On the Role of Monetary Policy in a Deflationary Economy : The Case of Japan

In this paper we review the role of monetary policy for a country facing deflationary pressure based on the recent experience of the Japanese economy. We discuss economic background of inflation policy in Japan and analyze the impacts of the policy. Japanese economy is in a liquidity trap now. Two types of reasons were pointed out to be in liquidity traps. They are a real factor and a monetary factor. The former factor is the case analyzed by Krugman, where IS curve shifts due to structural reason such as aging of population. Under this condition a negative real interest rate is requested to escape from the liquidity trap. However, liquidity trap can also arise from monetary reason and the scenario of escape from the trap is different. We illustrate the case where deflationary expectation leads the economy to a liquidity trap. If it is necessary to utilize monetary policy for generating inflation expectation, we then need some explicit monetary policy rules, which is strong enough to escape from liquidity traps but at the same time which is effective to suppress unnecessary political pressure and to keep the independence of the central bank. Inflation targeting is a candidate for such a rule