Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Japanese Monetary Policy: A Quantity Theory Perspective

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Japanese Monetary Policy: A Quantity Theory Perspective

Article excerpt

In the last half century, Japan has exercised an enormously beneficial influence on the world. After the end of World War II, it not only adopted democracy, but it also showed that non-Western countries could combine democracy with attainment of Western living standards. By embracing the use of Western technology and combining it with thrift and hard work, Japan modernized its economy and grew at double-digit rates for two decades in the 1950s and 1960s.

By the early 1970s, Japan took advantage of economies of scale in manufacturing and exported automobiles, steel, ships, and other manufactured goods to the world. By the early 1980s, it aggressively adopted new technology to create a range of electronic consumer goods for export, such as cameras and VCRs. At that point, Japan had also moved beyond importing innovative technology from the West to exporting its own innovations, such as just-in-time manufacturing techniques. More important, the range and quality of goods offered by Japanese firms forced Western companies to remain dynamic and competitive.

Over the post-World War II period, Japan has implemented a variety of monetary regimes. The world can learn valuable economic lessons from Japan by studying its monetary history. Japanese monetary policy divides naturally into two time periods separated by 1987. The first part includes the high inflation of the early 1970s and the establishment of price stability by the mid-1980s. The second part includes the boom-bust episode known as the bubble.1

The variety of monetary regimes implemented by Japan produced the results shown in Figures 1, 2, and 3. Figure 1 shows quarterly observations of four-quarter percentage changes in money (M2+CDs) and nominal output (GDP).2 Figure 2 reproduces the nominal output growth series of Figure 1 and adds real output growth. Figure 3 shows inflation measured by the GDP price deflator. Inflation is the difference between nominal and real output growth. The rest of the article attempts to breathe some life into these data series.


Until the demise of Bretton Woods in early 1973, Japan pegged the foreign exchange value of the yen to the dollar. With a pegged exchange rate and with U.S. prices beyond Japanese control, the Japanese price level had to adjust to achieve balance of payments equilibrium. To maintain ongoing balance in its external accounts, Japanese baseline inflation had to match U.S. inflation.3 Furthermore, as Japanese goods became more desirable to the rest of the world, their prices had to rise an additional amount. That is, a favorable change in the terms of trade required inflation in Japan beyond what was occurring at the time in the United States.

The external constraints imposed by a system of pegged exchange rates required the Bank of Japan (BoJ) to set its discount rate with the objective of targeting the current account balance rather than the state of the domestic economy. At times of current account surpluses, the BoJ lowered its discount rate and money growth and inflation rose. Similarly, at times of current account deficits, the BoJ raised its discount rate and money growth and inflation fell (see Ueda [1997]; Suzuki [1985]; and Yeager [1976]). Changes in economic activity followed changes in money growth with a lag of about three quarters (Yeager 1976, p. 526).

The pegged exchange rate regime served Japan well. In the 1960s, Japan's economy grew rapidly. From 1960 through 1969, Japanese real GDP grew at an annualized rate of 10.4 percent. A major reason for this growth was Japan's ability to mass-produce goods, such as compact automobiles, in big demand by consumers in the West. With its exchange rate pegged at 360 yen to the dollar, the resulting favorable change in the terms of trade required a rise in Japanese prices relative to U.S. prices. From 1961 through 1970, the difference between Japanese and U.S. (GDP deflator) inflation rates was 3 percentage points. …

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