Pumping Yen
Subject Monetary Policy, Exchange Rates
Topic International Finance and Monetary Policy
Key Words Interest Rates, Economic Growth, Exchange Rates
News Story

Japan's policy makers are struggling to revive a stagnant economy. Consumer and business spending has decreased in recent months because of a lack of confidence in their economic future. As a consequence, prices have fallen and so has the value of assets. Attempts by the government to stimulate the economy by large increases in spending have only resulted in larger budget deficits. The central bank of Japan, in an attempt to stimulate consumer and business spending, announced that it would increase the money supply and cut short-term interest rates essentially to zero. The central bank also promised to keep borrowing costs low.

Japan's economy is stagnant, its financial system is burdened with bad debts and the economy is deflating. Attempts to stimulate the economy by deficit spending have left Japan with a national debt of about 130 percent of gross domestic product. Monetary policy measures have also been failures, although the central bank had previously lowered interest rates by directives instead of by increases in the money supply. The bank's focus was on keeping the money supply stable. In a major shift, the bank announced that "economic conditions warrant drastic monetary easing, such as is unlikely to be taken under ordinary circumstances."

The Bank of Japan will increase the money supply by expanding the amount of reserves in the system. With greater reserves, the banks will be able to increase their lending. It is expected that this move will lower short-term interest rates to zero from its present level of 0.15 percent. The decrease in interest rates may stimulate exports as the bank's actions may push the yen lower against the dollar.

There is disagreement among economists as to whether increasing the money supply will stimulate the economy. With rates as low as 0.15 percent, consumers and business are reluctant to borrow. There is currently no credit crunch in Japan's financial system, and therefore an injection of reserves will therefore not stimulate borrowing.

(Updated May 1, 2001)

1. Explain how an increase in excess reserves in the banking system will lead to an increase in aggregate demand.
2. Last year, in the midst of a small economic revival, the Bank of Japan tightened monetary policy. What affect would you predict that this would have on the recovery? Are you surprised that the recovery fizzled?
3. It is hoped that Japan's economy might be stimulated by a decrease in the exchange rate between Japan and the United States. How would a decrease in the value of the yen vis-a-vis the dollar stimulate Japan's economy?
Source Stephanie Strom, "Japan's Bank Acts to Spur Spending in Ailing Economy," The New York Times, March 20, 2001.

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