Japan's contractionary monetary policy

The Japanese Central Bank - Bank of Japan has increased its baseinterest rate for the first time in 17 years in an attempt to tighten monetary policy (contractionary monetary policy). The rate has increased from -0.1% to a range of 0% to 0.1%. Japan's central bank has made this decision in response to rising wages and prices in Japan which have raised concerns about its inflation rate which is currently 2.80%, compared to 2.20% last month.

The Bank of Japan cut its base rate below zero in 2016 to try and increase the country’s economic growth rate after a long period of slow economic growth and periods of deflation.

Negative base rates are unusual but some country’s central banks along with Japan’s have adopted this approach including Switzerland, Sweden and Denmark. When a central bank sets a negative base rate it means the country’s commercial banks have to pay interest on deposits they have at the central bank. On a day-to-day basis commercial banks deposit and withdraw funds from the central bank.

When the Bank of Japan’s rates were -0.1% Japan’s commercial banks would pay this on the deposits they had with the bank and base rates are 0-1% the commercial banks will receive interest on their deposits with the Bank of Japan. When there are negative rates people have to pay to deposit money in a bank. They have been used by several countries as a way of encouraging people to spend their money rather than putting it in a bank.

The base rates set by a country’s central bank influence the rates of interest on borrowing and lending set throughout the economy. When the Bank of Japan cut interest rates to -0.1% Japan’s commercial had to pay interest to keep their funds with the central bank so the commercial banks kept as little funds as they could at the Bank of Japan and increased their lending. The commercial banks did not set negative interest rates themselves but they did set very low lending rates to their borrowers and savers. By using this approach, the Bank of Japan hoped low-interest rates in the economy would increase household and business borrowing to stimulate consumption and investment to increase aggregate demand and Japan’s economic growth.

The announcement by the Bank of Japan to increase the base interest rate should have the reverse effect of negative rates with commercial banks now passing their higher borrowing cost at the Bank of Japan to the country’s households and businesses which should reduce aggregate demand and inflation.

Some possible questions to discuss with a class

1. What is a base interest rate?

2. What is the role of the Bank of Japan?

3. How does a rise in base interest rates decrease aggregate demand?

4. Is contractionary monetary policy the best way to reduce inflation?