The Inflation Targeting

Ryoichi Imai

2002/02/07

Today, we have a serious debate on the role of the Bank of Japan to create inflation. Many people say that BOJ should announce certain rate of inflation, and do whatever they can do to achieve the rate of inflation that BOJ pledges to create.

Why is inflation necessary for the Japanese economy?

As you know, the nominal interest rate in Japan is incredibly low, while the the rate of inflation is low, too. So what is the problem?

You have to understand that the real cost of firms' investment is not the the nominal interest rate but the real one.

Suppose you are a CEO in a automobile industry. You consider to invest in a new project to construct an automobile plant by borrowing money from banks.

If the market prices of automobiles are rising, you will feel it easy to pay the money back to your banks. On the contrary, if the automobile prices are declining, it is hard to pay back. 

Therefore, you have to be careful about the nominal interest rate as well as the inflation rate. 

The real interest rate is defined as follows.

real interest rate = nominal interest rate - inflation rate

This equation is called the Fisher Equation.

Today in Japan, the short-term interest rate is almost zero. The long-term interest rate is less than 2%. So it seems that firms are enjoying the low interest rate. In fact, it is not true. If the nominal interest rate is equal to zero, and the rate of inflation equals -2%, then the real interest rate equals 2%, which is not so low to help the Japanese firms to service their debts, since the economy is in a serious recession.

Here is an important question. Why Japanese people do not invest all their money in assets denominated in the US dollar?

The nominal long-term interest rate in Japan is less than 2%. It is about 4% in the US. So it seems to be very strange if people would not invest all their money in the assets denominated in US dollars.

In economics, there is a very useful equation, which is called the interest rate parity. The equation is written as follows.

nominal interest rate in Home country + Home Currency appreciation rate = nominal interest rate in foreign country

If the nominal interest rate in Japan is 2% and the one in US is 4%, the equation implies that the market participants expect that Yen will appreciate to US dollar at annual rate 2% in the long-run.

In the short-run, the currency exchange rate is much volatile. It moves up and down around its long-run trend. The big difference of the nominal interest rates between Japan and US predicts the long-run appreciation of Japanese Yen against US dollar.

In fact, in the last several decades, Yen has been appreciating against US dollar.

Remember the following numbers. In 1960s, in the era of Bretton-Woods system, Yen was fixed at 360 yen per dollar. It achieved its highest value, 80 yen per dollar, in 1995.

Before 1970, the world economy was running on the fixed exchange rate system. Under this system, US is obliged to keep a certain exchange rate between the US dollar and gold. Other advanced country was required to keep the fixed exchange rate of their own currency with the US dollar.

In 1971(?), President Nixon announced that the US stopped to exchange the US dollar for gold at the fixed rate. After some period of transition, the global economy switched to the flexible exchange rate system, which is still prevalent across most advanced countries.

Yen reached 180 yen per dollar in 1979, when the Iranian revolution burst out.

In the early 80s, the President Reagan administration expanded the government spending and issued a great amount of government bonds. The policy attracted a huge amount of money from all over the world, and caused a large appreciation of US dollar. Yen hit the bottom of 240 y/d.

Since the Plaza Agreement in 1985, Yen continued to appreciate. Even in the 'lost 90s', the yen was still strong against the US dollar.

 What is the consequence of the long trend of Yen appreciation?

The continuing Yen appreciation forced the Japanese firms to increase their productivity. The productivity growth made them more competitive and created larger current account surplus, which, in turn, caused further appreciation of the Japanese Yen. Thus the Japanese firms always face the pressure to increase their productivity.

To be continued.