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Japan’s economy is the world’s third-largest economy by GDP after the US and China. However, the country has been experiencing deflation since 1991. How can a country be experiencing low price levels for more than 20 years and how does this affect its economy? How did this happen? In this article, we will look at the cause of Japan’s deflationary spiral and how despite the government’s aggressive policies, Japan's economy still can’t seem to get rid of deflation.
First, let us quickly recap our understanding of deflation before we see how it relates to Japan's economy.
Deflation is the decrease in the general price levels.
Deflation can be caused either by a fall in aggregate demand (AD) or a rise in aggregate supply (AS)
To learn more about deflation, check out our Inflation and Deflation explanation.
As you can see in the figure below, a decrease in aggregate demand causes prices to fall from P1 to P2 and real GDP also falls.
Figure 1. Deflation when AD falls, StudySmarter Originals
The decrease in AD could be caused by a number of factors:
You can read more about changes to AD. Check out our Aggregate Demand and Aggregate Demand Curve articles.
As you can see in Figure 2, an increase in aggregate supply will cause prices to fall from P1 to P2, but real GDP increases from Y1 to Y2.
Figure 2. Deflation when AS rises, StudySmarter Originals
The increase in AS could be caused by a number of different factors:
Deflation caused by these factors might not cause governments to worry because the economy is still able to grow.
However, constant deflation is worrying to an economy because it could lead to:
Without any intervention, deflation causes more deflation, and this is known as the deflationary spiral.
A deflationary spiral is when falling prices lead to further price falls.
As you can see in Figure 3, a deflationary spiral is a repetitive cycle consisting of falling prices and low wages that ultimately lead to a fall in AD. Falling prices cause consumers to delay their spending adding more deflationary pressure on the economy.
During a period of constant deflation, banks are less willing to lend, further causing a fall in spending, investment and confidence. The cycle continues further plummeting AD. Eventually, an economy will experience a recession or even a depression if not corrected. This was the case with Japan’s economy beginning in 1991.
Figure 3. Deflationary spiral, Alanna Odagbu. Created with icons from Flaticon.com - StudySmarter.
Japan’s deflationary spiral first began with a boom in the real estate market. Speculation and low-interest rates sparked the high valuations of property and public companies. As always, such booms are unsustainable, so to control speculation and prevent the pop of this bubble, the Bank of Japan (BoJ) increased interest rates. This policy caused the burst of the bubble and Japan’s stock market crashed. Many borrowers couldn’t pay their debts that were backed by speculative assets. This resulted in a debt crisis.
Japan’s economy was sent into a period known as the ‘lost decades’. Economic growth stagnated for 10 years, and deflation took over. The Japanese property market never returned back to its pre-boom levels.
Between 1991 and 2010, Japan’s GDP growth averaged around 0.5%. From 2011 to 2019, the Japanese economy grew by just under 1%.1
Different economists point to different causes of Japan’s prolonged slow economic growth and deflation.
Keynesian economist, Paul Krugman blames Japan’s liquidity trap.
The liquidity trap refers to when monetary policies become ineffective because of low or zero interest rates. Consumers hold onto their money instead of spending it and this continues to contribute to slow economic growth.
He believes that Japan was stuck in a liquidity trap. As Japan has an ageing population that has a high marginal propensity to save (MPS), and consumer confidence was continually falling, the saving and lower spending made the economy grow even slower.
Other economists believe that the issue began with Japan’s monetary policy prior to and during the lost decades. They believe that it wasn't accommodating and was too restrictive to kick start economic growth.
You can learn more about monetary policies with our Monetary Policy explanation.
To revive the Japanese economy, the Japanese government tried many different policies.
The government started by lowering interest rates, but this had no effect on consumers and businesses. So, the Japanese government tried to reflate the economy by increasing the money supply, which is also known as quantitative easing.
Quantitative easing is when the central bank increases the money supply.
The central bank buys back government and corporate bonds from financial institutions. Commercial banks have more cash reserves which allow them to give out more loans at cheaper rates to consumers and businesses. Consumers and businesses take advantage of cheaper loans to finance their spending or investments, thus increasing aggregate demand (AD), and increasing economic growth.
Read our Commercial Banks and Functions of Central Banks explanations to better understand quantitative easing and the role of central banks.
This is what the Bank of Japan did. However, when a central bank injects money into the financial system, commercial banks have more money to hand out, but they must be willing to lend that money out.
Banks in Japan, however, weren’t willing to lend out the money they had. This led Japan to experience a credit crunch.
A credit crunch refers to the unwillingness of lending by financial institutions.
Similar to a liquidity trap, a credit crunch also results in deflation. Less lending means that consumers and businesses are unable to borrow to finance their spending. This causes prices to fall because of the decrease in consumption and investment. Instead of Japan’s economy bouncing back, it worsened.
The general consensus among economists was that the Japanese government should've acted quickly if they were to avoid such long periods of deflation and low economic growth. However, let's consider two other policies the government introduced to help solve Japan's lost decades:
These solutions along with many others did see Japan's economy grow, and it was on the way to recovery.
The liquidity trap, credit crunch, and low consumer and business spending all impacted the Japanese economy.
Over the period 1995 to 2007, GDP in Japan fell from $5.54 trillion to $4.58 trillion.2 Real wages fell and interest rates still remain low at -0.10%.
The Covid-19 pandemic hasn’t helped Japan’s deflation and low and slow economic growth. The country’s GDP contracted by 7.9% during the summer of the pandemic.3 Consumer prices fell by 0.9% and continued to fall during 2021.
That is why the years 1991 to the present are known as Japan's lost decades.
Japan’s lost decades have provided many economic lessons for us:
Japan’s lost decades is a good economic case study to remember for your exams. It can be applied to many economic topics like deflation, the liquidity trap, and monetary policies.
Deflation is the decrease in the general price level and can be caused by either a fall in aggregate demand (AD) or a rise in aggregate supply (AS).
According to economist Paul Krugman, Japan was stuck in a liquidity trap and consumer savings made the economy grow even slower.
As altering interest rates had no effect on consumers and businesses, the Japanese government tried to reflate the economy by increasing the money supply, which resulted in a credit crunch.
Japan’s economy still suffers from low price levels, negative interest rates, and a property market that never returned back to its pre-boom levels.
1. World Bank, ‘GDP growth (annual%) Japan’, 2019.
2. World Bank, ‘GDP (Current US $) Japan, 2020.
3. Trading Economics, ‘Japan GDP Growth Rate’, 2022.
Japan’s lost decades refers to the two decades of deflation and stagnating economic growth that hit the Japanese economy.
The effects of the lost decades resulted in Japan’s GDP falling. Real wages also fell and interest rates still remain low at -0.10%. Consumer confidence was low and Japan fell into a deflationary spiral and credit crunch.
The lost decades caused Japan’s stock market to crash and the Japanese property market never returned back to its pre-boom levels.
Investing in companies like Fujifilm and Toray during Japan's lost decades would be a good investment as these companies were able to grow and avoid the impacts of the slowdown in the Japanese economy.
Japan was recovering from its lost decades period. It took almost 12 years, however, the COVID-19 pandemic did worsen deflation in Japan and the economy experienced slow economic growth.
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