UNR Economics Working Paper Series Working Paper No A Second-Best Rationale to Deflationary Monetary Policy in Japan

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1 UNR Economics Working Papr Sris Working Papr No A Scond-Bst Rational to Dflationary Montary Policy in Japan Thomas F. Cargill and Fdrico Gurrro Dpartmnt of Economics /0030 Univrsity of Nvada, Rno Rno, NV (775) Fax (775) mail: tcargill@att.nt; gurrro@unr.du Dcmbr, 2006 Abstract Th Bank of Japan prmittd a tn-yar priod of dflation ( ) which appars to hav ndd in Th dflation, as wll as th prcding disinflation, advrsly affctd th financial and ral sctors of th conomy that in turn, mad it difficult to rcovr from th collaps of asst prics in 1990 and Various ad hoc xplanations hav bn offrd to account for th dflation priod. This papr offrs a scond-bst xplanation basd on a two-playr policy gam btwn th Bank of Japan and th banking systm in which th banking systm rlis on an accommodativ policy of forgivnss and forbaranc by th Ministry of Financ to dal with wak balanc shts. Th papr dos not xplicitly modl th Ministry of Financ prfrnc function but incorporats th Bank of Japan s prcivd willingnss of th Ministry to accommodat th banking systm in th Bank s raction function. Th modl suggsts that in th contxt of stablishd dflationary xpctations and larg amounts of dbt, th Bank of Japan xplicitly rgardd th lvl of dbt as xcding th socially optimal lvl, that Ministry of Financ forgivnss and forbaranc contributd to this xcss, and lacking an instrumnt to rvrs dflationary xpctations, th Bank of Japan mployd dflation as a disciplining instrumnt to limit ral dbt. JEL Classification: E31, E58, E42, E50 Kywords: Montary Policy, Dflation, Japan.

2 A Scond-Bst Rational to Dflationary Montary Policy in Japan Thomas F. Cargill and Fdrico Gurrro(*) Profssor and Assistant Profssor Dpartmnt of Economics / 030 Collg of Businss Administration Univrsity of Nvada Rno, NV U.S.A. tcargill@att.nt gurrro@unr.du Draft: Jun 13, 2006 Abstract: Th Bank of Japan prmittd a tn-yar priod of dflation ( ) which appars to hav ndd in Th dflation, as wll as th prcding disinflation, advrsly affctd th financial and ral sctors of th conomy that in turn, mad it difficult to rcovr from th collaps of asst prics in 1990 and Various ad hoc xplanations hav bn offrd to account for th dflation priod. This papr offrs a scond-bst xplanation basd on a two-playr policy gam btwn th Bank of Japan and th banking systm in which th banking systm rlis on an accommodativ policy of forgivnss and forbaranc by th Ministry of Financ to dal with wak balanc shts. Th papr dos not xplicitly modl th Ministry of Financ prfrnc function but incorporats th Bank of Japan s prcivd willingnss of th Ministry to accommodat th banking systm in th Bank s raction function. Th modl suggsts that in th contxt of stablishd dflationary xpctations and larg amounts of dbt, th Bank of Japan xplicitly rgardd th lvl of dbt as xcding th socially optimal lvl, that Ministry of Financ forgivnss and forbaranc contributd to this xcss, and lacking an instrumnt to rvrs dflationary xpctations, th Bank of Japan mployd dflation as a disciplining instrumnt to limit ral dbt. JEL classification: E31, E58, E42, E50 Kywords: Montary Policy, Dflation, Japan. 1

3 1. Introduction Th Bank of Japan (BoJ) in th 1970s and th first half of th 1980s achivd a rmarkabl rcord of pric stability whil dfying th convntional wisdom that lgally dpndnt cntral banks gnratd highr inflation rats than lgally indpndnt ons (Alsina and Summrs, 1993). Ths yars rprsnt th high point of BoJ policy in th postwar priod and drw widsprad acadmic intrst to BoJ policy outcoms and cntral bank institutional dsign. In th lat 1980s and 1990s, howvr, th BoJ was criticizd for accommodating asst inflation and thn for a cold turky rspons to th asst bubbl in 1989 followd by anmic xpansionary policy aftr 1992 almost univrsally rgardd as insufficint to prvnt prics from falling (Htzl, 2003 and McCallum, 2003). In th first half of th 1990s Japan xprincd disinflation followd aftr 1994 by a gradual but prsistnt fall in th pric lvl that only by 2005 showd signs of incrasing. Th disinflation and dflation advrsly impactd th financial and ral sctors and limitd Japan s ability to rcovr from th collaps of asst prics in th arly 1990s via svral channls (s Cargill and Parkr, 2003 and 2004, for xampl). Th dflation priod appars to b coming to an nd in Combind with an xpanding conomy, th BoJ on March 9, 2006 announcd a gradual nd to its zro intrst rat policy (ZIRP), first stablishd in Fbruary 1999, and th quantitativ asing policy (QEP) initiatd as of March At th sam tim th BoJ announcd it was adopting a pric stability objctiv of ultimatly kping th inflation rat btwn zro and two prcnt with a focus on th midpoint. Whil not a formal inflation targt framwork, th announcmnt is dsignd to xprss th BoJ s dfinition of th pric stability objctiv in Articl 2 of th 1997 Bank of Japan Law. 2

