Economics For Managers

For more Notes, Presentations, Project Reports visit a2zmba.blogspot.com hrmba.blogspot.com mbafin.blogspot.com Q-1

Summarize the key message of this article.

Article states that Japan’s economy was in trap of deflationary forces for more than decade. Even after the sign of recovery in 2002, firm maintain negative attitude towards rising prices due to persistent deflationary mindset. Recovery was totally depended on export because firms fails to make high profit that leads to better pay packet and greater spending in economy. Japan has higher price level in era of 1970’s, then it starts reducing by 0.2%in decade to 2007.Bank of Japan has made its forecast for “Core Inflation” stating that inflation will rise by 1.8% from 1.1% in fiscal year 2009. As elsewhere in Asia, a price for Food and Energy in Japan has increased by 2% in June from 1.5% in May. This was the only measure of inflation in Japan at that point of time. Christopher Wood of CLSA has positive opinion for Japan’s Deflation as it will help overall economy to overcome its deflationary effects very fast. But there was different opinion by different economist that inflation is rise due to rise in dearer foods and energy prices. But John Richards, of the Royal Bank of Scotland in Tokyo argues this is not an actual domestic demand as Japan is importing food and energy from overseas. Initially four years of Deflation, import exceeds export, then after Japan made strong base of export by exporting wide variety of goods and services to China, Europe and Oil exporting countries. But during span of time, it shrinks export to America and Europe. Now company profit is decreasing to 17.5% which is lower then earlier year. On 1st July, Tankan survey conducted by BOJ which shows the picture of frustrated customers who cannot satisfies their day to day needs from limited earnings. That’s the Sign of Belt tightening. Even after great fall of Interest rate by 0.5%, people did not shift their savings into shares and property and it has been fallen by Nine tenths since 1990’s. Reason behind the failure of Japan Inflation is that bank of Japan is unsuccessful in rising interest rate which eventually unstabilize the economy.

2. (a) Use macroeconomic theory to explain the cause of deflation in Japan.

Macroeconomic is the study of national economy and global economy as a whole. It seeks to explain average prices and the total employment, income and production. It also studies the effect of government actions-taxes, spending and deficit-on total jobs and income (McTaggrat, Findlay, Parkin, 2006). AD-AS (Aggregate Demand-aggregate Supply) Model The Aggregate Supply-Aggregate demand model enables us to understand growth of potential GDP, inflation and business cycle fluctuations (McTaggrat, Findlay, Parkin, 2006). (I) Aggregate Demand: • Aggregate demand is the total quantity of goods and services, or real GDP, demanded by households, firms, governments and foreigners (McTaggrat, Findlay, Parkin, 2006). • Changes in fiscal policy and monetary policy, changes in world real GDP and foreign exchange rate, and changes in expected future disposable income, inflation, and profits change aggregate demand (McTaggrat, Findlay, Parkin, 2006). Aggregate demand is determined Aggregate expenditure, we can judge AD(Aggregate Demand) from the ratio of AE(Aggregate Expenditure). AD=AE=C+I+G+EX-IM C=The Consumption expenditure of the consumers

G=Government expenditure

I=Investment expenditure by the firms

X=Export

M=Imports

Japan’s case: In Japan’s case, Aggregate demand falls due to fall in consumption expenditure of households. (I) Aggregate supply: • Aggregate supply is the sum of all goods and services which all firms in economy plan to produce. (McTaggrat, Findlay, Parkin, 2006).

• is,

Aggregate supply is directly related with aggregate production. therefore AS function

Y= F (L, K, T) Y=Quantity of Real GDP L=Quantity of labour K=Quantity of Capital T=State of Technology (McTaggrat, Findlay, Parkin, 2006) short run aggregate supply : The relationship between the quantity of real GDP supplied and the price level (GDP deflator), holding everything else constant-in particular the money wage rate as other resource prices remains constant. (McTaggrat, Findlay, Parkin, 2006) Long run aggregate supply: The relationship between aggregate quantity of real GDP supplied and price level (GDP deflator) in the long run when real GDP equals potential GDP. Japan’s case: in Japan, With Reduced Interest Rate, Japan’s total capital outflow (K) has increased, which shifts short run aggregate supply curve towards right-hand side, whereby it achieves potential GDP, but at cost of increasing deflation rate.

