Monetary and international factors behind Japan's lost decade

J. Japanese Int. Economies 23 (2009) 200–219

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Journal of The Japanese andInternational Economies

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Monetary and international factors behind Japan’s lostdecade ✩

Koichi Hamada a, Yasushi Okada b,∗a Yale University, USAb The Economic and Social Research Institute, Cabinet Office of Japan, Japan

a r t i c l e i n f o a b s t r a c t

Article history:Received 5 February 2008Revised 12 January 2009Available online 14 February 2009

JEL classification:E31E32F31F33F41F42

Keywords:Japanese economyLost decadeDeflationExchange rate

Hamada, Koichi, and Okada, Yasushi—Monetary and internationalfactors behind Japan’s lost decade

Most studies on Japan’s “lost decade” have been broadly focusedon its real and domestic aspects, such as total factory productiv-ity (TPF), growth decline, non-performing loans, and governance.This paper shows that monetary and international factors playedas an equally important role as those non-monetary and domesticfactors in generating the prolonged Japan’s stagnation. The PlazaAccord in 1985 managed to alter the major exchange rates mainlyby verbal promises combined with coordinated monetary policies,and triggered the trend for the stronger real exchange rate of theyen. The subsequent monetary exchange rate policy kept the realexchanged greatly overvalued. Japanese industries endured a heavyburden during this period. J. Japanese Int. Economies 23 (2) (2009)200–219. Yale University, USA; The Economic and Social ResearchInstitute, Cabinet Office of Japan, Japan.

© 2009 Elsevier Inc. All rights reserved.

Takeshita1 then arranged to play golf at a course near Narita Airport, left his house with his golfshoes and clubs, and put his suitcase in the trunk of his car. He went to the golf course and played

✩ A paper prepared for the TRIO Conference, Tokyo, September 2007.

* Corresponding author at: Cabinet Office of Japan, Economic and Social Research Institute, Kasumigaseki 3-1-1, Chiyoda-ku,Tokyo, Japan.

E-mail address: [email protected] (Y. Okada).1 Noboru Takeshita was then Japan’s Finance Minister. He later became Prime Minister.

0889-1583/$ – see front matter © 2009 Elsevier Inc. All rights reserved.doi:10.1016/j.jjie.2009.01.004

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K. Hamada, Y. Okada / J. Japanese Int. Economies 23 (2009) 200–219 201

nine holes, but then, without playing the back nine, he rushed to the airport and flew to New Yorkon Pan American to avoid being recognized by Japanese executives.

Gyohten in Volker and Gyohten (1992), p. 252

1. Introduction

The story of Minister Takeshita above describes the start of a drama of exchange rate interventionand coordination rarely observed in history. In retrospect, the Plaza Accord succeeded in changing thecourse of exchange rates, and partly in changing the course of current accounts of Japan, the UnitedStates, and other countries in the Group of Five (later Seven). On the other hand, this coordinationattempt often left substantial burdens on the macroeconomic performance of participating nations,and particularly that of Japan, because the yen real exchange rates—expressed in terms of alternativeprice indexes—started an upward journey that ended only after a run that lasted more than 20 years.

Most studies of the “lost decade of Japan,” broadly focused on real and domestic aspects, such asTPF growth decline, non-performing loans, and governance. By tracing the course of real exchangerates after the Accord, we argue that the roles of monetary and international factors were as equallyimportant as those of non-monetary and domestic factors in generating the stagnating path of theJapanese economy during this period.

So many books and papers dealt with the causes and the consequences of Japan’s lost decadewithout attention on the international monetary environment facing Japan during the two decadesafter the Plaza. Our inquiries will open, we hope, a new perspective over the economic mechanismin the Japanese economy during this critical period. This line of thought starts from McKinnon andOhno (1997), and it is recently at least partially echoed by Obstfeld (2008).

Under the system of floating currencies, there are few, if any, benefits to be gained from exchangerate coordination; on the other hand, the coordination attempt of the Accord to balance the currentaccount resulted in imposing additional constraints for participating nations. We trace the effects ofappreciation of nominal exchange rate on the real exchange rate and, finally, on Japan’s macroeco-nomic performance. After the initial expansionary policy to react to the immediate effect of the yenappreciation after the Plaza Accord, the Bank of Japan undertook a very tight monetary policy accom-panies by a sharp reduction in the money supply, which supported the policy of keeping the nominalyen beyond the level of 80 yen to the U.S. dollar in 1995.

It required the adjustments of prices and productivity levels for the Japanese economy to securethe same competitive edge for the industries facing the hurdles of higher real exchange rate. Now thatthe real effective exchange rate of Japan are returning to levels prior to the Plaza Accord, it would bea good time to reconsider the policy implications of monetary and exchange rate policies.

Recently, Jorgenson and Nomura (2007) shed new light on the meaning of the real exchange ratein their elaborate analysis of industrial total factor productivity (TFP). They calculated the purchasingpower parity (PPP) exchange rate in terms of industrial sector price levels between the United Stateand Japan. If the actual nominal exchange rate is higher than the PPP exchange rate for the yencalculated for the sector, the real exchange rate in terms of sector prices will be higher than unity,so that the particular industry in Japan bears a higher burden in competing with the product inthe United States. At the aggregate level, around the peak of the unusual yen appreciation in 1995,Jorgenson and Nomura find that the dollar/yen real exchange rate calculated by the GDP deflatorsof Japan and the Unites States soared to about 78 percent above the level of pre-Accord situation.This paper argues that such a combination of monetary and exchange rate policy was instrumental ingenerating a long lasting recession in Japan, and that the combination brought the Japanese economyinto a liquidity trap. It was only after the courageous massive interventions in the exchange marketin 2003 to 2004 that Japan finally grappled its way out of the persistent liquidity trap.

In Section 2, we show that the merits of policy coordination under a floating currency regime arerather limited. The floating currency regime in principle allows effective and decentralized choicesof price levels and levels of macroeconomic activities without coordination, because policymakers areable to choose the levels of macroeconomic activities rather independently without any constraints onthe balance of payments. The coordination attempts after the Plaza Accord imposed on participatingcountries an additional current account constraint that reduced the degree of freedom of monetary

202 K. Hamada, Y. Okada / J. Japanese Int. Economies 23 (2009) 200–219

policies. As McKinnon and Ohno (1997) maintain, this constraint brought various difficulties to themacroeconomic management of Japan.

