## 1. Strengthening the Bank of Japan’s Communication Framework

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### Motivation: Japan’s persistent low nominal growth and deflation
- Since the early 1990s Japan has experienced deficient nominal and real GDP growth and repeated deflationary episodes.
- Monetary policy constrained by the Effective Lower Bound (ELB) on policy rates, impeding escape from the liquidity trap.
- Repeated fiscal stimulus combined with weak nominal growth has driven the public debt-to-GDP ratio to unprecedented peacetime levels.
- Abenomics (December 2012) adopted three arrows: bold monetary policy, flexible fiscal policy, and a growth strategy to promote private investment.
- Initial Abenomics outcomes: narrowing output gap, easing financial conditions, boosted corporate profits, increases in actual and expected inflation, modest increases in base wages; the first consumption tax hike generated considerable fiscal savings.
- Later developments: headline inflation returned to deflationary territory, base wage growth dampened, growth slowed, consumption and investment remained sluggish, sentiment deteriorated, the yen appreciated recently, equity prices declined, and inflation expectations fell.

### Key factors behind recent difficulties
- Structural impediments:
  - Aging and shrinking population reducing investment and credit demand.
  - Labor market duality and inflexibility impede wage pass-through.
  - Weak demand and a deflationary mindset reduce firms’ ability to raise prices.
  - Financial sector weaknesses limit risk-taking and access to risk-based capital; high reliance on fixed asset collateral and slow SME restructuring persist.
- Policy shortcomings:
  - Fiscal stance became too contractionary in 2014.
  - Stop-go fiscal policy (yearly supplementary budgets, discretionary VAT changes, optimistic growth assumptions) undermines credible medium-term fiscal anchor and raises policy uncertainty.
  - Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest hinder the rise in inflation expectations and BoJ credibility.
  - Structural reforms did not sufficiently address labor market rigidities.
- Global factors:
  - Sluggish global growth and overcapacity limited export boost from a weaker yen.
  - Financial volatility and safe-haven appreciation pressures from emerging market concerns and advanced-economy policy revisions.
  - Declining commodity prices forced the BoJ to repeatedly push out its inflation target timeline.

### Slow wage-price dynamics: a missing transmission link
- Causes identified:
  - Residual slack—weak manufacturing recovery and employment growth concentrated in less productive services.
  - Trend increase in female labor force participation concentrated in part-time jobs dampening average wage growth.
  - Labor market features: low horizontal mobility of regular workers, industrial relations emphasizing employment stability, backward-looking wage setting tied to recent actual inflation rather than a 2 percent target.
- Conclusion:
  - Without resolving coordination blockages, raising nominal GDP growth will remain elusive; an incomes policy is proposed to complement demand stimulus.

### Divergent policy views
- Bank of Japan (BoJ):
  - Current policy injects ¥80 trillion a year into bank system cash reserves via quantitative and qualitative easing (QQE), combined with marginal negative deposit rates; BoJ expected to raise inflation to target by early 2018 conditional on energy prices, closing output gap, forward-looking expectations, and upward wage pressures.
- Ministry of Finance (MoF):
  - Concern about effectiveness of fiscal stimulus and rising debt-to-GDP ratio; government decision (May 2016) postponed the 2 percent VAT increase to October 2019.
- Academic proposals summarized:
  - Ito (2015): further gradual VAT increases for fiscal consolidation.
  - Krugman (2015): large fiscal and monetary stimulus to reach escape velocity.
  - Svensson (2000): step depreciation of the yen followed by price-level-path targeting.
  - Turner (2015): one-off monetization of the fiscal deficit—practical but raises political economy concerns.

### Proposed response: Three Arrows Plus (overview)
- Package combines:
  - Monetary policy (continued and credibly communicated).
  - Fiscal policy (credible, transparent framework to reduce uncertainty and reinforce monetary policy).
  - Structural reforms (reduce labor duality, raise female participation, increase labor supply via foreign workers, reform sectors to raise potential output).
  - An unorthodox incomes policy aimed at sluggish wage-price dynamics to address coordination failure in wage setting.
- Coordination emphasized to exploit synergies across instruments.

### Communication framework and Inflation-Forecast-Targeting (IFT)
- Recommendations:
  - Move to an inflation-forecast-targeting framework where BoJ responds to deviations of the inflation forecast from the 2 percent target; BoJ forecast becomes the intermediate target.
  - Publish a medium-term baseline forecast with a path for key policy instruments (policy rate and balance sheet) consistent with achieving the 2 percent inflation target.
  - Make policy settings endogenous via a reaction function that hits the target over the medium term; time horizon for meeting the target need not be pre-specified.
  - Publish confidence bands and alternative scenarios showing contingent policy paths and uncertainties.
- IFT precedents and adaptations:
  - Canada, Czech Republic, and U.S. used IFT adaptations at the ELB with varying instruments and outcomes cited.

### Monetary policy stance under IFT and ELB
- IFT necessary but unlikely sufficient alone to exit the ELB; requires fiscal policy, incomes policy, and structural reforms for credibility.
- Monetary policy should remain flexible with all easing options available.
- Objective: plan for a modest overshoot of the 2 percent inflation target to get permanently out of the ELB.
- Unconventional measures modeled as compression in term and corporate risk premia.

### Fiscal policy: findings and recommendations (Arrow 2)
- Fiscal policy should manage public sector balance sheet risks over the long term while remaining flexible to support monetary policy.
- Recommendations:
  - Support BoJ inflation targeting through higher public wages and transfers.
  - Increase VAT rates in small steps over a very extended period to bring debt to a sustainable path.
  - Adopt a fiscal rule establishing a medium-term path minimizing public finance balance sheet risks while allowing anti-deflationary escape clauses.
  - Improve fiscal transparency, update consolidated balance sheet, strengthen fiscal risk management, and set up an independent fiscal council to validate projections and assess macro-effects.
  - Reorient fiscal stimulus to support incomes policy: government commit to raise public sector wages by 3 percent each year and increase transfers to low-income households.
  - VAT path recommended: 0.5 percentage points each year starting fiscal year 2017/18 to reach 15 percent by fiscal year 2029/30.

### Structural reforms: findings and recommendations (Arrow 3)
- Objectives: reduce labor market duality, increase labor force (including foreign workers), and boost potential output.
- Key proposals:
  - Introduce a single open-ended contract for new hires with employment protection increasing with tenure to reduce duality.
  - Improve female participation via flexible work arrangements and child care support; female participation was 65 percent in the 15–64 years age group at end-2014.
  - Consider increasing working visas for foreign workers; foreign-born workers were 1.3 percent of total labor force in 2010.
  - Reform agriculture, expand R&D tax incentives, and reform financial sector incentives to raise risk capital and foster SME restructuring.
- Quantified medium-term impact:
  - Structural reforms could raise annual growth by about 0.5 percentage point over 5 years.
    - o.w. productivity-enhancing and labor market reforms: 0.4 percentage point.
    - o.w. tax and incentive reforms: 0.1 percentage point.

