained less profit and consumers paid more. Hence the total quantity reduced from Q1 to Q2, as figure shown below.

Tax charged on producers

equilibrium without rising tax

The increases in price that consumers paid reduced the willingness to buy. The demand curve shifted to left from D to D1 as figure shown below. Hence the quantity demanded reduced from Q2 to Q3 and price of cigarette reduced from P2 to P4.

Tax affects demand indirectly

Less quantity demanded of cigarette means less quantity sold at the price lower than without tax. Therefore even lower government revenue collected. What have discussed above would repeat itself as a cycle if Japan government continues to rising cigarette tax.

The results of higher cigarette tax combined with several other factors together to reduce the aggregate demand in Japan market. The economy was near full employment level of output, with a small amount of spare capacity. The figure below indicated that as aggregate demand curve shifted to left, the quantity of output and average price level reduced.

Demand-pull deflation

The biggest problem associated with deflation is unemployment. If aggregate demand is low, business is likely to lay off workers. In fact, Japan already had unemployment rate around 4.7%. High unemployment rate linked with high suicide rate and other security uncertainties. Government tried to correct deflation and to reduce rate of unemployment by means of pass an emergency budget of $155 billion to boost domestic demand. However, the aim will not be fulfilled in short-run.

Japan is a developed country. There are periods of rising growth, followed by periods of slowing growth, and falling growth in developed countries. This is known as business cycle which is the periodic fluctuations in economic activity measured by changes in real GDP. The phases of business cycle are boom, recession, trough and recovery. Recession is two consecutive quarters of negative GDP growth. During a recession, consumption and investment fall. Falling aggregate demand leads to unemployment. If more people are unemployed, there will be even less consumption and deflation.

At some point the recession came to an end. Output cannot continue to fall as there would be some people with jobs to maintain consumption, foreigners demand exporters and government spending. Japan's economy bounced back from recession and started to recovery, triggered by earthquake, from June to September. The real GDP started to increase as government running budget for reconstruction and medical treatments after earthquake. However, the pace of recovery tends to be very slow as a result of the appreciation of yen.

The yen has appreciated 6% against dollar in the last six months. Appreciation of yen against dollar means the purchasing power of yen has risen. However, appreciation of yen against dollar occurs at the same time as the depreciation of dollar. An exchange rate is value of one currency expressed in terms of another currency. One of the disadvantages of a high exchange rate is damage to export industries. If value of exchange rate is high, then export industries find it is difficult to sell products because foreigners are likely to reduce the quantity imported since goods become more expensive. Therefore, lower the revenue from exports, slower the pace of recovery.

The fell of average price level (deflation) can also be explained by the high exchange rate. When value of exchange rate is high, price of imports will be relatively low. Taken import of oil as an example, the gasoline prices have dropped 1% since September. In addition, price of imported raw materials will reduce the costs of production for firms which could lead to lower prices for consumers. Low price of imported goods also puts pressure on domestic producers to be competitive by keeping prices low.

Japan’s government could lower the value of yen by means of buy foreign currencies on foreign exchange markets. Government uses its own yen to buy hence increases supply of yen on foreign exchange market and so lowers its exchange rate. Lower the level of domestic interest rates could lower the value of yen too. This will cause financial investment abroad more attractive. In order to invest abroad, investors will buy foreign currency thus exchanging their own currency and increasing supply of it on financial exchange market. This could lower its exchange rate.