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Will ‘Abenomics’ Save the Japanese Economy?

Abenomics

アベノミクス: Abenomics in Japanese

PDF File: “Will ‘Abenomics’ Save the Japanese Economy?” by Kim Sang Keun

I. Introduction

Ever since Shinzo Abe came to power, the Japanese government led by LDP has vowed to revive the stagnant economy by implementing bold economic policies. In effort to overcome so-called ‘Lost Decades,’ which has deteriorated the ego of many Japanese people, Abe has announced three simple economic policies that earned the name ‘Abenomics’ after its proposer. This includes indefinite quantitative easing, flexible public finance policy and economic growth strategy.[8] In this paper, we will look at the economic logic behind the Abenomics and problems and risks associated with it.

II. Economic Logic Behind Abenomics

Through Abenomics, the Japanese government hopes to revive its economy by implementing bold, powerful economic policies that will pull its economy out of deflation, depreciate Japanese yen, and induce CPI inflation rate of 2% per year. The Japanese government saw the constant decline of overall price level by lack of aggregate demand as the main culprit of the long-term recession that its country was going through.[3] In order to ‘reflate’ its economy, Abenomics tries to implement quantitative easing, fiscal policy through expanding government spending, and provide economic growth strategy. We will first look at the quantitative easing and its economic theory behind what the Abenomics is trying to achieve.

For analyzing the economic theory of Abenomics, the Mundell-Fleming Model for a large open economy was used in this paper as the main model. The following are the IS-LM equations for the model:

IS: Y = C(Y-T) + I(r) + G + NX(e)

LM: M/P = L(r,Y)

Notice that the assumption of r = r* was dropped, which is an equation for a small economy that cannot influence the world interest rate. As Japan is the third largest economy in the world, the assumption that it has little influence on the world financial market had to be dropped. Therefore, the interest rate was treated as an endogenous variable. As a result, LM curve got a positive slope, instead of being vertical.

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First of all, the Bank of Japan is targeting a 2% CPI inflation rate and increasing the money supply circulating in the economy by buying various financial assets such as the government bond, which is essentially monetary expansion policy.[3] It could be said that this indefinite quantitative easing is the core of Abenomics. On the graph above, the increase in the money supply shifts the LM curve to the right, raising the income from Y1 to Y2, and lowering the real interest rate from r1 to r2. The decrease in the real interest rate then increases the net capital outflow as is illustrated on the second graph.

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As the net capital outflow increases from CF1 to CF2, the supply of Japanese yen in the market for foreign exchange increases. The exchange rate falls from e1 to e2, depreciating the Japanese yen. This makes the Japanese goods relatively cheaper to foreign goods and the net export rises from NX1 to NX2. There are two channels for this mechanism. First, as the monetary expansion lowers the interest rate, this stimulates the investment. Second, as the monetary policy causes the currency to depreciate in the market for foreign exchange, this stimulates net exports.

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All in all, the Abenomics tries to devaluate its allegedly over-appreciated yen and cause an inflation rate of 2% as the output increases. As a result, the Japanese yen has depreciated until the 103.42 (JPY/USD) recently on May 22nd. This is the lowest in almost 6 years, ever since the Global Financial Crisis that hit the economy around the world in 2007. This is shown in the exchange rate graph above.

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Secondly, the Japanese government is trying to initiate fiscal policy by expanding government expenditures. As the government implements fiscal expansionary policies the IS curve shifts to the right. As the graph above illustrates, this shift in the IS curve leads to an increase in the level of income from Y1 to Y2 and an increase in the interest rate from r1 to r2. The increase in the real interest rate reduces the net capital outflow from CF1 to CF2.

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As the net capital flow falls, the supply of Japanese yen in the market for foreign exchange falls. This induces the exchange rate to appreciate from e1 to e2, which decreases the net export from NX1 to NX2 as the Japanese goods become more expensive relative to foreign goods.

