Abstract

In Japan, the inflation rate declined to near-zero, whereas the monetary policy faced
a zero lower bound (ZLB) in the 1990s. We examine whether trend inflation had fallen
to near-zero prior to the ZLB. To achieve this, we estimate Japanese pre-2000 trend
inflation developing a Markov-switching New Keynesian dynamic stochastic general
equilibrium (DSGE) model in which non-zero trend inflation is explicitly incorporated
as a Markov chain state. Our estimation results indicate that (i) the trend inflation
remained broadly stable at 3.0–3.5 percent from the 1960s to the late 1970s prior to
the second Global Oil Crisis. (ii) Then, over time, trend inflation gradually declined
to nearly 1.0 percent toward the Plaza Accord in 1985. (iii) Up until 1997 when the
ZLB was hit, trend inflation hovered well above zero, mostly near 1.0 percent.
JEL Classification: E31, E52, C54