A Cost-Benefit Analysis of Fiscal Consolidation Measures

We evaluate and estimate the effectiveness and the cost of monetary policy involving a massive expansion of the Central bank's balance sheet. The Bank of Japan (BOJ) buys a large amount of long-term government bonds at very low interest rates so as to raise the inflation rate. Successful implementation of this policy is likely to raise long-term interest rates, and the BOJ will lose money due to a fall in government bond prices. Commercial banks and insurance companies also will suffer from lower bond prices. Furthermore, households will suffer from lower returns on deposits and insurance policies. The government has to pay higher interest rates on its debt, and it may have to use public funds to protect depositors and insurance policy holders of weakened financial institutions.

Although the BOJ can absorb large losses due to profit earned from bank note issuance, there is a certain limit. If the losses are too large for the BOJ to absorb, it will have a serious problem in conducting monetary policy to stabilize the inflation rate. For example, the BOJ will have to stop fiscal transfer of its profit to the government. The BOJ also may have to raise reserve requirements or raise general prices to increase the demand for the monetary base to increase its profit.

Our second problem is the welfare cost of fiscal consolidation. The Japanese government must raise various taxes on a large scale to cut budget deficits and to finance the social security system. However, higher tax rates will impair efficient allocation of resources. We will compare the welfare cost and income distribution effects of fiscal consolidation measures under different taxation methods including higher income and social security taxes and an inflation tax on government debt. We also will evaluate the effects of changes in immigration policy on the potential growth rate.

April 8, 2014 - March 31, 2016