As the graph illustrates, the fiscal expansion by Abenomics will raise the income and output for the Japanese economy. However, it is to be pointed out that although implementing both the fiscal and monetary expansionary policies will increase the output of the Japanese economy, the effect on the exchange rate is conflicting. Yet, this problem is accounted for as the Japanese government will set its ‘desirable’ exchange rate, possibly above 100 JPY/USD, and fix it so that other variables can freely adjust, although it might compromise some of the output to some degree. Or if the Japanese government considers the increase in the economic output, and therefore the inflation rate, more important over the exchange rate, it might decide to compromise fixating the exchange rate to their ‘desired’ level for the economic growth.

Thirdly, on June 5th, the Japanese government announced the third policy for Abenomics, which includes economic growth strategy. The government announced plans for bringing up the financial integrity of Japan, however, there were no significant policies that were announced.

III. Problems and Risks Associated with Abenomics

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There is a rising skepticism towards whether Abenomics would really revitalize the Japanese economy as the exchange rate appreciated breaking the 100 JPY/USD boundary and as Nikkei Index crashed. Although, theoretically, Abenomics has a sound Keynesian background, many are pointing out the fact that it is too focused on the demand side of its economy, not on the supply side.

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Japanese Demography Data[11]

One of the fundamental problems that Japan is facing is its ageing population. As the population pyramid gets inverted, the labor population is shrinking every year. This brings about number of problems for the Japanese economy. First, the government commitment in spending on pensions, medical expenses and social security will continually act as a substantial burden to the already indebted country with a public debt of 240% its GDP.[11] This will further worsen the financial integrity of the Japanese government leading to an erosion of international confidence in Japanese economy. The lack of confidence can raise the risk premium (CDS) shifting the IS* curve to the left and LM* curve to the right, as θ increases for r = r* + θ. But, the exchange rate would depreciate more than what is desired by the Japanese economy, and it would force the Bank of Japan to decrease the money supply in order to bring up the yen value, shifting the LM* curve back to the left. This would aggravate the situation and lower the total income in the Japanese economy. This then would induce the interest rates to depress the prices of financial assets, which will then reduce the collateral being used as bank loans. As a result, this will lead to financial problems for Japan, further exacerbating the problems. Secondly, its dwindling workforce cannot sustain the economic output level that is maintained in the future.[11] As it is shown on the data, the demography will drastically change so that more young people will have to support for the older population, which implies that this change in demography is the main culprit for the last two decades of deflation and stagnant economic growth.[11] This has another implication to why the consumer demand might be falling behind.

In this sense, it could be said that Abenomics is failing to address the core problem of its economy. It must ask why consumer demand is inherently weak. Another major reason why the Japanese economy is stagnating is the poor productivity. This may sound strange to many people as Japan was once praised as technologically advanced country. However, according to the statistic, Japanese productivity lags badly behind world’s leading countries in many areas. For example, it lags 30% behind the U.S. in manufacturing with automobiles industry in exception.[9] Therefore, corporate reforms are needed in order to let inefficient firms downsize or die and be replaced to better ones.[9] In the case of Korea, as it suffered trough the so-called IMF Crisis in 1997, it underwent painstaking corporate reforms to let the inefficient firms die and raise the overall competitiveness of its economy. So it is doing relatively fine in terms of corporate competitiveness and financial integrity compared to Japan, although this is shaking a little due to Abenomics.

What is problematic right now is that the third policy for Abenomics lacks fundamental and specific content, which started to give erode out public confidence in Abenomics. As it was mentioned, this resulted in the crash of Nikkei Index and the re-appreciation of Japanese yen, breaking the 100 JPY/USD boundary. Shinzo Abe, afraid of losing the votes, has put aside the painstaking reforms to later, such as corporate tax cuts that will improve the productivity of Japanese firms. There was a discussion within the Japanese government in cutting the corporate taxes from 30% to 20% and to implement new policies that will make the labor market flexible.[5] However, flexible labor policy means temporary job losses[11], and it seems that Shinzo Abe is putting these essential reforms after the Japanese upper house elections. This could erode out confidence in Abenomics losing its force towards reviving the economy.