C B A Recessionary Deflation Y1 Yf P2 P1 P* SRAS1 SRAS AD1 AD LRAS GDP Price Gap

Explanation: 1) Due to deflation (price level goes down), firms earn low level of profit. To stay in competitive market, firm reduce real wage of households. As their income level is reduced, their spending capacity affected i.e. their purchasing power is reduced so their demand is goes downward with decrease in income level. This decrease in demand shifts the AD (Aggregate demand) curve to downward.

A decrease aggregate demand shifts demand curve from AD to AD1 potential GDP decrease from Yf to Y1. It not only increase level of deflation but also creates the problem of recession. Gap between Yf to Y1 is “Recessionary Gap”. 2) On other Hand, to overcome Deflation problem and increase demand, Bank of Japan have cut off the Interest rate which is just equal to zero. Due to low interest rate, Japanese investor reduces their investment in Japan and finds other country an attractive place of making investment. Investment outside Japan has increased Japan’s Capital outflow. Low interest rate increase capital outflow, which in turn cause short run aggregate supply curve to move downward. As the SAS curve moves rightward from SAS to SAS1, it intersects the aggregate demand curve AD1 at lower price levels and higher real GDP levels. Eventually, price level decrease to P2 and real GDP increase and come back to YfPotential GDP (Refer to appendix I for latest figure of GDP in Japan).

(B) Do you think deflation is good for an economy? Explain. Deflation is considered to be bad for any economy, however it proves to be fruitful for some economy, Japan is one of it as export has boosted due to low price level. 1) On one hand, as price is deceasing, that is deflation is takes place. So due to low level of price, Japan’s export is increasing, so demand for Japanese Yen was increased, that leads to appreciation of Japanese currency. Increase In value of currency leads to price level up that increase profit of companies. As companies profit level increase and cost of production decrease, firm may increase their real wage (wr), so finally household labor will earn more, as their increased earning leads more spending because of their growing demand. If more expenditure is made for goods and service that indicates their increased demand for that goods and services. This is positive effect of deflation on Japan. 2) On other hand, As Interest rate reduced to zero, which diverts the attention of Japanese investor outside the Japan. So more Japanese investor invest outside Japan where there is high interest rate like Australia. Increased investment outside Japan leads to more capital outflow from Japan to overseas, which depreciate value of Japan’s Yen that eventually leads to deflation problem.

3. What sort of monetary policy was the Japanese Central Bank (BOJ) following to solve the deflation problem? Do you think that the Japanese Central Bank was successful in solving the problem? There are various monetary policy actions of Bank of Japan under deflationary environment from 1998 to 2005. Deflation was getting worse in terms of negative inflation rate and unemployment rate was high. Bank of Japan has become independent in March 1998 with the objective of ending deflation and maintains stability in economy. All policy decision has been conducted under the leadership of new Governor Yujiro Hayami, appointed in March 1998. We will focuses on the period after 1998, when the Bank gained legal independence and the Economy fell into deflation (i.e., the CPI inflation rate became negative). I)

Zero interest rate policy (ZIRP), 12 February 1999

In Monetary policy meeting held by bank of Japan, by majority vote, the Policy Board determined to ease further the stance of money market operations for the Inter-meeting period ahead as follows: “The Bank of Japan will provide more ample funds and encourage the uncollateralized overnight call rate to move as low as possible” (Japan monetary policy 1998-2005)

Bank of Japan have lower call rate to 0.15% to avoid excess volatility in short term financial market and to increase the Aggregate demand. Call rate has been lowered from 0.50% to 0.25% after 1998. In the 28 February 1999, the official discount rate was cut to 0.25%, and the policy interest rate was cut from 0.25% to 0.10%. However, these changes did not make any impact on the market.(Refer to Appendix III for more details)

II)

Quantitative easing (QE)

