Japan’s ‘Lost Decade’: Analysis of the Effects of Interest Rate

Manipulation

Albert Lin

Rutgers University

awlin17@eden.rutgers.edu

Submitted to Professor Hiroki Tsurumi

5/07/09
Abstract:

Horioka (Japan and World Economy 18(4):378-400, 2006) argues that demand side

factors offer a better explanation of Japan’s economic stagnation (misguided government

policies) while others including Hayashi and Prescott (Review of Economic Dynamics 5(1):206-

235, 2002) suggest that supply side factors (low productivity growth) are more poignant in

explaining Japan’s economic stagnation. I hypothesized that theoretically interest rate

manipulation should increase private investment but in this case overall have no effect on GDP

growth due to supply-side problems such as low productivity growth but find that interest rate

changes have weak correlation to private investment. However, an OLS regression showed

moderate correlation of interest rate change to real GDP growth (if one does not observe

probability and f-statistics). This, I conclude, creates a disturbing impression that interest rate

adjustments have helped real GDP growth. Also, I find that private and public investment has

little correlation to real GDP growth.

Keywords:

Bank of Japan, Japanese Economy, Lost Decade, Monetary Policy, Ordinary Least Squared

Regression Model
Introduction:

Since 1990, Japan’s economic stagnation continues to persist. Although the credit boom

in the year 2000 created the illusion to declare Japan out its “Lost Decade”, the years did not

publish any higher levels of GDP growth higher than 2.90 percent according to Fig. 1. Hailing

as the second largest economy in the world, Japan has experienced significantly lower rates of

GDP growth (average of 1.17 percent from 1996 to 2005) when compared to that of the United

States (3.26 percent), Asia excluding the Middle East (3.24 percent) and the World (3.04

percent).

Fig. 1

Source: http://earthtrends.wri.org/text/economics-business/variable-227.html from EarthTrends Org.

Fig. 1 displays the trend in Japan’s GDP growth percentile from 1990 to the year 2005.

There is a decline in GDP growth starting at 1990, with the burst of the real estate bubble until

there seems to be modest recovery starting from 1993 (strong-armed fiscal policy in 1995) until

the shocks of the 97’ Asian financial crisis adversely affected the revival. In the year 2000, a
credit boom creates the illusion of a robust recovery of the Japanese economy (sixth column of

Table 1); however, GDP growth rates slump back to 0.20 percent in 2001.

Chart 1

The GDP growth in percentiles of these respective regions, 1996-2003

2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

World 3.5 4.1 2.7 1.9 1.5 4.1 3.2 2.3 3.7 3.4

Asia 4.7 5.1 3.9 2.8 2.2 4.6 2.4 -1 3.2 4.5

Europe 2 2.7 1.5 1.3 2.1 4.0 3.2 2.7 2.7 1.7

United States 3.2 3.9 2.5 1.6 0.8 3.7 4.5 4.2 4.5 3.7

Japan 1.9 2.7 1.4 0.3 0.2 2.9 -0.1 -2 1.6 2.7

Source: same as Fig. 1

Fig. 2

Source: http://www.e-stat.go.jp/SG1/estat/ListE.do?lid=000000730075 Official Statistics of Japan.

 Fig. 2 shows the trend over time of Japanese CPI. CPI, a common measure of inflation,

reveals that inflation rose steadily beginning from 1990 and peaking at 1998 even as GDP

growth dwindled (Fig. 1). The sharp turn upward in trend in year 1996 may be attributed to the

strong fiscal spending policies adopted by the government in 1995 as there had been an increase

in money supply.

What had been the government’s role during the so-called “post bubble” period? In this

paper I specifically investigate the government’s monetary policy of interest rate manipulation. I

assume that the government’s goals are to encourage the steady growth of GDP, maintain a low

rate of inflation, creating a positive trend of productivity and real GDP (per worker), and making

the most of resources/labor consistent with stable prices. Because relevant data on total factor

productivity had been processed and limited to 3 sets of data

http://www.kojin.org/papers/06_Japan_TFP.pdf, I chose data on the growth percentage of real

GDP (seasonally adjusted) to use in demand-side factors calculations as the determining factor of

policy effectiveness. I assumed that an effective change (that can be numerically measured) in

government policy will yield a positive change in real GDP growth. Also, since maintaining a

low rate of inflation and making use of resource/labor are inherently contradictory goals, I

choose the growth of GDP as an indicator of the government’s policy success.

But to briefly provide background on government policy tools; demand-side policies

would include fiscal and monetary stimulus, as well as interest rate manipulation. Fiscal policies

including taxation (changes in marginal tax-rate) and subsidizing of industries would all be

considered supply-side. However, other fiscal methods such as issuing and buying up bonds

affect aggregate demand.

The demand-side policy effect I choose investigate is primarily Bank of Japan’s interest
rate because interest rate has a negative correlation to investment. Because Japan has a cultural

tendency to save, increasing investment becomes increasingly important during economic

downturns so that aggregate demand will be sustained by raising investment:

Yd = C + I + G + (X – M)

where C is consumption, I is investment, G is government spending, and (X-M) is the net

export.