4 Th failur of th BoJ to prvnt dflation and rsistanc to outsid criticism has gnratd much dbat btwn th BoJ and th acadmic profssion, but mor important for th institutional dsign of th BoJ, th failur of th BoJ to prvnt dflation has brought th BoJ into conflict with th Ministry of Financ (MoF), Prim Ministr Junichiro Koizumi, and th Dit. Th criticism focuss broadly on th ntir priod of montary policy sinc 1994 and on concrn th BoJ will adopt a too rapid xit from th QEP in light of th prmatur shift to tightr policy in August Kuttnr and Posnr (2004) prsnt vidnc on th scar ffcts of this prmatur policy. Prim Ministr Koizumi in arly 2003, prior to slcting a rplacmnt for rtiring Govrnor Masaru Hayami, mad it clar h xpctd mor aggrssiv action against dflation and implid that an inflation targt framwork was a possibility. Evn though th Bank s QEP significantly incrasd in lat 2002 and 2003 and th rat of dflation dclind, th Bank of Japan has still bn subjct to criticism for past policis, rsisting calls for mor xpansionary policy, and rsisting an inflation targt framwork. This has gnratd intrst in modifying th nwly nhancd indpndnc achivd in 1998 (Fldman, 2006). Hizo Taknaka, ministr of Intrnal Affairs, as rcntly as Dcmbr 2006, statd that montary policy is not th sol rsponsibility of th Bank of Japan (Economist, Dcmbr 17, 2005). Th BoJ s March announcmnt might b intndd to ford off any institutional rdsign from th govrnmnt, spcially in th form of an xplicit inflation targt. Th consquncs of th tn-yar dflation hav bn significant both in conomic and political trms. Th unanswrd qustion to dat, howvr, is why th BoJ followd a policy that prmittd dflation? Th objctiv of this papr is to provid a 3

5 policy-gam intrprtation to th BoJ s dflationary policy as a scond bst solution from th prspctiv of th BoJ in th contxt of thr uniqu pr-xisting conditions: ntrnchd dflationary xpctations, larg amounts of privat and budgt dbt, and a prcivd willingnss of th MoF to substitut forgivnss and forbaranc for structural rform in daling with troubld financial institutions, spcially banks. This framwork fits th stylizd conditions of th Japans conomy in th 1990s and offrs a prspctiv on BoJ policis during th priod anchord in optimal bhavior on th part of th Bank. Th rmaindr of th papr consists of fiv sctions. Sction two summarizs various xisting xplanations to th Bank s failur to liminat dflation for so long a priod. Th policy-gam framwork is thn dvlopd in thr stps. Th first in Sction 3 shows that th BoJ has an incntiv to dflat in th contxt of pr-xisting dflationary xpctations and larg amounts of dbt, incorporating Fishr s (1933) dbt-dflationinflation procss in th BoJ s constraint function. Th scond stp in Sction 4 xpands th framwork to includ th BoJ s prcivd willingnss of th MoF to ngag in forgivnss and forbaranc in daling with troubld financial institutions. Th third stp in Sction 5 xplicitly modls how th gam btwn th banks and th BoJ gnrats a BoJ s raction function in which dflation is a scond-bst solution that acts as a disciplining instrumnt to limit furthr incrass in ral dbt. A concluding sction nds th papr with som rflctions on th modling stratgy utilizd in this papr. 4

