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1. Theoretical background of research on stagnation

Since 1990 Japan has been in the worst stagnation after World War II. People do not consume enough to attain full employment. Surprisingly, economics has not yet fully solved why an overall shortage of demand occurs. In the history of economic thought there are lots of attempts to clarify the mechanism of stagnation. A typical one is Keynes (1936). However, later economists have found lots of contradictions to the rationality of consumers’ behavior in his theory. They criticize the economists that still follow Keynes’s theory and cynically call them old Keynesians. Furthermore, they have almost given up providing a model that accommodates stagnation caused by an overall demand shortage.

Consequently, some theorists (called neoclassical economists) say that involuntary unemployment never occurs and that the unemployed voluntarily choose the present situation. They concentrate on analyzing the dynamics of an economy with full employment and full market equilibrium. Others (called new Keynesians) believe that frictional price/wage adjustment causes a demand shortage in each individual market. Therefore, they analyze the mechanism of price/wage rigidities, e.g., monopolistic behavior of firms or workers, and imperfect information of the labor market.1

Following these theories most economists, including Japanese and the U.S. ones, insist the following:
1) The present Japanese stagnation is caused not by a demand shortage but by production inefficiency. Therefore, inefficient firms should be removed and fiscal spending should be lowered.
2) The unemployed should be left as they are since they prefer being unemployed to employed.
3) Prices should be lowered more rapidly so that market equilibrium is smoothly reached.

In reality, however, lots of people are left unemployed although they are seriously searching for jobs. Prices continue to decline for more than 10 years and yet employment does not improve at all. A decrease in fiscal spending lowers national product. Therefore, policy makers cannot fully rely on the conventional theories and still use the old Keynesian analysis despite lots of shortcomings.

In this paper and Ono (1994) I establish a new stagnation theory that satisfies neoclassical criticisms against Keynes’s theory. In a competitive monetary economy with dynamically optimizing consumers and firms persistent stagnation is shown to occur although prices and wages continue to adjust. Preference for money/wealth holding plays a crucial role in generating stagnation. This stagnation is in sharp contrast to those of the old and new Keynesian theories since they either assume a priori some price rigidities or impose noncompetitive assumptions that might cause prices and/or wages to diverge from market-clearing levels.

This theory also requires a drastic change of neoclassical policy implications which most of Japanese policy makers believe in. For example, fiscal spending or monetary expansion is effective in increasing consumption and national product. Faster price/wage adjustment, leading to greater deflation, reduces employment.

1 See Blanchard and Fischer (1989) and Romer (1996) for these theories.


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