### Incomes policy: design, rationale, and risks (the "Plus")
- Purpose: end low wage growth and induce inflation to align with BoJ target.
- Implementation:
  - Use public sector wage policy and a “comply or explain” policy for private firms; government announces wage inflation guideline; firms comply or publicly explain.
  - Wage guideline not legally binding; policy acknowledges productivity and relative price differences.
  - Objective: move nominal variables in line with the 2 percent inflation target plus 1 percent productivity growth (target for wage inflation: around 3 percent).
- Risks and caveats:
  - Historical evidence mixed; U.S. NRA experience in 1933–35 correlated with price reflation but results are hard to disentangle.
  - Risks include increased hiring of non-regular workers, policy reversibility undermining expectations, declines in competitiveness and profitability for labor-intensive SMEs and exporters, and political resistance to public wage increases.

### Quantitative simulations: baseline vs. Three-Arrows-Plus outcomes
- Modeling approach: Flexible System of Global Models (FSGM); simulations are deviations from the baseline in the 2016 Staff Report on Japan.
- Baseline assumptions:
  - Authorities follow existing policy mix of ¥80 trillion yearly QQE, VAT increase to 10 percent in October 2019, and unchanged structural policies.
  - Baseline projections: real GDP growth averages 0.5 percent during forecast period; inflation remains below 2 percent; general government net borrowing averages 3.8 percent of GDP a year; current account surplus ~3.0 percent of GDP; REER unchanged.
- Baseline scenario key numbers (Japan: Baseline Scenario, Real GDP Growth and CPI Inflation; values are year-on-year/annual average):
  - Real GDP Growth:
    - 2016: 0.5
    - 2017: 0.3
    - 2018: 0.5
    - 2019: 0.8
    - 2020: 0.1
    - 2017-20: 0.4
  - CPI Inflation:
    - 2016: 0.2
    - 2017: 0.6
    - 2018: 0.6
    - 2019: 1.1
    - 2020: 1.7
    - 2017-20: 1.0
  - General Govt. Net Lending/Borrowing (Percent of GDP):
    - 2016: -5.0
    - 2017: -4.2
    - 2018: -3.9
    - 2019: -3.6
    - 2020: -2.9
    - 2017-20: -3.7
  - General Govt. Net Debt (Percent of GDP):
    - 2016: 130.4
    - 2017: 132.9
    - 2018: 134.8
    - 2019: 133.8
    - 2020: 132.8
    - 2017-20: 133.6
  - Current Account Balance (Percent of GDP):
    - 2016: 3.5
    - 2017: 3.0
    - 2018: 3.0
    - 2019: 2.8
    - 2020: 3.1
    - 2017-20: 3.0

- Three-Arrows-Plus (excluding structural reforms) headline outcomes:
  - Real GDP growth: on average 0.4 percentage point higher than baseline over the forecast horizon.
  - CPI inflation (excluding VAT effects): would overshoot the BoJ 2 percent target by 2019.
  - Output gap: turns positive by 2019 (baseline remains negative).
  - Policy rates: optimal to not respond while allowing a modest overshoot of inflation target.
  - Net-debt-to-GDP: downward trajectory due to higher growth, gradual VAT increases, and inflation; term premium reduced marginally.
  - REER: moderate depreciation followed by slight rebound in outer years.

- Our Proposed Policy Package key numbers (Japan: Our Proposed Policy Package):
  - Real GDP Growth:
    - 2016: 0.5
    - 2017: 0.8
    - 2018: 1.0
    - 2019: 1.2
    - 2020: 0.3
    - 2017-20: 0.8
  - CPI Inflation:
    - 2016: 0.2
    - 2017: 1.8
    - 2018: 2.2
    - 2019: 3.1
    - 2020: 2.8
    - 2017-20: 2.4
  - General Govt. Net Lending/Borrowing (Percent of GDP):
    - 2016: -5.0
    - 2017: -4.5
    - 2018: -4.5
    - 2019: -4.0
    - 2020: -3.5
    - 2017-20: -4.1
  - General Govt. Net Debt (Percent of GDP):
    - 2016: 130.4
    - 2017: 131.9
    - 2018: 132.8
    - 2019: 129.6
    - 2020: 127.9
    - 2017-20: 130.5
  - Current Account Balance (Percent of GDP):
    - 2016: 3.5
    - 2017: 3.1
    - 2018: 2.9
    - 2019: 2.7
    - 2020: 3.0
    - 2017-20: 2.9

### Key numeric assumptions for Three Arrows Plus (Table I.1)
- Monetary policy premia (basis points differences):
  - Term premium: 2017 = -10; 2018 = -15; 2019 = -20; 2020 = -10; 2021-: decays with AR=0.6.
  - Corporate risk premium: 2017 = -1.7; 2018 = -8.3; 2019 = -8.3; 2020 = -8.3; 2021-: decays with AR=0.6.
  - Short-term policy rate: fixed at baseline 2017-2022.
- Fiscal policy:
  - VAT: 0.5pp rise every year in 2017-2030, end tax rate = 15%.
  - Targeted transfers (% of baseline GDP): 2017 = 0.8; 2018 = 1.6; 2019 = 1.5; 2020 = 1.4; 2021- = 0.9, then 0.
- Incomes policy — expectations shocks (impact on core inflation and wages, net of VAT):
  - Inflation expectations shock 1/: 2017 = 0.9; 2018 = 1.1; 2019 = 1.8; 2020 = 1.5; 2021- = 1.2 then 0.
  - Wage inflation expectations shock 2/: 2017 = 0.9; 2018 = 1.6; 2019 = 2.3; 2020 = 1.8; 2021- = 1.2 then 0.
- Slow inflation adjustment scenario (altered incomes policy shocks):
  - Inflation expectations shock 1/: 2017 = 0.2; 2018 = 0.7; 2019 = 1.7; 2020 = 1.3; 2021- = 1.1 then 0.
  - Wage inflation expectations shock 2/: 2017 = 0.8; 2018 = 1.4; 2019 = 2.2; 2020 = 1.1; 2021- = 0.8 then 0.
- Notes:
  - 1/ Impact of inflation expectations shocks on core inflation (net of VAT).
  - 2/ Impact of wage inflation expectations on wage inflation.

