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Explaining Low Japanese Interest Rates In the 1990s and early 2000s Japanese interest rates became the lowest in the world Indeed in November 1998 an extraordinary event occurred Interest rates

Explaining Low Japanese Interest Rates

In the 1990s and early 2000s, Japanese interest rates became the lowest in the world. Indeed, in November 1998, an extraordinary event occurred: Interest rates on Japanese six-month Treasury bills turned slightly negative (see Chapter 3). Why did Japanese rates drop to such low levels? In the late 1990s and early 2000s, Japan experienced a prolonged recession, which was accompanied by deflation, a negative inflation rate. Using these facts, analysis similar to that used in the preceding application explains the low Japanese interest rates. Negative inflation caused the demand for bonds to rise because the expected return on real assets fell, thereby raising the relative expected return on bonds and in turn causing the demand curve to shift to the right. The negative inflation also raised the real interest rate and therefore the real cost of borrowing for any given nominal rate, thereby causing the supply of bonds to contract and the supply curve to shift to the left. The outcome was then exactly the opposite of that graphed in Figure 4.4: The rightward shift of the demand curve and leftward shift of the supply curve led to a rise in the bond price and a fall in interest rates. The business cycle contraction and the resulting lack of profitable investment opportunities in Japan also led to lower interest rates, by decreasing the supply of bonds and shifting the supply curve to the left. Although the demand curve also would shift to the left because wealth decreased during the business cycle contraction, we have seen in the preceding application that the demand curve would shift less than the supply curve. Thus, the bond price rose and interest rates fell (the opposite outcome to that in Figure 4.6). Usually, we think that low interest rates are a good thing, because they make it cheap to borrow. But the Japanese example shows that just as there is a fallacy in the adage, “You can never be too rich or too thin” (maybe you can’t be too rich, but you can certainly be too thin and do damage to your health), there is a fallacy in always thinking that lower interest rates are better. In Japan, the low and even negative interest rates were a sign that the Japanese economy was in real trouble, with falling prices and a contracting economy. Only when the Japanese economy returns to health will interest rates rise back to more normal levels.

Jun 18 2020 View more View Less

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