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Monetary Policy Framework and "Insurance Against Deflation"

July 2008
Naoko Hara*1
Takeshi Kimura*2
Kunio Okina*3

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Using the FRB/Global model on Japanese monetary policy in the early 1990s, Ahearne et al. (2002) argued that deflation could have been avoided in Japan if the BOJ had lowered short-term interest rates by a further 250 basis points at any time between 1991 and early-1995 as "insurance against deflation." That study raised interesting questions on how the central bank could offer "insurance against deflation" when the inflation rate is close to zero. However, the simulation by Ahearne et al. (2002) has some drawbacks: it assumes the central bank's commitment to permanent downward shift of the policy reaction function when policymakers are not sure what would happen, which is neither feasible nor credible.

In this paper, we show alternative policy frameworks of "insurance against deflation" that can be feasible and credible even under uncertainty. The simulation using the Japanese Economic Model (JEM), a large-scale macroeconomic model of the Research and Statistics Department of the Bank of Japan, suggests that what is important is not large cuts in interest rates at an early stage; rather, the central bank would commit to cut interest rates aggressively in the future, if the risk of deflation increases.

Asset Price, Collapse of Bubbles, Insurance Against Deflation, Monetary Policy, JEM (Japanese Economic Model)

This paper was prepared for the NBER-ESRI conference on June 23, 2008. We received valuable comments for the Japanese version of this paper from Messrs. Hiroshi Fujiki, Hibiki Ichiue, Kota Iijima, Kazuo Momma, Nobuyuki Oda, Kozo Ueda, as well as from the participants of the study group mentioned above. The opinions presented in this paper do not necessarily reflect any official views of the Bank of Japan, and the authors are solely responsible for any remaining errors in this paper.

  • *1 Research and Statistics Department, Bank of Japan
  • *2 Financial Markets Department, Bank of Japan
  • *3 Chuo University


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