Imf working Paper

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WP/03/215 
Understanding the Costs of Deflation in 
the Japanese Context 
Taimur Baig 

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© 2003 International Monetary Fund 
WP/03/215
IMF Working Paper 
Asia and Pacific Department 
Understanding the Costs of Deflation in the Japanese Context 
Prepared by Taimur Baig
1
Authorized for distribution by Saul Lizondo 
November 2003 
Abstract
The views expressed in this Working Paper are those of the author and do not necessarily 
represent those of the IMF or IMF policy. Working Papers describe research in progress by the 
author(s) and are published to elicit comments and to further debate.
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. It is seen that 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. 
JEL Classification Numbers: D31, E31, E52, G10, J39 
Keywords: Deflation, Monetary Policy, Wage Rigidity, Financial Sector 
Author
’
s E-Mail Address: 
[e-mail]
1
The author would like to thank David Burton, Dora Iakova, Kenneth Kang, 
Manmohan Kumar, Takuo Komori, Charlie Kramer, Saul Lizondo, and seminar participants 
at the Office of Asia and Pacific, Tokyo, in May 2003, for valuable comments and insights, 
as well as Janice Lee for outstanding research assistance. 

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Contents Page 
I. Introduction..............................................................................................................3 
II.
Conceptual Issues.....................................................................................................5 
III. 
Development of Deflation in Japan .........................................................................9 
IV. 
Costs of Deflation ..................................................................................................13 
V. Conclusion .............................................................................................................20 
References..........................................................................................................................25 
Figures 
1. Price 
Developments.............. ...................................................................................4 
2. Real 
Interest 
Rate and Output Gap ..........................................................................6 
3. Price 
Dynamics.......................................................................................................11 
4. One 
Step-ahead 
Forecast Errors, 1980-89..............................................................12 
5. One 
Step-ahead 
Forecast Errors, 1990-2003..........................................................12 
6. 
Actual and Taylor Rule-Based Interest Rates.........................................................14 
7. 
Impact of the Zero Bound on Real Output..............................................................15 
8. Real 
Wage 
Developments.......................................................................................16 
9. Unemployment........................................................................................................16 
10. Interest 
Rates...........................................................................................................17 
11. 
Average Open Interest Positions.............................................................................18 
12. 
CPI and its Components..........................................................................................21 

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