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15. The Domestic and Global Impact of Japan’s Policies for Growth

Author(s):
Alessandro Zanello, and Daniel Citrin
Published Date:
November 2008
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Author(s)
Nicoletta Batini, Papa N’Diaye and Alessandro Rebucci 

Introduction

The analysis presented in this chapter illustrates the impact of fiscal and structural reforms on the Japanese and world economies. Japan faces a sizable fiscal deficit, against a backdrop of weak trend growth and growing imbalances in the world economy. Moreover, upward pressure on healthcare and social security spending owing to an aging population will add significantly to strains on public resources in the years ahead. In light of these issues, the Japanese authorities have undertaken a range of reforms aimed at raising productivity growth and stabilizing the public debt in relation to GDP over the medium term.

The analysis is based on an extended version of the IMF’s Global Economy Model (GEM), building on approaches employed by Bank of Japan and Cabinet Office officials. The GEM is the IMF’s new multi-country model of macroeconomic interdependence that allows a rigorous assessment of the global adjustment process toward a more balanced external equilibrium.1 The version used in the present analysis has five regions: Japan, the United States, emerging Asia, the euro area, and the rest of the world.

Simulation results indicate that fiscal adjustment and productivity-enhancing reforms could reduce substantially Japan’s fiscal imbalance with limited spillovers to the rest of the world. Faster productivity growth would help lower Japan’s debt and limit the tendency of fiscal consolidation to increase the external surplus. If even faster productivity gains could be achieved, Japan would make a further contribution to global rebalancing through a decline in its external surplus. The spillovers to the rest of the world appear to be modest, partly reflecting the size of the shocks and the diminished size of Japan in the world economy.

The rest of this chapter is organized as follows. A first section provides more details on the GEM and describes the approach followed; the following section reports and discusses the main results of the analysis. The main conclusion are summarized in closing.

The research strategy

The model

The GEM has a number of features that make it well-suited to investigate the domestic and international impact of Japan’s policies. Unlike traditional macromodels, the GEM combines new-Keynesian features, such as monopolistic competition and nominal rigidities, with international trade in goods and assets derived from specialization, preferences, and technology, thereby offering rich transmission mechanisms.2 For example, the home bias in consumption (i.e. a relative preference for the traded good produced at home) and the impact of changes in demand on the prices of nontradable goods create additional channels through which changes in the international pattern of current accounts affect real and nominal exchange rates. As a result, the dynamics of key variables in response to shocks might differ markedly both in sign and magnitude from what one would obtain in more traditional macromodels. In addition, these features of the model allow key macroeconomic outcomes (such as economic activity, the exchange rate, and financial asset positions) to depend on underlying structural parameters that are invariant to changes in macroeconomic policies, such as consumer preferences, technology, costs of adjustment of volumes and prices, and the degree of financial frictions. The model is thus robust to the Lucas critique and suitable for policy evaluation, a strength gained at the cost of considerable complexity in model building.

Macroeconomic policies are represented by simple rules and affect the economy through a variety of channels. Monetary policy follows a standard interest rate rule in which the monetary authority raises or lowers interest rates to stabilize inflation. Fiscal policy aims to achieve a long-run debt target through changes in taxes on labor and capital income. Among the economic effects of policies, changes in the government debt engender changes to the demand for long-run holdings of foreign assets, which affect consumers’ net worth, and hence output. Also, fiscal policy affects the economy through its impact on the interest rate premium, defined as the difference between the interest rate on yen-denominated assets and that on U.S.-denominated assets of comparable maturities. Specifically, the interest rate premium depends explicitly on the level of debt in relation to GDP, thus inducing a positive long-run effect of fiscal consolidation on output.

Both the steady state and the dynamics of the U.S. block are calibrated to the data. For the other blocks, the parameters governing the dynamics are similar to those used to calibrate the U.S. block, but adjusted for country-specific information. Steady-state equilibrium values of key ratios and variables match actual data (2003 trade flow and foreign asset data and other structural features). The steady-state level of the real exchange rate and current account are broadly consistent with the benchmarks derived from structural estimation of saving-investment norms.3 The calibration of the relationship between government debt and net foreign assets uses elasticities found in overlapping generations models employed at the IMF, such as the Global Fiscal Model (Botman and others, 2006; Kumhof and others, 2005) and MULTIMOD (Laxton and others, 1998).

