From 1999 through 2004, nominal interest rates in Japan were very close to zero. During the same period, the nation’s price level fell. According to officials at the Bank of Japan, the Japanese central bank, the inability to push interest rates any lower meant that monetary policy could do little to raise aggregate demand. Thus, the officials argued, the Bank of Japan could not prevent Japan’s deflation.

Aside from a four-month period in 2002, the Japanese measure of the quantity of money, M2, decreased during the 1999–2004 period. The quantity theory of money and prices predicts that a negative rate of growth of the money supply will produce a negative rate of growth of the price level or deflation. Application of the quantity theory of money indicates that the Bank of Japan had a lot to do with Japan’s deflationary situation. It also implies that raising the rate of growth of the money supply to a positive level could have brought the deflation to an end.

How could an increase in the money supply have caused the Japanese price level to rise even though nominal interest rates temporarily remained close to zero?