In Section 3 we cast strong doubts on the idea that the current accounts of countries will or mustconverge to zero. One theoretical paper2 has investigated the open loop Nash equilibrium of a two-country differential game of the Ramsey–Cass–Koopmans type optimal capital accumulation. In thatmodel, the stationary level of international indebtedness can deviate substantially from zero as longas the rates of time preference differ across nations. In other words, the current account of a nationneed not be zero, and the real equilibrium exchange rate (REER) that balances the current accountneeds not to be a policy target.

In Section 4, we briefly review the conceptual differences between the real exchange rate and theterms of trade. The real exchange rate in terms of a sector price shows the ratio of its price at homerelative to its price abroad, and its increase means that the hurdles to export or import competitivelybecome higher for a Japanese producer so that domestic industry must cope with the cost differenceseither by technical progress or cost reductions. On the other hand, the terms of trade are the relativeprice of exports and imports; any improvement in the terms of trade would mean an increase in thereal full employment income of the country.

In Section 5, we will illustrate the implications of our theoretical considerations for the historicalevents after the Plaza Accord. When the Japanese economy was sailing with the favorable winds ofthe improvement in the terms of trade shortly after the Accord, it could counter the difficulty fromthe tide of the increasing real exchange rate. When the tail wind halted, however, it went into adifficulty period of recession, unemployment, and deflation.

After the Accord until the peak of the nominal exchange rate of 80 yen to a dollar, the yen ap-preciated almost 300 per cent, and this increase was supported by tight monetary and exchange ratepolicies. This led the Japanese economy into a textbook liquidity trap, perhaps the only distinctlyobserved case after the Great Depression.

2. Independence of monetary policy under the floating regime

First, let us sketch the differences in monetary interactions under a floating exchange rate regimeand under a fixed exchange rate regime. Under a floating regime monetary independence prevails ifa country is only interested in price levels, or if it is interested in the combination between pricelevel and unemployment, when a Phillips-curve trade-off exists. This may be known to many readers,but we review this in order to remind readers to relate these theoretical properties of exchangerate regimes to the actual policy interaction described below.3 Consider a world, for simplicity, thatconsists of two countries of identical size. We contrast working of the fixed exchange rate systemto the flexible system and show why the exact benefit of monetary coordination obtained under thefixed exchange rate system disappears under the flexible exchange rate system.

2.1. Benefits of coordination under fixed exchange rate

Consider first start the fixed exchange rate. Denote the economic variables of the home countrywithout asterisks and those of the foreign country with asterisks (∗). Assume the balance sheet M =R + D where M , R , and D designate money, foreign reserves, and the domestic credit or the amountof domestic securities. Define the excess monetary creation of the two countries as

x = D/M − k · gY ,

x∗ = D∗/M∗ − k · g∗Y .

2 Cheng et al. (2007).3 This is illustrated by the so-called “first generation approach” to international policy coordination. The “second generation

approach” does not provide microeconomic foundation to behavior in the system, but its prediction by the first generationapproach along the Mundell–Fleming model still retains significant explanatory power for policy issues.


Fig. 1. Fixed exchange rate case a = a∗ = 0, b > 0, b∗ > 0.

Here Y and D designate real GDP and the credit expansion in terms of buying operation of domesticbonds. g signifies the rate of growth in such a way that gM = M/M and gY = Y /Y . Finally k is theincome elasticity of demand for money. Under the fixed exchange rate regime, the common rate ofprice change π is given by π = (x+x∗)/2. The normalized balance of payments, z = S/M , z∗ = S∗/M∗ ,where S , and S∗ are the surplus of the balance of payments in the two countries, are given (e.g.Johnson, 1972; Hamada, 1976) by

z = (x∗ − x)/2,

z∗ = (x − x∗)/2.

If the countries have the policy objectives to minimize the price deviation and the deviation from thebalance of payments constraints, that is,

(π − a)2 + θ · (z − b)2 and (π − a∗)2 + θ · (z∗ − b∗)2,

where a and a∗ are the most desirable rate of price increase for the home and foreign countries, andb and b∗ are the most desirable balance of payments in the home and foreign country, respectively.Then, as shown in Hamada (1976), the Nash equilibrium—that is, the intersection of reaction curves—lies outside the contract curve, the Pareto efficient configuration for two countries, unless b + b∗ = 0.Thus, except when b∗ = −b, independent policy interactions will result in a combination unsatisfac-tory to both countries. Fig. 1 indicates that the intersection of reaction curves diverts from the Paretoefficient configuration, except when the two bliss points coincide. This is a typical case of strategicsubstitutes in a game of policy interplay.

2.2. Monetary independence under the flexible exchange rate

Consider next a world consisting of two economies with floating currencies, where goods pricesadjust instantaneously, then the price level in each country follows an excess of money creation under


the floating regime. (We distinguish here the inflation rate between the two countries.) Then M canbe identified as D and M∗ as D∗ . It follows that

π = x, π∗ = x∗ and, at the optimum, x = a, x∗ = a∗.

If price rigidities exist, as we actually observe in the world economy, the short run monetary inter-dependence under float is most likely in the negative direction,4 indicating the beggar-thy-neighboreffect of the monetary policy. Thus the beggar-thy-neighbor effect under float in the short run is suchthat π = x + γ · (x − x∗), and π∗ = x∗ + γ · (x∗ − x), where γ is a small positive coefficient.5

Suppose that each country targets its own price level (and accompanying employment level in thepresence of the Phillips curve trade offs). The two countries minimize:

(π − a)2 = (x + γ · (x − x∗) − a

)2and (π∗ − a∗)2 = (

x∗ + γ · (x∗ − x) − a∗)2.

The first-order condition is given by solving a pair of equations:

(1 + γ ) · x − γ · x∗ = a,

−γ · x + (1 + γ ) · x∗ = a∗.

It is easy to see that both countries can achieve their first, best points. This does not depend on thesign of the spillover effect. If γ > 0, as the negative spillover implies, this will become a typical caseof strategic complements.6

This structural difference is exactly the implication of the Tinbergen type of arithmetic betweenthe number of objectives and the number of instruments.7

This principle has, however, an important exception. When Japan went into a zero-interest regime,a typical and tenacious liquidity trap emerged so that the money demand function takes the extremeor degenerate form with infinite interest elasticity. No matter how large an amount of money maybe supplied to the market, the public absorbs the extra money with a very low (practically zero)rate of interest. Thus, neither money supply nor open market purchase (that is, essentially excesscredit creation as defined above) can determine the price level of the country under the grasp of aliquidity trap. Accordingly, the reaction curve of such a country cannot be defined in terms of moneysupply. Only the implementation of exchange rate intervention policy could rescue a country from theimpasse of a liquidity trap.