Scenarios

The analysis compares a baseline and two alternative scenarios based on different assumptions for fiscal policy and productivity growth.4

  • In the baseline scenario, Japan’s total factor productivity growth remains low at 1.5 percent per year over the medium term (Figures 15.1 and 15.2).5 Fiscal deficit reduction proceeds at a pace of ½ percent of GDP per year over a ten-year period. The ratio of net general government debt to GDP rises to 150 percent over the medium term, from about 80 percent in 2004.

  • In the first alternative scenario (“structural and fiscal reforms”), productivity growth increases to 2 percent by 2010 (entailing a gradual increase of ½ percentage point between 2005 and 2010). Also, a supplementary adjustment in the primary deficit of a ¼ percentage point of GDP per year over a ten-year period is simulated, reducing the primary deficit by an additional 2½ percentage points relative to the baseline. The debt-to-GDP ratio stabilizes at around 110 percent over the medium term.

  • In the second alternative scenario (“larger structural reform payoffs”), an additional ½ percentage point increase in productivity growth is considered compared with the previous scenario (with a total gradual increase of 1 percentage point between 2005 and 2010). Fiscal deficit reduction proceeds at the same pace as in the baseline scenario.

Figure 15.1Productivity Growth—Baseline Scenario

(quarterly, in % at annual rates)

Source: IMF staff calculations.

Figure 15.2Productivity Growth—Alternative Scenario

(quarterly, in % at annual rates)

Source: IMF staff calculations.

Both the baseline and the alternative scenarios assume that the economy has emerged from the liquidity trap, deflation has ended, and the interest rate channel of monetary policy is fully effective. While this is not the current situation, this assumption is expected to apply in the medium term.

Results

The simulation results suggest that faster productivity growth would both facilitate the reduction of Japan’s fiscal imbalance and largely offset the adverse impact of fiscal consolidation on output growth and the external imbalance in the short run (Figures 15.3 and 15.4, and Table 15.1). Output growth declines about ¼ percentage point for only the first year, and thereafter follows the gradual increase in productivity growth. The current account surplus declines only about 0.1 percent of GDP initially and thereafter increases ½ percent of GDP (about US$25 billion). This amount is, however, small in comparison with global trade flows and global imbalances.

Figure 15.3Structural and Fiscal Reforms (Alternative Scenario 1)

(% deviation from baseline)

Figure 15.4Structural and Fiscal Reforms (Alternative Scenario 1)

(% deviation from baseline)
Table 15.1Effects of Structural and Fiscal Reforms(Alternative Scenario 1)
(% deviation from baseline)2005201020152020
Japan
Real GDP (level)-0.20.72.55.3
Current account (% of GDP)-0.10.80.70.6
Government debt ((% of GDP)-0.3-5.8-17.8-36.8
United States
Real GDP (level)0.00.00.00.1
Current account (% of GDP)0.0-0.2-0.2-0.2
Euro area
Real GDP (level)0.00.00.00.0
Current account (% of GDP)0.00.00.00.0
Emerging Asia
Real GDP (level)0.0-0.10.00.1
Current account (% of GDP)0.00.00.00.0
Rest of the world
Real GDP (level)0.00.00.00.0
Current account (% of GDP)0.00.00.00.0
Source: IMF staff estimates using GEM.
Source: IMF staff estimates using GEM.

In more detail:

  • The direct effect of faster productivity growth and fiscal adjustment lowers Japan’s government debt-to-GDP ratio by about 37 percentage points over 15 years.

  • The gradual increase in productivity growth lifts current and future factor returns, and hence stimulates investment and consumption through a wealth effect, despite the negative effect on domestic demand from increased taxes. Overall, the strengthening of demand raises imports and narrows the trade surplus. Given the small size of the productivity improvement, the decline in Japan’s external surplus is short-lived as it is dominated by the impact of fiscal consolidation in the medium term.