There is another risk associated with Abenomics. As the yen depreciates, net export increases as domestic products gets cheaper abroad, however, imports get more expensive. This is a big problem for Japan as ever since the Fukushima nuclear disaster, the word ‘energy crisis’ was lingering around the Japanese newspapers for two years. As Japanese public refused to use nuclear power, the Japanese government had to turn to more expensive imported energy, such as LPG, oil and naphtha, increasing the monthly value of Japanese energy imports from 1.4 trillion yen to 2.2 trillion yen.[12] This could deteriorate the competitiveness of Japanese companies, as energy prices go up. In addition, export accounts for only about 14% of its economy.[1] So the core of Abenomics should be in order to revive the domestic economy, not through export. The increase in energy prices could raise the domestic consumer prices without actually improving the income of the Japanese firms and consumers. Therefore, there is a risk towards Abenomics in that expensive energy imports will drag the Japanese economy into another lost decade.

IV. Conclusion

In conclusion, Abenomics is a sound Keynesian policy that could save the Japanese economy from deflation. The Mundell-Fleming Model was used to illustrate the economic theory behind Abenomics. However, there were considerable risks associated with Abenomics, such as the ageing population, poor productivity and the energy crisis. The key to success for Abenomics would be dependent on whether the Japanese government effectively manages these risks and confronts the fundamental reforms that would improve the supply side of its economy.

Reference

1. 박영철, 아베노믹스 실패 가능성 높다, <주간조선>, 2013.03.18, http://weekly.chosun.com/client/news/viw.asp?nNewsNumb=002248100014&ctcd=C05

2. 박형준, 日 환율-주가-금리 3각 부메랑… 아베노믹스 두달만에 휘청, <동아일보>, 2013.06.05, http://news.donga.com/3/all/20130605/55643597/1

3. 이형근, 아베노믹스, 디플레이션 탈출과 엔고 시정 추진, 2013년, 평화문제연구소, 통일한국 제352호, pg34-35, http://www.dbpia.co.kr/Article/3129836

4. 정성춘, 이형근, 서영경, 일본 아베노믹스의 추진 현황과 정책 시사점, 2013년, 대외경제정책연구원, 오늘의 세계경제, Vol. 13, No. 5

5. 차학봉, 아베노믹스 세 번째 화살 ‘不發’, <조선일보>, 2013.06.06, http://news.chosun.com/site/data/html_dir/2013/06/06/2013060600263.html

6. 한영기, 아베노믹스의 효과 및 과제, 2013년, 한국은행 동경사무소

7. 한창만, 아베노믹스 ‘거꾸로 효과’, <한국일보>, 2013.02.20, http://news.hankooki.com/ArticleView/ArticleView.php?url=world/201302/h2013022021083122510.htm&ver=v002

8. Adams, W. J. (2013). Japan: Assessing the Future of Abenomics, The Boston Company, http://www.thebostoncompany.com/assets/pdf/views-insights/April13_Views_Insights_Future_of_Abenomics.pdf

9. Katz, R. (2013). Abenomics Is Bad Medicine, The Wall Street Journal, http://online.wsj.com/article/SB10001424127887324590904578287472450294546.html

10. Mankiw, N. G. (2013). Macroeconomics Eighth Edition, Macmillian

11. McNerney, G. J. (2013). Will ‘Abenomics’ Ensure Japan’s Revival?, Thomas White International, http://www.thomaswhite.com/pdf/Will-Abenomics-Ensure-Japans-Revival.pdf

12. Schaede, U. (2013). Abenomics cannot succeed without cheap nuclear power, The Japan Times, http://www.japantimes.co.jp/opinion/2013/06/05/commentary/abenomics-cannot-succeed-without-cheap-nuclear-power/#.UbFlP-uPJBy

Data

13. St. Louis Economic Research: http://research.stlouisfed.org/fred2/graph/?id=DEXJPUS

14. Naver금융: http://info.finance.naver.com/marketindex/worldExchangeDetail.nhn?marketindexCd=FX_USDJPY

15. Naver금융: http://finance.naver.com/world/sise.nhn?symbol=NII@NI225#

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Diagrams: AD/AS + Section 4

The increase in the aggregate demand from AD1 to AD2 increases both price level and real output from P1 to P2 and from Q1 to Q2 respectively.