### Model highlights (FSGM Japan module)
- Real GDP: sum of demand components in short run; potential output in long run with Cobb-Douglas technology.
- CPI: driven by a Phillips curve with expected inflation, output gap, exchange rate pass-through, oil and food prices.
- Households: mix of forward-looking OLG and liquidity-constrained households.
- Investment: extended Tobin's Q responding to real interest rates and output gap.
- Government: sets long-run debt/GDP target and adjusts transfers via a fiscal reaction function.
- Monetary policy: inflation-forecast-based reaction rule; 10-year JGB rate = expectations theory + term premium.

### Comparison with alternative proposals and scenario risks
- Krugman scenario (summary):
  - Fiscal shock profile (2017–21): 2 percent of GDP in year 1; 4 percent in year 2; 5 percent in years 3 and 4.
  - Monetary policy: BoJ policy rate fixed at zero for five years; term premium assumptions similar to Three Arrows Plus.
  - Risks: If term premium rises (e.g., +100 or +200 basis points), debt outcomes worsen; +200 basis points leads to explosive debt path.
- Svensson’s Foolproof Way:
  - Requires BoJ–MoF coordination, initial depreciation and crawling peg, and maintaining low long-term nominal rates while raising inflation expectations.
  - Direct VAT impacts in simulations: 0.3 and 1.0 percent in 2019 and 2020 respectively in Svensson scenarios.
- Turner’s debt monetization:
  - Could end deflation if credible, but risks political backsliding on fiscal consolidation, ratcheting inflation expectations, and undermining inflation-targeting regime.
- Slower inflation response to incomes policy:
  - A one- or two-year lag does not cause substantial differences if the overall package is credible; slower inflation implies slower debt-to-GDP decline but medium-term improvements still materialize.
- Comparative assessment:
  - Three Arrows Plus is judged more likely to mitigate adverse private sector responses than alternatives due to a combination of long-run frameworks, preannounced VAT path, premia compression, targeted transfers, and an incomes policy to anchor expectations.

### Policy inventory: principal actionable recommendations
- BoJ adopt an Inflation-Forecast-Targeting framework with published medium-term baseline forecasts, interest-rate and balance-sheet paths, confidence bands, and alternative scenarios.
- Maintain monetary flexibility and all easing tools on the table; plan for a modest overshoot of the 2 percent target.
- Fiscal: commit to gradual VAT increases of 0.5 percentage points annually from fiscal year 2017/18 to reach 15 percent by fiscal year 2029/30; establish a fiscal rule with anti-deflationary escape clauses; raise public sector wages by 3 percent annually and increase transfers to low-income households.
- Structural reforms: implement labor contract reforms (single open-ended contract with tenure-linked protection), expand child care and flexible work arrangements, increase working visas for foreign workers, reform agriculture and financial incentives for R&D and SME restructuring.
- Incomes policy: publicly announce wage inflation guidelines, use “comply or explain” for private firms, and lead with public wage increases to coordinate private sector wage-setting.

*Source: _wp16157 - 1. Strengthening the Bank of Japan’s Communication Framework (selected pages).*

### 1. Strengthening the Bank of Japan’s Communication Framework ____________________17

### 1. Strengthening the Bank of Japan’s Communication Framework ____________________17

### Motivation: Japan’s persistent low nominal growth and deflation
- Since the early 1990s Japan has experienced deficient nominal and real GDP growth and repeated deflationary episodes.
- Monetary policy has been constrained by the Effective Lower Bound (ELB) on policy rates, impeding escape from the liquidity trap.
- Repeated fiscal stimulus combined with weak nominal growth has driven the public debt-to-GDP ratio to unprecedented peacetime levels.
- Prime Minister Abe’s administration (December 2012) implemented Abenomics: three arrows—bold monetary policy, flexible fiscal policy, and a growth strategy to promote private investment.
- Initial outcomes of Abenomics included narrowing the output gap, easing financial conditions, boosted corporate profits, increases in actual and expected inflation, and modest increases in base wages; the first consumption tax hike generated considerable fiscal savings.
- Recovery later stalled: headline inflation returned to deflationary territory, base wage growth dampened, growth slowed, consumption and investment remained sluggish, sentiment deteriorated, the yen appreciated recently, equity prices declined, and inflation expectations fell.

### Key factors behind the recent difficulties
- Structural impediments:
  - Low confidence in economic prospects related to an aging and shrinking population is holding back investment and credit demand.
  - Labor market duality and inflexibility impede pass-through from a tightening labor market and high corporate profits to wage increases.
  - Weak demand and a lingering deflationary mindset reduce firms’ ability to raise output prices.
  - Financial sector weaknesses limit risk-taking and access to risk-based capital; high reliance on fixed asset collateral and slow restructuring of non-viable SMEs persist.
- Policy shortcomings:
  - Fiscal stance became too contractionary in 2014, beyond the anticipated consolidation from the consumption tax hike.
  - Stop-go fiscal policy (yearly supplementary budgets, discretionary changes in consumption tax hikes, optimistic growth assumptions) undermines a credible medium-term fiscal anchor and heightens policy uncertainty.
  - Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest hinder the needed rise in inflation expectations, posing a communication and credibility challenge for the Bank of Japan (BoJ).
  - Structural reform efforts did not sufficiently address labor market rigidities.
- Global weakness and volatility:
  - Sluggish global growth and overcapacity in traded goods limited the export boost from a weaker yen.
  - Emerging market concerns and revisions to advanced-economy monetary policy paths raised financial volatility and safe-haven appreciation pressures.
  - Declining commodity prices exerted downward pressure on headline inflation and forced the BoJ to repeatedly push out its timeline for hitting the inflation target.

### Slow wage-price dynamics: a missing transmission link
- Causes of sluggish wage-price dynamics:
  - Residual slack in the economy—weak recovery in manufacturing—puts downward pressure on wages; employment growth concentrated in less productive services sectors.
  - Trend increase in female labor force participation concentrated in part-time jobs dampens average wage growth.
  - Structural labor market features: low horizontal mobility of regular workers, an industrial relations system emphasizing employment stability over wage increases, and limited wage bargaining power.
  - Wage setting tends to be backward looking, based on recent actual inflation rather than the 2 percent monetary policy target.
- Conclusion: Without strong efforts to resolve market coordination blockages, raising nominal GDP growth will remain elusive.

