Monetary Policy in Japan’s ‘Great Recession:’

This paper estimates a reduced-form model of the Japanese economy that incorporates a role for money in the determination of GDP growth and inflation. Real base money growth is shown to be a significant determinant of GDP growth, suggesting a role for money even under a monetary policy operating regime in which base money is endogenous to the determination of an official interest rate. An aggregate supply curve is estimated, in which a velocity gap derived from a p-star model of the equilibrium price level is included as an explanatory variable. The estimated supply function suggests a role for both financial and goods market equilibrium in the determination of inflation outcomes, however, the relationship between the velocity gap and inflation breaks-down in the 1990s. The properties of a modified McCallum (1988) base money growth-nominal GDP targeting policy rule are also examined. The paper considers whether a McCallum-type policy rule provides a basis for overcoming the non-linearities and global instability problems implied by Taylor-type interest rate rules in the presence of the zero bound on nominal interest rates and low inflation.