Understanding the Costs of Deflation in the Japanese Context

IMF Working Papers, November 1, 2003

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This paper examines the cost of deflation in the context of Japan's ongoing deflationary episode.
The impact of deflation owing to the zero interest rate bound on monetary policy, wage rigidity, redistribution of wealth from debtor to creditor, and inflexibilities in the financial sector are examined.
The generalized decline in the Japanese price level, however gradual or mild, has substantially exacerbated the economy's adjustment process under already difficult economic conditions.

Zero interest rate bound: Deflation limits monetary policy effectiveness by interacting with the zero interest rate bound.
Wage rigidity: Wage rigidity amplifies the real burden of debt and hinders labor market adjustment during deflationary periods.
Wealth redistribution: Deflation produces redistribution of wealth from debtor to creditor, with macroeconomic consequences for demand and investment.
Financial sector inflexibilities: Inflexibilities in the financial sector worsen the propagation and persistence of deflationary pressures.
Aggregate effect: Even gradual or mild generalized price declines materially exacerbate Japan's economic adjustment challenges.

Subjects: Asset prices, Consumer price indexes, Deflation, Financial services, Inflation, Prices, Real interest rates
Keywords: aggregate demand, Asset prices, Consumer price indexes, Core CPI deflation, debt-deflation theory, Deflation, deflation pressure, Financial Sector, GDP deflator, Inflation, inflation expectation, monetary policy, monetary policy efficacy, price, Real interest rates, rising prices, unanticipated deflation, Wage Rigidity, WP