Incidentally, this loss in the grasp of Japan’s monetary policy will be illustrated by the so-called“Soros” diagram, a folk tale in the business world. As Fig. 3 indicates, the dollar/yen exchange ratewas rather closely related to the ratio between the increase in money supply in Japan and that in theUnited States. Since 1998, when the dollar hit bottom, this relationship was quite close in terms ofthe directions of movements. This may be considered as an amazing fit as can be found in this kind offolklore diagram. Understandably, when Japan went adopted its zero interest policy or liquidity trap,Japanese monetary policy lost its grasp on its price levels and, accordingly, on the exchange rate. Onlythe money supply in the United States could affect the exchange rate so that it can be predicted bythe U.S. monetary policy.

For such a country to achieve its macroeconomic objective, it remains only a subtler, indirect wayof influencing its price level through foreign exchange interventions. The government has to rely onthe instrument that can affect the choice between the assets denominated in the home currencyand the assets denominated in foreign currency, which can be considered imperfect substitutes. By

4 Canzoneri and Jo (1985).5 The results of this section, however, do not depend on the sign of γ as long as |λ| < 1.6 One of the authors was aware, through an earlier study, of the important structural differences in the interactions of mon-

etary policies between fixed and floating rates. “Thus, for a nation to adopt a flexible exchange rate by itself is something veryclose to the maxi-min strategy” (Hamada, 1974, 1985).

7 As long as the objective of the price level is common in both regimes, the floating exchange rate takes away one objectiveand frees the system. Just as the Golden fetters during the gold standard were a constraint, so was the balance of payment con-straint an additional objective. No wonder economists found few benefits with respect to the empirical world macroeconomicmodel from international monetary coordination under float (Eichengreen, 1995).


Fig. 2. Flexible exchange rate case. If a = a∗ = 0 then P coincides with the origin. All points on the reaction curves are blisspoints. According the intersection P achieved the first best.

Fig. 3. “Soros” diagram: yen/dollar exchange rate and the ration of HPM.


Fig. 4.

absorbing the dollar-denominated asset in the market by dollar purchases in the exchange market, theJapanese government could at least in principle change the dollar/yen exchange rate and indirectlygive positive stimulus to price levels in Japan.

This can be interpreted in the theoretical domain as follows. According to the monetary approachto the exchange rate, the exchange rate is associated to the relative amount of money. When Japanwas in the zero-interest and “quantitative easing” situations, this channel did not work. Here theimplication of the portfolio balance approach to the exchange rate makes some sense. That is theratio between the net yen-denominated asset and the net dollar-denominated asset that the rest ofthe world possesses will determine the exchange rate.

Thus, after 1999 Japan went into a zero interest rate period, the viable strategic instrument for theJapanese government changed structurally from domestic credit creation to the purchase interven-tions of the dollar in the yen market. On the other hand, the United States hardly intervened in theexchange market; and the strategic instrument for the U.S. government remained the money supplyor interest rate itself. Accordingly, the reaction diagram can no longer be drawn between excess mon-etary creations of the two countries. Instead, the diagram must be drawn, as in Fig. 4, between themoney supply of the United States and the foreign exchange intervention in Japan. The U.S. monetarypolicy can determine price levels, but the Japanese open market operation no longer influence theprice level in Japan. Only the interventions in the exchange rate market will be able to influence theJapanese price levels indirectly through the nominal exchange rate. A higher level of dollar purchaseinterventions implies a higher value of the dollar; it would require a higher level of monetary expan-sion on the side of the United States in order to keep the same price levels. A more expansionarymonetary expansion of the United States would require a larger amount of dollar buying interven-tions. Accordingly, the reaction curves are both drawn upward sloping. The slope of the Japanesereaction curve is quite flat, indicating the fact that it would require a large amount of interventionsto influence Japan’s domestic price levels through the indirect route of currency interventions.

We state it is a Proposition: For a country with a liquidity trap, it is impossible to attain its monetaryobjective unless it relies on foreign exchange market interventions.


Fig. 5.

2.3. The flexible exchange rate with an additional balance of payments constraint

Countries after the Plaza Accord were not typically engaged in coordination for achieving the mon-etary objectives in those countries, however. The Plaza Accord intended to achieve a target differentfrom that of monetary stability, that is, a target on the current account balance.

Consider the effect of a constraint on the current account of balance of payments in a the simplestcase of our model without a liquidity trap, where b = b∗ = 0. Suppose that an Accord requires abalanced current account for both countries.8 These objectives are consistent with one another ifthese constraints should happen to require that the monetary policy be symmetrical so that x = x∗ .Then the new requirement that is depicted by the area of shaded broken lines in Fig. 5 would passthrough the intersection of two reaction curves derived in Fig. 2 and the current account requirementcoincides with the mutually agreeable choice of price levels or the accompanying unemploymentlevels.

Usually, however, the current account imbalances are the results of the savings/investment choiceof the two countries and a structural and long-run phenomenon, and they are hard to be manipulatedby monetary policy, even in the short run.9 Let us consider the situation; however, as it might havehappened after the Plaza, where policymakers misunderstood this nature of the current account andthought that the structural and long-term imbalance of current accounts could be manageable bymacroeconomic policy. In 1985, when the Plaza Accord took place, the United States could not adoptmore stringent fiscal policy because the fiscal measures to stimulate the economy were prohibitedby the Gramm–Rudman–Hollings Act of 1985, and Japan was not capable of taking a more activefiscal policy because of the accumulated government deficit. Accordingly, monetary policies in the twocountries have had to bear all the burden of adjustments. For the U.S. government, one prerogative

8 In the next section, we will show that the current account balance does not correspond to the normal situation in the longrun growth path of an economy.

