Abenomics

Japan, worlds third largest economy (in terms of nominal GDP) went into a great depression
after the asset price bubble collapse in the Japanese economy during 1991 and has still not
completely recovered from the same.
It showed strong economic growth during the prosperous 1980s but the situation worsened as
it reached the 1990s, as the interest rates offered by banks in Japan became very low. Due to
high personal savings rates during the 1980s, Japanese firms started relying heavily on
traditional bank loans rather than issuing stock or bonds via the capital markets to acquire
funds. The close relationship of corporations to banks and the implicit guarantee to a taxpayer
bailout of bank deposits reduced the lending standards. The banks lent more regardless of the
quality of the borrower and thus inflated the asset bubble economy. Due to the availability of
cheap and easily available credit, people stated borrowing hugely and invested heavily in
domestic as well as foreign stock markets. To curb inflation the Bank of Japan increased the
interest rates sharply resulting in credit crisis and crash of equity market. Debt crisis followed
and the Japanese banks and insurances were loaded with huge debts. The financial
institutions were bailed out through capital infusions from the govt. and loans from the
central bank but that didnt rectify the situation. Instead the banks kept on offering funds to
the debt ridden firms which could barely sustain on them and as a result worsened the
economic growth of Japan. Firms started to employ temporary workers thus increasing the
unemployment rate and the nominal wages decreased. GDP growth was slow and unable to
absorb the resulting increase in unemployment. In response, the Japanese government raised
VAT rates from 3% to 5% in 1997. The consumption-tax-hike in 1997 worsened the
recession, deflating the economy. Since the people were discouraged from spending, retail
businesses experienced lower prices. The decline in retail sales was followed by a decrease in
nominal wages. The nominal GDP growth rate lowered to 1.8% in 1998, and the
unemployment rate rose to 4.1%. Due to the huge crashes in stock market, increasing govt.
deficit, high debt to GDP ratio, lack of significant investments, decline in living standard,
high unemployment and absence of any real growth rate despite the very low interest rates
the years since 1991 have been labelled as the Lost Decade.
This situation of Japan has been described differently by various economists. Some view it as
a case of great recession, some as huge deflation whereas some others such as Paul Krugman
have emphasized on the fact that Japan has entered the so called Liquidity trap. It is a
situation where even the constant infusions of money into the market by the central bank is
unable to lower the interest rate further and consequently fail to stimulate economic growth.
The indicators of a liquidity trap are near zero short term interest rates and change in
monetary supply which fails to bring about any change in the general price levels i.e.
fail to cause inflation. A liquidity trap is caused when people start saving cash immensely
due to the expectation of an adverse event in the future such as deflation, insufficient
aggregate demand or an event of war. If people have low expectations about their future
incomes then even with a zero interest rate they tend to save more than the economy can
absorb. And consequently, no matter what the central bank does with the money supply, it
cannot bring about inflation in the economy sufficiently to restore full employment. Thus it is
a classic case in which the economy needs inflation in order to recover and function
efficiently. We can visualize the condition of a liquidity trap by the IS-LM approach by
drawing a simple graph as follows:

From the IS-LM graph it is evident that changes in the monetary policy are absolutely
ineffective to tackle the situation of liquidity trap. An increase in money supply by the
central bank simply shifts the LM curve to the right i.e. to the position of LM and has
no change on the prevailing interest rate or the output of the economy. But changes in
fiscal policy do have an impact on the economy. From graph we can see that an increase in
govt. purchases shifts the IS curve to the right i.e. to the position of IS. This has no
significant impact on the interest rate but it does increase the output of the economy to
Y. From this we can infer that Japan is in a liquidity trap as the aggregate demand in
Japan sufficiently falls below the productive capacity despite the zero short term
nominal interest rates. During the lost decade the nominal interest rates were as low as
0.37% and still the aggregate demand in the market was way below the productive capacity
of the economy. The growth rate has been very low indicating a great slump in the
economy. Also the expectations of future productive capacity of Japan are actually lower
than the current capacity, the skewed demography being the underlying cause. Declining
birth rate and lack of immigration in Japan apparently means a shrinking and a rather
growing (old) labour force. As the labour force decreases faster than the growing
population, because of shifting composition, it is easy to infer that the productive capacity
in Japan will be lower in future as compared to today. As a result the future expected
income of people decreases and eventually they tend to save incessantly despite a near
zero nominal interest rate.
Now the question arises, what is Abenomics? The current Prime Minister of Japan, Mr.
Shinzo Abe introduced a set of bold economic policies in order to bolster the on-going
deflation and to regain the growth rate that died down in the lost decade. These economic
policies are collectively referred to as Abenomics on the name of its proposer.

