Negative Rates, Positive Hopes? Japan’s Monetary Dilemma
By Gaargi Jamkar
Sexiest 8:10 ex-member
Estimated Reading Time: 5 min
What are the first few things that pop up in your mind when I say the word ‘Japan’?
Anime? Cherry Blossoms? Kawaii? Ramen? Jiggly cheesecakes?
Does the phrase ‘Unconventional Monetary Policy’ ring a bell……?
For a period of eight years from 2016 to 2024, Japan’s central bank (Bank of Japan) fixed the country’s interest rate at a shocking -0.1%. While Japan was not one of the first countries to adopt this policy, its case remains unique due to the factors that led the central bank to adopt this stance.
Historically, Japan’s inflation rate had fluctuated between 0% and 1.5% (World Bank Group, 2024), and many economists viewed this as an obstacle to growth. Thus, in 2013, the Bank of Japan (BOJ) introduced a new inflation target of 2% that would ideally combat deflationary pressures and anchor sustainable economic growth.
(YOY Japan Inflation rate, Data Source: World Bank Group 2024)
The first few quarters of 2014 saw progress with the inflation rate rising steadily to 2%. However, in early 2015, global oil prices dropped drastically. The cost of a barrel of oil in 2014 was around $110 per barrel, which then plummeted to $50 per barrel in 2015 ( Prest, 2018). The logical next step would be to question why global oil prices were relevant to Japan’s monetary policy. Since the Fukushima disaster in 2011, Japan has reduced its dependence on nuclear power as a source of energy and has become the world’s third-largest importer of crude oil. In fact, 91.4% of the country’s energy requirements in 2016 were met by imported crude oil (Yoshino et al., 2017). Thus, the non-domestic variable of global crude oil prices became an instrumental factor that impacted Japan’s macroeconomic variables.
The fall in oil prices brought good news for the manufacturers in Japan. Producers had the scope to make higher profits due to the fall in input prices. Thus, there was a rightward shift in the country’s Aggregate Supply (AS) curve (refer to the graph below). By the same logic, it became cheaper to consume products that used crude oil as an intermediate good and other derivatives. Hence, the Aggregate Demand (AD) curve also experienced a shift to the right. However, it is important to note that the magnitude of the shifts of both curves was not the same. The AS curve shifted more than the AD curve. This was primarily because of two reasons. The first being Japan’s ageing population. A higher percentage of the country’s population was composed of senior citizens who were unable to stimulate the aggregate demand by a huge extent (Mathieu, 2024). Secondly, the automobile industry had designed more efficient engines over time that had reduced the consumption of petrol by individuals using private vehicles (International Energy Agency, 2021).
(AD AS shifts, Source: Yoshino et al., 2017)
Therefore, the macroeconomic variables: consumption and investment, did not improve, and the economy was unable to attain its inflation target of 2%. In 2016, the situation worsened with oil prices declining to $30 a barrel. The Bank of Japan saw this event as a warning sign, and given the past dynamics of the AD and AS shifts, it was imperative to shield the country from an economic downturn.
Thus, the central bank introduced the Negative Interest Rate Policy (NIRP) in January 2016, pegging the interest rate at -0.1% to encourage spending and improve aggregate demand. This would also result in banks reducing their holdings and loaning more funds to the public, which would in turn strengthen capital formation and investment. This policy was also accompanied by an aggressive monetary policy easing by the central bank. This involved the Bank of Japan purchasing most of the long-term government bonds that were available in the market. The goal of these open market operations was to inject liquidity into the Japanese economy and boost the country’s economic growth and GDP.
The implementation of this program had varied results. The YOY inflation rate, which was negative in 2016, recovered to almost 0.5% in the next year, showing signs of improvement. However, the open market operations failed in increasing the country’s gross product. Japan’s economy exhibited a peculiarity in the form of a vertical Investment-Savings (IS) curve. This meant that the investment and savings level in the country was unresponsive to the changes in interest rates. The monetary stimulus provided by the central bank from the purchase of government bonds was rendered futile as well. This move caused a rightward shift in the Liquidity-Money (LM) curve, but the vertical IS ensured that the GDP did not change. Thus, the negative interest rate and quantitative easing policy were unable to propel Japan’s economy towards higher levels of consumption, investment, and ultimately GDP.
(IS-LM of Japan, Source: Yoshino et al., 2017)
The case of the vertical IS curve is particularly interesting as economic literature describes it as a hypothetical case rather than a realistic situation in any economy. This raises the question of why Japan had a vertical IS curve.
