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When Stimulus Works, and When it Does Not: COVID-19, GFC and Japan

Updated: Dec 29, 2022


As prices soar, the faith in the economics profession falls – indeed, sometimes, the effect of a policy is not clear to experts until after it has already happened. For instance, to cushion the impact of the 2007-2009 global financial crisis (GFC), extensive stimulus packages and monetary accommodations were implemented – and yet, little inflation occurred. But now, following the 2020-2021 COVID-19 crisis, similar measures have led to prices rising at the fastest pace in decades. What changed?

For any additional liquidity to have an effect, it must reach and be spent within the real economy first – though this does not always occur. The behaviour of economic agents is crucial to understanding when policies do or do not work as intended.

It should be noted that fiscal and monetary policies are not the only drivers behind current inflation in western economies – the Russian invasion of Ukraine perpetuates cost-push inflation, while lingering supply chain disruptions due to the Omicron wave and China’s zero-COVID policy creates demand-pull inflation. For the purposes of this column, we shall focus on government and central bank policies as possible causes of inflation, bearing in mind that they may not always be the only cause.

When Policies Cause Inflation – Fiscal policy in the US in 2020-2021

The current inflation levels in the US are no accident – the policies implemented during and after the COVID-19 pandemic worked as intended, and economic agents behaved in a way that furthered inflation: when authorities pumped money into the economy, banks lent, households consumed and firms increased their prices.

Throughout the 2020-2021 pandemic, the United States (US) government spent an accumulated $5 trillion on stimulus for the economy – by the end of 2021, Americans faced a CPI rate of 7%, 3% of which can be directly attributed to the effects of the pandemic relief packages, according to the Federal Reserve Bank of San Francisco.

Such packages include the $1 trillion American Rescue Plan, providing the vulnerable with loans, grants, tax credits and even direct cheques worth $1400. While the US may have achieved “one of the strongest periods of economic growth in a century” (U.S. Department of Treasury), it did so through a profoundly demand-driven recovery. Consumers had more disposable personal income available to them, which, in turn, lead to greater demand and consumption. Additionally, supply chain disruptions did not subside alongside economic recovery, as authorities believed when they first implemented such stimulus policies, so supply could not satisfy the post-lockdown explosion of demand. Demand-pull inflation is the logical end result.

When Policies do not Cause Inflation – Unconventional Monetary Policy in 2013-2019

Average consumer prices recorded in 2013-2019 read 0.87% for the eurozone, 1.54% for the US and 1.68% for the UK. Surprisingly, this was also a period in which western central banks carried out extensive quantitative easing (QE) programs, which increase the money supply of the economy and stimulate demand by incentivising banks to lend. So, why did QE not cause high inflation?

It is worth bearing in mind that global availability of credit tightened as banks faced stricter regulation, and – most notably – may have become more risk-averse. One may connect the latter development with a theory proposed by Benn Steil and Benjamin Della Rocca, economists at the Council on Foreign Relations.

Despite no obvious liquidity risks, banks seem to have hoarded the credit available to them, so the money had no way of reaching the real economy. Steil and Della Rocca were even able to predict inflation in the US by observing the gap between central bank bond holdings (used to generate liquidity for commercial banks) and excess bank reserves (reserves in excess of the reserve asset ratio) – it was only in 2022 that banks started to use up their excess reserves, pumping money into the economy. Only then, QE worked as intended.

Quantitative Easing and Bank Reserves

This frugal behaviour of banks may underline the persistent lack of inflation in 2013-2019. Nonetheless, critics have pointed out that banks may not have been able to give out loans simply due to a lack of demand for loans, or that banks’ excess reserves may have been funnelled into other programs in 2022.

But, let us take a look at an even more striking example.

Japan – The Anomaly

Low inflation – and even deflation – has prevailed in Japan for decades – despite ambitious fiscal and monetary stimulus programs.

One possible reason may be that the Japanese economy is experiencing what the International Monetary Fund calls “shrinkonomics”, referring to its ageing population. For instance, changes in the priorities of households may weaken consumption and investment behaviour, decreasing aggregate demand. A shrinking workforce may also negatively impact the potential growth of an economy, which in turn pushes the natural rate of interest into the negative, potentially undermining the effectiveness of monetary policy. These developments in Japan could also serve as an indicator of the impact of demographic changes on other western economies. Consequently, these key drivers behind inflation – aggregate demand and monetary policy – may be of limited effect.

Additionally, the Japanese seem to possess a “deflationary mindset”, making cost-push inflation and wage-price spirals unlikely. Companies are less likely to pass higher production costs onto the consumer, and workers are less likely to demand higher wages (perhaps due to the rigidity of the Japanese labour market, or low inflation expectations). Ergo, deflationary – not inflationary – pressures arise.

Most remarkably, there is little indication that the COVID-19 relief programs implemented by Japan have had an impact on inflation. These programs were the third largest amongst G7 countries, with a package the size of 16% of Japan’s GDP targeting aggregate demand. Yet, Japan’s inflation level is still well below that of other G7 countries.

Consumer price inflation (annual percentage change in the Consumer Price Index)

The Bank of Japan (BOJ) has not expressed any intent to change its accommodative monetary policy, stating that they wish to further support the still recovering Japanese economy, and authorities assume that current inflationary pressures – caused by global supply chain disruptions – shall occur merely in the short run. However, it is true that as western nations raise their interest rates, import costs are exasperated by the low rate maintained by the BOJ, though this seems to be one of the very few instances in which the BOJ’s policies have succeeded in putting upward pressure on inflation.

It should still be noted that the Japanese economy is by no means immune to inflation. In fact, large monetary and fiscal packages caused the speculative boom that led up to Japan’s financial bubble crash in the 1990s. Consequently, it was due to inflation fears that the BOJ decided to raise interest rates, contributing towards the depth of the recession. One might theorize that the aforementioned Japanese “deflationary mindset” is a remnant of this bubble crash that now reinforces a Japanese deflationary spiral.

As such, the Japanese economy can show us that stimulus packages may only result in inflation if the conditions are right for it. In other G7 countries, variables such as “shrinkonomics” or the “deflationary mindset” do not exist (or exist to a lesser degree), making their economies riper for inflation.


External circumstances may undermine the calculations of governments – the unpredictable nature of external shocks as well as the volatility of the behaviour of economic agents may lead to policies not always working as intended.

The reason why no inflation occurred in the 2013-2019 period is still contested and requires further research. Understanding the differences between 2013-2019 and 2020-2021 may help economists in the future finetune their policies and maintain a healthy economy.

Additionally, Japan is a fascinating example of how differing mindsets and demographic changes may impact inflation levels – and it is an example that other countries steering towards similar demographic patterns may want to have a look at.


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