16 November 1998

This morning, the Japanese Cabinet approved new government spending of approx. $139 billion and tax cuts of more than $49 billion over the next two years. Japan has been in recession for several years, unemployment is much higher than normal in Japan, and current short-term interest rates in Japan are approximately 0.25% (yes, 1/4 of one percent) per year.

  1. What kind of fiscal policy is this?


    2. Discretionary, expansionary (or expansionist) fiscal policy; also activist, and increasing the budget deficit. They are trying to increase aggregate demand, and thereby output, income, and employment by (a) increasing government real purchases (directly increasing demand) and (b) increasing disposable incomes (by cutting taxes), thereby indirectly increasing demand by (they hope) increasing consumer spending (in Japan, as elsewhere, this does not always work as well as expected; sometimes, particularly in a recession, and if households believe the tax cut is temporary, households choose to save much of the tax cut rather than spend it). Aggregate Demand is C + I + G + (X - M); this policy makes sense because "unemployment is much higher than normal", they are in a recession, so there is plenty of spare capacity to produce more output in Japan.
     
     

  2. Why are they using fiscal policy, not monetary policy?
The conventional view of expansionary monetary policy is that it works by reducing interest rates and making loans more easily available, and thereby increases spending financed by borrowing (business investment, house and consumer durable purchases). But if short term interest rates are already as low as 1/4 of one percent a year, there is very little scope for making borrowing any cheaper than it already is. So expansionary monetary policy is likely to be relatively ineffective; the opportunity cost of holding money is already so low, that agents may well be willing to hold more, not spend it. This is sometimes (following Keynes) called a "liquidity trap," meaning that agents in the economy are all very liquid (holding lots of money), but interest rates are so low nobody expects them to fall further, so there is no willingness to hold bonds rather than cash (because if interest rates rise, bond prices will fall).

Not so much for this course, but more generally, you should note that the Japanese situation is somewhat more complex than this discussion suggests, and there is considerable disagreement about the appropriate policy for the Japanese government to follow to spur the economy out of its recession. Many observers believe a large part of the problem concerns certain structural features of the Japanese economy, especially the deep structural difficulties of the banking and finance sector, where many institutions (banks and other lending institutions) have very large amounts of bad debts ("non-performing loans"), and are very unwilling to extend new credit to companies, many of which are themselves in financial difficulties. In these circumstances, with most people very pessimistic about the future, it is very difficult to induce households and companies to increase their spending on final goods, and the crisis in other parts of Asia is also reducing export demand from Japan, at the same time that Japan continues to be criticized by the US and Europe for running a large trade surplus. Many observers suspect that the Japanese economy is unlikely to recover fully until the government tackles the problems of the financial sector, but since this is likely to involve the closing/merger/bankruptcy of several large banks and other financial institutions, this is proving a very difficult thing for the Japanese government to do quickly [for political reasons, largely].