2003 OECD Economic Surveys: Japan 2003

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Despite recent acceleration of growth in Japan, OECD warns in its 2004 survey that Japan still faces serious structural problems that limit its growth potential and weaken demand.  This report carefully examines such issues as deflation, fiscal sustainability, product market competition, and further structural reforms and makes recommendations to strengthen Japan’s macroeconomic framework.

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Bringing Deflation to an End

Faced with the zero constraint on nominal interest rates, the Bank of Japan has substantially increased the quantity of base money through its quantitative easing policy. In addition, the scope of this policy has been expanded by broadening the range of assets purchased by providing credits directly to small and medium-sized enterprises. At the same time, intervention in the foreign exchange market has limited the appreciation of the yen, effectively supporting the recovery of exports. These monetary policy measures have been successful in maintaining financial-market stability and accommodating the current economic recovery. Nonetheless, the central bank has failed to achieve the objective of sustained growth in nominal income as deflation, as measured by the GDP deflator, remained persistent at an annual rate of 3 per cent in the first half of 2003. Moreover, the current policy has serious negative side effects that will complicate the exit from the current situation. Given the corrosive impact of deflation on economic prospects and the risk of a deflationary spiral, achieving a positive rate of inflation is a key priority. This chapter begins by outlining recent developments in monetary policy and the reasons why it has failed thus far to fully achieve the desired impact. It then outlines policy changes that will help bring deflation to an end. One necessary condition is to resolve the problems in the banking sector, which have closed the credit transmission mechanism. The chapter analyses the factors responsible for the fragile banking industry and suggests measures to help restore it to financial health, before offering an overall conclusion...

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