Japan’s Interest Rate Hike by the Bank of Japan

Introduction

In late 2025, the Bank of Japan (BOJ) announced that it was likely to raise its policy interest rate by the end of the year, marking a major shift from decades of near-zero and negative interest rate policies. The BOJ’s decision came amid rising inflation, wage growth, and a depreciating yen, which had made imports more expensive and added further upward pressure on domestic prices.

This move represents a classic example of contractionary monetary policy, where a central bank raises interest rates to curb inflation by slowing down borrowing and spending. After years of stimulus aimed at combating deflation, Japan’s new monetary stance seeks to restore price stability and prevent the economy from overheating.

Application to IB Economics

This real-world case provides a clear example of how central banks use monetary policy to influence aggregate demand (AD) in the economy.

• Policy Effect on Aggregate Demand (AD): Higher interest rates increase the cost of borrowing for households and firms, which reduces consumption and investment. As a result, AD shifts to the left, helping to lower inflationary pressures.
• Exchange Rate Impact: An increase in interest rates typically strengthens the national currency, as foreign investors seek higher returns. A stronger yen makes exports more expensive and imports cheaper, which further contributes to a reduction in net exports and AD.
• Price Stability: By reducing demand-side pressures, contractionary policy helps the BOJ achieve its inflation target of around 2% while maintaining long-term macroeconomic stability.

In IB Economics, this example can be used in Paper 1 (15-mark) essays related to monetary policy, inflation control, or macroeconomic objectives. It demonstrates how interest rate adjustments can stabilize prices but also comes with trade-offs, such as slower growth and potential increases in unemployment if demand falls too sharply.

Key Terms Explained

• Contractionary Monetary Policy: A policy that raises interest rates or reduces the money supply to decrease aggregate demand and control inflation.
• Interest Rate: The cost of borrowing or the reward for saving money, set by the central bank to influence economic activity.
• Aggregate Demand (AD): The total spending on goods and services in an economy at a given price level (C + I + G + (X − M)).
• Inflation: A sustained increase in the general price level of goods and services in an economy over time.
• Exchange Rate: The value of one currency in terms of another; influenced by interest rate changes and capital flows.
• Price Stability: A situation where inflation is low and predictable, allowing consumers and businesses to plan effectively.

This case of Japan’s interest rate hike illustrates how monetary tightening can be used to slow inflation and maintain macroeconomic balance, even though it may temporarily reduce growth or output in the short run.