What Explains Japan's Persistent Deflation?

While the asset price collapse of the late 80s in Japan might explain the disinflationary pressures that followed, it is hard to attribute the persistent deflation that the country has faced since the mid 90s to that initial shock. We argue that a failure to account for demographic trends when calibrating monetary policy might explain Japan's persistent deflation. The demographic transition, and in particular the increase in life expectancy, puts downward pressure on the real interest rate. Monetary policy rules that do not internalize this effect may end up being to restrictive, and lead to deflation in equilibrium. We calibrate a stylized model of a dynamic, monetary economy with a life-cycle structure to japanese data, and find that it accounts remarkably well for the low frequency developments in inflation and other macroeconomic variables since the early 90s. We also provide evidence that deflation was somewhat predictable -- an implication of the model -- and explore to what extent differences in the demographic transition help explain cross-sectional differences in the path of real interest rates across major developed economies.