I develop a comparative regression analysis using this data, interest rate adjustments, and that of

private and public investment in order to discover if there are strong relationships between these

factors.

Background Discussion:

I chose to use the ordinary least squares regression model through the eviews program to

see if there is a strong relationship between interest rate change and private/public investment.

The OLS model is especially useful and accurate in predicting expected values of the dependent

variable. Hayashi and Prescott (Review of Economic Dynamics 5(1):206-235, 2002) run simpler

regression models in which they produce a cross section regression. However, they develop a

more complex equation of the aggregate output function where they combined the results of their

regression. But their main focus is to discover the relationship between aggregate production

and the shortened work week implications i.e. hours worked per employee and aggregate

employment.
Ceteris paribus, I view the relationship of investment to be positively correlated to aggregate

demand:

Yd r Ipub + Ipriv r Ratebank

Therefore, I mimic the same regressions methods used by Hayashi and Prescott, OLS;

however, because my data is in a time series, I ignore the stationarity hypothesis test and proceed

with the OLS regression.

Regression Model:

OLS model, which is mathematically explained by the following equation:

1
S xy := ∑ x i2 − (∑ yi )2
n

In my case:

1
S ri := ∑ ri ii − (∑ ri )(∑ ii ) where r = real gdp growth and i = investment, interest rate
n

I determine the real GDP growth to be the dependent variable because of the framework:

Yd = C + I + G + (X – M) where I = investment, keeping all other factors constant.

Data: Sources and Construction

I use the information from the Japanese statistics bureau, a division of the Ministry of

Internal Affairs and Communications as my primary data source. Ultimately I take GDP growth

change to be the dependent variable, as well as the ‘measurement’ for the effectiveness of each

government policy alteration. A few adjustments were made to the GDP growth rate so that it is
real GDP and also seasonally adjusted.

Interest rate data from the Bank of Japan was initially downloaded to contain monthly

data; I refitted the data to quarterly, taking the lowest interest value of each quarter to be

significant because in the economic downturn, the government aims to increase credit flow by

lowering interest rate as much as possible. I took data available from the official Bank of Japan

website.

The private and public investment data had been left as-is. The statistics were taken from

the Cabinet office of Japan website official statistics page that can be found here:

http://www.esri.cao.go.jp/en/sna/qe084-2/gdemenuea.html.

Empirical Results:

Dependent Variable: REALGDP

Method: Least Squares
Date: 03/29/09 Time: 10:45
Sample: 1994Q1 2000Q4
Included observations: 28

Coefficie
Variable nt Std. Error t-Statistic Prob.

C 519235.1 3935.536 131.9351 0.0000

-
BA4KRATE 15903.93 2019.718 -7.874335 0.0000

R-squared 0.704563 Mean dependent var 489699.2

Adjusted R-squared 0.693200 S.D. dependent var 11380.63
S.E. of regression 6303.679 Akaike info criterion 20.40440
Sum squared resid 1.03E+09 Schwarz criterion 20.49956
-
Log likelihood 283.6616 F-statistic 62.00515
Durbin-Watson stat 0.466860 Prob(F-statistic) 0.000000
Dependent Variable: REALGDP
Method: Least Squares
Date: 03/29/09 Time: 10:58
Sample: 1994Q1 2000Q4
Included observations: 28

Coefficie
Variable nt Std. Error t-Statistic Prob.

C 541478.6 31590.57 17.14051 0.0000

PRIV_I4VEST 1.480922 0.963323 1.537306 0.1368
-
PUB_I4VEST 1.406301 0.831727 -1.690821 0.1033

R-squared 0.178335 Mean dependent var 489699.2

Adjusted R-squared 0.112602 S.D. dependent var 11380.63
S.E. of regression 10720.76 Akaike info criterion 21.49871
Sum squared resid 2.87E+09 Schwarz criterion 21.64144
-
Log likelihood 297.9819 F-statistic 2.713021
Durbin-Watson stat 0.214283 Prob(F-statistic) 0.085838

Dependent Variable: PRIV_I4VEST

Method: Least Squares
Date: 03/29/09 Time: 11:01
Sample: 1994Q1 2000Q4
Included observations: 28

Coefficie
Variable nt Std. Error t-Statistic Prob.

C 1388.426 1360.918 1.020213 0.3170

-
BA4KRATE 223.5503 698.4232 -0.320079 0.7515

R-squared 0.003925 Mean dependent var 973.2607

-
Adjusted R-squared 0.034386 S.D. dependent var 2143.289
S.E. of regression 2179.827 Akaike info criterion 18.28063
Sum squared resid 1.24E+08 Schwarz criterion 18.37579
-
Log likelihood 253.9288 F-statistic 0.102450
Durbin-Watson stat 0.739380 Prob(F-statistic) 0.751467
Conclusion:

Empirical results show that there is weak relationship between bank interest rate

adjustment and private investment. This result seems anomalous because theoretically and

logically there should exist a negative relationship between lowered interest rates and increased

aptness to invest. My hypothesis becomes disproved by further multiple regression testing

between the relationship of private and public investment to real GDP. According to the R2

values, and ignoring the t-statistic because the sample size is smaller than 30, the probabilities of

bank rate having a relationship with GDP growth is insignificant at the 5% level. However, at

first glance there seems to be moderate correlation between interest rate adjustment and real

GDP growth. I believe this creates the false impression that these factors may be directly related.

