Economics for Managers Japan Case - Essay Example

Economics for Managers – Japan Case Summarize the key message of this article After a long decade of deflationary problem in Japan, the country finally faces inflation. However, this inflation is not the type the country has long wanted for its economy: this sort is of a cost-push variety, instead of the demand-pull. The cost-push inflation Japan faces currently is due to the rising prices of commodities around the globe. With the rice of fuel prices and primary goods such as rise, the rise in the costs of production has increased too. While the country wants the deflationary problem to stop, and years for some inflation, this sort of inflation further frustrates the economy and keeps the country’s economic growth lower. Figure 1.2 shows the shift of aggregate supply upwards because of the increase in production costs—this is in turn the cause of the inflation. For almost a decade, the Japanese have started to adopt a risk-averse mindset after the fall of the dotcoms. Due to the circumstances, zero-return in cash has become the mindset of the people. While prices continue to drop, people further delay their consumption for the hope of lower prices. This hoarding of cash or investing in zero-return or non-interest-bearing savings, leads to stagnation and later, worsening deflation in the economy. Thus the country wishes for some inflation to happen by increasing aggregate demand either through increase in consumer spending, or channeling of money to some real investments in order to stimulate growth in the economy. Because of inflation, the relatively low or zero-return of investments most Japanese consumers have produces a negative interest rate. The Japanese Central Bank now hopes that consumers will then shift their investments to interest-bearing or higher-yielding investments to offset the effect of inflation, such as shares and real estate in order to give a boost to the economy. The cost-push inflation in the economy thus requires the Japanese Central Bank to use some monetary policy to curb it. However, Japanese Central Bank cannot just increase the interest rate for the mean time. While the global economy seems to pose a threat, increasing the interest rate will hurt the economy and worsen the impact of this threat if it happens. Thus, the Japanese Central Bank will keep the interest rates low in order to lessen the impact of the economic crisis abroad to the Japanese economy. 1. Use macroeconomic theory to explain the cause of deflation in Japan. Do you think deflation is good for an economy? Explain. The aggregate prices or the overall inflation within an economy is set by the interaction of the aggregate demand and aggregate supply. On one hand, aggregate demand is determined by the total amount of consumption, investment, government spending and net exports in an economy. This determines the level of output to be produced. On the other hand, the aggregate supply is determined by the level of output businesses are willing to produce, which is influenced by both the potential output and production costs. This interaction determines output or real GDP, the levels of employment and unemployment, prices and inflation and foreign trade in an economy. With deflation being defined as a downward movement in the level of prices in an economy, we can analyze what causes deflation in Japan by looking both at the aggregate demand and aggregate supply of their economy. The deflationary mindset in Japan long started after the falls of the dotcoms before the start of the new millennium. This event had eventually resulted in the downward spiraling of prices in Japan, which discouraged and delayed consumption, for the hope of lower prices in the subsequent months. As Evan Davis of BBC had put it, “Consumers think ‘why buy now, if prices will be lower next month?’(2001).” Aside from it, the mindset of saving for retirement by delaying consumption and hoarding cash had developed among the Japanese. Instead of spending, consumers were encouraged to save and postpone consumption for the hope of lower prices in the future. As aggregate demand is consists of consumption, investment, government spending and net exports (please refer to figure 2.1)—consumption significantly dropped because of the mindset. While in most cases delaying consumption is good for the economy, it only happens when the money that is saved is spent on real investment such as capital infrastructures within the economy. This is not what happens to Japan. The delay of consumption leads into hoarding cash, and does not lead to spending in real investment. The result—lower aggregate demand. The decrease in consumption lowers down the aggregate demand not by its exact amount, but multiplied by the amount of the multiplier in the economy (figure 2.2). This is due to the fact that when consumption is lower, firms are less motivated to spend more on capital or real investments because their efforts will not be rewarded by sales from consumers. When consumption is decreased, it decreased the aggregate demand through a vicious cycle: aside from the decrease in investment spending, because businesses now have smaller revenues, government can collect smaller in taxes. With lower taxes, government will have smaller amount to spend which will in turn increase aggregate demand. While consumers decrease consumption to hoard cash, the aggregate demand is largely affected. In the case of Japan, with aggregate demand becomes lower and lower because of the delay in consumption which leads to non-interest bearing savings on the part of the consumer, deflation worsens given the relatively fixed aggregate supply. This deflation is the overall result of the mindset that the Japanese developed after the fall of the dotcoms. The current inflation in Japan, which as mentioned in the article is not the kind of inflation the country hopes to have is illustrated in figure 2.3 where the cause of the increase in price level is the increase in production costs which then shifts the aggregate supply curve upwards. As for my opinion, deflation is not good to the economy as a whole. The downward spiral of prices does not give incentive to businesses to invest and expand their operations, due to the fact that deflation sometimes is a result too of a decrease in consumption. Because of this, many businesses find it hard to sustain their operations within the economy as lower prices require them to increase sales volume in order to break-even. In the worst case, these events can lead many firms to leave the industry. The spending as a whole for the economy is reduced, and people tend to feel poorer in the process. 2. 