Tuesday, August 8, 2017

Japan's Disinflationary Boom Is Hard To Explain With Economic Theory

Interest rates in Japan are close to zero, and there is virtually no unemployment.  Economic theory suggests that wages should rise with low unemployment.  That should drive up the cost of goods and services and produce price inflation.  The inflation rate in Japan is close to zero.  It looks like the Phillip's curve, which shows a positive relationship between the unemployment rate and the inflation rate,  does not apply to Japan.  The government has been unable to hit its 2% inflation rate target.  Japan appears to be in a disinflationary boom.

The central bank has been keeping interest rates low to sustain a reasonable level of economic growth without producing inflation.  This enables the government to replace higher interest debt with lower interest rate debt as notes become due.  Consequently, the central bank is forced to maintain low interest rates.  Japan is in a period of fiscal policy dominance as a consequence. 

Japan can enjoy its disinflationary boom for some time but primary government spending, which does not include interest payments,  is growing faster than government revenue.  The government will have to worry about the primary budget deficit because mandatory spending on entitlements is growing faster than government revenue.  That will put pressure on the ratio between government debt and GDP which will continue to grow.

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