Abhishek Sen Economics HL April 18, 2013

Fiscal Policy Commentary

In Saranya Kapur article, Japans New Fiscal Policy Explained and Why It Matters, she explores Japans bold new fiscal and monetary measures to push up inflation and its GDP. In times of debt and recession, these measures can result in either solving the debt crisis or a meltdown of the economy. The Bank of Japan recently elevated its assessment of the economy, a first in eight months, on the back of daring monetary actions implemented by the new Japanese Prime Minister, Shinzo Abe, in order to fuel the Japanese economy, comprising of an open-ended assurance by the Bank of Japan to buy assets and drive inflation up to 2 percent, while concurrently increasing fiscal spending. However, once the financial crisis along with the European crisis hit, all advances were nullified. As an extremely export dependent economy, Japan was doubly affected by the disaster. Markets in the US and Europe started to disappear, where demand for its products weakened. Furthermore, the yens prominence as a safe haven currency, one that fortifies through financial recessions because of the rise in precariousness of former assets, resulted in its appreciation. These factors combined caused a drop in real GDP growth and intensified the lingering price deflation that Japan continuously struggles with. One of the fiscal measures taken by the government of Japan was to raise fiscal spending. This means that there is an increase in government spending immediately increasing the GDP of the country, despite adding to its astronomical debt. Figure 1 shows a right shift in the AD curve as government spending is a component of Aggregate Demand. This is an effective method to raise real GDP in the short run because of the added advantages of the economic multiplier. This means that the amount by which the government will increase its spending, will be multiplied by a factor of 1/(1 Marginal Propensity to Consume), with the multiplied value being put into the economy. One of the goals of the Japanese government is to increase the inflation rate. By increasing government spending, the AD shifts right and prices rise. The Phillips curve then, is proof that the increase in prices results in a higher

Figure 1

Figure 2

Abhishek Sen Economics HL April 18, 2013

inflation rate, as the government is trying to achieve. The rightward shift in AD would move the economy left along the Phillips Curve, as shown in Figure 2, increasing inflation and reducing unemployment in the short term. In the long term, however, this would push up inflation too far and consumers would hold off buying products while waiting for their wages to rise with inflation. Whereas the nominal wages would rise along with inflation, in the short term, the sticky wage theory would prevent real wages from rising, causing an eventual decrease in consumption, moving the AD curve leftward and nullifying the effect of the increased government spending. One of the biggest issues with the new fiscal measures in the increase in debt it will cause to the Japanese government. While the fiscal initiatives taken by Japan are appropriate to their situation, it is complicated by Japans extraordinary levels of public debit. This is currently at nearly 300% of GDP. The monetary and fiscal assistance projected from Abe, will undoubtedly inflate Japans astonishing debt. However, Japan may be implement their policy successfully as its debt is nearly exclusively held internally. This means that interest expenses on independent debit is generally repaid into the Japanese economy, and the country can, as a result, utilize tax income to pay interest on it. While Japan has traditionally consistently had more exports than imports, the yen economic strength could be its downfall and reduce Japans exports. Japans part as a creditor to the world guarantees a persistent demand for the yen, which force its value up. The government, however, is relentlessly trying to drive the worth of the yen down to make Japans economy dependent exports more competitive exports in the international market. The audacious actions of Japans new prime minister has ensured that action will be implemented in the Japanese economy. Their measure could prove highly successful, and backfire with irrefutable consequences. The first reactions to these measures however, are positive from the markets. The pronouncement resulted in a 17-month low on Japanese corporate bond risk, as well as Japanese stocks rallying due to the news. In the long-run, the best possible scenario would be Japans venture being effective while the worst case would be a meltdown la Greece, which would likely bring most of the world down with it.