9 See McKinnon and Ohno (1997).


was to stop the current account deficit of the United States, and, in order to do so, it also had theprerogative to reduce the current account surplus of Japan.10

In Fig. 5, the excess money creation in Japan is measured by the horizontal axis and the excessmoney creation in the U.S. by the vertical axis. If the policymakers thought that more restrictions onthe side of the Japanese monetary policy would be necessary for the exchange rate adjustment, thenthey would restrict the choice by such a constraint as x � x∗ − c where c was positive. Then, by theimposition of the constraint, as shown in Fig. 5, the available ranges for the monetary policies wouldbe limited. The combination of excess monetary creation at Q will be most desirable for the UnitedStates but undesirable for Japan, and the choice of R will be most desirable for Japan but undesirablefor the United States. They have to settle at some point between Q and R . The imposition of currentaccount equilibrium would bring back an additional constraint that would work exactly as binding asthe as the reserve constraint under the fixed exchange rate. Under the flexible rate, the imposition of thecurrent account equilibrium by the coordination of monetary policies will prevent the attainment of mutuallydesirable price levels and bring back the monetary constraint that existed under the fixed exchange rate butwas lifted under the floating exchange rate.11

3. The long run theory of international capital movements

The underlying presumable premise for the call of policy coordination to balance the current ac-count or to mitigate the current account imbalance is that the current account equilibrium is thenatural outcome for countries in the world economy. This section presents a sketch of an argumentthat, in the growing world economy, the current account balance is neither a normal outcome frominter-temporal choice, nor the desirable target that countries should pursue to enhance their dynamicnational welfare. In addition, this world economy model incorporating Ricardian equivalence, not onlymonetary policies but also government expenditure policies can hardly exert a significant effect onthe capital account of the balance of payments, which is in turn equal to the current account. Theimbalance in the current account can occur not as an exception but almost as a norm in the worldwhere, across countries, the rates of exogenous growth or the rates of time preference can differ.

In a simple good growth model consisting of two countries, Cheng et al. (2007) have consideredthe question of what is the path of international capital movements under free capital mobility if twonations take the Ramsey–Cass–Koopmans type of optimal savings strategies.

Finessing the differential game approach, we will report the results in the situation in which thereis a difference in the rates of time preference between the two countries while the rates of exogenousgrowth are identical.

The key assumptions of the model are:

(1) The capital market allocates physical capital efficiently at any instant of time, and the marginalproduct of capital is equalized and paid to the owners of capital.

(2) The savings decision is the only strategic variable to the owners of capital, and they play the openNash strategy in the differential game of capital accumulation given the other player’s dynamicstrategy of savings.

The second assumption is a standard extension of the Ramsey optimization to two players. Theworld economy will then converge to a stationary state, where the rate of return to capital is equal-ized to the average rate of time preference. Moreover, the stationary per capita borrowing of a

10 Incidentally, policymakers on both sides of the Pacific presumably thought that the combination of a more-expansionarymonetary policy on the part of Japan would achieve the current account balance for both countries. This was opposite to whatthe Mundell–Fleming model would indicate.11 Of course, even under the flexible rate, fiscal policy can be employed to adjust the current account imbalance. It is easy

to interpret the above results in terms of the theory of effective assignment of economic policies originated from Tinbergenand Mundell. The flexible exchange rate system relinquished the target of the balance of payments and enabled countries tochoose their macroeconomic price targets freely. The introduction of a current account target brings the system back to one ofconstraint, again. Moreover, the attempt to adjust the current account by monetary policy, or equivalently exchange rate policy,instead of fiscal policy, is nothing but a wrong assignment of policy instruments given the Mundell–Fleming framework.


less-patient country—that is, the stationary per capita lending of a more patient country—is equal tohalf of the difference in the rates of time preference divided by the second derivative of the commonproduction function.

To illustrate this, let us write per-capita variables k, y, and b as the per capita value of capitalstock, income, and borrowing (the negative values are lending) divided by the identical population ofthe two countries. Then, the analysis gives us the value of rate of returns, given the rate of the twocountries as ρI and ρII .

f ′(k) = ρI + ρII

2.

And the stationary value of indebtedness of the less-patient country I , as

b = − ρI − ρII

2 · f ′′(k)= −ρI − ρ

f ′′(k).

In sum, the rate of return of capital is equated to the average rate of time preference, and the long-run indebted position is proportional to the difference between the rates of time preference minusthe average rate of time preference in the world.12

To assess the magnitude of influence to this stationary value of indebtedness from a small differ-ence in the rates of time preference, let us illustrate by a numerical example (Hamada, 2007). Considera per-capita production function for the borrowing economy as Cobb-Douglas type of f (k) = A · kα ,where α is 3/10, and k/y is 5, and the rate of return r = f ′(k) = 0.06. Since f ′′(k) = −(1−α) · f ′(k)/k,

b = ρI − ρII

− f ′′(k)= ρI − ρII

(1 − α) · f ′(k)· k = 10

7· 100

6· 1

2· (ρI − ρII) · k

or

b

k= 1000

42· 1

2· (ρI − ρII).

Therefore, even a difference in the time preference by a 0.1 percent (ρI − ρII) = 1/1000 would makeb/k equal to about 1.19 percent. About the 1.19 percent of the total capital of the borrowing countrywill be owned, and the assumed capital output ratio of 5, the net debt position of the country wouldbe close to 6 percent of its income. If the difference in the time preference is about a quarter percent(=0.25 percent), then the debt capital ratio would be close to 3 percent, and the debt income ratiowould be close to 15 percent. The reader may calculate the scope of the impact of the difference inrates of time preference if it were, for example, a full percent.

Thus, the current account balance or the absence of net indebtedness in a stationary state is not the norm;it is a result that depends on a strong assumption about the similarity of the rates of time preference betweencountries.

4. A conceptual note on the real exchange rate and the terms of trade

This section gives the economic meaning of the real exchange rate and the terms of trade whennominal exchange rate is changing. The real exchange rate is calculated for the home country (Japan)and the foreign country (United States) as (the dollar/yen nominal exchange rates) multiplied by(Japanese price level/U.S. price level).

Here, the price levels may be those with respect to a particular industry, or general price levelslike the GDP deflators. When the yen appreciates—that is, when the dollar/yen rate rises—Japaneseexporters will find it difficult to export, other things being equal, but the export condition will beimproved if the dollar price of their product in the United States increases, and if the yen price oftheir product in Japan decreases. When a price of a particular good is used, then the real exchangerate in terms of a good indicates the competitive condition of the industry encountered in export orimport.

12 This result will hold for a situation in which the world consists of more than two countries.


Fig. 6. Yen/dollar rate and effective exchange rate of yen (August 1985 = 100).

If the world is classical, where only real shocks matter, then the real exchange rate in terms ofa commodity price index or the general price level should not move immediately, as long as theshock is from the monetary side. Therefore, the Plaza Accord, which was merely nominal or even averbal promise, the real exchange rate should not move along with the nominal exchange rate. Fig. 6indicates that that was definitely not the case. For the period until one year after the Accord, the realexchange rate followed almost exactly the same pattern of increases. This tendency became less exactlater, but the overall contour of the change in the real exchange rate followed very closely, thoughless sharply, the change in the nominal exchange rate. It appears almost certain that this tendencywas created by the sluggish movement of prices in Japan as well as abroad.