The three main arrows of Abenomics are:
Aggressive monetary easing from Bank of Japan
A massive fiscal stimulus
A set of structural reforms to increase Japans competitiveness
We will be discussing the specific policies and their function in improving the condition of
Japan in detail in this article. We will be analysing the policies based on their effect on the
macroeconomic variables in as simple way as possible using the Keynesian theory and the
IS-LM model.

o Aggressive monetary easing from BOJ

o Quantitative easing =>
Quantitative easing is a monetary policy used by the central bank, whereby it buys
financial assets from commercial banks and other private institutions. The aim is to
inject money into the economy, thereby lowering interest rates and inducing
investments to increase output. Aimed at creating inflation (or at least at halting
deflation) and devaluing the yen.
Another question which pops in our head is
Why only Quantitative easing and why not other conventional expansionary
policies? Other expansionary monetary policies such as regulating the cash reserves
of commercial banks to increase the availability of loanable funds or buying short-
term Government bonds also help increasing the money supply and thereby lower
short-term interest rates. However, when the interest rate is already either at or close
to zero, then what? Quantitative easing is a monetary policy used then to boost the
economy by purchasing financial assets of longer maturity, thereby lowering long-
term interest rates as well. However there has to be an equiproportional increase in
money supply in all periods so that it raises prices in same proportion. Even if the
economy is in liquidity trap in the sense that the nominal interest rate is stuck at zero,
the monetary expansion would raise the expected future price level, and hence reduce
the real interest rate.
If we try to visualize it in terms of the IS-LM model we will see that:
BOJ buys securities ->money supply increases in economy ->interest rates fall ->
opportunity for investments with attractive loans ->output increases
Money supply increase causing interest rates to fall and demand for money to
increase.

The effect of the expansionary monetary policy of quantitative easing causes the LM
curve to shift outwards. However, there is no shift in the IS curve except for a
movement along the line. The new lower rate (i2) induces investment and hence,
higher output. Thus, the new equilibrium O' is reached at a lower interest rate (i2) and
higher output (Y2).

In Japan, with quantitative easing, BOJ flooded commercial banks with excess liquidity to
promote private lending, leaving them with large stocks of excess reserves, and therefore
little risk of a liquidity shortage. The BOJ accomplished this by buying more government
bonds than would be required to set the interest rate to zero. It later also bought asset-backed
securities and equities, and extended the terms of its commercial paper purchasing operation.
o Depreciation of Yen

Japan recently used its foreign exchange reserves to buy bonds issued by the European
Stability Mechanism. This policy will increase the supply of the Yen in foreign exchange
markets and reduce the currencys value.
Now let us analyze this using IS-LM model and simple supply and demand graphs.
I S: Y =C(Y-T) +I (r) +G +NX(e)
LM: M/P =L(r,Y)

As there is indefinite Quantitative easing, the LM curve shifts to the right increasing
income and decreasing the interest rates. This decrease in interest rates assures an
increase in net capital outflow as shown in the graph below.

As the net capital outflow increases from CF1 to CF2, the supply of Japanese yen in the
market for foreign exchange increases. The exchange rate falls from e1 to e2,
depreciating the Japanese yen. This makes the Japanese goods relatively cheaper to
foreign goods and the net export rises from NX1 to NX2 as shown in the following
graph.

o Inflation targeting @ 2% =>

As the nominal interest rates are already below or near 0 percent, BOJ has to
employ quantitative easing policies. This will increase the money supply and
thereby increase average price levels (or the rate of inflation) as per the Quantity
Theory of Money.

How?
We know that,
M*V=P*Y
If we assume V and Y to be fixed (long run), it follows that:
(M/M)/t = (P/P)/t, where t denotes time.
Therefore, as M increases, P also increases.
This can also be explained using the IS-LM Curve:

This effect will be in the short run, but in the long run LM2 LM1 but with greater
P.

Thus, all in all, Abenomics tries to devaluate its over appreciated yen and cause an
inflation of 2% as the output rises. As a result the exchange rate as gradually decreased
over the years as can be seen in the graph below.

o Negative real interest rates =>
The case that a negative real interest rate is necessary can be strengthened if we allow
for heterogeneity among individuals plus imperfect capital markets. Suppose that at
any given time some people expect their future income to be higher than their current
income, others expect it to be lower. In a perfect capital market those who expect their
income to rise would tend to engage in dissaving. But suppose that this is difficult -
that consumption loans are hard to come by. Then those who expect their income to
rise will not contribute as much to the demand for funds as those who expect it to fall
contribute to the supply, and the equilibrium real interest rate will be lower than it
would have been in a more efficient capital market.

In simple terms, as the real interest rates become negative, it will be a disincentive for
households to save and thus this may promote consumption and investment which
would in turn benefit the economy.

A massive fiscal stimulus =>
As we have already seen in the situation of liquidity trap, monetary policy is of no use
whereas fiscal expansion is the only option available. A tax cut would definitely not
be of any significant use as it would not stimulate the overall demand and
consumption. But govt. purchases of goods and services in the long run would
definitely increase the demand and output.
The Japanese govt. is trying to initiate fiscal policy by expanding government
expenditures. As the government implements fiscal expansionary policies the IS curve
shifts to the right. As the graph below illustrates, this shift in the IS curve leads to an
increase in the level of income from Y1 to Y2 and an increase in the interest rate from
r1 to r2. The increase in the real interest rate reduces the net capital outflow from CF1
to CF2.