### Divergent views on policy direction
- Bank of Japan (BoJ) view:
  - Current policy injects ¥80 trillion a year into bank system cash reserves via quantitative and qualitative easing (QQE), combined with marginal negative deposit rates, and is expected by the BoJ to raise inflation to the target by early 2018—conditional on energy prices rising, the output gap closing, inflation expectations becoming more forward looking, and upward wage pressures naturally emerging.
- Ministry of Finance (MoF) view:
  - Increasing concern about effectiveness of fiscal stimulus and rising debt-to-GDP ratio. Government decision (May 2016) to postpone the 2 percent VAT increase by two and a half years, to October 2019, in view of weak domestic and foreign demand.
- Academic proposals summarized in the paper:
  - Ito (2015): further gradual VAT increases for fiscal consolidation.
  - Krugman (2015): “irresponsible fiscal and monetary policies” to reach escape velocity and inflate away debt.
  - Svensson (2000): step depreciation of the yen followed by price level path targeting.
  - Turner (2015): one-off monetization of the fiscal deficit—practical but raises political economy concerns about future abuse.

### The proposed response: Three Arrows Plus
- The paper proposes a comprehensive policy package—Three Arrows Plus—that reinforces Abenomics by combining:
  - Monetary policy (continued and credibly communicated);
  - Fiscal policy (credible, transparent framework to reduce policy uncertainty and reinforce monetary policy);
  - Structural reforms (to end labor market duality, raise female participation, increase labor supply through foreign workers, and reform sectors to raise potential output over time);
  - An unorthodox incomes policy aimed directly at sluggish wage-price dynamics to address the coordination failure in wage setting.
- The package is coordinated to exploit synergies across monetary, fiscal, structural, and incomes policies to maximize the chance of success.

### Historical experience and macro facts (selected figures and statistics from the text)
- Nominal and real GDP growth averaged 0.7 percent and 1.0 percent during the period 1990–2015.
- For the average G-7 country excluding Japan the comparable averages were 3.8 percent and 1.7 percent.
- Inflation (CPI) has averaged 0.5 percent since 1990, with mild deflation most of the time.
- Using the GDP deflator, annual inflation has averaged -0.3 percent, with almost two decades of continuous deflation from 1995 to 2013.
- Government net debt rose to 125 percent of GDP by end-2015; gross government debt is about twice as high.
- Over 95 percent of government debt is domestically held.
- The BoJ’s current QQE involves injecting ¥80 trillion a year into bank system cash reserves.
- The BoJ adopted a negative interest rate policy (NIRP) in January 2016.
- The government postponed the 2 percent VAT increase to October 2019.
- Consensus economic survey of May 2016 expected wage growth of 0.8 percent in 2016 and 1.0 percent in 2017.
- Consumption growth was expected to be just above 0.1 percent in 2016 and 2017.

*Source: _wp16157 - 1. Strengthening the Bank of Japan’s Communication Framework ____________________17*

### 0.5 percent in 2016 and 0.3 percent in 2017, while potential growth will decline slowly

### 0.5 percent in 2016 and 0.3 percent in 2017, while potential growth will decline slowly

### Tight labor market but sluggish wage-price dynamics
- Key observation:
  - Japan’s labor market has tightened considerably in recent years across standard metrics, with declines in the unemployment rate among all age groups and types of unemployed, and reductions in alternative measures of labor underutilization (including discouraged workers, marginal attachment, and part-time employment for economic reasons).
- Paradox:
  - Tight labor market indicators coexist with overall economic slack, reflected in a considerable decline in total hours worked and an apparent shift toward part-time employment.
- Okun’s Law and sensitivity:
  - A 10 percent increase in output is estimated to reduce unemployment by 1.2 percentage points in Japan (Steinberg and Nakane (2011)), which is lower than estimated responses for other G7 countries of about 4 percentage points.
- Labor market mismatches:
  - Evidence of increased mismatches consistent with a shift in the Beveridge Curve in the 1990s, leading to a higher vacancy rate for a given level of unemployment.
  - Reports of increasing labor shortages in services and construction and among specialists and technicians (Ganelli and Miake (2015)).
- Factors contributing to subdued nominal and real wages:
  - Shifting employment share from manufacturing to services with lower labor productivity and wages.
  - Increase in the share of part-time employment, concentrated in the services sector.
  - Low horizontal mobility of regular workers under lifetime employment; regular workers hired as generalists reduce firms’ incentives to raise wages to attract external hires.
  - An industrial relations system emphasizing employment stability over wage increases; unions and workers accepting wage moderation in exchange for low unemployment and stability.
  - Limited wage bargaining power: firm-level bargaining and coordinated Shunto rounds dominated by large firms and regular workers; rising share of non-regular workers has weakened the Shunto’s importance; declining unionization rates and reduced labor conflicts.
  - Real wages have not kept up with productivity over the past two decades, more so than in most comparable economies (Porcellachia (2016)).
- Coordination problem and expectations:
  - Low actual and expected inflation, an entrenched deflationary mindset, and backward-looking inflation expectations generate weak nominal wage growth.
  - Unions, employees, and public wage-setting look at recent actual headline inflation rather than anticipating the 2 percent inflation target.
- Policy implication:
  - Unless policies change significantly, the labor market may not tighten enough to generate wages consistent with the inflation objective.
  - Need for a new incomes policy to accompany short-term demand stimulus to remove residual slack.
  - Labor contract reforms to reduce duality and increase mobility would stimulate more sustained wage-price pressures.

### Diverging views on policy to exit the ELB and end deflation
- General consensus:
  - Agreement on need for a stronger policy package to exit the effective lower bound (ELB), but divergence on the appropriate policy mix among authorities and academics.
- Bank of Japan (BoJ) view:
  - QQE and NIRP, together with rising energy prices, closing output gap, and strengthening wage-price dynamics, will bring inflation to about 2 percent by early 2018.
  - Proposal for an explicit inflation-forecast-targeting framework to increase transparency and effectiveness and anchor longer-term inflation expectations.
- Fiscal policy stance and government actions:
  - Structural primary deficit declined from 7.5 percent of GDP in 2013 to 4.5 percent in 2015, partly due to the consumption tax increase from 5 to 8 percent in April 2014.
  - In May 2016, the government announced a second postponement of the VAT increase to 10 percent from April 2017 to October 2019.
  - Recommendation: adopt a fiscal policy framework that responds to macroeconomic conditions in the short term while maintaining debt sustainability for the longer run to reduce policy uncertainty and tail risk of a fiscal crisis.
- Academic perspectives:
  - Ito (2015): advocates further gradual increases in the VAT rate; warns of a possible fiscal crisis in the early 2020s as household savings decline and government financing needs are increasingly met by foreign investors, pushing up interest rates; recommends a balanced package of fiscal adjustment, continued monetary easing, and accelerated structural reforms.
  - Krugman (2015): advocates a burst of fiscal stimulus combined with monetary easing to reach “escape velocity”; warns required stimulus would need to be very large given a relatively flat Phillips curve and could provoke negative financial market responses without frameworks to maintain debt sustainability and anchor expectations (see Appendix II).
  - Svensson (2000) “Foolproof Way”: use exchange rate and price-level-path targeting (PLPT) with (1) an upward-sloping PLPT path, (2) an initial depreciation followed by a crawling peg to reach PLPT, and (3) an exit by abandoning the crawling peg once the PLPT path is achieved. Practical constraints for Japan: legal obstacles (MoF responsible for exchange rate policy; BoJ legally not allowed to intervene in FX market), potentially large required depreciation for a relatively closed economy, and need for complementary measures (forward guidance and more QQE) to stimulate domestic demand and imports (Appendix III).
  - Turner (2015): proposes monetization of a portion of the deficit as a one-off measure to increase nominal GDP without adding to fiscal debt; warns political incentives could lead to repeated monetization, inflation scares, higher real interest rates, and renewed unsustainable debt growth (Appendix IV).

