Introduction: Toward a Monetary and Fiscal Theory of the Price Level

This chapter briefly provides empirical and theoretical motivations for research papers that are collected in this book. In the modern Japanese economy, strong money demand has appeared twice. It first appeared during World War II and then, more recently, after the mid-1990s. Such strong money demand enabled the Japanese government to finance large-scale military spending in the first occasion, while it has supported massive fiscal operations developed by the government in the second. For the former part, the economy was forced to implement strict fiscal reforms to prevent hyperinflations from happening once the strong money demand disappeared immediately after the war ended. For the latter, on the other hand, near-zero rates of interest and stable prices continue to coexist with affluent money and poor fiscal surpluses, while strong money demand survives.

The observations associated with the emergence and disappearance of strong money demand are hard to explain by either the quantity theory of money or the fiscal theory of the price level. Here, a monetary and fiscal theory of the price level is proposed as their alternative. In particular, it can successfully identify additional sources of money demand. More concretely, the strong money demand appearing during the war was attributed to immense demand for BOJ notes from black markets, while the current one has been driven by extremely low interest rates, starting from 1995. Employing rich implications from this alternative theory, I fully elucidate the extent to which the current monetary and fiscal situation of the Japanese economy is sustainable, and how it will break down in the near or far future.