The Bank of Japan made a substantial policy change in the MPM meeting of 19 March 2001. They decides to change the policy instrument from the interest rate to current accounts at the Bank of Japan, the sum of required and excess reserves, and that excess reserves would be maintained. this change of policy instrument was a radical move towards QE. Quantitative easing means that the Bank of Japan provides enough liquidity to financial markets so that commercial banks will pile up excess reserves at the Bank of Japan. The balance of the current account at the Bank of Japan becomes the policy variable. Bank of Japan tried several steps to enhance QE. First, it increased the target amount of current account balances in several steps (August 2001, December 2001 and October 2002). Second, the Bank increased the purchase of JGB in four steps (August 2001, December 2001, February 2003 and October 2002) from 400 million yen to 1.2 trillion yen. Third, the official interest rate was reduced from 0.50% to 0.35% in February 2001, then to 0.25% in March 2001 and to 0.10% in September 2001. (Japan monetary policy 1998-2005) III) Purchases of Government Bond (JGB): One of the non-conventional monetary policies was to increase the amount of long-term Bond purchases. The Bank increased the amount of monthly purchases of government Bonds (JGB) from 400 billion yen in 1998, in several steps, to 1,200 billion yen by October 2002. Purchasing assets that are riskier than short-term government paper would help asset reallocation in the economy, so that the private sector would take more risk. It was also expected that the Bank of Japan purchasing longer-term assets would flatten the yield curve, so that investment that is sensitive to a long-term interest rate, rather than a short-term interest rate, would be stimulated.(Refer to Appendix IV for more details). IV) Inflation Targeting: Government took initiative to introduce inflation targeting to resolve the deflation problem. Inflation targeting helps to reduce deflation by changing the forward-looking real interest rate. Moreover, clarifying the goal of the policy might be necessary for an independent central bank to be accountable for its action. ( Japan monetary policy 1998-2005) Monetary policies of 2003-2005. The Bank of Japan, under the leadership of Mr Fukui, explored ways to stimulate the economy and stabilise the financial system. 1) Bank of Japan have increase the target level of current account balances from 22-27 trillion to 27-30 trillion in May, to 27-32 trillion in October and finally to 30-35 trillion in January 2004. 2) Providing more liquidity to the banking system leads to the expansion of monetary base and then expands money supply in economy.

So this was the review of various monetary policies followed by the independent Bank of Japan but none of them has really successful to overcome deflation and incur inflation level. There was sign of recovery after introduction of zero interest rate in the spring of 1999. Recovery after Zero Interest rate Policy: 1) Japan’s premium to western bank for interbank transaction has disappeared in April 1999. 2) The worldwide IT stock price increases boosted confidence thus stimulating consumption and investment. ( Japan monetary policy 1998-2005)

4. Deflation has boosted the Japanese exports on the one hand and on the other hand the Japanese Central Bank has kept interest rate low to solve the deflation problem — what impact do these two effects have on the Japanese foreign exchange market. As Japan is facing deflation from last decade, so price of all related goods and service is drops to grater extent. To solve the deflation problem, bank of Japan have implement Expansionary Monetary policy i.e. they have reduced the interest rate which is equal to zero. But these two factors have worsened condition for forex market. Foreign exchange market is most volatile market which involves cross border transaction, whereby one currency is convert into another at specified rate. Rate at which currency is converting called exchange rate. Exchange Rate is determines by market forces. Exchange Rate can be indicate by any of two ways, 1) Direct Quote: Direct quote is specifies into foreign currency in terms of domestic currency. If AUD is local currency then, 1US$ =? AUD $ eD A$/U$ 2) Indirect Quote: Indirect quote is specifies into Local currency in terms of Foreign currency. If AUD is local currency then, 1A$=? US$ eID U$/A$

Source:http://finance.yahoo.com/echarts? s=USDJPY=X#chart12:symbol=usdjpy=x;range=19990101,20081003;indicator=volume;char ttype=line;crosshair=on;ohlcvalues=0;logscale=off Above fig shows exchange rate of Yen versus US dollar from year 2007 to 2008. Yen was very strong in the month of June 07 that is above 120 but after that it drops below 100 in just 8 months which says that the falling interest rate or the supply curve had more impact on the

exchange rate than the demand curve which consequently was the reason which led to depreciation of Japanese Yen.