### The Three-Arrows-Plus policy package
- Overarching premise:
  - A coherent, comprehensive approach is necessary, embedding monetary and fiscal stimulus in a long-term framework to stabilize expectations and adding an incomes policy to raise wage inflation.
  - Target for wage inflation: around 3 percent, consistent with the BoJ inflation target of 2 percent for consumer prices plus 1 percent productivity improvement.
- Arrow 1: An Inflation-Forecast-Targeting (IFT) Framework
  - Recommendation:
    - BoJ should move to an inflation-forecast-targeting framework where monetary policy responds to deviations of the inflation forecast from the 2 percent target.
    - The BoJ forecast of inflation becomes the intermediate target for policy, based on all available information and views about the state of the economy.
    - Use the forecast to communicate transparently how the BoJ manages the short-run output-inflation tradeoff, build credibility with financial markets, and better anchor long-term inflation expectations to 2 percent.
  - International precedents and adaptations:
    - IFT has been adapted at the ELB in Canada, the Czech Republic, and the U.S. through various instruments.
    - Canada: credibility of IFT allowed Bank of Canada to induce a depreciation of the exchange rate since 2014 to soften commodity-price shocks (Clinton and others, 2015).
    - Czech Republic: central bank announced an exchange rate ceiling of 27 koruna per euro on November 7, 2013, implying a step depreciation of about 5 percent; policy was credible and inflation picked up while real interest rates fell (Alichi and others, 2015a).
    - United States: quantitative easing and forward guidance since adoption of IFT in 2012 helped keep long-term inflation expectations anchored to 2 percent despite commodity price falls (Alichi and others, 2015b).
  - Box 1 — Strengthening BoJ communication framework (selected recommendations):
    - Effective BoJ communication and consistent policy action are essential to defeat the deflationary mindset, anchor inflation expectations, and reduce excessive asset price volatility.
    - Publish a medium-term baseline forecast with a path for key policy instruments (policy rate and balance sheet) consistent with achieving the 2 percent inflation target.
    - Make policy settings endogenous via a reaction function designed to hit the target over the medium term; the reaction function incorporates preferences over short-run tradeoffs between the output gap, deviations of inflation from target, and instrument variability, determining the time profile by which inflation returns to target.
    - Note: the time horizon for meeting the target does not need to be pre-specified.
- Additional elements of the package (summarized from the chapter):
  - Embed monetary and fiscal stimulus within a long-term framework to stabilize expectations.
  - Add an incomes policy aiming at sustained wage inflation consistent with inflation and productivity goals.
  - Undertake labor contract reforms to reduce duality and increase mobility to bolster wage-price dynamics.

*Source: IMF Working Paper excerpt titled "0.5 percent in 2016 and 0.3 percent in 2017, while potential growth will decline slowly" (selected pages).*

### Box 1. Strengthening the Bank of Japan’s Communication Framework (concluded)

### Box 1. Strengthening the Bank of Japan’s Communication Framework (concluded)

### Communication framework and inflation-forecast targeting (IFT)
- The published baseline policy rate path would, through expectations, influence the term structure of interest rates, the exchange rate, and asset prices, in a manner helpful for the efficient achievement of policy objectives. This improves the effectiveness of the policy rate as an instrument of monetary policy. This, in combination with other policies, would make the path for inflation more credible.
- The baseline provides a common point of reference for Policy Board deliberations. Members of the Policy Board may have differences with the staff’s baseline forecast. Where these are substantial, a member may publish a reservation as in other central banks that have adopted an IFT framework. This would not be a radical change from the current practice at the BoJ, considering that members’ dissenting votes on policy actions are recorded.
- Confidence bands would indicate the estimated range of uncertainty around the baseline forecasts. In countries where the central bank publishes the forecast path for the interest rate, markets have quickly accepted that this forecast is conditional. Confidence bands underscore the point.
- Alternative scenarios would show the implications of selected shocks, or of basic differences in forecast assumptions that may exist among policymakers. The BoJ should discuss contingent policy paths under alternative outlook scenarios. This would generate a better understanding of the BoJ approach to managing the macroeconomic risks, and thus help improve policy predictability. It also would reinforce that the baseline forecast is conditional.

### Monetary policy stance under IFT and the effective lower bound (ELB)
- Adoption of the IFT framework in Japan is necessary but unlikely to be sufficient to jolt the economy out of the ELB as the framework is unlikely to be credible upfront.
- Support required from fiscal policy, incomes policy, and structural reforms to be effective in getting the economy out of deflation.
- Monetary policy would need to continue to be managed flexibly with all easing options remaining on the table to respond to demand conditions.
- Objective: plan for a modest overshoot of the long-term 2 percent inflation target to get the economy permanently out of the ELB.
- If the response to fiscal or incomes policy or structural reforms is stronger/weaker than expected, monetary policy would need to adjust flexibly to provide less/more stimulus as needed to ensure attainment of the inflation target over the medium term.
- Unconventional measures in the proposed policy scenario are modeled through a compression in term and corporate risk premia (see Appendix I reference in source).