During these two decades after the Accord, the yen’s real exchange rate remained high for mostof that time, as Fig. 6 indicates. For producers in an industry, whether they are exporters or importcompetitors, the real exchange rate appreciation in terms of the product price meant that they faceda harder competitive situation. They have to cope with these harder conditions by either increas-ing their productivity and/or reducing price by economizing costs, in particular wage costs. It is ourcontention that this was one of the reasons for the long-run stagnation of the Japanese economy.

Let us make a cautious note on the difference between the real exchange rate and the termsof trade because the difference can be misunderstood. Suppose good 1 (car) is an export of Japan,good 2 is a non-traded good (service), and good 3 (petroleum) is an import of Japan. Suppose therelative price of petroleum is reduced relative to car, then it would be a terms of trade improvementin Japan. It will raise the potential (full employment) income of Japan. Whether this increases the realexchange rate depends on the nominal exchange rate and the price movements of goods in the exportand import sectors.

In other words, full employment, potential, real income of Japan will be favorably affected byimproved terms of trade. This is a real effect and continues to be favorable as the terms of tradestays the same afterward. On the other hand, a higher level of real exchange rate will give moredifficult competing conditions and accordingly more difficult adjustment process for those industries.If prices and wages fully adjust instantaneously, full employment can be sustained; the real exchangerate would then automatically adjust to sustain full employment. The history of 20 years after thePlaza shows that prices and wages were hardly as flexible, and that levels and changes in the realexchange rate had crucially important impacts. The misalignment of the real exchange rate may createunemployment problems in the economy with rigid prices and wages. In the long run, productivity


changes and price changes on the both sides of the Pacific work to adjust the real exchange rate toits proper level.

We owe this insight to Jorgenson and Nomura (2007), who calculated the PPP exchange rate thatindicates the competitive conditions that the Japanese industries had to face during the adjustment.Remarkably, they found, at the peak of the nominal yen appreciation in 1995, that the real exchangerate was much higher than unity. The following quote tells the crux of the story.

The Plaza Accord of 1985 was a crucial turning point for the Japanese economy. In 1985 the Yenwas undervalued by 17 percent based on a comparison between our output-based PPP for GDP andthe Dollar/Yen exchange rate. In the late 1980s, the rapid strengthening of the Yen relative to theU.S. Dollar reversed this relationship, leading to an overvaluation of the Yen by 25 percent in 1990.The revaluation of the Yen continued through 1995, leading to an overvaluation of 78 percent! Thiswas followed by a gradual devaluation through 2004, leaving the Yen overvalued by 24 percent,very close to the 1990 level.”13

“Japan has overcome the impact of the very substantial over-valuation of the Yen that followedthe Plaza Accord of 1985. However, this has required a decade of domestic deflation, accompaniedby depressed investment levels and, and, especially, by insufficient investment and software.” (ibid.p. 27)

Jorgenson and Nomura investigate the sources of these PPP gap from industry data in their Table.The industrial sector, with its formidably high technological levels, could sail through the high valueof the yen, but many other major industries could not. It remains to be seen how those real exchangerate burdens affected the industry performance in terms of production and unemployment (see alsoDekle and Fukao, 2008).

5. Tracing external monetary conditions over the past two decades

Based on the above theoretical framework, let us patrol Japan’s macroeconomic path after 1985.We focus on the movement of the real exchange rate of the yen, which could be figuratively comparedto an outside temperature that Japan faced during these 20 years.

Fig. 6 shows the movement of the real effective exchange rate of the yen plotted on the nominaleffective exchange rate of the yen since 1980; both indexes have been normalized as 100 in August1985.

5.1. The Plaza Accord

In the Plaza Accord, the Group of 5 (G5) countries (United States, Japan, Germany, United King-dom, and France) attempted a coordinated exchange rate interventions to recover the continuing tradedeficit of the United States. The macroeconomic policy mix in the United States was then the com-bination of the extreme budget expansion under the doctrine of Reaganomics, and the high interestpolicy to contain inflation. As was predicted by the Mundell–Fleming framework, this type of policymix resulted in a large trade deficit and a higher value for the dollar. The Plaza Accord was a drasticreaction to this situation.

There is a valuable documentation of the Plaza Accord (Funabashi, 1988) and an excellent eco-nomic analysis (Ito, 1987, 1991). By utilizing his analysis of news and market responses around theglobe, Ito examined the five waves of the yen appreciation during the immediate two years after thePlaza Accord. We agree with his general assessment that mere interventions in the market or verbalcomments of policymakers could not sustain the medium to long-term exchange rate movements.

13 According to the recent BOJ statistics, the overvaluation has been corrected during the past few years in terms of the yenreal effective exchange rate. The Real Effective Exchange Rate of the yen was 94.3 in August 1985, just a month before the PlazaAccord. It recorded a historical high (165.5) in April 1995. After the end of the Great Intervention, it started to decline from120.6 (January 2005), and then reached 96.8 (December 2007).


The exchange rate was set to a range in which the United States economy could be viable. Inthis sense, this agreement was considered to be crafted primarily so that the outcome would restorethe savings-investment balance of the U.S. economy. One may say, therefore, the Plaza Accord wasthe Stackelberg equilibrium, with the United States as the Stackelberg leader and other countries asfollowers, in the coordination game described in Section 2.

This was primarily an attempt to correct the current account deficit of the United States and Japan,and not an attempt to achieve the stability goals in the domestic economy. This is the example of thesituation discussed in Section 2, where the coordination to achieve a current account deficit or surpluscould be far from fruitful.

Therefore, Japan relied primarily on the monetary policy for achieving and sustaining the coordi-nated manipulation of the dollar/yen exchange rates. The Bank of Japan (BOJ) raised the call rate twomonths later than the Plaza Accord, from Oct. 24 to Dec. 18, 1985, and the Ministry of Finance (MOF)engaged in extensive sales of the dollar. This meant that interventions were supported by monetarypolicy; they were, in other words, unsterilized, so that their effect could be substantial. In fact, inabout 24 hours, the dollar/yen rate had appreciated by about 20 yen.

5.2. Beyond the Plaza expectations

On January 24, 1986, Finance Minister Takeshita surprised the market by saying “The dollar couldgo to 190 yen.” More than to fulfill this prediction, the yen soared to 180 yen per dollar in February,six months after the Accord. The call rate was reduced in Japan—which was raised until December1985—in January of 1986, which was a sign that the yen had appreciated more than policymakerscould expect and tolerate. They now had to moderate its rapid appreciation.