As the net capital flow falls, the supply of Japanese yen in the market for foreign exchange
falls. This induces the exchange rate to appreciate from e1 to e2, which decreases the net
export from NX1 to NX2 as the Japanese goods become more expensive relative to foreign
goods.

As is clear from the above graph, the fiscal expansion would increase the income and output
of the Japanese economy. However, the point to be noted is that the simultaneous
implementation of fiscal and monetary policies does raise the output but it has conflicting
effect on the exchange rate of Japanese yen to USD. This problem can be tackled if the
Japanese government will set its desirable exchange rate, possibly above 100 JPY/USD, and
fix it so that other variables can freely adjust, although it might compromise the output to
some degree. Or if the Japanese government considers the increase in the economic output,
and therefore the inflation rate, more important over the exchange rate, it might decide to
compromise fixating the exchange rate to their desired level for the economic growth.

A set of structural reforms to increase Japans competitiveness =>
These include cleaning up of its banks, deregulation of service sector, reformation
of its corporate accounting etc so as to come up with an appropriate economic
growth strategy and maintain its financial integrity.
Measures that raise Japan's supply capacity but leave demand as it is will not help
the situation. For ex: if unemployment rises as a result of increased efficiency the
country might actually be worse off.
To be helpful in the current situation, structural reform must somehow induce
people to spend more. This can happen in the following ways: A reformed
financial sector might be able to lend to people and firms that are now credit-
constrained. Deregulation might create new investment opportunities, raising
investment demand. And conceivably reform might raise expectations of future
income, encouraging higher spending now.
But structural reforms alone cannot increase the aggregate demand. And also they
alone cannot drag the economy out of the current liquidity trap. So it has to be
coupled up with the other policies so as to bring about the desired effect.
Structural reforms as such avoid the economy from sliding back into the liquidity
trap rather than jolting it out of it.
The various problems faced by Abenomics are:
It focuses more on the demand side of the economy rather than on the supply side. .
The major problem stagnating the Japanese economy is the poor productivity. This is
a serious issue concerning the economy and need to be addressed as soon as possible.
Productivity can be increased by reducing corporate taxes which would be an
incentive for them to produce more.
One of the fundamental problems that Japan is facing is its ageing population. As the
population pyramid gets inverted, the labor population is shrinking every year. This
brings about number of problems for the Japanese economy. First, the government
commitment in spending on pensions, medical expenses and social security will
continually act as a substantial burden to the already indebted country with a public
debt of 240% its GDP. This will further worsen the financial integrity of the Japanese
government leading to an erosion of international confidence in Japanese economy.
The lack of confidence can raise the risk premium (CDS) shifting the IS* curve to the
left and LM* curve to the right, as increases for r = r* + . But, the exchange rate
would depreciate more than what is desired by the Japanese economy, and it would
force the Bank of Japan to decrease the money supply in order to bring up the yen
value, shifting the LM* curve back to the left. This would aggravate the situation and
lower the total income in the Japanese economy. This then would induce the interest
rates to depress the prices of financial assets, which will then reduce the collateral
being used as bank loans. As a result, this will lead to financial problems for Japan,
further exacerbating the problems.
Also, its dwindling workforce cannot sustain the economic output level that is
maintained in the future. As it is shown on the data, the demography will drastically
change so that more young people will have to support for the older population,
which implies that this change in demography is the main culprit for the last two
decades of deflation and stagnant economic growth. This has another implication to
why the consumer demand might be falling behind.

As it is shown on the data, the demography will drastically change so that more young
people will have to support for the older population, which implies that this change in
demography is the main culprit for the last two decades of deflation and stagnant
economic growth.
Conclusion:
Thus although Abenomics is currently not able to tackle the problems prevailing in Japan
currently but it definitely has the potential to do so in the near future and bring back the
economy to new heights. There were considerable risks associated with Abenomics, such
as the ageing population, poor productivity and the energy crisis. The key to success for
Abenomics is dependent on whether the Japanese government effectively manages these
risks and confronts the fundamental reforms that would improve the supply side of its
economy. The need of the hour is to change peoples perception. The economy can only
recover if the people expect inflation in the near future and thus start investing and
consuming rather than saving. The challenge lying ahead for the govt. and the PM Mr.
Abe is to convince the citizens of the country who are the key holders to the recovery of
the economy. If the policies end up doing their role and everything proposed goes right
on track then the economy is bound to recover and emerge as the developed economy
that it used to be.

Submitted by-
Amit Kumar Rath- 2011013
Kulpreet Singh- 2011046
Kritika Verma- 2011045