Author: Israel Lutalo
The Short-run Economic Policies Adopted by Japan During the Global Financial Crisis
Given Japans past experiences with economic shock, namely the Lost Decade1 many economists and financial experts have compared Japan’s lost decade to the 2008 GFC. Some key lessons Japan took away from the Lost Decade include acting quickly to stem the crisis before it gets out of hand, not overspending, counteracting demographics and taking on too much debt. Despite being better protected in their financial sector in 2008, Japan was still hit quite hard mainly due to their heavy dependence on external demand. This report aims to identify and evaluate Japan’s economic climate, fiscal policy initiatives and monetary actions during the 2008 Global Financial Crisis (GFC).
Fuelled by a meltdown in the U.S. housing market, what was first dubbed the ‘Sub-Prime Crisis2’, and now referred to as the ‘Global Financial Crisis3 (GFC)’, was a period characterized by a modest downturn in the level of economic activity in the world markets. With the timing and scale of events varying from country to country, many financial systems around the world were vulnerable during this period in time. The GFC began in late 2008 when the U.S Government refused to bailout Lehman Brothers4, forcing the Investment Bank to file for Bankruptcy. This event led the market to believe that all banks were at risk and ultimately forced Western Governments to inject vast sums of money into the economy as to prevent a potential domino effect. Following the events that led to the GFC, the Bank of Japan published in its Outlook for Economic Activity and Price (April 2009), ‘economic conditions around the world have deteriorated simultaneously and sharply since the autumn of 2008 with the intensification of the turmoil in the U.S and European financial systems and in global financial markets’. The basis of this report aims to identify and evaluate Japan’s economic climate, fiscal policy initiatives and monetary actions during the crisis. In breaking down the analysis, we will first set the stage by covering an overview of economic growth, inflation, and unemployment prior and shortly after the GFC. Following this, we will evaluate the effectiveness, (or lack of) Japan’s fiscal policy as a tool to combat the crisis. Similarly, the effectiveness (or lack of) Japan’s monetary policy actions will also be taken into account. This report concludes with a short summary of the key topics and highlights discussed in this paper and adds commentary on what could have been done differently.
Part I: Economic Climate – Growth
In this section we aim to identify and evaluate Japan’s economic climate by characterising economic growth, inflation, and unemployment numbers. These tools will be utilised to analyse the state of the economy and provide insights as to how the business cycle evolves over time. Economic growth is generally reflected as an increase in a country’s real Gross Domestic Product (GDP) per captia. The significance of maintaining economic growth lies in its contribution to national prosperity. Growth in in terms of real GDP is desirable as it enables a community to consume more goods and services, whilst also contributing to the provision of a greater quantity of social goods, (e.g. Public Schools, Public Hospitals, National Defence, etc.) in an economy. In the short-run, economic growth is defined as a period in time in which prices do not adjust in response to either a recessionary or an expansionary output gap. This can be represented by Okun’s Law5, which defines the output gap in an economy as the difference between actual (or measured) level of real GDP and a measure of potential output:
Intuitively, the output gap can be conceptualised as the utilisation rate of the economy. An actual output, > potential output, is representative of an expansionary gap, whilst the inverse also holds true for a deflationary gap. In this environment, fluctuations in aggregate demand is the primary force driving output to either being above or below its potential level. This is a fundamental prediction of the basic Keynesian model, (B. Bernanke et.al, 2009). Between the period of 1999-08′ the Japanese economy experienced a steady expansion as the business cycle matured. The following charts illustrate this point:
(Data retrieved from FRED, Federal Reserve Bank of St. Louis6)
It can be observed that Japan experienced an annualised real GDP growth rate of 0.30 percent, over a nine-year expansionary stretch7. Real GDP peaked at 507767.5 Billion JPY8 on 1st January 2008, followed by a minor contraction at the end of Q1 08′. (Otto. G, 2017) states that ‘a technical recession is defined by the simple rule of at least two consecutive quarters of negative growth in real GDP.” As per the chart depicting real GDP growth, this would infer that the recession began in Q1 08’. Having said this, it should also be mentioned that in periods Q1 07′ & Q2 07′ both quarters measured negative growth9. Hence, this is why we must always use technical analysis in conjunction with more complex methods whenever possible.
Part I: Economic Climate – Employment
As Japan is a member of the OEDC10, the working age population is defined as those aged between
15-64, usually recide in Japan and are not members of the Japanese Army. Members of the working age population are divided into two groups, currently employed and currently unemployed but actively seeking work. We can state the labour force definitions using the equation (Otto G, 2017).
Where LF is the labour force;
L is the number of people employed; and
U is the number of people unemployed.
Participation rate is then calculated by dividing labour force by participation rate; and
Unemployment rate is calculated by dividing unemployed by labour force.
