Here is an extract from the minutes of last Tuesday’s BoJ Board meeting:
Shirakawa (Governor): Minosan (everyone please listen). Prime Minister Abe-san has set us a 2% inflation target. How are we going to achieve this target?
Board members: (collective silence)
And that was that … lets face it, what can the BoJ do to raise the inflation rate after having flooded the economy with Yen for the last decade or two? The Keynesian/monetarist response that is necessary to drive money into price increases doesn’t work. This transmission mechanism is naively the following: (i) BoJ buys assets in exchange for Yen and (ii) the sellers of assets buy consumption goods bidding up prices. The first step works well, but the second step does not – instead of buying consumption goods, the sellers have been ploughing their new Yen back into asset markets, primarily deposits.
This is the micro-economic reality in monetary theory. A little known problem in monetary theory is just how difficult it is to get economic agents to hold cash. Theoretical models force agents to hold cash either by putting money into each agent’s utility function (very weak justification for this) or through a ‘cash-in-advance’ constraint which forces people to hold cash balances now to pay for consumption tomorrow. The need for cash-in-advance is arguably justifiable in economies with less developed financial systems, however difficult to assume in Japan…near money assets which substitute for cash renders monetary policy ineffective.
So what can the BoJ do to create price pressures now that we understand that printing Yen wont work? Investors react favourably to anything which raises the marginal productivity of capital ie higher profits. Deregulation and a lower currency have this effect. Adopting an openness to investment from both domestic and foreign sources will stimulate real activity, which may reflect in the future as higher prices.