While there isn’t much literature that pinpoints the exact cause, many factors have been identified that potentially explain this phenomenon. Firstly, there is the argument that a sizable portion of Japan’s population being senior citizens has a negative impact on aggregate demand. The country has a shrinking labour force and the world’s highest old-age dependency ratio, which increases the economic burden on the working population (Mathieu, 2024). Many economists have also attributed the vertical IS curve to Japan’s conservative banking system that follows a ‘keiretsu’ structure. This system is steeped in traditions and results in banks making lending decisions based on legacy, trust, and historical relations with firms (Klim, 2021). This has led to a breakdown between interest rate, investments, and lending operations, which has rendered the IS curve vertical.
Finally, the economic downturn caused during the pandemic years acted as the policy’s final nail in the coffin. As a result, the NIRP was terminated in 2024 as it failed to meet expectations and stimulate the Japanese economy. This failure is a classic example of how economic literature isn’t directly reproducible in real life. While in theory, the negative interest rates should have strengthened Japan’s GDP, the central bank failed to account for the structural problems in the country’s economy, which prevented the same.
Another point to note is the fact that Japan’s IS curve is vertical. While formulating the policy and the objectives, the BOJ assumed the economy’s IS curve to be ‘normal’ and therefore downward sloping. In reality, this assumption did not hold true and proved to be detrimental to the policy’s failure. This brings up a more notorious topic about an economy’s IS and LM curves’ elasticity that define their shapes. Macroeconomic literature and analysis focuses on the canonical case of an upward-sloping LM and a downward-sloping IS curve. Many factors such as the political situation, geopolitical tensions, and country demographics are NOT considered while constructing these curves which does not translate correctly for policy applications. Therefore, it is crucial for any economy to calculate the elasticity of these curves with precision and accuracy for successful policy outcome. This can only be achieved by taking into account all the contributing factors and pushing beyond the scope of primitive text.
Having said that, it is important to note that policy making, and especially economic policy making, is a layered and complex task. The analysis done above and the limitations discussed of the negative interest rates was done in ‘hindsight’ (i.e after the policy was implemented). In the nascent stages of designing a policy it is difficult to identify factors and variables that can affect outcomes. In this case the BOJ didn’t account for the IS curve’s shape. Variables can also change over time and adversely affect policies. Thus it is very difficult to craft a policy that stands the test of time or is dynamically stable. Realistically, such a policy can only be made if you have the powers of Dr Strange and can see all the future possibilities and point to ‘the one’ solution (if that even exists).
References-
1) Feingold, S. (2024, March 26). Japan ends era of negative interest rates. A chief economist explains. World Economic Forum. https://www.weforum.org/stories/2024/03/japan-ends-negative-interest-rates-economy-monetary-policy/
2) Haba, S., Ito, Y., & Kasai, Y. (2025). The impact of negative interest rate policy on interest rate formation and lending (BOJ Working Paper Series No. 25-E-1). Bank of Japan. https://www.boj.or.jp/en/research/wps_rev/wps_2025/data/wp25e01.pdf
3) International Energy Agency. (n.d.). Fuel economy in Japan. https://www.iea.org/articles/fuel-economy-in-japan
4) Klim, S. (2021, May 24). A historical perspective on the Japanese keiretsu. Review of Banking & Financial Law. https://www.bu.edu/rbfl/2021/05/24/a-historical-perspective-on-the-japanese-keiretsu/
5) Mathieu, E. (2024). Japan has the highest ratio of elderly people relative to working-age people globally. Our World in Data. https://ourworldindata.org/data-insights/japan-has-the-highest-ratio-of-elderly-people-relative-to-working-age-people-globally
6) Prest, B. C. (2018). Peaking interest: How awareness drives the adoption of fuel-efficient vehicles. Energy Economics, 70, 500–510. https://www.sciencedirect.com/science/article/abs/pii/S0140988318302020
7) World Bank. (n.d.). Inflation, consumer prices (annual %) – Japan (FP.CPI.TOTL.ZG). https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG?locations=JP
8) Yoshino, N., Taghizadeh-Hesary, F., & Miyamoto, H. (2017). The effectiveness of monetary policy in Japan (ADBI Working Paper 652). Asian Development Bank Institute. https://www.adb.org/sites/default/files/publication/225371/adbi-wp652.pdf