Japan's growth problems | An analysis in light of the AD-AS Model

In yesterday's edition of Financial Times, Robin Harding, an Associate Professor in the Department of Politics and International Relations at the University of Oxford and the Gillian Peele Fellow in Politics at Lady Margaret Hall (Harding, 2018), focused (unfortunatelly, I won't be able to display the link, as the article is only available for subscribers) on a threatening fact: Japan is expected to see its labor force shrink by almost 13 million people (from 65.3 million in 2017 to 52.5 million in 2040) in the next 20 years, according to the country's health minister. These forecasts are based on the long lasting, low levels of fertility in the country, in articulation with a severe population aging.

In light of the AD-AS Model (as soon as possible, I will write an article explaining the main economic mechanisms at play with it), inspired by the thoughts and work of John Maynard Keynes during the first half of the last century, it is possible to analyze the Japanese current situation. To do so, I made some research on the data presented by Bank of Japan regarding the Japanese output gap and potential growth rate (the following).

Source: Bank of Japan

According to the chart, it is possible to state that Japan has been experiencing an above full-employment situation lately (more precisely, from about the end of 2016 onwards), a conclusion given by the positive output gap. This means that the unemployment rate in the country has been below its natural rate (that comprising frictional and structural unemployment, excluding the cyclical one) in recent years. That is, Japan is currently facing an inflationary gap, thereby existing, in light of the AD-AS Model, an upward pressure on wages, increasing production costs and, hence, the level of prices, so that it is possible to restore the level of potential output in the long-run, closing the gap generated. Actually, positive inflation levels nowadays after more than a decade of deflation can be understood by this reasoning. In the following chart, I plot what is happening in Japan right now, using the model proposed.

Even though it is undeniably interesting to further discuss Japan's current situation, the article written by Robin Harding mainly focuses on Japan's growth problems and they are unmistakably related to potential GDP behavior throughout time, which is presented in the following chart.

Source: Bank of Japan

With respect to the level of potential output, it is expected to decrease in the next 20 years, as a result of a shrinking labor force, due to aging and lack of natality. Indeed, the level of full-employment will decrease severely and that has negative effects on output in the long-run. To offset this inevitability, «the participation of women and older people in the workforce is essential», according to the health's ministry's comission on worforce research. Moreover, a «huge expansion in productivity» or «large-scale immigration» are pointed out as capable policies to mitigate the demographic situation impacts in the labor market. In light of the AD-AS Model, the implementation of this kind of policies would be welcome, as it would allow the level of full-employment to decrease less than it is expected, thus sustaining the level of output. Providing a graphical depiction, we have the following.

Final conclusions: Japan faces a dramatic situation regarding demography which will harm its economy sooner or later. Therefore, the Government has the duty to act quickly, stimulating immigration through attractive programs, designing incentives for natality and for women to work, as well as supporting Research & Development, in the pursuit of increasing levels of productivity.