One year after the Plaza, the dollar/yen rate was 153.6, an appreciation of 95 yen from the one-year average of the dollar/yen rates between September 1984 and August 1985. Thus, the intent ofthe Plaza Accord had been well fulfilled, but perhaps a little too well. The surprise announcement ofthe joint interventions by the G5 in a coordinated fashion had a strong impact on the sentiment ofthe market.

The obvious lesson from these sections is that exchange interventions and verbal commitment on fu-ture exchange rates could, under some circumstances, create substantial changes in the real as well as nominalexchange rate.

5.3. Japan’s low-interest policy and the continued appreciation of the yen

In a frictionless, classical world where money is neutral, the change in nominal exchange ratewould not change the real exchange rate unless there is an accompanying change in real factors. InJapan’s actual performance after the Accord, however, the movement of the real exchange rate for awhile followed very closely in a parallel movement the path of the nominal exchange rate.

A major message of this paper is: The manipulation of the yen nominal exchange rate exerted, throughthe change in the yen real exchange rate, significant impacts on the real economy of Japan. The Plaza Accordmight not have been the only and permanent source of the real exchange rate thereafter, but it couldhave been one of the catalysts that freed the real exchange rate to start its high-level flight throughoutthe next two decades, the decade when the Japanese economy suffered from recession and deflation.

5.4. Failure of the Louvre Accord, Black Monday

The Plaza Accord embedded the yen-appreciating psychology even more than intended by poli-cymakers, and the dollar started depreciating steadily against most major currencies. The G7—nowan enlarged G5 with the addition of Italy and Canada—was so concerned with the excessive dollardepreciation that they thought it might trigger international monetary impasses. In particular, theyagreed on joint interventions, and coordinated monetary and fiscal policies to maintain the dollar/yenrate between 140 and 160, and to maintain the deutschemark/dollar rate between 1.8 and 1.9, both asreference ranges.


This agreement was soon to be found as infeasible.14 To realize the Louvre Accord, the UnitedStates had to keep its interest rates higher than other major countries, but it was reluctant to takethis measure in consideration of its own business conditions. Then, in Japan and Germany, economicrecovery was obvious and both central banks started to raise interest rates. The Louvre Accord wasaccordingly in conflict with the domestic macroeconomic objectives of these countries, and interna-tional achievement of the joint objectives of current account became difficult. More importantly, themarket perceived that the targets of the Louvre Accord would be unlikely to be realized.

As discussed clearly in Ito (1991), there were talks about implicit target zones. Target zones mighthave worked if they were well announced and if the market had trusted the commitment to thepromise of the government. No announcements were made, and any credibility hardly emerged.

The market was in somewhat unstable situation when the New York stock exchange recorded asudden fall of 508 points on the Dow Jones Index on “Black Monday,” October 19, 1987. The dollardepreciated on 29th of October and went down to 133 yen on November 10. Thus, the content ofLouvre agreement became suddenly out of context. To repeat, if an international agreement was notcompatible with the objectives of a domestic economy, the market will never endorse the content ofthe international commitment.

5.5. Why was Japan’s low-interest policy sustained for so long?

The second puzzle after Plaza period was then why Japan did not keep its interest rates higher,if the target was to resolve the U.S. trade deficit. From the Mundell–Fleming formulation, the bestway for other countries to help the United States with its macro policy was to contract instead ofexpand their money supply. The tentative answer to the puzzle would be that central bankers didnot understand Mundell–Fleming, and, more importantly, or that the shock of Black Monday was toostrong for monetary authorities outside the United States to conceive of anything but reducing theirinterest rates. The BOJ bankers were no exception.

The process of yen appreciation did continue despite the decrease in the call interest rate inJapan, maintained for just two months, from October to December. Though the yen as well as thedeutschemark appreciated a great deal, the world economy, including Japan and Germany, went intoa sustained growth period. Consequently, the largest puzzle is: Why Japan and Germany grew sorapidly, even with their appreciated currencies?

The major key to this puzzle seems to lie in the improvement in the terms of trade due to the fallof energy prices. Energy prices fell about 50 percent in dollars (for example, Japan’s import price indexof crude oil in U.S. dollar terms dropped 49 percent in August 1986), when the yen had appreciatedby some 50 percent. Energy prices in terms of the yen fell to a quarter of the previous levels. InJapan’s case, the ratio of imported energy to GDP fell from 8 percent in 1980 to 2 percent in 1986. Asis discussed in Section 4, the terms of trade appreciation worked as transfer payments to Japan fromthe oil-producing countries, and expanded Japan’s potential income. Since energy consumption had alow elasticity to its price in the short run, the terms of trade effect worked as if a large transfer ofabout 5 percent of income was made to the Japanese public.

This favorable, long-run effect of expanding the permanent income of Japan worked throughservice industries like distribution, transportation, and travel, and this effect probably offset the un-favorable, short-run effect suffered in the export or import competing industries by the higher realexchange rate. This created the heap of “three highs: the high yen, high stocks, and high bonds—en-daka, kabu-daka, and saiken-daka.” In terms of the framework presented in the previous section, thetotal full employment benefit of the terms of trade is obvious.15

In Fig. 7, we observe that when the real exchange rate appreciated after the Plaza Accord alongwith the nominal exchange rate followed up exactly, hand in hand, for a year. The yen’s real appreci-ation with respect to the dollar was offset by the improvement in the terms of trade.

14 Ito (1991).15 Of course, if the decline in energy price affects the domestic competitive energy industry, the decline in oil prices would

have had an adverse effect on Japan as a real exchange rate increase. However, there were hardly any import competitors inpetroleum industry.


Fig. 7. Real effective exchange rate of yen and terms of trade.

When a rise in terms of trade was missing, or insufficient relative to the rise of hurdles implied bythe real exchange rate, we generally observe a slump of the Japanese economy, for example between1992 and 1995, and after 1999. Thus, the real exchange rate appreciation generally hurt the welfare of theJapanese economy by creating harder competitive conditions for Japanese industries, unless it was accompa-nied by a terms of trade improvement.

Facing unexpected expansions by the energy boom, Germany and Japan attempted to tighten theirmonetary policies. In Japan, the call rate hit bottom at 4.4 percent, recovering gradually to 4.76 per-cent in September. Black Monday reversed this course to bring the call rate down to 3.81 percent inNovember. It was not until September of 1988, a full year later, that the call rate was brought back tothe 4 percent level.