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? In order to address the deflationary problem of the economy, the Japanese Central Bank keeps the interest rate low as part of its monetary policy. By keeping the interest rate low by increasing the money supply in the economy (figure 3.1), the Japanese Central Bank intends to increase investment per year. The effect of decreasing the interest rate encourages investors to shift their money from risk-free or government securities to higher-yielding interest-bearing investments such as shares or real estate, which then generates real investment in the economy. When investments are increased (as seen in figure 3.3), real output or GDP increases too by the amount of a multiplier in the model. Increasing investments will then increase in total spending for the economy—as part of the aggregate demand, it will push aggregate demand upwards (figure 3.4) in order to keep prices from falling, and in order to induce inflation. The higher level of aggregate demand with its interaction with the aggregate supply raises the overall level of prices in the economy. This is what the Japanese Central Bank aims to do by keeping the interest rates low as part of its monetary policy. Looking at figure 3.5, we see the effect in the economy through a multiplier model. By increasing investment, due to the monetary policy Japanese Central Bank employs, GDP will increase by the amount of a certain multiplier. This increase in total spending therefore aims to push the price level in the economy, thus combating deflation and encouraging inflation in the process. However, this monetary policy, according to the article, has been employed by the Japanese Central Bank over the years. While keeping the interest rates low in order to combat deflation, and induce inflation in turn, the investments do not grow as expected. This is because of the risk-averse mentality that the Japanese have developed over the years. So, even when they are encouraged to shift their investments to higher-yielding ones, unless the real interest rate (nominal interest rate less the inflation) is still positive, they would not go for the opportunity. Because of the risk-averseness of the Japanese, this monetary policy has not solved the deflation as it is long expected. 3. 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. Deflation has boosted the Japanese exports: deflation creates a movement along the curves, both the demand and the supply curve. With the price of a certain good decreases overseas, the quantity of the good that is demanded has increased (figure 4.1). This increase in the quantity of goods demanded increase the overall demand for Japanese goods overseas. The increase in the overall goods of the Japanese creates an increase in the demand for the Japanese yen, in turn (figure 4.2). This increase in the demand for yen makes the yen makes the yen more expensive—the yen appreciates. On the other hand, those countries that demand yen in order to buy Japanese goods, in turn have currencies that depreciate. Thus, the boost in export due to deflation results in yen appreciation: more of those foreign currencies are willing to be exchanged for a single yen. On the other hand, the Japanese Central Bank has kept interest rate low to solve the deflation problem: as we can see in figure 4.3. This monetary policy has an effect in the investment side of the economy. Due to lower interest rates, foreign investors that put their money in financial instruments such as government securities find those rates not enough as incentives to continue on investing in the country. Why invest in Japan if other countries offer higher interest rates in return? They would pull their money out of the Japanese economy and shift their investments to other countries. This, in turn decreases the demand for yen (figure 4.4); yen depreciates. The lower demand for yen makes yen less expensive in terms of other foreign currencies; the other foreign currencies in turn appreciate. Deflation has boosted exports of Japan which appreciates the yen on one hand; on the other hand keeping the interest rates low results in depreciation of yen. The relative impacts of these two activities will determine the result of how much yen appreciates and depreciates over time. 4. In the third paragraph of the second page of this article the authour 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 . Figure 5.1 shows the interaction of the demand and supply in the market. Decrease in the prices of goods result in movement along the curves of demand and supply. This movement in the prices of goods determines the quantity to be demanded and the quantity to be produced given a certain price level. However, decrease in demand is different from the decrease in quantity demanded; decrease in demand happens when the price of a substitute product decreases, which will in turn increase the demand for it. But what happens when the other products which is a substitute to one has falling prices, and then its substitute’s substitute has falling prices too like a domino effect? Overall decrease in demand, which in turn decreases consumption, is a result of this domino effect, which is more apparent at the presence of deflation. Thus, deflation decreases demand for a product, which in turn produces a domino effect that decreases demand overall. This decrease in demand is what the author suggests as “consumers tightening their belts.” This belt-tightening among consumers in turn results in falling profits among companies. By referring at figure 5.2, we can see that at a given price, the quantity demanded produces revenues for a company. The average costs the company incurs at this quantity level are then subtracted from the total revenues. This is the profits, as represented by the gray rectangle in the figure. Decrease in the price level of a certain good decreases the quantity demanded, as seen in figure 5.3. While the price is reduced, the level of reduction in overall revenue depends on the relative increase in quantity demanded, at some instances where demand curve is more elastic, the price reduction increases revenues. But in the figure, the decrease in price decreases the profit as a whole. Given the amount of average cost for a certain quantity level that is demanded, by decreasing the price on the normal circumstances, or when everything else remains constant, decreases in profit follow. As if the decrease in price is not enough, when deflation is present as we have discussed earlier, it decreases the demand for a product because of the substitution effect (figure 5.4). This in turn decreases the demand for most products because of the domino effect that is inherent in deflation. The decrease in overall demand for a product, different from the quantity demanded of the product, because of deflation lowers the profit of a company further. In this situation, the quantity demanded for a good at a certain price is lower too, for every price level. Not only will the price be affected, but also the quantity at that price level, so that when both are reduced, revenues as a whole are reduced. When the level of average costs is constant, this can significantly hurt the profitability of the company, if not incurring a net loss at the worst. Bibliography Appleyard, Field, & Cobb. (2006). International Economics (5th ed.). McGraw-Hill Irwin Davis, E. (2001, October 31). “Japan’s Fading Economy.” BBC News Business. Available from http://news.bbc.co.uk/2/hi/business/1629737.stm. [Accessed 19 September, 2008] BBC Business (2005, November 25). “Japan’s Fading Economy.” BBC News Business. Available from http://news.bbc.co.uk/2/hi/business/4468826.stm . [Accessed 21 September, 2008] Bremner, Brian. (2002, March 18). “Japan's Deflation Disaster.” Business Week, International Business. Available from http://www.businessweek.com/magazine/content/02_11/b3774063.htm . [Accessed 21 September, 2008] Brooks, D., & Quising, P., (2002, December). “Dangers of Deflation.” Economics and Research Department Policy Briefs Series, Number 12. Asian Development Bank. Available from www.adb.org/Documents/EDRC/Policy_Briefs/PB012.pdf . [Accessed 21 September, 2008] Read More