The Bank of Japan (BOJ), despite admitting that its inflation target of 2% would not be met in the

next few years, has confirmed the continuance of its expansionary monetary policy that it has
maintained for years, albeit with minor tweaks. The bank now forecasts that by 2020, its initial 2%
inflation deadline, the inflation is likely to hit 1.6%. According to the article, one of the factors that
are keeping the inflation low is the vicious cycle of stagnant salaries and stagnant prices.

The aggressive monetary policy that BOJ has been employing works largely in two ways: through
negative interest rates and through large-scale bond and asset purchases. The negative interest rates
provide consumers with an incentive to consume over saving and firms with an incentive to invest
over hoarding cash. Interests on savings are too low to encourage saving while interests on loans are
low enough to encourage investment. What is more, it discourages foreign investment into the country
thereby decreasing the demand for and hence the price of yen. Cheaper yen helps increase exports and
decrease imports through improved price competitiveness and so three components of aggregate
demand (AD) increase. Bond purchases are also supposed to encourage investment since bond
issuance is a way in which firms raise capital for investment, and hence is a capital injection.

As AD is boosted and AD curve shifts to the right from AD1 to AD2 in the diagram above, price level
is expected to rise from PL1 to PL2, by 1.1% in 2018 according to the BOJ. This results in an
inflationary gap between Y1 and Y2. The problem is that it is realizing to a lesser extent than the BOJ
wants, since the increase in AD is not sufficient and the AD is crossing the Keynesian AS curve
where there still is spare capacity. So an increase in AD does not translate to a big increase in the
price level.
The former, according to the article, is due to stagnant salaries and ‘deflation mindset’. A long period
of stagnant prices has rid of need or call for wage increases and the ‘deflation mindset’ likely has
formed a perception among consumers to not want inflation and among firms to not accommodate
price hikes even if that means sacrificing profit margins, which in turn would deter wage hikes.
Prolonged deflation and low growth also likely have resulted in low business and consumer
confidence, hence delaying consumption and investment. The well-known demographic changes that
is ageing population also could have contributed to the hesitance to increase consumption and
investment. With an older (and hence smaller) workforce, productivity tends to decrease and wage
hikes are hard to be justified. With an older population, burden on pension increases, and younger
consumers become less confident and save more for the future.

It seems that there are several measures that the Japanese government can resort to, while maintaining
the expansionary monetary and fiscal policies. Wage hikes can be encouraged using subsidies, but
there is a possibility that the firms may not pass this on and use it to increase the crushed margins, and
years of expansionary policies could have rendered Japanese government impossible to take on a
sizeable increase in budget without hiking taxes. Higher taxes would further deter AD growth so the
government could instead attempt wage negotiations and implement labour market reforms. An
increase in retirement age and re-training of older workers could offset the shrinkage of workforce,
while an attempt to increase the proportion of full-time workers could increase the wages.
Encouraging and training female workers outside the current labour market or implementing
accommodative immigration policies could also increase the workforce, productivity and income, and
boost consumption and investment. Not only so, these reforms would increase the AS too, thus
accommodating a ‘healthy’ increase in price level and GDP.
These measures combined with consistency in the expansionary monetary and fiscal policies would as
a result boost consumer and business confidence and increase both AD and AS, as in the diagram
above. Attraction of foreign investment using tax reliefs and encouraging the growth of the industries
that would attract strong demand from older consumers such as healthcare can also pile on. Since it is
likely that the Japanese government and the BOJ have allocated enormous amount of budget to the
expansionary policies in the past years, more creative and unconventional measures seem highly
necessary to fight the deflation.