It is not definite but quite reasonable to infer that the delay of monetary restraint was a majorcause of the extreme boom in the stock market in Japan. Judged from the writings of Shijuro Ogataand other Bank of Japan staff, many BOJ officials were reluctant to pursue the kind of expansionarypolicy that is more or less imposed by the Ministry of Finance.16 The pretext used during this timewas that Japan kept its macroeconomic policy expansionary because of policy coordination with othercounties. This logic could have been justified in the case of fiscal policy, but not at all in the case ofmonetary policy, because in the presence of price and wage rigidity, monetary expansion was mostlikely to exhibit negative spillover effects to other countries under the flexible exchange rate. The needfor monetary expansion for cooperation purposes was never finally warranted. Thus, “monetary coor-dination” was used not as a genuine rationale but as a pretext for a lower yen that would presumablyassist the interests of export industries.

5.6. Why did the BOJ turn into such a stringent monetary policy?

Then, after the middle of 1988, the BOJ finally changed its stance of monetary lenience to extreme,we might say, monetary restraint. Just as the period of lenience was long, the degree of its monetary

16 A Central Banker compared the situation to the case “The wood in the fireplace is about to go up in flames.” On the otherhand, McKinnon and Ohno (1997) cite a paper by Tomohiko Taniguchi (1993) that refers to a BOJ official (without revealing hisidentity) who said the increase in asset prices was intended by the BOJ so that the expansion of domestic demand would beachieved by increased consumption and investments by the asset effect of booming stocks and land prices.


austerity was strict after the turning point. The BOJ’s attitude could be well understood if its staffhad believed that it had made mistakes in overestimating the damage of Black Monday, and that itshould not have accommodated outside pressures, particularly those from the Ministry of Finance,and from outside. It also believed that the very active stock market boom of 1988 and 1989 exhibitedan abnormal diversion from fundamentals.

In the mean time, the Tokyo stock price index (Nikkei 225), which was a little more than 20,000during 1987, soared close to 40,000 at the end of 1989, and finally came back down to 20,000 inthe latter half of 1991. According to the alleged view held by the BOJ, the stock market boom wascaused by the allegedly wrong judgment in monetary policy, which was nearly imposed from outside,in particular by the Ministry of Finance. The BOJ appeared to have believed that monetary policyhad to correct the overvaluation of the stock market until it returned to the level of 20,000 in 1987.Meanwhile, the Gulf War erupted in the summer of 1990, and oil prices soared. This was anotherrationale for the call interest rate to be sustained above 6 percent until the end of 1991.17

This process of containing the “bubble” did not appear effective at first. Its ineffectiveness gaveanother justification for the contractive monetary policy. Since the CPI inflation rate was close to4 percent in the latter half of 1991 (see Fig. 9), it might be natural that the BOJ tried to curb inflationby restraint because it would allegedly never allow inflation to exceed 5 percent. This view justifiesthe claim that the BOJ tried to contain the price inflation caused by the Gulf War. The picture looksdifferent, however, if we take as the price index the Core price, which excludes fresh food and energy.The Core index never went above 3 percent in 1991.18

Accordingly, the monetary contraction that took place in the aftermath of the drastic stock marketbreakdown—and that precisely targeted to the apparent CPI increase that accompanied oil prices—reversed the macroeconomic variables that followed the move to a “bubble.” The possibility that theBJJ delayed reversing the switch to monetary expansion for too long was clearly depicted by the au-thors in the U.S. Federal Reserve.19 We suspect that the paper (Ahearne et al., 2002) was written forthe Fed in order not to be trapped in the impasse into which BOJ policy had unfortunately strayed.Perhaps reflecting the spirit of comradeship between the central banks, the paper shows ample sym-pathy for the conduct of the BOJ by suggesting that Japan’s deflation was almost impossible to predict.Still the following two paragraphs well summarize their points. The first paragraph was technicallysupported by the analysis of the modified Taylor rule.

While the loosening of monetary policy in the early 1990s by the Bank of Japan (BOJ) seemedappropriate given the expectations of future economic developments held at the time, in light ofthe weakening of spending and prices that took place subsequently, this loosening proved to beinadequate. To reach this assessment, we compared the actual path of short-term Japanese interestrates to that predicted by an estimated Taylor rule based on future inflation rates and output gaps.Actual interest rates fell about as quickly, or more so, than the interest rates called for by theTaylor rule when Federal Reserve staff forecasts of output gaps and inflation were fed into thatequation. However, when the actual, and weaker, values of future output and inflation were fedinto the Taylor rule instead, the equation indicated that interest rates should have declined morerapidly than was in fact the case.

17 According to the usual usage of economists, a bubble brought about by excessive monetary policy was not a bubble. Ac-cording to journalistic usage, as well as the common usage of the BOJ or MOF, however, the stock market increase caused byexcessive monetary policy was a bubble. In this sense, the bubble in the stock market was judged by the BOJ or MOF officialsto have returned to normal after 1991.18 The constraint on quantitative lending, “the total restriction of lending,” was also adopted. As Horiuchi (1980) already

clarified for the banks’ lending in Japan in general, however, such constraint might have affected the share of channels oflending but could not have significantly affected the total financing of land or stocks. In fact, non-banking agricultural financialinstitutions (norin-kei kinyu kikan) increased the lion’s share of lending because of the restriction on the lending through banks.Even worse, the political clout of those agricultural financial institutions was really strong; most of the liabilities originatedfrom unsound lending to land were shifted to the banking sector. This created not only incentive problems for future finances,but made the financial health of banks deteriorated as well as uncertain. Then they became serious about the crisis in the stockmarket because even the 20,000 levels were found to be impossible to sustain after the rate of interest started to decline.19 Ahearne et al. (2002).


Fig. 8. Japan’s monetary policy after the stock market crush in 1990’s.

