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Inciting Inflation
Subject Inflation
Topic International Finance, Monetary Policy
Key Words Interest Rates, Deflation, Inflation
News Story

The Bank of Japan, Japan's political and business leaders as well as economists throughout the country are all searching for ways to stimulate Japan's sagging economy. Japan's central bank has kept short-term interest rates at zero for almost four years, without initiating the hoped-for stimulus. In reaction to falling prices, climbing budget deficits, a declining yen and a tightening of business and consumer spending, there is a push to try inflation. Japan's central bank and it's governor, Masaru Hayami, has had price stability as one of its policy objectives, but many are pushing the bank to establish an inflation target as a means of revitalizing Japan's economy. With Mr. Hayami scheduled to retire in March, the government will have an opportunity to replace price stability with inflation targeting.

With prices still falling and the economy headed for another recession, there is no shortage of proposals for remedying Japan's economic ills. Some, like Nobuyuki Nakahara who served on Japan's central bank board, are arguing for further monetary easing. Mr. Nakahara wants the money supply to expand by 5 or 6 percent per quarter and to increase the amount of long-term bonds that it buys in the market. Others believe that the problem lies with Japan's banking industry. There is an ample supply of capital, proponents of this view argue, the problem is that it is being used unproductively. . The proposal that is gathering increasing support, however, calls for the central bank and the government to work together to create inflation.

Some analysts are skeptical about a push for inflation. Interest rates would likely rise as a result of inflation, depressing bond prices and increasing the cost of financing the government's debt. This would likely increase a budget deficit that, in relation to the size of the economy, is the highest among developed countries. Retirees and others on fixed incomes would suffer from inflation and many fear workers would not receive wages that match price increases.

(Updated April 3, 2003)

Questions
1.

Japan's economy is stalling. A contributing factor is deflation. What is deflation? Why are borrowers reluctant to borrow, when prices are falling (and interest rates are positive)? How does deflation cause Japan's economy to sputter?

2. Suppose that Japan is successful in initiating inflation. One expected impact of slightly rising prices is for Japan's consumers to increase their spending. What are the consequences to real GDP and the aggregate price level of an increase in consumer spending?
3. What is the likely impact of inflation on Japan's budget deficit?
Source Ken Belson, "Inflation's Fans Step Up Pressure in Japan," The New York Times, January 21, 2003.

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