Question

In Japan, the government and central bank have enacted policies recently to raise inflation permanently from persistently low levels, however inflation continues to remain near zero. How, if at all, might credibility of the central bank explain the low inflation persistence?

Short answer

When markets believe in a central bank's ability to maintain price stability, the central bank has to do less to maintain it.

Step-by-step solution

Content Introduction

Cost push and demand pull are the two fundamental causes of inflation. The former refers to an increase in production costs, which results in a price increase, whereas the latter refers to an increase in aggregate demand as a result of changes in consumption, investment, and government spending. According to experts, Japan's ageing and dwindling population contributes to the persistent shortfall in consumer demand by urging people to be cautious resulting in inflation.

Content Explanation

When markets believe in a central bank's ability to maintain price stability, the central bank has to do less to maintain it. In the absence of credibility, more forceful action is required to attain the same goal. When there is a lot of ambiguity, credibility becomes even more vital.