Real rates and consumption smoothing in a low interest rate environment: The case of Japan

• Published date: 01 December 2018
• DOI: http://doi.org/10.1111/1468-0106.12284
• Date: 01 December 2018
• Author: Thomas A. Lubik,Jonathon Lecznar

ORIGINAL MANUSCRIPT

Real rates and consumption smoothing in a low

interest rate environment: The case of Japan

Jonathon Lecznar

1

| Thomas A. Lubik

2

1

Department of Economics, Boston University,

Boston, Massachusetts

2

Department of Economics, Federal Reserve Bank

of Richmond, Richmond, Virginia

Correspondence

Thomas A Lubik, Research Department, PO Box

27622, Richmond, VA 23261, USA.

Email: thomas.lubik@rich.frb.org

Abstract

We study the dynamics of consumption, the real interest

rate and measures of labour input in Japan over the period

from 1985 to 2014. We identify structural breaks in mac-

roeconomic aggregates during the 1990s and associate

them with the zero interest-rate policy pursued by the

Bank of Japan and the surprise increase in the consump-

tion tax rate in April 1997. Formal estimation using the

generalized methods of moments shows that the mid-

1990s are characterized by breaks in the structural param-

eters governing household consumption and labour supply

decisions. Specifically, following the tax hike and during

the low nominal rate period, Japanese households became

less risk averse and exhibited a higher degree of habit

formation.

1|INTRODUCTION

The behaviour of aggregate consumption in Japan changed considerably in early 1997. Evidence

obtained from comovement patterns, structural break tests and more formal generalized method of

moments (GMM) estimation on structural Euler equations for consumption growth indicates that the

behaviour of aggregate consumption suffered a break during that time period. Based on the historical

record, we can correlate this finding with two dramatic policy actions: the Bank of Japan’s (BoJ)

implementation of a highly accommodative low-interest policy in mid-to-late 1995 and a

2-percentage point rise in the consumption tax rate to 5% in April 1997.

1

We argue that the results in

our paper show that these policy changes coincided with a break in the aggregate consumption series.

The changes can be explained in terms of a simple consumption-choice model whereby Japanese

households formed stronger habit preferences towards their purchases and exhibited greater sensitiv-

ity to real interest rate movements following the policy changes.

The economy of Japan is a congenial environment to study the behaviour of aggregate consump-

tion. The period from the mid-1980s to the early-2010s can be tersely described as a boom, then bust,

followed by a multi-decade period of primarily stagnation and intermittent deflation throughout this

Received: 12 May 2017 Revised: 13 June 2018 Accepted: 9 August 2018

DOI: 10.1111/1468-0106.12284

Pac Econ Rev. 2018;23:685–704. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 685

period. There were marked changes in multiple facets of governmental policy occurred. With regards

to monetary policy, the BoJ lowered its policy rate to hitherto historic lows in 1995, only to eventu-

ally go further in 1999 by introducing the zero interest-rate policy (ZIRP). The BoJ’s policy rate has

not deviated very far from zero ever since. On the fiscal policy side, beginning in 1992 numerous

rounds of fiscal stimulus were passed, labour laws on temporary employment were relaxed in 1998,

and a tax on consumption was initially introduced in 1989, then subsequently raised in 1997.

We first assess whether key macroeconomic time series exhibit changes in their behaviour over

the period from 1985 through 2013. In particular, we consider measures of consumption, the real

interest rate, and the extensive and intensive margins of employment. A simple ocular inspection of

the data suggests such changes, as both consumption growth and the real rate of interest appear to

begin behaving differently in the mid-1990s. Using a bevy of structural break tests, we identify the

second quarter of 1995 as a break in the real interest rate series, which coincides with the onset of a

period when the BoJ held the policy rate fixed at 50 basis points. We also find a break in consump-

tion growth in the second quarter of 1997, coinciding with the hike in the consumption tax rate that is

often regarded as the starting point of the lost decade. Moreover, we find evidence of a structural

break in the behaviour of employment and hours worked that started earlier in the 1990s. The picture

that emerges of Japan’s economy during the 1990s is one of considerable change in the macroeco-

nomic environment.

2

Given the dramatic changes in the economic and policy environments during this time, we ask

whether the standard consumption Euler equation is a good and consistent descriptor of consumption

growth throughout such a period. Economic theory suggests that the key explanatory variable for

consumption growth is the real rate of interest. A convenient way of thinking about this relationship

can be found in the optimal savings decisions of households. More specifically, we consider the

canonical consumption Euler equation arising from constant relative risk aversion (CRRA) prefer-

ences with risk aversion parameter σ.

3

It describes how consumption C

t

, a (gross) nominal interest

rate R

t

, and (gross) inflation π

t

are related to each other:

C−σ

t¼βRtEtC−σ

t+1

1

πt+1

,σ>0:ð1Þ

Here, βis a parameter that discounts future consumption and E

t

is a rational expectations opera-

tor. This relationship can also be expressed in a more compact form by rewriting it in terms of a log-

linear approximation:

EtΔe

Ct+1¼1

σe

Rt−Eteπt+1



¼1

σe

rt,ð2Þ

where the tilde (~) denotes logarithmic deviation s from the steady state. The real interest rate, e

rt,is

defined as the log-difference of the nominal rate and expected inflation.

The Euler Equation (2) and its variants discussed below provide testable implications for how

consumption and real rates comove under the assumption of underlying optimizing behaviour.

4

This

relationship also implies that the degree of risk aversion dictates the strength of the responsiveness of

consumption growth to real interest rate changes.

5

However, underlying this time-series relationship

is the assumption of structural stability which requires that both σand the theoretical framework that

gave rise to this conjectured relationship remain constant over the period considered. The statistical

tests on the Japanese macroeconomic time series described above give us strong reason to believe

that the assumption of structural stability is violated during this period.

We therefore develop a baseline specification that generalizes the basic relationship conjectured

in Equation (2) to incorporate external habit formation. Using GMM to estimate this relationship, we

686 LECZNAR AND LUBIK