Aggregate demand could be increased by many factors. First of all, reduction in taxation could increase the consumption. Secondly, the reduction in interest rates will most likely shun away consumers to save their money but spend them. Also, due to the low interest rate, there will be less burden to borrow money. Therefore, this would both increase the consumption and the corporate investment. Thirdly, increase in government spending would increase the aggregate demand because it is one of the factors that comprises of the aggregate demand. The governmental spending boosts up the consumption in products and increases the earning/income in the sector. Finally, the improved competitiveness could also increase the aggregate demand as the opportunity cost in production would decrease. In addition, the increase in the competitiveness could also boost up the export, which also increases the aggregate demand.

The decrease in the aggregate demand from AD1 to AD2 decreases both price level and real output from P1 to P2 and from Q1 to Q2 respectively.

Decrease in aggregate demand is caused by many factors. First of all, the increase in the taxation could decrease the consumption. Secondly, the increase in the interest rate could allure consumers not to spend money but to save them. In addition, the high interest rate would attract lots of money in to the bank, draining the money out of the market. Also, the high interest rate decreases the corporate investment. Thirdly, decrease in the governmental spending would also decrease the aggregate demand. Finally, decrease in the competitiveness could also decrease the aggregate demand by increasing the opportunity cost associated with the production. In addition, loss in competitiveness could also lead to decrease in export, which also decreases the aggregate demand.

Increase in the aggregate supply from AS1 to AS2 increases real output from Q1 to Q2 but decrease the price level from P1 to P2. This is desirable as the price level is decrease and the real output has increased.

Increase in the aggregate supply could be caused by many factors. First of all, reduction in indirect taxation could lead to increase in the aggregate supply. As the taxation is reduced from the price of the product, the producer could manufacture products at much lower opportunity cost and gain price advantage. Secondly, the reduction in wages of the employees would lead to cut in the production cost and therefore gain price competitiveness. This way, the manufacturer could sell more products at much cheaper price, increasing the aggregate supply. Thirdly, the reduction in price of raw material also leads to the increase in the aggregate supply due to the cut in the production cost. Finally, favorable weather conditions could help industries that depend on the weather to produce more. Therefore, this would also increase the aggregate supply.

The decrease in aggregate supply from AS1 to AS2 decreases real output from Q1 to Q2 but increases the price level from P1 to P2. This is the worst scenario as the price level increase and the real output decreases.

There are many factors affecting the decrease in the aggregate supply. First of all, the increase in the indirect taxation could lead to increase in the cost of production. Therefore, the producer would only be able to produce less products than he/she used to produce. Secondly, the increase in the wages could also lead to the increase in the opportunity cost and the production cost. This would also increase the aggregate supply. Thirdly, the increase in the price of raw materials also increase the production cost that aggravates the decrease in aggregate supply. Finally, adverse weather conditions could ruin the production of industries that depend on the weather. So, this would also worsen the decrease in the aggregate supply.

Japan and China are in a comparative advantage to each other. Japan produces more automobiles at QA2 than what China’s producing at QA1. However, China produces more break pads at QB2 than what Japan is producing at QB1. In conclusion, Japan has a comparative advantage in automobiles over China, however, China has a comparative advantage in break pad over Japan. In these countries were to initiate FTA, they would both have loss and gains.