This suggests that, with the benefit of hindsight, perhaps the most important concern raisedby Japanese policy during this period was not that policymakers did not predict the oncomingdeflationary slump–after all, neither did most forecasters–but that they did not take out sufficientinsurance against downside risks through a precautionary further loosening of monetary policy.(p. 3)

Growth rates of these aggregates20 fell nearly continuously from 1990 to 1992, perhaps in-dicative of excessive policy tightness. Moreover, while the growth of the monetary base pickedup thereafter, the growth rates of the broader aggregates—particularly M2 plus CDs—recovered byless, suggesting that the BOJ’s reductions in interest rates, substantial as they were, may not havebeen sufficient. (Ahearne et al., 2002, p. 23)

Their paper also points out that, as a background, two significant announcements, one by BOJGovernor Hayami to the effect that too-low interest rates invite moral hazards, and another by DeputyGovernor Yamaguchi that decisive monetary easing might have dampened the restructuring efforts atJapanese financial institutions. Behind the scene of the ever-rising real rate of the yen exchange rateexisted the firm belief that the alleged bubble was mistakenly created by the excess liquidity createdby the BOJ and that monetary austerity should be continued until stock and land prices returned to“normal” levels.21

In terms of the call rate or discount rate, the monetary policy was restrictive in that the call ratewas kept increasing over a year after the major crash of stock market at the end of 1989. If you

20 Broad liquidity, M2 plus CDs, and the monetary base. We understand that the interest rate, rather than money supply,gradually became the major policy instrument.21 There are many papers related that criticize Ahearne’s analysis published by the BOJ economists. Most of these analy-

sis are skeptical about the relationship between deflation and recession in this period. The most comprehensive analysis isdone by Hara et al. (2008). By some simulation experiments of the BOJ’s large scale macro-dynamic model (Japan EconomicModel), preventing deflation by strong monetary measures might be possible but it could not have significant effects on realoutput.


Fig. 9. Nominal effective exchange rate of yen and Japanese type core CPI inflation rate (excluding only fresh foods from theheadline CPI).

observe the pace of reduction in money supply, it was startling. Fig. 8 indicates that the M2 + CDmeasure declined precipitously, from more than 13 percent in 1990 to about −1 percent in 1992.

When an economy starts from a situation of growing money and a low rate of inflation, reductionin the rate of money supply expansion (even in the range of positive monetary growth) by the centralbank will reduce the expected rate of inflation and, accordingly, increase the demand for moneyso much that the current price level may start to decline.22 This is the symmetric opposite of thismechanism mentioned in any macroeconomic textbook in case of accelerated inflation: An increase inmoney supply may increase price levels more than proportionately because of the increased velocityof money. The deflation obtained here is not the Great Depression type of deflation, with a drasticdecrease in the money supply “level,” but may be a mild and transitory deflation.

The overvaluation of yen finally stopped in the late 2000s. Why it stopped is not certain. It may becaused by intervention, monetary policy change in Japan or in the U.S., or some other factors. Indeed,even the change in the U.S. monetary policy (low interest policy by Greenspan around 2003) thatnarrowed the real interest rate differential might have been an important factor.

This paper can list the great intervention as only one of the possible reasons for the end of over-valued yen, just as we can claim the Plaza Accord as a trigger of temporary rise in real as well asnominal exchange rate. The theoretical logic of this paper concerning the intervention is, however,modestly supported by the following papers by Ito (2004a, 2004b) and Fukao et al. (2005).

Ito (2004a, 2004b) discusses the rationale and contest of these intervention in detail. Though hesuspects that interventions might have had only temporary effects, he suggests, however, the possibil-ity that they could have had a weakening effect on the yen up to 13 percent compared to the counterfactual case of no intervention.

Fukao et al. (2005) also calculated this counterfactual difference. He used an asset approach inwhich the choice between dollar assets and yen assets is determined by the risk premium, which

22 Okada (2006).


depends on the existing debt in dollar terms.23 The intervention by the MOF in the form of thepurchase of the dollar assets then affects the balance of the assets, risk premium, and finally thedollar/yen exchange rates. According to his estimation, interventions succeeded to reduce the real yenexchange rate as much as by 21 percent.

6. Concluding remarks

We have argued that monetary coordination by monetary authorities is superfluous under thefloating currency regime because each country is able to attain its macroeconomic goals. Monetarycoordination can even become harmful when the extraneous constraint on the level of current ac-count balance is introduced as the target of the coordination. In the case of Japan, the Plaza Accordimposed an unnecessary constraint on the current account.24 After an intermediate period of the Plazarecession, the Japanese economy went into an asset bubble during the late 1980. Then monetary au-thority changed its stance to monetary restraint too drastically. The monetary authorities achievedtheir goal of the appreciation of the real exchange rate by the combination of the nominal exchangerate policy and very stringent monetary policy. They succeeded too well, however. Hereafter, the realexchange rate stayed appreciated for a long time.25

The macroeconomic consequences of the long-journey of the appreciated yen real exchange ratewere serious. This could be one of the major reasons why the Japanese economy was trapped intoits long period of stagnation, often referred to as the “lost decade.” As Jorgenson and Nomura (2007)argue, the resulting high real exchange rate brought heavy burdens on many sectors. It took a longtime for Japanese industries to adjust themselves to the high levels of real exchange rates, thoughoccasionally they could take a breath, thanks to improving terms of trade and thanks to their owneffort of productivity increases.

The overly restrictive monetary policy drove the Japanese economy into a severe and lengthy liq-uidity trap. Conventional monetary policy was neither sufficient to recover its desirable price levelsnor an appropriate exchange rate, both of which are needed to revive the economy when the yenwas.

To conclude, under the presence of wage–price rigidity or inertia, the nominal yen exchange ratedid strongly affect the real exchange rate and, accordingly, created an international pressure thatpromoted deflation as well as recession of the Japanese economy. The high real exchange rate alsodeterred Japan’s recovery. Indeed, money may be neutral in the long run, but monetary and exchangerate policy could create serious damage on the real economy.

Acknowledgments

We are indebted to Adrian de Lagarza, Mitsuhiro Fukao, Takatoshi Ito, Adam Posen and YosukeTakeda, an anonymous referee and the editor of JJIE for their valuable comments.

23 Essentially, his model predicts exchange rate by the real exchange rates and risk premium factors that are dependent onthe holiday of foreign assets. For English reading readers we will sketch his model. His estimation equation is

eJPN = α + β(rJPN − rUS) + γ

4∑

k=1

MUSUS,k Bk, k = Japan, Euro area, UK and Canada,

where

eJPN : real exchange rate with respect to U.S. dollar,rJPN − rUS: real interest rates differential assuming the perfect foresight of inflation rate,MU S

US,k : variance–covariance of nominal exchange rates in terms of U.S. dollar,

Bk : k-country’s net foreign asset position of private sector which is defined as the total of accumulated current surplusand net direct investments. Naturally the amount of intervention is a part of this variable.

24 McKinnon and Ohno (1997).25 Even though the Plaza Accord was not to be blamed for the entire period of Japan’s high real exchange rates, we might be

allowed to say: the Accord certainly liberated the real exchange rate from a kind of the Pandora’s box to wander in the upwarddirection.


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Monetary and international factors behind Japan's lost decade