Performance of the Monetary Policy in Japan - Literature review Example

Performance of the Monetary Policy in Japan Total Number of Words: 2,251 Introduction Japan is known for being the world’s 5th biggest importer and exporter (EW World Economy Team, 2013). However, several news reports highlighted the fact that the economic growth of advanced economies like Japan was badly affected by the global financial and economic recession that has occurred between 2008 to 2011 (Rasmus, 2013). As a result, Japan’s annual GDP growth rate fell from 2.2% in 2007 down to -1.0% and -5.5% in 2008 and 2009 respectively (The World Bank, 2014c). In general, either monetary or fiscal policies can be used to prevent a slow economic growth (Rasmus, 2013). Considering the economic development of Japan, this study will focus on analyzing the monetary policy framework that Japan has adopted to improve its economic situation. To give the readers a better understanding of this subject matter, Japan’s monetary policy framework will first be tackled in details. Right after discussing the measures taken by the Bank of Japan in dealing with the global recession, this study will focus on critically analyzing its effectiveness in terms of preventing economic stagnation or economic crash. Japan’s Monetary Policy Framework The economic term ‘price stability’ means that the market prices of goods and services are free from sudden and uncontrollable fluctuations (Bank of Japan, 2013). In general, having strong price and financial stability is necessary to ensure that deflation would end (Kramer and Stone, 2005). To make Japan’s economic activities have a strong foundation, the Bank of Japan has decided to focus its monetary policies on maintaining price stability at 2% year-to-year change in its consumer price index (CPI) (Bank of Japan, 2014a; Bank of Japan, 2013). The Bank of Japan has also been using the interest rates strategy as their way of controlling its monetary currency (Kramer and Stone, 2005). To ensure that the members of the monetary policy board are able to make important decisions, the Bank of Japan requires all board members to attend its Monetary Policy Meetings (MPMs) (Bank of Japan, 2014a). Often times, it is through these meetings, that the board members are able to discuss the on-going economic and financial situation (Blinder et al., 2001). For example, in exchange of collateral, the Bank of Japan purposely extends some form of loans to the affected financial institutions in times of serious financial crisis (Bank of Japan, 2014a). As a common knowledge, there will always be a domino effect between banking or financial failure and the socio-economic situation in each country. Therefore, in the process of extending loans, the Bank of Japan can help prevent the long-term socio-economic consequences caused by a serious financial depression (Bank of Japan, 2014a). Other than extending some loans to financial institutions, the Bank of Japan also has the option to issue and sell bills to the affected parties (Bank of Japan, 2014a). Measures Taken by the Bank of Japan In response to the global recession, the Bank of Japan immediately conducted MPM on the 22nd of January 2008. Since May 2007, the Bank of Japan has implemented its zero-interest policy (Masaru, 2007). Instead of its using zero-interest rate policy, the Bank of Japan decided to increase the uncollaterized overnight call rate at 0.5% between the 22nd of January 2008 up to the 20th of November 2008 (Bank of Japan, 2008a; Bank of Japan, 2008f). On the 21st of November 2008, the Bank of Japan decided to decrease its uncollaterized overnight call rate down to 0.3% (Bank of Japan, 2008f). On the 19th of December 2008, the Bank of Japan decided to reduce its uncollaterized overnight call rate down to 0.1% (Bank of Japan, 2008g). As explained by BOJ Governor Fukui Toshihiko, the main reason for increasing the uncollaterized overnight call rate at 0.5% is to avoid misallocation of the economic and financial activities which could eventually slow down Japan’s sustained economic growth (Masaru, 2007). Even though the Bank of Japan has the option to increase its interest rates, the bank insisted on keeping its interest rates low. By keeping their interest rates low, the Bank of Japan was able to ease the companies’ access to necessary funding (Young et al., 2009). Likewise, this particular monetary policy was useful in terms of narrowing down the spread of its corporate bonds (Young et al., 2009). Therefore, the decision of the Bank of Japan to increase the uncollaterized overnight call rate at 0.5% is good. Often times, at zero interest, increase in Japan’s monetary base would only