Reason for deflation
One reason for the deflation in Japan is the increased goods being imported from China and other Asian Countries. Since Japan imports more goods, the Net Exports (Exports – Imports) has decreased significantly, creating a lower Aggregate Demand (AD) which leads to a recessionary gap; which drops the price level of goods and services and also causes unemployment. It is said that imports from China has accounted for a third of the increase in Japanese imports during 2004-2005 (OECD 2005). Since businesses are selling cheaper goods than when selling domestic goods, the total revenue of the company decreases and therefore in the long-run, the wages will go down as well. Therefore, consumption of goods and services will decline as well. Then, it will result in a decrease in company’s revenue, bringing down the wages again. This process will continue until some action is taken by the government or the FED.
Actions taken to end deflation
Monetary Policy has been used to stop deflation from continuing. Specifically, the Open Market Operations have been used. The Bank of Japan (BOJ) has been trying to increase Money Supply (MS) in order to increase AD. The first step BOJ takes is increasing the prices of Japanese Government Bonds (JGB). By doing this, bond owners will give up their bonds; resulting in the FED buying the JGB (We can see this buy looking at the Bonds Market). After doing this, the FED successfully should have increased the MS, which also brings down the interest rate (Money Supply and Demand Graph). The lowered interest rate will result...