Deciphering the Message in Japanese Deflation Dynamics

This paper uses linear and nonlinear neural network regime-switching (NNRS) models to decipher the message in Japanese deflation dynamics and thus identify the channels through which Japan's economy can escape its deflationary spiral. The NNRS model is superior to a linear model with respect to in-sample specification tests and out-of-sample forecasting accuracy. The most important variables affecting inflation are interest rates and the output gap. Given the zero lower bound on interest rates, it will be most effective to end Japan's deflationary cycle with policies that reverse the output gap by stimulating investment.