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Milton Friedman and Inflation: Lessons from Japan's Case Study

Milton Friedman and Inflation: Lessons from Japan’s Case Study

PREPARED BY: Chris Stanford 

DATE:5/20/23

 

Inflation, the rise in prices over time, has long been a concern for economists and policymakers worldwide. Among those who emphasized the importance of inflation was Milton Friedman, a renowned economist who believed that inflation was primarily caused by an increase in the quantity of money. Friedman’s theories on inflation hold particular relevance in the case of Japan, a country that has experienced a prolonged period of economic stagnation and implemented unconventional monetary policies such as near-zero interest rates and quantitative easing. This article explores the key insights from Friedman’s theories on inflation and how they apply to Japan’s unique economic situation.

FRIEDMAN'S THOERY OF INFLATION

Milton Friedman argued that inflation is mainly driven by an increase in the quantity of money circulating in the economy. He posited that monetary policy, rather than government policies, plays a significant role in creating inflation. According to Friedman, an increase in the money supply leads to inflation, which can indirectly result in higher taxes for individuals as they are pushed into higher income brackets with higher tax rates. These ideas laid the foundation for understanding the relationship between monetary policy and inflation.

JAPAN: A MODERN CASE STUDY

Japan provides a compelling case study to examine the implications of Friedman’s theory on inflation. The country has faced one of the longest periods of economic stagnation and currently holds the title of the most indebted nation globally. Since the late 1990s, Japan has maintained near-zero interest rates, which have been steadily declining since the 1980s. Additionally, the Japanese government has implemented quantitative easing as a means to stimulate the economy.

Based on Friedman’s theory, Japan should have experienced severe inflation due to the increased money supply resulting from near-zero interest rates and quantitative easing. However, the reality has been quite different—Japan has been grappling with deflationary pressures instead. This discrepancy raises intriguing questions about the relationship between low interest rates, money supply, and inflation.

RELUCTANCE IN LENDING AND MONEY SUPPLY

One possible explanation for the absence of significant increases in the money supply in Japan despite low interest rates is the reluctance of banks to lend. Traditionally, lower interest rates should stimulate borrowing and lending activities, boosting demand in the economy. However, Japanese banks have shown hesitation in lending the excess capital they possess, which challenges the conventional understanding of how monetary policy influences the money supply.

EXCHANGE RATE AND MONETARY POLICY IMPACT

Another factor contributing to Japan’s unique situation is the stability of the Japanese yen’s exchange rate. The market’s expectation of no changes in interest rates, given the two-decade-long period of near-zero rates, has influenced market behavior and dampened the anticipated impact of monetary policy. This stability has further complicated the relationship between interest rates and inflation in Japan.

SENSITIVITY TO PRICE RISES

Japanese households exhibit a heightened sensitivity to price increases, influencing the behavior of Japanese companies. In response to this consumer sensitivity, companies have been cautious about raising prices significantly, fearing the potential negative impact on their customer base. This sensitivity has created a self-regulating mechanism that constrains inflationary pressures in the Japanese economy.

OUR OVERALL CONCLUSION

Milton Friedman’s theories on inflation find resonance in Japan’s case, offering valuable insights into the complexities of monetary policy and its implications for inflation. Despite a prolonged period of economic stagnation and the implementation of unconventional policies such as near-zero interest rates and quantitative easing, Japan has experienced deflation rather than the expected inflation. Factors such as the reluctance in lending, exchange rate stability, and household sensitivity to price rises contribute to Japan’s departure from traditional expectations. By examining the case of Japan, we gain a deeper understanding of the complexities surrounding inflation and the challenges faced by policymakers in managing monetary policy.