In this diagram, India is at absolute advantage over Fiji Island. India produces clothes at QC2 which is way more than what Fiji Island is producing at QC1. Also, India produces more hats at QH2 that is more than what Fiji Island is producing at QH1. In conclusion, as India produces more products in both items, India is in an absolute advantage over Fiji Island.

This economy is in a free trade with the world without any trade barriers. The price dropped from Peq to Pworld.  Also, the quantity demand increased from Qe to Q2. This means that only consumers until Qe were able to buy a product, but now consumers until Q2 are able to buy the product they could buy before. From Q1 to Q2, it indicates the amount of imported goods and services. However, the domestic production decreases from Qe to Q1 to the price-competitive world providers. In conclusion, the consumers benefit the most from this situation.

In this economy, it imposes tariffs on imported goods. The tariff increases the price from Sworld to Stariff. This decreases the quantity demand for the product from Q2 to Q4. This means that consumers from Q4 to Q2 no cannot buy the product because of the increased price. Also, the deadweight loss occurs due to inefficient domestic producers entering the market. The amount of imported goods decreased from (Q2-Q1) to (Q4-Q3). This is a great loss for the world providers because they are losing the market share both ways from left and the right whereas the domestic providers are only gaining by one side from the left. The government also gains revenue from the tariff imposed on the imported goods.

In this economy, quota is imposed on the economy. The quota increase the price from Sworld to Stariff. This decreases the quantity demanded from Q2 to Q4. This decreases the imported good to the market from (Q2-Q1) to (Q4-Q3). Also, the foreign producers that avoided the quota benefits greatly by the windfall gain. However, there will be a deadweight loss caused by the inefficient producers. In addition, the government will gain nothing from this situation because they are not imposing a tariff.

In this diagram, the government is subsidizing the domestic industries to fight off the competitive foreign providers. The subsidy shifts the supply curve for the domestic providers from Sdomestic to Sdomestic+subsidy. This allows the domestic providers from Q1 to Q3 to re-enter the market. In the other hand, the imports decrease greatly by (Q3-Q1), which was taken from the domestic providers that are subsidized. The consumers are not hurt in this situation because there is no decrease in the quantity demanded, which means there was no increase in number of consumers who are not able to buy the product. Also, unlike the tariff and quota situation the importers do not lose by 2 ways but by only 1 way (from the left).

The fixed exchange rate could cause shortage of the quantity of the currency. As the demand for the imported goods increase, people would need more of the currency to buy another currency. This is why the supply curve should move from S1 to S2. However, due to the fixed exchange rate, the shortage in supply of the currency occurs.

Fixed exchange rate could cause the surplus in the supply of the currency in the market. As the demand for the exports increase overseas, the foreigners would demand more of the currency to buy the exports. This is why the demand curve should move from D1 to D2. However, due to the fixation in exchange rate, the surplus of currency occurs.

Floating exchange rate well suits the demand and the supply of the currency. Also, it does not have the problems of surplus/shortage of currency that fixed exchange rate systems have. The currency is demanded at the quantity of Q and the value of the currency in terms of another currency is at P.

Demand for the currency could be increased from the increased demand of exports. If foreigners are attracted to the exports, they would demand more of the currency to buy the exports. Therefore, this would increase the demand for the currency from Q1 to Q2 increasing the value of the currency in terms of another currency from P1 to P2. This is called appreciation of the currency as the value of the currency increased.

Demand for the currency could decrease by the lack of interest in exports. The foreigners would not demand less of the currency, decreasing the demand curve from D1 to D2. This decreases the quantity demanded for the currency from Q1 to Q2 and decrease the value of the currency in terms of another currency from P1 to P2. This is called the depreciation of the currency as the value of the currency has been decreased.

The increase in the supply of the currency could be caused by the increased interest in the imports. The consumers would need more of their currency to buy another currency to buy imports. This would increase the supply curve for the currency from S1 to S2. This increases the quantity demanded for the currency, however, it depreciates the currency from P1 to P2.