6 2. Four Explanations of th Tn-Yar Dflation Priod Thr hav bn various xplanations to account for dflation during th past tn yars which can b labld th BoJ viw, th indpndnc trap, th policy rror trap, and th consrvativ trap xplanations. Whil non of ths xplanations has bn rigorously framd thy hav all bn offrd in various forms as xplanations to account for th BoJ policy outcoms of th last tn yars. Each is brifly outlind. Th BoJ at various tims has argud it xhaustd th potntial of its traditional instrumnts of targting th call rat at zro (ZIRP) and prmitting th account balanc to rach unprcdntd lvls (QEP) through discounting and opn markt oprations in Japan Govrnmnt Bonds (JGBs). According to th Bank s viw, th ZIRP and QEP wr not succssful bcaus of th structural problms in th ral and financial sctors and low pricd Chins imports. Not only would ths constraints hav prvntd nontraditional montary policis such as larg scald purchass of JGBs from bing ffctiv, nontraditional montary policy would wakn th Bank of Japan s capital position, xpos it to intrst-rat risk, and rduc its flxibility to dal with th postdflation priod (Cargill, 2005). Th Bank viw, howvr, has bn rjctd by th majority of rsarchrs who almost univrsally conclud th BoJ was capabl of prvnting th tn-yar dflation procss or nding it much soonr. Cargill, Hutchison, and Ito (2000) suggst a political conomy prspctiv that mphasizs an indpndnc trap xplanation. Th politics of cntral bank indpndnc in 1997 ld to an ovrly consrvativ approach on th part of th BoJ and a gnral rsistanc to outsid advic and/or coopration with th MoF in daling with dflation that would b viwd as inconsistnt with th BoJ s nw found lgal 5

7 indpndnc. This is a variation of th viw that cntral banks can asily bcom prisonrs of thir own indpndnc, spcially in daling with xtraordinary situations. Ito (2004) provids xtnsiv discussion of BoJ policy in th contxt of its rfusal to adopt an inflation targting framwork and suggsts that lack of undrstanding or a policy rror trap might offr an xplanation. Much of th writings of Posn (1998 and 2000) also fall into this catgory. This viw suggsts that th BoJ s dcision-making procss was intrruptd by th rsignation of th Govrnor and Dputy Govrnor in 1998 ovr allgations of impropr conduct of th Banking Sction of th BoJ and thn followd by th appointmnt of Masaru Hayami as Govrnor (until March 2003) who lackd undrstanding about th nw financial and montary nvironmnt of Japan and focusd on nominal rathr than ral intrst rats as indicators of montary as. Th BoJ in th postwar priod has bn a consrvativ cntral bank, partly bcaus of th advrs xprinc with inflation in th 1930s and arly 1970s and partly bcaus of th consrvativ position of th cntral govrnmnt rgarding th budgt. As a rsult, starting in 1973 th BoJ focusd on a vry low inflation rat --abstracting th 1990s, and most rcntly th BoJ announcd its dfinition of pric stability as an inflation targt btwn zro and two prcnt with a focus on a on prcnt rat. Formr Govrnor Hayami in a March 2000 spch offrd an vn mor consrvativ viw and statd: Mainstram thinking now says that pric stability should b maintaind by a policy which prvnts inflation from arising in th first plac (Hayami, 2000, p. 6); hnc, pric stability is zro prcntag chang in th pric lvl. A low inflation rat (or zro inflation rat) in th contxt of th wll-stablishd masurmnt rror in pric indxs suggsts that BoJ policy outcoms may hav a tndncy to gnrat mild dflation. 6

8 It should b notd that all four of th xplanations ar rminiscnt of th dbat ovr th Fdral Rsrv s policy outcoms in th 1930s whn it prmittd prics to dclin in th first part of that dcad. In that dbat th Fdral Rsrv claimd it had don all that was possibl and that concrn with formal indpndnc, lack of undrstanding, and consrvativ attituds wr prominnt xplanations for what is now rgardd as inappropriat cntral bank policy. Th indpndnc trap, policy rror trap, and consrvativ trap offr maningful insights into BoJ policy outcoms; howvr, thy do not xhaust th rang of possibl and plausibl xplanations. In particular thy do not addrss th following critical qustion connctd to th incntivs th BoJ facd: could it hav bn th cas that th BoJ mildly dflationary montary policy was th Bank s optimal rspons in a scond-bst scnario whr critical policy instrumnts wr lacking? Th following thr sctions xplor an xplanation along thos lins in th contxt of a gam btwn th BoJ and commrcial banks in a Barro-Gordon framwork that suggsts th BoJ had incntivs to gnrat dflation in th prsnc of thr pr-xisting constraints: ntrnchd dflationary xpctations, larg amounts of privat and public dbt, and a prcivd willingnss of th part of th MoF to adopt forgivnss and forbaranc in daling with troubld financial institutions. Th thr pr-xisting conditions sm rasonabl givn Japan s macroconomic prformanc throughout much of th 1990s. Whil ths thr conditions ar assumd as th background for th modl dvlopd in this papr, thr is considrabl ancdotal vidnc thy ar rasonabl assumptions. 7