create little or no effect on its economic activities (Kimura et al., n.d.). Although keeping the interest rates low has been effective in terms of easing the companies’ access to funding, the long-term use of this particular monetary policy may not always be good in the long run. By keeping the real and nominal interest rates low, both domestic and foreign investors may find it more difficult to have good returns from their investments (Young et al., 2009). Likewise, the bond market in Japan is at risks of facing more difficulty in tracking down the creditworthiness of companies that issues corporate bonds. As such, a lot of financial dealers or brokers have been complaining that the low interest rates make it more difficult for them to cover the costs of financial dealings (Kramer and Stone, 2005). As a result, there is a slow growth in Japan’s capital production. This explains why despite being the world’s 5th biggest importer and exporter (EW World Economy Team, 2013), Japan has accounted for only 7% of the world’s bond market (Young et al., 2009). In July 2008 onwards, Japan’s CPI inflation rate was roughly at 1.5% because of the sudden increase in the market prices of food and petroleum products (Bank of Japan, 2008b). Since the Bank of Japan decided not to react to oil price shock, Japan’s CPI inflation rate increased up to 2.5% on the 17th of September 2014 (Bank of Japan, 2008d). As a result of higher inflation rate, Japan economic growth suffers because of the slow growth in its exports. Instead of using monetary policy to control the economic condition in Japan, the Bank of Japan decided not to do something and just allow the aggregate demand and aggregate supply to control the market prices of goods (Bank of Japan, 2008c). Again, the decision made by the Bank of Japan is good. Even though increase in the market prices of oil can contribute to a sudden decrease in production output, the effects of oil price hike in Japan’s economic activities is only short-term (Kramer and Stone, 2005). Therefore, the best way to avoid financial and economic imbalances is to keep the interest rate constant (Liu, 2014; Leduc and Sill, 2004). In line with this, the use of monetary policy may only trigger roughly 40% decrease in production output immediately after the sudden increase in the market price of oil (Leduc and Sill, 2004). By not responding to oil price shock, the Bank of Japan can easily avoid the risks of developing the long-term economic consequences of having speculable bubbles (Liu, 2014). In response to the continuous decline in Japan’s economic activities, the Bank of Japan announced its decision to provide liquidity measures as a way to promote and maintain the stability of its financial markets. In line with this, the Bank of Japan decided to decrease its interest rates policy on top of making its money market operations more flexible (Bank of Japan, 2008e). As such, the Bank of Japan decided to reduce its uncollateralized overnight call rate at 0.3% and reduce the basic loan rate to 0.5% effective on the 31st of October 2008 (Bank of Japan, 2008e). On the 19th of December, the Bank of Japan lowered down the basic loan rate to 0.3% and interest rate on deposit facilities down to 0.1% (Bank of Japan, 2008g). Likewise, the Bank of Japan decided to implement a temporary measure on its excess reserve balances by applying 0.1% between November 2008 up to March 2009 (Bank of Japan, 2008e). On the 19th of February 2009, the Bank of Japan decided to extend its financial support or liquidity measures to both private and public companies. As such, the Bank of Japan offered the “special funds-supplying operations” which aims to extend low interest corporate financing for a short span of three (3) months (Bank of Japan, 2009a). Likewise, the Bank of Japan also offered outright purchases of corporate bonds (Bank of Japan, 2009a). In the process of offering these two (2) options, it makes a lot of sense that the Bank of Japan could prevent companies from filing bankruptcy. In times of serious global financial and economic crisis, the business activities of both private companies and banks are badly affected. Therefore, to cut down the possible losses, the best thing that central banks can do is to make sure that financial institutions and private companies would remain liquid at all times. Basically, the use of this particular monetary policy is good in terms of preventing bank losses or bank insolvency caused by unpaid loans (Arnold, 2014). In the process of reducing the basic loan rate, it will be much easier on the part of the borrowers to repay their bank loans. This will increase the chance wherein borrowers will