  • With only a gradual supply-side response in tandem with the phased-in increase in productivity, in the near term there is excess demand for both domestically and foreign produced goods, and domestic prices rise relative to foreign prices. This induces a temporary appreciation of the exchange rate, reinforcing the impact of higher domestic demand on external balances. Over the medium term, however, supply catches up with demand both from the gradual increase in capacity and the negative effect of fiscal consolidation on demand. Accordingly, domestic prices decline, leading to a depreciation of the exchange rate back toward the baseline that dampens the negative effects of higher demand on external balances.

  • Inflation is mainly driven by the changes in the exchange rate, as inflation falls initially and then rises subsequently. Rising inflationary pressure calls for a tighter monetary stance, which somewhat dampens the depreciation pressure on the exchange rate.

  • However, because debt declines in relation to GDP, the interest rate is lower than it would otherwise be given that higher debt places a premium on the interest rate. With less crowding out in the transition and a higher capital stock, this also implies that output is slightly higher than it would otherwise be.

  • Spillovers to the rest of the world are negligible in light of the size of the shocks.

Even faster productivity growth could contribute to a near-term reduction in Japan’s current account surplus, and hence help reduce global current account imbalances. A gradual one percentage point increase in Japan’s productivity growth would on impact reduce its trade and current account surpluses by about ½ percentage point of GDP (about US$25 billion) and ¾ percentage point of GDP (about US$35 billion), respectively (Figures 15.5 and 15.6, and Table 15.2).6

  • In this case, the current account surplus narrows more than with a smaller increase in productivity growth because the positive wealth effects stimulate investment and consumption to a larger extent. This decline in the current account balance is magnified by a larger appreciation of the exchange rate than under the previous scenario.

  • The rapid response of demand relative to supply puts upward pressure on inflation, calling for a tighter monetary stance and therefore higher interest rates, which reinforces the initial appreciation of the exchange rate.

Figure 15.5Larger Structural Reform Payoffs (Alternative Scenario 2)

(% deviation from baseline)

Figure 15.6Larger Structural Reform Payoffs (Alternative Scenario 2)

(% deviation from baseline)
Table 15.2Effects of Large Structural Reforms Payoffs(Alternative Scenario 2)
(% deviation from baseline)2005201020152020
Japan
Real GDP (level)0.03.17.814.6
Current account (% of GDP)-0.7-0.10.30.4
Government debt (% of GDP)0.1-4.3-11.0-22.6
United States
Real GDP (level)0.0-0.10.00.1
Current account (% of GDP)0.10.0-0.1-0.1
Euro area
Real GDP (level)0.00.00.10.1
Current account (% of GDP)0.00.00.00.0
Emerging Asia
Real GDP (level)0.20.10.10.2
Current account (% of GDP)0.10.00.00.0
Rest of the world
Real GDP (level)0.00.00.00.1
Current account (% of GDP)0.00.00.00.0
Source: IMF staff estimates using GEM.
Source: IMF staff estimates using GEM.

Under this second scenario, the spillovers to the rest of the world would be marginally larger (Figures 15.5 and 15.6):

  • In the United States, output growth is virtually unchanged as a temporary reduction in domestic demand is partly offset by an improvement in the trade balance. Domestic demand falls because investment is highly sensitive to interest rates, which rise to curb the inflationary effects of the initial depreciation of the U.S. dollar. However, this deterioration of domestic demand, along with the depreciation of the dollar, causes the U.S. trade deficit to decline. Together with positive valuation effects arising from the dollar depreciation, the decline in the trade deficit improves the U.S. net foreign assets (NFA) position in the short run.7

  • In the euro area, the transmission mechanism is similar to that in the United States, although the spillovers are very small in light of the region’s more limited trade linkages with Japan.

  • In emerging Asia, output growth picks up slightly in the short run, mainly due to an increase in both domestic and net external demand. Domestic demand improves mainly due to higher investment following a decline in real interest rates.8 The exchange rate—which is pegged to the U.S. dollar-depreciates, boosting export growth and slowing import growth. The improvement in the current account is limited and does not lead to a significant change in the NFA position in relation to GDP.