### Arrow 2: The Fiscal Policy Framework — findings and recommendations
- Fiscal policy should manage public sector balance sheet risks over the long term while maintaining flexibility to support monetary policy as appropriate.
- Exiting deflation is key to reducing long-term real interest rates and increasing growth.
- Fiscal policy mix recommendation:
  - Support BoJ inflation targeting through higher public wages and transfers.
  - Increase VAT rates in small steps over a very extended time period to bring debt on a sustainable path.
  - Advantage of small, frequent VAT increases: avoid volatility and uncertainty from large intertemporal substitution effects and minimize negative effects on spending.
- Institutional and rule-based recommendations:
  - Fiscal rule establishing a medium-term fiscal path that minimizes public finance balance sheet risks, while allowing for anti-deflationary escape clauses.
  - Fiscal rule guided by a clear and transparent fiscal compass tied to general government net worth.
  - Institutional reforms: improve fiscal transparency and budget procedures, update general government consolidated balance sheet, strengthen fiscal risk management, set up an independent fiscal council.
  - Independent fiscal council roles: validate long-term projections, provide real-time assessment of macro-effects of policy actions, assess long-term impact on public sector balance sheet.
- Reorientation of fiscal stimulus to support incomes policy:
  - Government commit to raise public sector wages by 3 percent each year for the foreseeable future to lead private sector wage setting.
  - Increase transfers to low-income households.
  - Such policies would boost domestic demand without a large deviation from debt stabilization and reduce likelihood of an increase in term premiums.
- VAT path recommendation (structural fiscal consolidation):
  - Government commit to a gradual increase of 0.5 percentage points in the VAT rate each year starting with the fiscal year 2017/18 in order to get the VAT rate to 15 percent by fiscal year 2029/30.
  - These policies would ensure a gradual decline in the debt-to-GDP ratio over the long term.
  - Precise path should secure political buy-in given compliance costs for firms and administrative burden for tax authorities.

### Arrow 3: Structural reforms — findings and recommendations
- Objectives: reduce labor market duality, increase the labor force through foreign workers, and boost potential output.
- Labor market duality:
  - Regular lifetime employment model vs. non-regular temporary employment.
  - Duality can reduce productivity by lowering non-regular worker effort and employer training incentives.
  - Proposal cited: introduction of a single open-ended contract for all new hires, with employment protection increasing with tenure (Aoyagi and Ganelli (2013) reference).
- Increasing labor supply:
  - Female labor force participation at 65 percent in the 15–64 years age group at end-2014; has increased significantly since Abenomics.
  - Room to improve female participation via flexible work arrangements and child care support.
  - Consider increasing numbers of working visas for foreign workers: foreign-born workers accounted for 1.3 percent of the total labor force in 2010 (Statistics Bureau of Japan).
- Sectoral reforms:
  - Reform agricultural sector to eliminate traditional support to certain food staples.
  - Expand tax incentives to foster research and development.
  - Financial sector reforms to foster incentives for raising risk capital and restructuring small- and medium-sized enterprises.
- Long-term impact:
  - Structural policies could provide a significant long-term boost to potential output, making it easier to sustain economic growth, end deflation, and make the debt sustainable over the long run.

### The Plus: Incomes policies — design, rationale, and risks
- Purpose: end low wage growth and induce inflation (through cost-push pressures) to move in line with the BoJ target.
- Builds on recent measures: tax incentives for firms that raise wages, higher minimum wage increases, and moral suasion.
- Implementation:
  - Use public sector wage policy (see fiscal policy section) and a “comply or explain” policy for the private sector.
  - Government would announce a wage inflation guideline; companies either comply or publicly explain why they cannot.
  - Wage inflation target would not be binding law; policy rejects a “one-size fits all” approach due to productivity and relative price differences.
  - Objective is to move nominal variables in line with the BoJ’s inflation target, not to change relative prices, raise real wages, or reduce competitiveness.
- Historical evidence and caveats:
  - Mixed experiences historically; often ineffective during war/high inflation episodes and sometimes produced supply shortages (example: French loi du maximum, 1793).
  - U.S. experience during the Great Depression: National Recovery Administration (NRA) correlated with an end to deflation and a 55 percent expansion in industrial production, 1933–35; NRA struck down in 1935; results are difficult to disentangle from other policies but Romer (1999) attributes a crucial role to the NRA in price reflation.
  - France in the 1930s: departure from gold standard plus large wage increases ended deflation and lowered real interest rates but output stagnated (Cohen-Setton and others (2016)).
- Risks:
  - Firms might increase hiring of non-regular workers if timing and coordination problems arise or “comply-or-explain” fails to secure sufficient compliance.
  - Perceived reversibility of policies could undermine effectiveness.
  - Possible declines in competitiveness and profitability—especially for labor-intensive SMEs and export-oriented companies—could adversely impact employment and growth in the near term.
  - Proposals to increase public wages likely to encounter political resistance amid fiscal consolidation plans.

### Quantitative simulations: baseline and Three-Arrows-Plus outcomes
- Modeling approach: Flexible System of Global Models (FSGM); simulations are deviations from the baseline projections for Japan included in the 2016 Staff Report on Japan.
- Baseline assumptions:
  - Authorities follow existing policy mix of ¥80 trillion yearly QQE, same fiscal policy including VAT increase to 10 percent in October 2019, and unchanged structural policies.
  - Under baseline, real GDP growth projected to average 0.5 percent during forecast period; inflation remains well below BoJ 2 percent target.
  - General government net borrowing averages 3.8 percent of GDP a year, resulting in an increase in the net-debt-to-GDP ratio.
  - Current account surplus broadly unchanged at around 3.0 percent of GDP.
  - REER assumed unchanged during projection period.
- Baseline scenario key numbers (from Table 1: Japan: Baseline Scenario)
  - Real GDP Growth (Year-on-year):
    - 2016: 0.5
    - 2017: 0.3
    - 2018: 0.5
    - 2019: 0.8
    - 2020: 0.1
    - 2017-20: 0.4
  - CPI Inflation (Annual average):
    - 2016: 0.2
    - 2017: 0.6
    - 2018: 0.6
    - 2019: 1.1
    - 2020: 1.7
    - 2017-20: 1.0
  - General Govt. Net Lending/Borrowing (Percent of GDP):
    - 2016: -5.0
    - 2017: -4.2
    - 2018: -3.9
    - 2019: -3.6
    - 2020: -2.9
    - 2017-20: -3.7
  - General Govt. Net Debt (Percent of GDP):
    - 2016: 130.4
    - 2017: 132.9
    - 2018: 134.8
    - 2019: 133.8
    - 2020: 132.8
    - 2017-20: 133.6
  - Current Account Balance (Percent of GDP):
    - 2016: 3.5
    - 2017: 3.0
    - 2018: 3.0
    - 2019: 2.8
    - 2020: 3.1
    - 2017-20: 3.0

- Three-Arrows-Plus package (excluding structural reforms) outcomes:
  - On average, real GDP growth would be 0.4 percentage point higher over the forecast horizon relative to baseline.
  - CPI inflation (excluding effects of the VAT increase) would overshoot the BoJ 2 percent target by 2019.
  - Output gap would turn positive by 2019, in contrast to baseline where negative output gaps persist.
  - Policy rates would not respond as it is optimal under these circumstances to overshoot the inflation target.
  - Combination of higher real GDP growth, gradual VAT increases, and inflation would put net-debt-to-GDP ratio on a downward trajectory and reduce the term premium marginally.
  - REER would depreciate moderately, followed by a slight rebound in outer years.
  - Overall: proposed policy would end deflation and moderately improve real GDP growth and debt sustainability over the medium term.