9 Entrnchd dflationary xpctations cam to dominat Japans public attituds by th lat 1990s in light of disinflation in th first half of th 1990s and actual dflation by all of th pric indicators aftr Continud dclins in ral stat prics and mploy compnsation furthr contributd to dflationary xpctations and most important th incrasing criticism of th BoJ and scandals in 1998 furthr contributd to th public s lack of confidnc in th ability of th BoJ to rvrs th gnral pric dclin. Th larg amounts of privat and public dbt also bcom a major fatur of th Japans conomy in th 1990s with Japan s ratio of gross govrnmnt dbt to GDP bing on of th highst among th industrial conomis. Thr is no doubt th MoF along with much of th rst of govrnmnt has bn willing to ngag in forgivnss and forbaranc in daling with troubld institutions and at tims has diffrd with th BoJ ovr th pac of structural rforms. 3. Dflation as an Optimal Rspons Whn Dflationary Expctations ar Prvalnt and th Cntral Bank Lacks a Sufficint Instrumnt to Chang Expctations Th qustion this sction addrsss is th following: could dflation vr b an optimal policy rspons whn th cntral bank lacks th instrumnt to chang prxisting dflationary xpctations and hnc has to tak thos xpctations as givn whn choosing inflation? W formulat th problm in th contxt of a standard loss function framwork. function: Assum th BoJ s prfrncs can b rprsntd with th following loss (1) 1 * 2 1 * 2 L = ( D t D ) + θ ( π t π ) θ >

10 * * Whr D and π dnot th socially optimal lvls of ral dbt and inflation, rspctivly. Now considr an xpctations-augmntd Phillips curv in which unxpctd inflation (dflation) rducs (incrass) th currnt lvl of ral dbt abov (blow) its socially optimum lvl. Equation (2) acts as a constraint in th Bank s minimization problm. (2) * ( D D ) = ( π π ) + ε Whr π dnots th public s xpctations about th rat of chang of th pric lvl (inflation if positiv; dflation if ngativ) and ε is an iid shock. This xplicitly incorporats th dbt-dflation hypothsis of Fishr (1933), sinc an incras in unxpctd dflation incrass ral dbt byond its socially optimal lvl. Assuming all variabls tak positiv valus, xprssion (1) and (2) yild th standard Barro-Gordon outcom. In a on-vnt gam th cntral bank has an incntiv to inflat and rduc th lvl of ral dbt and hnc, montary policy displays an inflation bias. Th framwork can also asily show that th BoJ has a dflation bias in an nvironmnt of pr-xisting dflationary xpctations, that is, whn π < 0 is takn as givn by th BoJ whn choosing its optimal policy. Substituting (2) into (1), diffrntiating th rsulting xprssion with rspct to π, stting th first ordr condition qual to zro and solving for π yilds: (3) 1 π = π 1+ θ θ * ε + π + 1+ θ 1+ θ In xprssion (3), st ε = 0 to focus on th dtrministic solution, impos th pr- xisting condition of dflationary xpctations ( π < 0 ), and assum that th socially optimal rat of inflation from th cntral bank s prspctiv is non-ngativ ( π * 0 ). 9

11 This gnrats th rsult that th optimal policy is actual dflation ( π < 0 ), as long as th following condition holds: (4) π 1 π θ * <, or, quivalntly: * θ π < π Th rsult in (4) says that dflation will b an optimal policy so long as th socially optimal rat of inflation wightd by its rlativ importanc in th BoJ s loss function is strictly lss than th (absolut valu) of th xpctd rat of dflation This rsult mans that if th BoJ considrs that th socially optimum rat of inflation is indd low (its uppr bound bing xactly givn by (4)), thn a policy of dflation can indd b a bst rspons in an nvironmnt whr thr ar widsprad xpctations of continual dflation, and th cntral bank lacks an instrumnt to chang thos xpctations, so that it has to tak thm as givn whn stting its optimal policy. 4. Th Qust for th Missing Instrumnt: Dflation as a Disciplin Dvic Th abov framwork can b xtndd to incorporat a BoJ prcivd viw that th MoF is pron to policis of forgivnss and forbaranc in daling with troubld financial institutions. This is historically rasonabl as th BoJ has gnrally bn mor supportiv of financial libralization and markt solutions than th MoF, which on many occasions has attmptd to slow th procss of libralization and aftr 1990 rsistd gratr transparncy, markt disciplin, and dpartur from th old financial rgim. As way of xampl, considr th following rfrnc to th BoJ s actions: Th Bank sms to b mostly concrnd that by crating inflation it might lt dbtors off th hook and thrby rduc th prssur on firms to rstructur and on th govrnmnt to mak structural rforms. Yt in playing this gam th Bank of Japan has faild in its primary duty as a cntral bank: to nsur pric stability. Its agnda of prssing for structural rform and corporat rstructuring, commndabl as it is, is outsid its mandat (Economist, May 31 st, 2001). 10