Conclusions

This chapter has presented an illustration of the possible response of the domestic and world economies to productivity-enhancing reforms and fiscal adjustment in Japan. There are three main conclusions:

  • Such a combination of actions would contribute to reducing Japan’s fiscal imbalance, without jeopardizing the economic recovery or exacerbating existing global external imbalances.

  • If the increase in productivity growth were more substantial, Japan’s internal balance would improve further, output growth would be stronger, and the external surplus would decline.

  • In both instances, however, the spillovers to the rest of the world appear modest, partly reflecting the size of the shocks and Japan’s limited share of the world economy.

The analysis presented here does not account for a possible disorderly U.S. dollar depreciation. It is not clear how the conclusions would be affected by such an event, which could be a useful area of future research. Indeed, to the extent that fiscal policy and structural reforms in Japan and elsewhere contribute to an orderly resolution of global imbalances, and thus help prevent disruptive adjustments in currency and capital markets, the economic payoffs of reforms could be higher than envisaged here.

References

    BatiniNicolettaCallenTim and WarwickMcKibbin2005The Global Implications of Demographic ChangeIMF Working Paper No. 06/9 (Washington, D.C.: IMF).

    BotmanDennisDouglasLaxtonDirkMuir and AndreiRomanov2006A New Open Economy Macromodel for Fiscal Policy EvaluationIMF Working Paper No. 6/45 (Washington, D.C.: IMF).

    FaruqeeHamid2004Euro Area Policies: Selected IssuesIMF Country Report No. 04/235 (Washington, D.C.: IMF).

    FaruqeeHamid and PeterIsard1998Exchange Rate Assessment: Extensions of the Macroeconomic Balance ApproachIMF Occasional Paper No. 167 (Washington, D.C.: IMF).

    FaruqeeHamidDirkMuirDouglasLaxton and PaoloPesenti2004The United States Current Account and Global Rebalancingpaper prepared for NBER volume on global current account imbalances.

    GhironiFabioTalan B.Işcan and AlessandroRebucci2005Net Foreign Asset Position and Consumption Dynamics in the International EconomyIMF Working Paper No. 05/82 (Washington, D.C.: IMF).

    KumhofK.DouglasLaxton and DirkMuir2005The Consequences of U.S. Fiscal Consolidation for the Current Accountunpublished manuscript.

    LaxtonDouglasPeterIsardHamidFaruqeeEswarPrasad and BartTurtelboom1998MULTIMOD Mark III The Core Dynamic and Steady-State ModelsIMF Occasional Paper No. 164 (Washington, D.C.: IMF).

    PesentiPaolo2008The Global Economy Model: Theoretical FrameworkIMF Staff Papers 5524384 (Washington, D.C.: IMF).

The April 2005 World Economic Outlook (WEO) essay on global current account imbalances (Chapter III) and the follow-up analysis in the September 2005 WEO provide examples of how the GEM can be used to analyze the global imbalances. These essays build on a sizable body of related work at the IMF, notably by Ghironi and others (2005), Faruqee (2004), Faruqee and others (2004), Batini and others (2005), and Kumhof and others (2005).

Pesenti (2008) describes the theoretical structure of the model. The version used here is also presented in Faruqee and others (2004).

See Faruqee and Isard (1998) for details.

The results are not particularly sensitive to the choice of the baseline, so paths for the baseline are not presented. A similar baseline is presented and discussed by Faruqee and others (2004). It assumes that there are pre-existing global external imbalances, in line with Chapter III in the April 2005 WEO.

In the long run, steady-state equilibrium requires that productivity grows at the same rate (assumed to be 2 percent) in every region.

In this scenario, fiscal consolidation is assumed to proceed at the same pace as in the baseline.

Some features of the medium- to long-term effects may result from the specific combination of shocks used to build the baseline scenario (e.g. the large reduction in the U.S. debt-to-GDP ratio that starts in 2009).

With monetary policy in emerging Asia assumed to continue to be geared toward maintaining the peg to the U.S. dollar, nominal domestic interest rates increase in tandem with U.S. rates, but the magnitude of the increase is not enough to offset the rise in inflation.

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