In theory, interest rates affect investment, which in turn contribute to GDP. However,

there proves to be barely any relationship between the government’s interest rate policy and

private investment. This leads to other possible studies about the efficacy of interest rate

adjustment. Also, it suggests that there is indeed a supply-side economic problem of low

productivity.
REFERE4CES

K. Assenmacher-Wesche, Stefan Gerlach, Toshitaka Sekine, Monetary factors and inflation in Japan, Journal of the
Japanese and International Economies, Volume 22, Issue 3, September 2008, Pages 343-363, ISSN 0889-1583, DOI:
10.1016/j.jjie.2007.09.001.
http://www.sciencedirect.com/science/article/B6WMC-4RJK125-1/2/fd4cbe575fd0d918840d30e691150ed1

T. Bayoumi, The morning after: Explaining the slowdown in Japanese growth in the 1990s, Journal of International
Economics 53 (2001) (2), pp. 241–259.
http://www.nber.org/papers/w7350.pdf

BRAUN, R. ANTON; WAKI, YUICHIRO. Japanese Economic Review, Jun2006, Vol. 57 Issue 2, p324-344, 21p, 3
charts, 2 graphs.
http://web.ebscohost.com/ehost/pdf?vid=3&hid=6&sid=bdd0c0d8-160e-44bc-a8da-243d3da0ed0d%40sessionmgr3

Fukao, Mitsuhiro. "Japan's Lost Decade and Its Financial System." World Economy 26.3 (Mar. 2003): 365-
384. EconLit. EBSCO. 15 Apr 2009
https://login.proxy.libraries.rutgers.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=ecn&AN
=0737221&site=ehost-live.

F. Hayashi and E.C. Prescott, The 1990s in Japan: A lost decade, Review of Economic Dynamics 5 (2002) (1), pp.
206–235
http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VF1-4JRVF1V-
2&_user=526750&_coverDate=12%2F31%2F2006&_alid=914194105&_rdoc=4&_fmt=high&_orig=search&_cdi=
5997&_sort=d&_docanchor=&view=c&_ct=10&_acct=C000023759&_version=1&_urlVersion=0&_userid=52675
0&md5=c3be8806dd1000306182b70604c6bdae#bbib14

Horioka, Charles Yuji. Japan & the World Economy, Dec2006, Vol. 18 Issue 4, p378-400, 23p.
http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6VF1-4JRVF1V-
2&_user=526750&_coverDate=12%2F31%2F2006&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C00
0023759&_version=1&_urlVersion=0&_userid=526750&md5=0c02917d27925f9afedca2e266b89771

Koo, Richard C. International Economy, Fall 2008, Vol. 22 Issue 4, p69-73, 5p.
http://web.ebscohost.com/ehost/pdf?vid=3&hid=6&sid=bdd0c0d8-160e-44bc-a8da-243d3da0ed0d%40sessionmgr3

Portier, Franck. "Comment 'A 'News' View of Japan's Lost Decade': Monetary Policy during Japan's Lost
Decade." Japanese Economic Review 57.2 (June 2006): 345-357. EconLit. EBSCO. 1 May 2009
https://login.proxy.libraries.rutgers.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=ecn&AN
=0879108&site=ehost-live.

Yoshikawa, Hiroshi. "Japan's Lost Decade: What Have We Learned and Where Are We Heading?." Asian
Economic Policy Review 2.2 (Dec. 2007): 186-203. EconLit. EBSCO. 15 Apr 2009
https://login.proxy.libraries.rutgers.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=ecn&AN
=0991412&site=ehost-live.
4EWS SOURCES

"Asia 'must cut export dependency'" BBC NEWS | News Front Page. 01 May 2009
http://news.bbc.co.uk/2/hi/business/8031456.stm

"Fiscal Policy: The Concise Encyclopedia of Economics |." Library of Economics and Liberty. 02 May 2009
<http://www.econlib.org/library/Enc/FiscalPolicy.html>.

"Japan cuts rates to zero." BBC NEWS | News Front Page. 01 May 2009
<http://news.bbc.co.uk/1/hi/business/1228152.stm>.

"Japan's economy in quarterly dive." BBC NEWS | News Front Page. 12 Apr 2009
<http://news.bbc.co.uk/2/hi/business/7891849.stm>.

"Supply-Side Economics: The Concise Encyclopedia of Economics |." Library of Economics and Liberty. 12 Apr
2009 <http://www.econlib.org/library/Enc/SupplySideEconomics.html>.