In above diagram, it has been clearly shown how Japanese currency is appreciates and how it is depreciating because of Export and Capital outflow. 1) Deflation leads to export booming, which increase demand for Japanese Yen which eventually appreciates Japan’s currency. Therefore demand curve for Japanese Yen shifts from D to D1 which shows appreciation of Japanese currency form ex to e1. 2) Bank of Japan have reduced Interest rate up to zero, so that Japan’s investor have divert their investment from Japan to outside country where Interest rate is high. They borrow money from Japan and invest in another country at high interest rate. This increase Japan’s currency outflow i.e. Japan’s capital outflow is increased which ultimately depreciates the value of Japanese currency. Thereby Supply curve for Yen has been shift to the right-hand side which depreciates value of Japanese Yen and increase capital outflow. In other words, magnitude of shifting Supply curve and effect of supply curve dominates demand curve effect that leads to currency depreciation. On one hand, Japan’s Yen appreciates due to more demand of Yen (Increase in export), and on other hand, Yen depreciates due to increase capital outflow from Japan (as interest rate is equal to zero).

5. In the third paragraph of the second page of this article the author has argued that, because of deflation, “company profits are now falling...” and “consumers are also showing signs of belt-tightening” – Use the relevant microeconomic theories to analyse such behaviour. Above case study can be explain with the help of firms and consumer behaviour theory. Microeconomics is the study of the decisions of individual people and businesses and interaction of those decisions in markets. It seeks to explain the prices and quantities of individual goods and services (McTaggrat, Findlay, Parkin, 2006). To explain this in brief we can took a relation between consumer and firm or company size. The relationship between firm and consumer can be describe as producer manufacture and supply goods and services to consumer or we can say in other word consumer demand for goods which firm supplies to consumer; but in return firms demand for labour supply from consumer. This relationship is shown in below diagram. And this is exactly how these two are related to each other.

Demandfor Supply ofConsu ofgoods for Labour goods Labour Fir

mer ms

Individual firm: In short run, if deflation occurs, price drops which tend to lower profit level of company. In such situation company cannot cut nominal wage of worker because of

fixed term contract. So with low profit company may face high cost of production, and eventually incur economic loss. Reserve bank of Japan use expansionary monetary policy to solve deflation problem in Japan. However, because of the lack of customer's confidence, customers do not response to the lowering interest rate and the aggregate demand did not improve. In other words, Price falls leads to low profit and high cost of production and eventually huge economic loss. If we look at Japans case, the profit of firms is dropping. A firms profit is its total revenue (TR) less the total cost (TC) = TR -TC But, TR= Price (P) * Quantity (Q) and TC= Cost for land (L), labour (W) and capital (K). As Japan is facing deflation problem and the prices of all goods and services have dropped. Let’s say prices are dropped down to P1 where as demand is still same hence same amount of cost required for land (L), labour (W) and capital (K) required to produce same amount of output Q, hence the profit of company also drops by same amount. We come to conclusion that the cost for the goods is same but selling price drops due to the deflation. In long run, if deflation takes place, wages are cut down by firms due to the continue falling products' prices. Firms are hard to survival because small profit or no profit generated and choose to exit the market. Many firms are meet economic loss (total cost > total revenue) and this is the reason to cause these firms exit from the market. In other words, cost for production is decrease and profit level increases and firm can earn good economic return. Individual customer: In short run, firm can’t change Nominal wage so that increase household income of workers individual. With Increase in earning, workers can increase their spending. In short run, individual customer is in better off. Whereas In long run, when wage rate goes down consumer get less income that means their demand goes down and they cannot spend as much money as they did before and hence showing signs of belt tightening.

References: McTaggart, Findlay and Parkin. Economics 4th edition 2006 Japanese monetary policy: 1998-2005 and beyond, Takatoshi Ito, BIS Papers No 31. Retrieved on 26th September 2008. Exchange rate Yen to USD, reviewed on 5th Oct 08 http://finance.yahoo.com/echarts? s=USDJPY=X#chart12:symbol=usdjpy=x;range=19990101,20081003;indicator=volume;charttype=line;c rosshair=on;ohlcvalues=0;logscale=off

Appendix- I

Above diagram highlight GDP growth rate of Japan for last decade to 2005 for each and every quarter, as we can see moderate growth since 1994 which comes to highest point in 2000 and then it declines in subsequent years.

Appendix II

This is diagram stating inflation rate for Japan from 1995 onwards 2005, as clearly shows that there was positive inflation rate in 1995, which comes to its peak level in 1997 about 2.5%, then it shows negative inflation rate which is below 0% from last one decade to 2005.

Appendix III

Appendix IV

For more Notes, Presentations, Project Reports visit a2zmba.blogspot.com hrmba.blogspot.com mbafin.blogspot.com