“Finance” means lending money from places with surplus funds to places with insufficient funds. Banks and the Bank of Japan (the central bank) play central roles in this system.
Basic Knowledge
Money has three functions: ① a medium of exchange, ② a measure of value (unit of account), and ③ a store of value. Finance includes indirect finance, in which banks act as intermediaries (firms receive loans from banks), and direct finance, in which funds are raised directly by issuing shares and bonds. The Bank of Japan (BOJ) is Japan’s central bank and has three roles: ① the issuing bank (issuing Bank of Japan notes), ② the bank of banks (lending to commercial banks), and ③ the government’s bank (managing government funds). The BOJ adjusts economic conditions and prices through monetary policy. During economic overheating and inflation, it conducts monetary tightening to reduce the amount of money in the market, such as by raising interest rates (selling operations rather than buying operations). During recessions and deflation, it increases the money supply through monetary easing (low interest rates and government bond purchases (buying operations)). Inflation is a situation in which prices continue to rise and the value of money falls, while deflation is a situation in which prices continue to fall.
Indirect finance (a method of transferring funds through banks as intermediaries)
Direct finance (a method of raising funds directly from the market by issuing shares and bonds)
Bank of Japan (Japan’s central bank. Its three functions are issuing money, serving as the bank of banks, and serving as the government’s bank)
Monetary policy (a policy in which the BOJ controls economic conditions and prices by adjusting interest rates and the money supply)
Inflation (a continuing rise in prices and a decline in the value of money)
Deflation (a continuing fall in prices. There is a risk of falling into a deflationary spiral)
Further Study (Background and Significance)
After the collapse of the bubble economy in the 1990s, Japan suffered from long-term deflation. From 2013 onward, the BOJ continued large-scale government bond purchases and low-interest-rate policies as “unprecedented monetary easing,” while setting a 2% price stability target. From 2022 onward, prices in Japan continued to rise under the influence of global inflation, and in 2024 the BOJ ended its negative interest rate policy. Financial systems cross national borders and are closely connected with the world economy through exchange rates and international capital movements. The development of fintech (finance × technology) has also brought new forms of finance, such as cashless payments by smartphone and crypto-assets.
- Three functions of money: medium of exchange, measure of value, and store of value
- Three roles of the BOJ: issuing bank, bank of banks, and government’s bank
- Monetary easing (recession policy): low interest rates and buying operations → increased money supply
- Monetary tightening (inflation policy): high interest rates and selling operations → decreased money supply
- Deflationary spiral: falling prices → worsening corporate profits → lower wages → lower consumption → further falling prices
- Indirect finance is Japan’s main method of raising funds (main bank system)
- In 2024, the BOJ ended its negative interest rate policy (a shift away from monetary easing)
Points to Note (Easily Confused Concepts)
① Do not reverse the directions of monetary easing and monetary tightening: easing supplies funds during economic stagnation, while tightening restrains the money supply during inflation. ② Distinguish between buying operations (the BOJ buys government bonds → funds are released into the market) and selling operations (the BOJ sells government bonds → funds are withdrawn from the market). ③ Inflation means that prices rise and the value of money falls (people holding cash are disadvantaged), while deflation means that prices fall and the value of money rises (people holding cash are advantaged, but the economy stagnates). ④ A rise or fall in the yen’s exchange rate has opposite effects on exports and imports.
Practice
- Name the Bank of Japan’s “three roles” and explain each one.
- What kind of policy is “monetary easing”? Explain, including the economic conditions in which it is implemented.
- What is a “deflationary spiral”? Explain the chain involving prices, firms, wages, and consumption.