The decrease in the supply of the currency could be caused by the decrease in the interest for the imported goods. As consumers would demand less of their currency, the supply curve would shift from S1 to S2 decreasing the quantity demand for the currency but increase the value of the currency in terms of another currency. This causes the currency to appreciate.

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How can demand/supply side policies help variety of people?

How should the government implement demand/supply side policy to help corporate leaders, unemployed workers and retired people? The government should utilize the policy that both stabilizes the inflation rate and lowers the unemployment rate to help all of these people. There aren’t any absolute solutions to these problems all simultaneously, yet there are always ‘best’ solutions.

The government could nullify the labor union’s power and make the wages flexible. By lowering to wages to an apt level, there will be surplus of money that can be used to employ a number of people. Also, the money that’s left could be used to increase the pension of the retired people. People who were employed will be angry, however, it’ll give them a strong sense of job security by looking at numbers of people coming in.

In order to protect the working population from the inflation, the government should implement the monetary policy in order to cut down money supply. By cutting down money supply, it’ll significantly decrease the inflation rate  to stable state. Also, the government could increase the interest rate in order to curb inflation.

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China’s Skyrocketing Oil Consupmtion

China’s Astonishing Rate of Oil Consumption

BBC News: Click Here

The Heat Zone: Click Here

According to BBC News, China’s demand for oil jumped by an ‘astonishing’ 28% in January compared with the same month a year earlier. As the headline tells us, China’s consumption of oil is skyrocketing as it tries to fulfill the energy hunger engendered by rapid economic growth. There are many concerned voices that this ‘astonishing’ (for some, ‘horrifying’) consumption of oil could stir up several ecological and economcial problems.

First off, many are concerned that this incredible rate of oil consumption will eventually result in depletion of oil. The concern for the depletion of oil was an old issue for industrial countries, however, this issue recently became an hot potato because of China’s increasing consumption of  oil. Some analystist say that as China’s consumption of oil increases tremendously the world supply of oil can be depleted earlier than expected. It would certaintly stir up sever problems if the supply of oil depletes. It might be difficult for both developing and developed countries to even sustain itself.

Secondly, China’s tremendous consumption of oil has several negative externalities. For example, it could emit tons and tons of CO2 in the atmoshpere which in turn will aggravate the global warming. In the graph above, the external cost to the society is not reflected in the current oil market price. It is at the curve of MPB, which should be at MSB. In my opinion, even though the market price for oil reflects the external cost and the curve on MSB, China’s consumption of oil is so high that it will do no good.

As you see in the graph above, the demand for oil is much higher than the supply. The demand is always higher than the supply and that is why market price of oil is high (about 80$ or above for a barrel). However, with higher demand by China, the price for the oil will increase significantly. Therefore, with extremely high market price for oil, many developing countries (other than China) will have a great difficulty in their economic growth and development. It will also affect the developed countries by some extent. In my opinion, the countries importing oil, like Japan, will be hurt the most.

In conclusion, China’s increase in consumption of oil could stir up many problems such as depletion of oil, global warming, and high market price for oil.

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Elasticity: Hovis Case Study

bread

News Article: Click Here

Premier Food’s Hovis has experienced some significant decline in its bread sales. This is mainly because of

  1. Increase in price of bread.
  2. Rival companies keeping the low price.

Hovis’ increase in price of bread was said to be inevitable. They simply could not maintain the price as the production cost were exceeded the selling price. Consumers have turned their back on Hovis for following reasons.

  1. Whenever there is an increase on price of a product, the demand decrease. It’s the law of demand. (The degree of its decrease is determined by its elasticity). So the consumers started to buy less of their bread.
  2. Usually, bread are told to be inelastic. However, in the article it reported that there are 2 other rival companies selling bread. This has made a substitution effect for Hovis’ bread. Therefore, it has made the bread elastic.

It’s simple. There are other companies selling low-price bread, but Hovis rose its price. No consumer would leave a cheap bread to the side and buy Hovis’ expensive bread.

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