Quality changes that are not fully captured in price

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Unformatted text preview: ot fully captured in price measurement, in either the CPI or GDP deflator, would create an upward bias.8 That explains part of the deviation. However, the reason for the widening of the bias is not immediately clear. It is also puzzling that even the directions of changes from 1998 to 2003 are different. For example, from 2000 to 2002, CPI deflation worsened, while GDP deflation moderated; and from 2002 to 2003, CPI deflation disappeared, while GDP deflation worsened. At the time of writing, the CPI is showing about zero inflation, while the GDP deflator is indicating 2 to 3 per cent deflation. Whether this magnitude of deflation is a serious problem is debatable; Bank of Japan economists tend to take the optimistic view. Moreover, in 1999 and 2000 many Board members, including Governor Hayami, strongly argued that a decline in prices due to technological innovation, such as in computers, and cheap imports, 7. Since 1994:Q1 to the present, the change in the GDP deflator was continuously negative, except for the period from 1997:Q2 to 1998:Q1. This period was possibly influenced by the increase in the VAT rate from 3 per cent to 5 per cent. Theoretically, the GDP deflator should not be affected by the VAT, but the numbers are suspiciously higher for one year. An adjustment for the VAT tax increase is made in the following analysis. 8. Shiratsuka (1999) estimated the bias in the Japanese CPI to be 0.9 per cent. Inflation Targeting and Japan: Why has the Bank of Japan not Adopted Inflation Targeting? 225 Figure 1: Inflation Rates in Japan % 3 2 CPI 1 0 -1 -2 GDP deflator -3 -4 -3 -4 1 0 -1 -2 % 3 2 1984 1988 1992 1996 2000 2004 Notes: Adjustments are made to the original series in order to remove the effects of value-added tax (VAT) rate increases. A 3 per cent VAT rate on all goods and services was introduced in April 1989, alongside the abolition of many excise taxes. Some very small businesses were exempted from charging the tax. The tax rate was increased from 3 per cent to 5 per cent in April 1997. Adjustments are as follows: for 1989:Q21990:Q1, 1.3 per cent and 1.4 per cent are deducted from the CPI and the GDP deflator, respectively; for 1997:Q21998:Q1, 1.5 and 1.3 per cent are deducted from the CPI and the GDP deflator, respectively, to offset the VAT increase. is good deflation and is not a concern for policy-makers.9 However, as the duration of deflation increases, the decline in prices becomes large, and this has an impact on the real side of the economy. The impact of technological advancement and cheap imports on the price level raises the question of whether deflation occurred due to supply-side factors (that is, the aggregate supply curve shifted right) or to demandside factors (that is, the aggregate demand curve shifted left).10 Since technological innovation and cheap imports from China are global phenomena, and not just Japan-specific phenomena, it would be incorrect to think 9. Though it is true that prices of a number of products have been declining, this is against the backdrop of various revolutionary changes including the so-called IT revolution, that is, the progress of technological innovation in information and telecommunications, as well as the revolution in distribution networks represented by the emergence of so-called "category killers". Such phenomena cannot necessarily be regarded as pernicious price declines (Hayami 2000a). 10. Hayashi and Prescott (2002) argued that the economic stagnation of Japan in the 1990s was largely due to the slowdown in productivity growth, resulting from a reduction in the working week and other supply-side factors, such as capital deepening, which resulted in low returns to capital. The basic methodology assumes that actual GDP was tracing potential GDP most of the time, a tradition of real business cycle theory. This view sharply contrasts with the dominant view that aggregate demand growth was far less than potential, although estimates of the GDP gap vary from one researcher to another. See McKibbin (2001) for a simulation analysis which shows that inflation targeting would be beneficial for the Japanese economy. 226 Takatoshi Ito that this is a major reason for the Japanese deflation. In the case of the US, where the new economy (high growth, low unemployment and stable prices) was observed, it could be argued that the supply-side effects, namely productivity increases, made possible an output expansion without accelerating inflation. It should also be noted that computers and other ICT-related products and services, and imports from China, are only a small fraction of consumer prices. The gross import-to-GDP ratio is around 10 per cent in Japan and the Chinese share in imports is about 20 per cent. So, the direct impact of China on GDP should be about 2 per cent. Even if the import prices from China dropped by a large margin, the direct impact would be limited. However, those who emphasise the impact from China argue that indirect effects on Japanese-made products are important. Many Japanese goods, including...
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This note was uploaded on 05/12/2010 for the course COMMERCE finc at University of Sydney.

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