be able to pay back their loans on a future date when Japan’s economic activities have already gained its stability. It is clear that in times of serious economic and financial recession, it is always best for the Bank of Japan to offer liquidity measures to all affected corporate and financial institutions. In the process of using monetary policy to ease up the financial challenges most firms, banks and financial institutions are facing, the Bank of Japan could somehow avoid a more serious economic downturn caused by corporate bankruptcy as well as banking and financial crashes or insolvency. Because of the monetary policy framework of Japan, its economic situation started to improve on the 11th of August 2009 (Bank of Japan, 2009b). Evidences behind the Effectiveness of Japan’s Monetary Policy There are quite a lot of evidences suggesting that Japan’s monetary policy has been effective in terms of improving its economic situation in times of global recession. As such, the effectiveness of Japan’s monetary policy can be noted from the improvements of their GDP, import/export of goods and services (% of GDP), foreign direct investment (FDI) net inflows, and unemployment rate. For instance, between 2007 and 2008, Japan’s exportation of goods and services was 18% of its gross domestic product (GDP) (The World Bank, 2014a). Because of the global economic recession, Japan’s exportation of goods and services gradually decreased up to 13% of its GDP in 2009 (The World Bank, 2014a). Since its monetary policy has been effective in managing Japan’s economic situation, the level of its exportation of goods and services increased around 15% of its GDP between 2010 to 2012 (The World Bank, 2014b). The same can be noted in Japan’s importation of goods and services. In 2008, Japan’s importation of goods and services was 18% of its GDP (The World Bank, 2014f). Because of the global recession, its importation of goods and services was down to 12% of its GDP (The World Bank, 2014f). Since Japan’s monetary policy has been effective in solving its economic problems, its importation of goods and services gradually increases up to 14%, 16%, and 17% of its GDP in 2010, 2011, and 2012 respectively (The World Bank, 2914g). Between 2007 and 2008, Japan’s foreign direct investment (FDI) net inflows increased from US$22.9 billion up to US$29.3 billion (The World Bank, 2014d). Because of the global recession, its foreign direct investment (FDI) net inflows decreased from US$29.3 in 2008 down to US$15.4 billion in 2009 (The World Bank, 2014d). Since the global recession lasted between 2008 to 2011, Japan’s foreign direct investment (FDI) net inflows decreased from US$1.0 billion in 2010 down to its lowest at US$79 million in 2011 (The World Bank, 2014e). Indirectly because of Japan’s monetary policy and further improvements in the global economic status, the foreign direct investment (FDI) net inflows of Japan has gradually increased from US$2.5 billion in 2012 up to US$3.7 billion in 2013 (The World Bank, 2014e). Based on ILO estimates, Japan’s unemployment rate increased from 4.0% of its total labour force in 2008 up to 5.0% of its total labour force in 2009 and 2010 (The World Bank, 2014h; The World Bank, 2014i). As a result of continuous improvements in Japan’s economic situation, its unemployment rate gradually decreases from 4.5% of its total labour force in 2011 down to 4.3% of its total labour force in 2012 (The World Bank, 2014i). Conclusion Japan’s monetary policy has been effective in terms of helping firms and financial institutions regain their financial stability during serious global financial and economic recession. In times of serious global financial and economic recession, central banks should not try to control the progress of their economy. Basically, the use of this strategy will help prevent the long-term consequences of economic and financial bubbles. Instead, the central banks should provide better liquidity measures to avoid corporate bankruptcy or bank insolvency. Better liquidity measures can be done by lowering the interest rates and loan rates. By offering low interest corporate financing option, companies can have more time solving their business-related problems. Instead of thinking of filing bankruptcy, companies with financial problems can think of other ways to restructure their business operations. By increasing the capacity of firms to pay back their loans, banks will have better chance of avoiding bank insolvency. References Arnold, R. (2014). Economics. 11th Edition. Mason, OH: Cengage Learning. p. 283. Bank of Japan. (2014a). Outline of Monetary Policy. 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