The Role of Money and Growth Expectations in Price Determination Mechanism

There is a positive cross-country correlation between money growth and inflation rate, and both money growth and inflation rate of Japan are lower than those of other advanced countries. In the"Money view" based on the quantity theory of money, it can be interpreted that Japan's low inflation results from the low growth of money. However, the time-series correlation between money growth and inflation rate in advanced countries including Japan has declined since the mid 1990s. Furthermore, during this period, a strong positive correlation between the potential growth rate and the long-term inflation expectation is observed in Japan, and these facts are not consistent with the Money view. Japan's potential growth rate declined sharply in the past two decades in contrast to other advanced countries, and as a result expectations for future economic growth also declined, which may possibly have caused deflation in Japan. In the"Expected Burden view" based on the fiscal theory of the price level, growth expectations affect the price level as follows: 1) the decline in growth expectations increases the future fiscal burden on the private sector; 2) the private sector then cuts its expenditures to increase savings for the future burdens; 3) as a result, the aggregate demand decreases and hence the aggregate price level falls. This paper examines whether such a mechanism has indeed worked in Japan or not, comparing the inflation developments in the US and the euro area.