Cyclical unemployment is the overall unemployment that relates to the business cycle of an economy. It refers to the extra unemployment that occurs during periods of economic contraction and recessions. The natural rate of unemployment, is largely unaffected by short-term fluctuations in real GDP as it is measured as the sum of frictional and stractural rates. Therefore, the natural rate of employment is reltated to some key structural features of the economy; for frictional unemployment, this is the efficiency with which the labour market facilitates the process of people searching for the right job. For structural employment, it is the way available jobs are distributed in the economy relative to the talents and aspitations of the workforce. Referring back to Okun’s law, cyclical unemployment can be described as the difference between real GDP and potential GDP. During a period of continuous growth in real GDP, real (actual) GPD will be greater than potential GDP and will lead to a steady rise in employment levels. The following chart illustrates this point:
(Data retrieved from FRED, Federal Reserve Bank of St. Louis11)
The recession began in Q1 2008; however, it can be seen that Japanese employment numbers had already been tapering since mid 2007.
Part I: Economic Climate – Inflation
Inflation is simply the tendency for all goods to increase in price, relative to a period in time. The Consumer Price Index, (CPI) is used to calculate the aggregate price level in an economy. Specifically, the CPI measures the cost of a basket of goods and services at a certain period in time, relative to the cost of the same basket of goods and services in a base, (fixed) year. ‘Policy makers are interested in measuring the overall cost of living for households and how that changes over time’, therefore the basket of goods and services must accurately reflect the average consumption pattern for various households, (Otto. G, 2017). The CPI in any given year is computed using this formula:
The rate of inflation is simply the percentage change in CPI:
This chart illustrates how inflation varies during different business cycles:
(Data retrieved from FRED, Federal Reserve Bank of St. Louis12)
It can be seen that inflation rises with expansion, as aggregate demand increases. The opposite case can also be made for a recessionary period, as more people save, aggregate demand drops. Therefore, in linking inflation back to Okun’s Law, we see that when cyclical unemployment increases, the output gap will also increase. An output gap is undesirable by policy makers because it reduces the total economic pie and is insufficient. In a contractionary gap, capital labour resources are not fully utilised and in expansionary gaps there is relatively higher rate of inflation.
Part II: Fiscal policy actions
Discretionary fiscal policies are polices specifically planned and executed by the government to either increase or reduce planned spending, depending on whether the output gap is an expansionary or contractionary gap. Varying the level of government spending or varying the tax rates can achieve this. Automatic stabilisers on the other hand refer to the tendency for a system of taxes and transfers which are related to the level of income to automatically reduce the size of GDP fluctuations, for example, when GDP declines, income tax fall and unemployment and welfare benefits rise, without action by government. There are three main limitation on the ability of fiscal policy to stabilise the economy:
· Supply-side (affects potential output as well as PAE, undesirable long-run effects);
· Problem of deficits; and l
· Lack of flexibility.
o Discretionary fiscal policy (deliberate change in government spending, transfer payments or tax rates;
o Automatic stabilisers (taxes and transfer payments respond automatically to output gaps; when GDP declines, income tax collections fall because HH taxable income falls)
Part III: Monetary policy actions
An economy with a recessionary output gap would experience a falling rate in inflation as competing firms try to boost their sales. In response, the Bank of Japan reduced real interest rates in succession, encouraging more spending in the economy and this continues until potential output is gained. This chart illustrates what the Bank of Japan did post-GFC:
(Data retrieved from FRED, Federal Reserve Bank of St. Louis13)
In response to the recessionary climate, the BoJ begins lowing the economy’s real interest rate, as to encourage consumer spending. As illustrated from the chart above, Japan’s real interest is drops to an all-time low of -0.24 percent in terms. The effect of this monetary action
In conclusion, this report aimed to identify and evaluate Japan’s economic climate, fiscal policy initiatives and monetary actions during the global financial crisis. In breaking down the analysis into three separate bodies, covering economic growth, inflation, and unemployment evaluating the effectiveness, (or lack of) Japan’s fiscal policy as a tool to combat the crisis and evaluating the effectiveness (or lack of) Japan’s monetary policy actions we were able to draw insights into what challenges government and central banks faced. Even though the exogenous forces following the GFC were not as impactful on the Japanese economy, as compared to Europe, it’s worth noting that the solicited responses taken by Central Banks and Government bodies all around the world look strikingly similar. Developed nations such as Japan, were able to utilise large fiscal stimulus packages, capital injections, reduced interest rates, and conduct monetary easing.
1 J. Kuepper, 2017;
2 Investopedia, 2018;
3 Investopedia, 2018;
4 Investopedia 2017.
5 Otto G, 2017, ‘Introduction to Macroeconomics 1st Edition’;
6 Source: JP. Cabinet Office ; Release: National Accounts of Japan ;
7 Orange Area (refer to chart);
8 Billions of Chained 2011 Japanese Yen;
9 -0.08% and -0.31%, respectively.
10 Organisation for Economic Co-operation and Development;
11 Source: Organization for Economic Co-operation and Development ; Release: Main Economic Indicators .
12 Source: World Bank ; Release: World Development Indicators ;
13 Source: Organization for Economic Co-operation and Development ; Release: Main Economic Indicators