12 To accommodat th analysis that follows, w nd to modify th BoJ s prfrnc function rgarding dflation and th dviations of th lvls of dbt rlativ to its socially optimum lvl, so that th nw BoJ s loss function is now givn by: (5) 2 * L( D, ˆ) π = c ˆ π + ( D D ) ; c > 0 Whr πˆ now dnots th rat of dflation (taking non-ngativ valus) and πˆ.dnots th xpctd rat of dflation (also taking non-ngativ valus). Th dviations of ral dbt rlativ to its socially optimal lvl now ntr th loss function in a linar fashion (th tchnical rason for this will bcom apparnt whn w introduc a modifid BoJ s constraint function that maks room for dflation to act as a disciplining dvic ). Th implicit function thorm indicats th BoJ now facs a trad-off btwn th lvl of ral dbt and dflation. In ordr to rduc th dviations of dbt rlativ to its socially optimal lvl, th BoJ nds to incras dflation bcaus L D (6) = ˆ π = 2c ˆ π < 0 ˆ π L D To illustrat th implications of th tradoff w mak a slight but subtl modification of xprssion (2), th constraint function, to prmit a disciplining ffct stmming from dflation --on top of th Fishr rvaluation ffct alrady incorporatd into xprssion (2). Th dviations of currnt dbt rlativ to th socially optimal lvl of dbt ar now xprssd in th following quadratic form: (7) ( D D * ) = γ ( ˆ π ˆ π ) 2 ; γ > 0 11

13 In this cas, th lvl of dbt is incrasd rlativ to its socially optimal lvl by dviations of th dflation rat in ithr dirction. What is th conomic rational of such a formulation? If dflation is lowr than xpctd, th burdn of rpaying alrady xisting dbt by troubld banks is rducd. If combind with a lnint policy by th MoF, this lads to an incrasd capacity of troubld banks to scur soft loans implicitly guarantd by th MoF. That is, if dflation is lss svr than xpctd, troubld banks can borrow mor undr a lnint MoF and hnc, th lvl of dbt xcds its socially optimal lvl. If dflation is highr than xpctd this has th potntial to gnrat a dbt-dflation procss pr Fishr and hnc, th lvl of dbt will also incras rlativly to th socially optimal lvl but via a diffrnt procss than whn th dflation is lowr than xpctd. In ithr vnt, dviations of dflation from th xpctd rat gnrat a highr lvl of dbt rlativ to th socially optimal lvl of dbt. Th optimal dflation rat from th BoJ s prspctiv can b dtrmind by substituting (7) into (5) and minimizing th rsulting xprssion rlativ toπˆ, taking dflation xpctations as givn. Stting th first ordr condition qual to zro and solving for πˆ provids th following optimal rspons by th BoJ: (8) γ ˆ π = ˆ π c + γ Not that so long as thr ar xpctations of dflation, th BoJ s optimal rspons is to gnrat dflation in a lss than on-for-on fashion bcaus of th γ condition 0 < < 1. c + γ 12

