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Monetary Policy and the Lost Decade: Lessons from Japan

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I investigate how monetary policy can avoid a deflationary slump when policy rates are near zero by studying interest rate policy during Japan's “Lost Decade.” Estimation results suggest that the Bank of Japan's interest rate policy fits a conventional reaction function with an inflation target near 1%. The disapointing economic performance thus seems primarily due to adverse economic shocks rather than extraordinary policy errors. Also, counterfactual policy simulations suggest that simply raising the inflation target would not have substantially improved performance. However, price-level targeting or combining a higher inflation target with an aggressive output response would have achieved superior stabilization results.

Keywords: Bayesian econometrics; C22; E31; E52; deflation; liquidity trap; monetary policy

Document Type: Research Article

DOI: http://dx.doi.org/10.1111/j.1538-4616.2010.00309.x

Affiliations: Daniel Leigh is an Economist in the Research Department of the International Monetary Fund (  )., Email: dleigh@imf.org

Publication date: August 1, 2010

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