- Our Proposed Policy Package key numbers (from Table 2: Japan: Our Proposed Policy Package)
  - Real GDP Growth (Year-on-year):
    - 2016: 0.5
    - 2017: 0.8
    - 2018: 1.0
    - 2019: 1.2
    - 2020: 0.3
    - 2017-20: 0.8
  - CPI Inflation (Annual average):
    - 2016: 0.2
    - 2017: 1.8
    - 2018: 2.2
    - 2019: 3.1
    - 2020: 2.8
    - 2017-20: 2.4
  - General Govt. Net Lending/Borrowing (Percent of GDP):
    - 2016: -5.0
    - 2017: -4.5
    - 2018: -4.5
    - 2019: -4.0
    - 2020: -3.5
    - 2017-20: -4.1
  - General Govt. Net Debt (Percent of GDP):
    - 2016: 130.4
    - 2017: 131.9
    - 2018: 132.8
    - 2019: 129.6
    - 2020: 127.9
    - 2017-20: 130.5
  - Current Account Balance (Percent of GDP):
    - 2016: 3.5
    - 2017: 3.1
    - 2018: 2.9
    - 2019: 2.7
    - 2020: 3.0
    - 2017-20: 2.9

### Quantified impact of structural reforms
- Structural reforms could increase potential growth, raising the annual growth rate by about 0.5 percentage point (Table 3).
- Table 3: Japan: Impact of Structural Reforms on Average GDP Growth (Percentage point difference over 5 years)
  - All structural reforms: 0.5
    - o.w. productivity enhancing and labor market reforms: 0.4
    - o.w. tax and incentive reforms: 0.1
- Note: Productivity-enhancing and labor market reforms account for four-fifths of the growth-enhancing effect; changes in incentives and taxes add 0.1 percentage point to potential growth over the medium term.
- Structural reforms’ short-term impact is uncertain; fiscal and monetary frameworks should be able to keep the economy on desired growth path whether or not structural reforms have contractionary short-run effects.

*Source: IMF staff box text from the referenced PDF content.*

### 1. Product market reforms, changes in employment protection legislation, child care reform,

### 1. Product market reforms, changes in employment protection legislation, child care reform,

### Policy package and conclusions
- Proposed comprehensive package: Three Arrows Plus — consolidates fiscal stimulus, monetary easing, structural reform, and adds an incomes policy.
- Key aims:
  - End deflation in Japan.
  - Anchor private sector expectations about inflation and public debt over the long run.
  - Use multiple coordinated instruments rather than separate instruments.
- Principal policy recommendation:
  - Combine monetary and fiscal policies within long-term frameworks and add an incomes policy (public wage increases and temporary transfers) to reinforce credibility.

### Main features of the Three Arrows Plus simulation
- Monetary policy:
  - Additional QQE by the Bank of Japan assumed to compress long-term yields (term premium) and corporate risk premium.
  - Short-term policy rate: Fixed at the ELB (effective lower bound) throughout the whole simulation period.
- Fiscal policy:
  - VAT: annual increases of 0.5 percentage points every year in 2017–2030, end tax rate = 15%.
  - Targeted transfers to liquidity-constrained households to offset negative demand consequences of VAT hikes.
- Incomes policy:
  - Modeled as shocks to expectations of price and wage inflation.
  - Calibrated so core inflation (CPIX) is higher by around 1 percentage point in the first year (net of VAT impact).
  - Includes an initial boost to real wages as productivity increases are factored into wage setting.
- Structural reforms:
  - Modeled separately (examples listed in the content unit header: product market reforms, changes in employment protection legislation, child care reform, active labor market policies, unemployment benefit replacement reforms; and tax and pension reforms).

### Key numeric assumptions for Three Arrows Plus (from Table I.1)
- Monetary policy assumptions by year:
  - Term premium (basis points difference): 2017 = -10; 2018 = -15; 2019 = -20; 2020 = -10; 2021-: Decays with AR=0.6.
  - Corporate risk premium (basis points difference): 2017 = -1.7; 2018 = -8.3; 2019 = -8.3; 2020 = -8.3; 2021-: Decays with AR=0.6.
  - Short-term policy rate: Fixed at baseline 2017-2022.
- Fiscal policy:
  - VAT: 0.5pp rise every year in 2017-2030, end tax rate = 15%.
  - Targeted transfers (% of baseline GDP): 2017 = 0.8; 2018 = 1.6; 2019 = 1.5; 2020 = 1.4; 2021- = 0.9, then 0.
- Incomes policy — expectations shocks (impact on core inflation and wages, net of VAT):
  - Inflation expectations shock 1/: 2017 = 0.9; 2018 = 1.1; 2019 = 1.8; 2020 = 1.5; 2021- = 1.2 then 0.
  - Wage inflation expectations shock 2/: 2017 = 0.9; 2018 = 1.6; 2019 = 2.3; 2020 = 1.8; 2021- = 1.2 then 0.
- Slow inflation adjustment scenario (altered incomes policy shocks):
  - Inflation expectations shock 1/: 2017 = 0.2; 2018 = 0.7; 2019 = 1.7; 2020 = 1.3; 2021- = 1.1 then 0.
  - Wage inflation expectations shock 2/: 2017 = 0.8; 2018 = 1.4; 2019 = 2.2; 2020 = 1.1; 2021- = 0.8 then 0.
- Notes:
  - 1/ Impact of inflation expectations shocks on core inflation (net of the impact of VAT).
  - 2/ Impact of wage inflation expectations on wage inflation.

