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Monetary Policy and the Lost Decade: Lessons from Japan


  • The World Economic Outlook of the International Monetary Fund (IMF) of April 2009 forecast output at 5% below potential, and inflation below 0.5% during 2009–10 in major advanced countries, and found a high probability of zero policy rates in the United States, the Euro Area, and Japan until 2011.

  • I am especially grateful to Alan Auerbach, Laurence Ball, Christopher Carroll, Jörg Decressin, Thomas Lubik, Athanasios Orphanides, Pau Rabanal, Jiri Slacalek, and Jonathan Wright for helpful comments. I also thank participants at seminars hosted by the NBER's Working Group on Japan, the Bank of Canada, and the IMF Research Department. Yasuo Hirose kindly provided me with the data. The views expressed in this study are the sole responsibility of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.


I investigate how monetary policy can avoid a deflationary slump when policy rates are near zero by studying interest rate policy during Japan's “Lost Decade.” Estimation results suggest that the Bank of Japan's interest rate policy fits a conventional reaction function with an inflation target near 1%. The disapointing economic performance thus seems primarily due to adverse economic shocks rather than extraordinary policy errors. Also, counterfactual policy simulations suggest that simply raising the inflation target would not have substantially improved performance. However, price-level targeting or combining a higher inflation target with an aggressive output response would have achieved superior stabilization results.

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