Japan AD (C, I and G). As seen

Japan has been experiencing a fall in consumer prices for the past years ever since the 1990’s, falling 0,5% alone in the month of July (2016). A sustained decrease in consumer prices is also known as deflation.


During deflation consumers delay their purchases, as they expect future prices to decrease. This means increased saving and decreased consumption. Consumption spending (C) is a component of Aggregate Demand (AD= C+I+G+(X-M)) and refers to the total expenditure of households on goods and services. Firms are forced to lower prices in order to attract buyers, decreasing their retained profits. Investment spending (I), is the spending done by firms and businesses on capital goods. By lowering prices firms are forced to cut costs, which results in the lowering of wages and the layoff of workers. Hereby we have a self-propagating system, where decreased consumer spending leads to decreased investment, which then again leads to lower discretionary income and lower consumer spending.


                 Diagram to show the effect of expansionary demand-side policies

In theory, the Keynesian school of thought would say that this ‘deflationary spiral’ could be solved by increased AD. This can be achieved by increasing any of the components of AD. By using a demand-side policy such as expansionary fiscal or expansionary monetary policy, there should be an increase in AD. Examples of expansionary fiscal policy would be increasing government spending and lowering taxes. By lowering income tax and business tax, both consumers and firms are left with higher discretionary income and higher retained profits. This should then incentivise both consumption and investment spending. Examples of expansionary monetary policy would be lowering interest rates and changing the money supply. By lowering interest rates, it becomes cheaper for both consumers and firms to borrow money from banks and less profitable to save money, as the return on savings is lower. This should also incentivise spending and discourage saving.  When combining both expansionary fiscal and monetary policy there should be an increase in all three components of AD (C, I and G). As seen on the diagram, AD1 would increase to AD2, causing both an increase in the price level (p1 to p2) and real output of the economy (y1 to y2), closing the recessionary gap.


This is exactly what Japanese prime minister Shinzo Abe has been attempting to do, running a “28 trillion-yen annual bond buying programme to spur growth”. However, this attempt to lift the Japanese economy out of deflation has not worked so far, as consumer prices have kept decreasing.” The unwillingness among the Japanese consumers and businesses to spend the country out of stagnation..” is what has stopped Shinzo Abe’s demand-side policies from working. Not only do consumers expect prices to go down but the real value of outstanding debt such as mortgages increases. This means that indebted consumers become hesitant to make purchases and indebted firms hesitate to make investments, leading to a further decrease in AD. It follows that some of the households and firms won’t be able to pay back their debt to commercial banks. As these ‘bad’ loans accumulate the risk of a banking crisis and even worse repercussions for the real economy increase. Furthermore, interest rates cannot be decreased past the 0% interest rate barrier, meaning that monetary policy can only be used in the short run and will falter in the long run. Expansionary fiscal policy is weakened due to the decreased confidence both consumers and firms have in the economy.


Usually, deflation can be corrected by the increase in AD that arises from more competitive exports. As Japan suffers from deflation, their products become relatively cheap to produce and would, therefore, increase in competitiveness. However, the yen’s “recent rise against the greenback and other major currencies” means that Japan’s export industry has also suffered from less competitive exports.

By running such huge fiscal stimuli, the government is creating a large budget deficit which cannot be maintained in the long term. A potential solution could be for the government to print dated vouchers instead of money, which would expire unless spent within a certain time. This would force consumers and business to spend their rather than save. The only option that Japan has is to somehow convince the public that interest rates will rise, and restore economic stability to encourage consumption and investment spending.