### Model and mechanism highlights (FSGM Japan module)
- Core modeling features:
  - Real GDP: sum of demand components in short run; potential output in long run.
  - CPI: modeled by a Phillips curve.
  - Consumption: mix of forward-looking OLG households (Blanchard-Weil-Yaari) who treat government bonds as wealth and liquidity-constrained (LIQ) households who consume all income.
  - Investment: extended Tobin's Q; negatively correlated with real interest rates and positively with output gap.
  - Government: consumption, infrastructure (raises productivity), transfers; sets long-run debt/GDP target and adjusts lump-sum transfers per fiscal reaction function.
  - Prices: core price index (CPIX) driven by Phillips curve with expected inflation, output gap, exchange rate pass-through, oil and food prices.
  - Monetary policy: inflation-forecast-based reaction rule; 10-year JGB rate = expectations theory + term premium.
- Potential output:
  - Cobb-Douglas technology with trend TFP, steady-state labor force, NAIRU, and actual capital stock.

### Comparison with alternative proposals and scenario risks
- Krugman’s Irresponsible Fiscal and Monetary Policy (simulation summary):
  - Fiscal shock profile (2017–21): builds up gradually — 2 percent of GDP in year 1; 4 percent in year 2; 5 percent in years 3 and 4.
  - Fiscal composition: increased government spending equally distributed across public infrastructure investment, targeted fiscal transfers, and government purchases of goods and services.
  - Monetary policy: BoJ policy rate fixed at zero for five years; beyond 2020 monetary policy reacts to output gap and inflation.
  - Assumed monetary premia effects (baseline): Term premium: 2017 = -10; 2018 = -15; 2019 = -20; 2020 = -10; decays with AR=0.6. Corporate risk premium same as Three Arrows Plus.
  - Results and risks:
    - If financial markets do not adjust expectations, Krugman’s scenario yields higher real GDP growth and inflation and a falling net government debt-to-GDP ratio over the medium term.
    - Alternative scenarios with term premium increases:
      - Term premium rise by 100 basis points: net government debt as a percentage of GDP eventually ends up at the same level as in the Three Arrows Plus package by 2021.
      - Term premium rise by 200 basis points: debt path becomes explosive; REER appreciates first due to higher long-term interest rates, making exchange rate a shock amplifier.
    - Conclusion: Krugman’s proposal critically depends on market expectations about future taxes and higher inflation.
- Svensson’s Foolproof Way:
  - Would require close coordination between the Bank of Japan and the Ministry of Finance to manage initial depreciation and a crawling peg.
  - Would necessitate an upfront depreciation of the currency to end deflation if the regime change is fully credible.
  - If not fully credible, a larger depreciation may be required, risking accusations of “beggar-thy-neighbor” policy or currency manipulation and potentially higher term premiums that offset depreciation benefits.
- Turner’s proposal to monetize the debt:
  - Could end deflation if consumers believe additional government spending will not come with higher taxes later.
  - Risks:
    - Politicians might delay necessary fiscal consolidation (e.g., VAT increases).
    - Private sector may lower consumption due to uncertainty about timing of future tax hikes.
    - Monetization could ratchet up private inflation expectations and unhinge the inflation-targeting regime.
- Slower inflation response to incomes policy:
  - Simulations in Appendix V show a response lag of one or two years does not cause substantial differences to simulations if the policy package is credible.
  - Slower achievement of the 2 percent inflation target implies a slower decline in debt-to-GDP, but growth and inflation improvements still materialize over the medium term.
- Comparative assessment:
  - Three Arrows Plus is more likely to mitigate adverse private sector responses than many alternative proposals, given its combination of long-run frameworks, fiscal credibility (preannounced VAT path), monetary easing focused on premia compression, targeted transfers, and an incomes policy to anchor expectations.

*Source: IMF working paper content unit _wp16157 - 1. Product market reforms, changes in employment protection legislation, child care reform,*

### Appendix III. Svensson’s Foolproof Way

### Appendix III. Svensson’s Foolproof Way

### Policy description
- Svensson (2000) proposes a Foolproof Way to escape a liquidity trap composed of:
  - A credible commitment to price level path targeting (PLPT).
  - Exchange market intervention.
  - Measures to maintain low long-term interest rates (e.g., forward guidance, central bank long-term bond purchases).
  - A return to flexible inflation targeting once the PLPT is achieved.

### Key modeling assumptions (Table III.1)
- Monetary policy reaction function includes the deviation from the target path for the price level with a coefficient of 0.05 for 2017, 2018, 2019, 2020, and 2021-.
- Long term price level target: Gradually reaching 10 percent higher target price level (baseline scenario).
- Short-term policy rate: Fixed at baseline 2017-2022.
- FX premium shock path (baseline): 0.6 in 2017, 0.4 in 2018, 0.3 in 2019, 0.1 in 2020, -0.5 in 2021- with decay of AR=0.75.
- Alternative "With rise in term premium" variant:
  - Long-term price level target: Gradually reaching 5 percent higher target price level.
  - Inflation expectations shock (impact on core inflation net of VAT): 0.5 in 2017, 0.4 in 2018, 0.4 in 2019, 0.4 in 2020, 0.4 in 2021- with decay of AR=0.75.

### Transmission mechanisms emphasized
- Credible expectation of a higher future price level causes immediate nominal exchange rate depreciation; official FX intervention may be used to support this.
- PLPT raises medium-term inflation expectations above longer-term objectives while preventing long-term expectations from ratcheting up.
- Higher medium-term inflation expectations lower real interest rates (if BoJ maintains low nominal long-term rates), stimulating domestic demand.
- The policy has "memory": negative deviations are countered by targeting positive deviations in future periods via PLPT.

### Simulated outcomes (qualitative and quantitative highlights)
- The Foolproof Way generates:
  - An inflation overshoot.
  - A positive output gap around 1.5 percent (resulting from depreciation and measures to keep long-term real rates low).
  - Gradual adjustment of inflation and wage inflation expectations if PLPT is credible.
  - Lower interest rates and higher tax revenues that put government debt-to-GDP on a gradually decreasing path.
- Compared to the authors' proposed policy package:
  - The Foolproof Way delivers higher output, lower net debt, and a slightly smaller inflation overshoot provided long-term rates do not adjust upward to expected higher nominal interest rates.

### Sensitivity to long-term interest rate dynamics
- If special measures fail to prevent a rise in long-term interest rates (BoJ aims for a more gradual inflation increase), the positive impacts largely fade:
  - Outcome becomes lower inflation and higher debt than under the authors' proposed policy.
- The effectiveness of Svensson’s approach is thus crucially dependent on the ability to maintain low nominal long-term interest rates while raising inflation expectations.

### Direct VAT impacts noted in simulations
- Direct VAT impact is 0.3 and 1.0 percent in the Svensson scenarios for 2019 and 2020, respectively.
- Direct VAT impact in the Three-Arrows-Plus Policy Package is 0.4 percent for 2017 and 0.5 percent thereafter.

*Source: Appendix III. Svensson’s Foolproof Way, authors' simulations.*

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