14 5. Explicit Exprssion of th BoJ s Prcivd MoF Policy of Forgivnss and Forbaranc and Equilibrium of th Policy Gam It rmains to b shown that th lvl of dbt will indd b systmatically abov its socially optimal lvl from th BoJ s prspctiv, vn if dflation and xpctd dflation ar always th sam, and not only as th rsult of a tmporary misalignmnt btwn th two, as was th cas in th prvious sction. In othr words, th distortion introducd on th lvl of dbt by th MoF s policy of forgivnss and forbaranc, as prcivd by th BoJ, nds to b modld mor xplicitly Th BoJ s bst rspons in th prsnc of (prcivd) forgivnss and forbaranc Rwrit xprssion (6) in th following mannr: (9) ( bd D * ) = γ ( ˆ π ˆ π ) 2 ; 0 < b < 1 * Evn if ˆ π = ˆ π, D > D so long as b < 1. That is, th BoJ prcivs that th lvl of dbt is systmatically too high bcaus troubld banks borrow too much mony ncouragd by th implicit guarant of th MoF. Not that in th prvious sction, th lvl of dbt could xcd its socially optimal lvl only so long as dflation and xpctd dflation diffrd from ach othr, but thr was no systmatic bias. Now, thr is an xplicit political distortion, capturd by th paramtr b < 1. To s how th BoJ s prcption of th xistnc of a bias on th part of th MoF toward forgivnss and forbaranc influncs BoJ bhavior, solv (9) for D, substitut th rsulting xprssion into (5), diffrntiat th rsulting xprssion rlativ to πˆ, st th rsulting xprssion qual to zro and solv for πˆ to arriv at th following: (10) ˆ π = γ ˆ π cb + γ 13

15 γ Thr ar two considrations to xprssion (10). First, sinc th cofficint < 1, cb + γ th BoJ s raction function cushions som of th xpctd dflation; that is, th BoJ dos not translat dflationary xpctations on-for-on into actual dflation policy. Scond, th BoJ gnrats mor dflation givn th sam dflation xpctations whn th prcivd policy of forgivnss and forbaranc imposs an upward bias on th lvl of banks dbts bcaus th cofficint in (10) is largr than th cofficint in γ γ (9), >. Th BoJ uss dflation policy as a disciplining instrumnt at th cb + γ c + γ margin. That is, th BoJ intrnalizs th soft bhavior of th MoF toward troubld banks and sks to prvnt xcssiv dbt incras on th part of banks: th highr th prcivd lax attitud of th MoF (th lowr th valu of b), th mor dflation th BoJ crats, for a givn xpctd dflation rat Optimization by distrssd banks (or whr dflationary xpctations ar coming from) Th BoJ s raction function givn by (10) is an lmnt of th policy gam btwn th BoJ and troubld banks and a critical componnt of th quilibrium of th (on stag) gam. What nds to b considrd at this point is to account for th distrssd banks bst rspons; that is, will distrss banks choos to xpct dflation whn trying to maximiz th amount of dbt thy hold undr th lnint suprvision of th MoF? Th answr to this qustion is non-trivial for th framwork dvlopd in this papr. If troubld banks choos to maximiz quation (7) --aftr solving it for D-- subjct to th constraint givn by (10), thir optimal choic would b ˆ π = 0, and thus, 14

16 no quilibrium with dflationary xpctations would xist. Whil this may not b a rasonabl optimization procss for banks (th constraint function of on playr dos not hav to b th objctiv function of anothr, and vic vrsa), its possibility suggsts that dflationary xpctations ar not an obvious optimal choic of distrssd banks in th on stag gam with th BoJ. Howvr, if distrssd banks xplicitly incorporat in thir objctiv function th notion that th BoJ uss dflation as a mans to disciplin dbt bhavior by troubld banks, thn a dflationary Nash quilibrium bcoms possibl in which distrssd banks optimally choos to xpct dflation in thir maximization problm. This can b illustratd by considring th following maximization procss for distrssd banks. Privat, distrssd banks tak (10) as givn and choos th xpctd dflation rat that maximizs th following function: 1 2 ˆ π ( 11) ΔD = ( ˆ π ˆ) π D 0 D 0 ; 0 < φ < + 2 φ Th scond addnd in xprssion (11) shows that distrssd banks intrnaliz th BoJ s us of dflation as a disciplin dvic (i.., th initially prvailing lvl of dbt is bing rducd by th mr xistnc of dflationary xpctations). In trms of notation in xprssion (11), D 0 dnots th stock of dbt outstanding at th tim of th maximization, ΔD dnots th incras in th dbt --what troubld banks ar trying to maximiz, and φ is an attnuation paramtr indicating to what a dgr th usag of dflation as a disciplin dvic to modrat dbt incrass is attnuatd, in th prcption of troubld banks. Whn φ +, th prcption of dflation as a disciplin dvic is havily attnuatd and tnds to carry no wight in distrssd banks 15

