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Global Disinflation

June 13, 2003
Yoshikazu Morimoto*1
Wataru Hirata*2
Ryo Kato*3

Click on ron0306a.pdf (509KB) to download the full text.

The views expressed in this paper are solely those of the authors and should not be interpreted as reflecting those of the Bank of Japan or the International Department. We thank our colleagues at the Bank of Japan for helpful comments. We are particularly indebted to Koichiro Kamada (Research and Statistics Department) for his valuable comments on the empirical analysis and giving us permission to use his empirical results on Japan. We also wish to acknowledge the enlightening discussions that we had with Akira Otani (Institute for Monetary and Economic Studies). All errors remain ours.

  • *1Global Economic Research Division, International Department, Bank of Japan (E-mail:yoshikazu.morimoto@boj.or.jp)
  • *2Global Economic Research Division, International Department, Bank of Japan (E-mail:wataru.hirata@boj.or.jp)
  • *3Global Economic Research Division, International Department, Bank of Japan (E-mail:ryou.katou@boj.or.jp)

Summary

A long-term disinflationary trend is widely observed all over the world. Since the mid-1990s, this trend has been more pronounced in industrial countries and many emerging economies in Asia. Japan is faced with a deflation problem. Emerging economies in Asia and several industrial countries, arguably including the United States, have also shown clear disinflationary trends. Hong Kong SAR has been experiencing much deeper and prolonged deflation than Japan.

This paper discusses factors contributing to "global disinflation" to reexamine Japan's deflation in a broader context and shed some light on the prospect of the global economy. For this purpose, we try to empirically answer the following questions in the paper. Namely, 1) does the expansion of supply capacity in emerging economies play a significant role in slowing down global inflation, especially in industrial countries? And, if that is the case, 2) why does economic performance differ among countries?

There are five major possible sources of the recent global disinflation: 1) anti-inflationary monetary policy and restrictive fiscal policy, 2) output gaps coincidentally observed in many countries under a synchronized international business cycle, 3) productivity increase in the information technology-related sector, 4) global supply shocks caused by the expansion of supply capacity in emerging economies, and 5) the collapse of asset price bubbles. With regard to 4) above, it is noteworthy that in the tradable goods sector global competition has intensified since the beginning of the 1990s, as more emerging economies in Latin America and eastern Europe, and China have entered the world market.

There can be counter-arguments about the fourth factor, i.e. the global supply shock caused by the expansion of supply capacity in emerging economies. First, it does not take account of economic adjustments through exchange rates. Second, declines in prices of tradable goods may change relative prices, but not necessarily aggregate prices. Regarding the first argument, if foreign exchange rates move so that the purchasing power parity holds, or if they move quickly enough to adjust current account imbalances between countries, emerging economies will face appreciation of their currencies and subsequent declines in their price competitiveness. However, in reality, this does not always hold true at least in the short run. Regarding the second argument, if a domestic economy adjusts itself to a supply shock without major costs, there would not necessarily be a decline in aggregate price levels or a downturn of the economy. However, in reality, there are certain rigidities particularly those regarding the reallocation of labor that impede adjustments in the short run. Therefore, an external shock on tradable goods prices can put downward pressures on aggregate price levels and economic activities.

In fact, our empirical analysis shows that there were certain shocks, which cannot be attributed to output gaps or inflationary expectations behind global disinflation since the mid-1990s. We also find a certain degree of positive correlation between this shock and the expansion of supply capacity in emerging economies.

Based on our findings and applying the structural VAR model proposed in Kamada and Hirakata [2002], this paper analyzes how each of those factors we discussed in this paper affects inflation rates of major industrial countries. Specifically, we breakdown historical inflation rates into three kinds of structural shocks: 1) a cyclical demand shock, 2) a productivity shock, and 3) a supply shock caused by the expansion of supply capacity in emerging economies. We find that the supply shocks caused by the expansion of supply capacity in emerging economies have put significant downward pressures on prices in major industrial countries since the mid-1990s.

This result also poses a different question: why does economic performance differ among countries under such global supply shocks? Based on the findings in this paper, it seems that how such shocks affect each economy depends on the magnitude of the shocks and the degree of structural flexibility of each economy in response to various shocks. From this perspective, Japan's poorer economic performance as compared with that of the United States in recent years can be largely attributed to Japan's structural rigidities. This is consistent with the results of our empirical analysis. On the other hand, in the case of relatively advanced economies in emerging Asia, notably Hong Kong, the issue is not as much as their structural rigidities as the magnitude of the supply shocks. In those economies, the supply shocks seem extremely large partly due to the absence of adjustments of exchange rates vis-à-vis their trading partners including China.

Our findings have the following implications for economic policy. First, since the expansion of supply capacity in emerging economies is considered to be a permanent structural change in the global economy, reform to enhance the structural flexibility of the economy is essential for sustainable economic growth. Second, a sound financial sector is essential to achieve and maintain structural flexibility. In fact, those countries that have a sound financial sector such as the United States and South Korea have managed to deal with adjustment pressures and shown, at least so far, relatively good economic performance. In contrast, Japan does not seem to be successful in dealing with pressures for structural changes. Japan seems to be trapped in a vicious circle of its financial sector problem dampening growth of its real economy. Policymakers must tackle with both the financial sector problem and the real economic problem simultaneously.