17 optimization problm. Convrsly, whn φ 0, thr tnds to b no attnuation and th prcption of dflation as a disciplin dvic by th BoJ plays a dominant rol in distrssd banks optimization problm. Substituting xprssion (10) into xprssion (11), diffrntiating th rsulting xprssion for πˆ, stting it qual to zro and solving for πˆ gnrats th following optimal rspons to BoJ policy by troubld banks: (12) ˆ π 1 cb + γ = [ ] φ cb That is, troubld banks com to anticipat dflation basd on thir undrstanding of th BoJ s policy. In th cas whr thr is no upward bias in th lvl of dbt inducd by th MoF s policy of forgivnss and forbaranc (b = 1), thn (12) is simply: ˆ π 1 c + γ = [ ], which implis a lowr xpctd dflation on th part of troubld banks. φ c Thus, troubld banks intrnaliz th BoJ stratgy of dflation as a disciplin dvic, rcognizing th implicit htrognity of prfrncs btwn th BoJ and th MoF on th optimal lvl of dbt and th consqunt stratgic bhavior of th BoJ rgarding th actions of th MoF --capturd by quation (9). Also not that whn attnuation is high (that is, whn φ + ), th optimal choic by distrssd banks implid by (12) is: ˆ π 0. Whn high attnuation is coupld with prfct forsight xpctations ( ˆ π = ˆ π ), zro dflation bcoms th Nash quilibrium of th on-shot gam, sinc quation (5), th loss function of th BoJ, collapss to ˆ 2 cπ + (1 b ) D *, with th implication that th optimal choic is givn by ˆ π = 0. 16

18 6. Concluding Commnts This papr offrs an xplanation for th tn-yar priod of dflation in Japan that strsss th incntivs facd by th BoJ whn making dcisions in a scond-bst scnario whr various policy instrumnts could hav bn missing. Th approach consists of a policy gam within what Drazn (1999) calls th nw political conomy branch of macroconomics. In particular, this papr strsss th importanc of thr pr-xisting distortions in shaping BoJ s incntivs: ntrnchd dflationary xpctations, larg amounts of outstanding dbt, and a prcivd MoF prfrnc for a policy of forgivnss and forbaranc toward troubld banks. Th xplanation suggstd in this papr complmnts (rathr than substitut) xisting xplanations that try to mak sns of BoJ policy during th tn yar priod of dflation in Japan. Whil lack of undrstanding on th part of th BoJ, concrns with protcting formal indpndnc, and ovrly consrvativ viws about pric stability might b part of th xplanation for th tn-yar priod of dflation in Japan, thy do not focus on undrstanding what shapd th incntivs facing th BoJ whn making its montary policy dcisions. This papr offrs a straightforward analytical framwork that provids som insight by modling th dflation priod as a rational scond-bst solution to a on-stag policy gam btwn th BoJ and troubld banks, which in th prspctiv of th BoJ rly on MoF forgivnss and forbaranc as a policy to dal with wak balanc shts. Two cavats ar in ordr, howvr. 17

19 First, th modl dos not incorporat an xplicit prfrnc function for th MoF, but rathr adopts a shortcut that incorporats th influnc of th MoF on th BoJ actions via th BoJ constraint function, by modling how th BoJ prcivs th MoF bias toward too much dbt, too littl rform. This modling stratgy simplifis th analytical problm at hand, avoiding th nd to modl a thr playrs gam. Whil th cost paid is that th MoF bhavior and motivation ar lft unxplaind, th modl still offrs a rasonabl xplanation of why th BoJ prmittd dflation for such a long priod of tim: an upward bias on th lvl of dbt prmittd by a policy of MoF forgivnss and forbaranc (as prcivd by th BoJ) inducs th Bank to us dflation policy as a disciplining instrumnt. Th modling approach prsntd in this papr is basd on th sam concptualization of macroconomic prformanc as th outcom btwn gam playing btwn policy makrs rcntly suggstd by Nordhaus and Hoshi. Nordhaus (1994) provids a formalization of th gam playd btwn th montary and fiscal authoritis and shows that a lack of coordination btwn thm lads to both a highr budgt dficit and a highr intrst rat than ithr authority considrs optimal. Hoshi (2004) modls th non-cooprativ quilibrium btwn th cntral bank and th bank suprvisor and finds that in quilibrium a lack of coordination lads th montary authority to pay too much attntion to bank suprvision and to choos a montary policy that is too tight rlativ to th on that would prvail in th cas whn policis ar coordinatd. Our papr xplors th stratgic intraction that has, so far, bn lft unxplord: th on btwn th BoJ and troubld banks that ar not undr th Bank s suprvision and by doing so shds nw light on a vry important policy problm. 18

20 A scond cavat is rlatd to th assumption that th BoJ dirctly controls th rat of inflation. As forcfully argud by Blindr (1998), this assumption is unralistic as a dscription of th montary policy-making procss and should always b kpt in mind. Th rational for th us of th assumption in this papr rlis on a cost-bnfit rlationship btwn th modl and trying to account for BoJ bhavior in an optimizing framwork. Th prspctiv offrd in this papr that incntivs facd by a cntral bank in a scond-bst world gnrats suboptimal macroconomic prformanc and th applicability to th BoJ in th rcnt past sms wroth th tradoff. An obvious qustion that mrgs from th framwork in this papr is to what dgr it can b usd to xcus th BoJ for prmitting dflation in violation of Articl 1 of th 1997 Bank of Japan Law and th advrs ffcts of dflation on th conomy for such a long priod in Japan. Th Bank of Japan likly xcdd its rol in th Japans conomy as spcifid in th 1997 Bank of Japan Law in pursuing its agnda of inducing mor rform and lss dbt whil simultanously ignoring its main goal of prsrving pric stability by using dflation as a disciplining instrumnt. Th pr-xisting distortions modld in this papr provid an undrstanding of th Bank s actions from a positiv prspctiv, but do not justify thm on a normativ basis. 19

21 (*) Th authors would lik to thank Kn Kltzr, Tako Hoshi, and othr participants of th May 12, 2006 Wst Coast Japan Economic Sminar, jointly organizd by th Intrnational Rlations and Pacific Studis program of th Univrsity of California, San Digo and th Santa Cruz Cntr for Intrnational Economics of th Univrsity of California, Santa Cruz. Th usual disclaimr applis. Rfrncs Alsina, Albrto and Lawrnc H. Summrs, "Cntral Bank Indpndnc and Macroconomic Prformanc: Som Comparativ Evidnc," Journal of Mony, Crdit, and Banking, 25 (1993): Blindr, Alan S, Cntral Banking in Thory and Practic, Th MIT Prss: Cambridg, MA, Cargill, Thomas F., Is th Bank of Japan s Financial Structur an Obstacl to Policy? IMF Staff Paprs, Vol. 52, Numbr 2, Cargill, Thomas.F., Michal M. Hutchison, and Takatoshi Ito, Financial Policy and Cntral Banking in Japan. Th MIT Prss: Cambridg, MA, Cargill, T.F., & E. Parkr, Why dflation is diffrnt, Cntral Banking 14: 35-42, Cargill, T.F., & E. Parkr, "Pric dflation, mony dmand, and montary policy discontinuity: A comparativ viw of Japan, China, and th Unitd Stats," North Amrican Journal of Economics and Financ 15(1): , Drazn, A. Political Economy in Macroconomics. Princton Univrsity Prss, Nw Jrsy, NJ, Economist, Th, Mony still mattrs. May 31 st, Economist, Th, Land of th rising pric. Dcmbr 17 th, Fldman, Robrt A. Inflation Targting: A Trojan Hors for Structural Rform. Morgan Stanly Equity Rsarch Japan, January 10, Fishr, Irving, Th dbt-dflation thory of Grat Dprssions, Economtrica, 1, Octobr 1933: Hayami, Masaru, Pric Stability and Montary Policy, Prsntd to th Rsarch Institut of Japan, Tokyo, March 21, Htzl, R., Japans Montary Policy and Dflation, Economic Quartrly, Fdral Rsrv Bank of Richmond, 90, Summr 2003:

22 Hoshi, Tako, Montary Policy and Bank Suprvision. Prsntation at ESRI Confrnc Japans Montary Policy: Exprinc and Futur, Jun 22, Ito, Takatoshi, Inflation Targting and Japan: Why has th Bank of Japan not adoptd Inflation Targting? National Burau of Economic Rsarch Working Papr #10818, Cambridg, MA, Sptmbr Kuttnr, K. N. & Adam S. Posn, Th difficulty of discrning what s too tight: Taylor ruls and Japans montary policy, North Amrican Journal of Economic and Financ 15: 53-74, McCallum, B., Japans montary policy, , Economic Quartrly, Fdral Rsrv Bank of Richmond, 89:1, Wintr Nordhaus, William D., Policy Gams: Coordination and Indpndnc in Montary and Fiscal Policis, Brooking Paprs on Economic Activity 2, Posn, Adam S., Rstoring Japan's Economic Growth, Washington, D.C.: Institut for Intrnational Economics, Posn, Adam S., Th Political Economy of Dflationary Montary Policy, In Ryoichi Mikitani and Adam S. Posn (ds), Japan s Financial Crisis and Its Parallls to U.S. Exprinc, Institut for Intrnational Economics, Washington, D.C., Sptmbr