Japan's average GDP growth rate was around 9.5 per cent between 1955 and 1970, and 3.8 per cent between 1971 and 1990. But in the past two decades it has dropped to just 0.8 per cent a year. This big drop in the growth rate is synonymous with 'Japan's two lost decades'.

Inflation also disappeared through the lost decades, from 2.5 per cent in the 1980s and 1.2 per cent in the 1990s, to an average of -0.2 per cent in the 2000s. This prompted claims that aggregate demand has not been large enough to match aggregate supply, or, in other words, output has been below its full employment capacity. The Bank of Japan has been blamed for not having pursued an expansive enough monetary policy to boost aggregate demand and incomes.

In 1999, the Bank of Japan reduced its policy interest rate to 0.15 per cent, thus starting its so-called zero interest rate strategy. Given that nominal interest rates cannot go below zero, any deflation (or negative inflation) results in higher real interest rates. Throughout the 2000s the Japanese inflation rate was, on average, negative. Hence deflation could have had a negative impact on aggregate demand through higher real interest rates.

Just how high was Japan's real interest rate?

Because expectations about inflation are not observable, expected real interest rates cannot be set with precision. Roughly measured, long-term real interest rates - or the difference between nominal bond yields and realised inflation rates - in both Japan and in the United States actually tend to show very similar trends, in both their levels and the way in which they have changed. The free international movement of capital means that the real interest rates will tend to be similar in all countries, although, to be precise, this depends on a host of factors and conditions, including the similarity in consumption patterns and the exchange rate risk premium, among many others. A rough measure of real interest rates in Japan and the United States shows that they actually became very similar after the 1985 Plaza Accord and grew even more similar in the 2000s, until recently. Deflation, together with a zero lower bound on the nominal interest rate may not, after all, have caused Japanese real interest rates to deviate significantly from the theoretically consistent level that was operating in the global economy.

Though real interest rates are not heavily influenced by domestic factors, deflation can still have long-run detrimental effects and, through nominal appreciation of the exchange rate, adversely affect exports and aggregate spending.

Persistent deflation might arguably have been avoided if the Bank of Japan had adopted a more aggressive and expansionary monetary policy in the 1990s. But the Bank of Japan was operating under uncertainty about responses in the economy - an inevitable problem with policy making in real time. Optimal policy can look very different with the benefit of hindsight.

Japan's per capita GDP level reached almost the level of the United States toward the end of the 1980s. When that happened Japan's era of high growth, which was based on the technological catching-up, inevitably came to an end. Thus, the puzzle of the lost decades is not what caused the fall in growth chronologically, but the difference in growth rates across countries, and particularly between Japan and other advanced economies. Between 2000 and 2010 (in the second of the two lost decades), other advanced economies grew at an average rate of 1.4 per cent while Japan grew at around 0.9 per cent.

What are the reasons for this difference and can the growth rate be lifted now?

The rapid ageing of Japanese society is a widely known phenomenon. Total population has recently started to fall, and the working age population had already started to fall around 1995. A most important factor in producing economic output is the input of labour. With the working age population shrinking, unless technology allows a smaller workforce to produce more output per head, GDP is bound to grow more slowly. Yet, if the output growth rate per person of working age is compared with that of other industrial nations, Japan records the highest growth rate among advanced economies in the 2000s.

Now that Japan is becoming a greyer society, gross national product (GNP) is the variable that should be monitored to assess the health of the Japanese economy and the welfare of its people. Offshore assets are now providing income for the elderly in Japan, so GNP is a better measure because, unlike GDP, GNP includes financial income from the rest of the world stemming from investment of assets abroad.

These supply side factors have had a significant impact on Japan's GDP growth rate, at least since 2000. Society's ageing results in not only a decrease in production inputs, but also in a future increase in the scope for fiscal and social security expenditure. This is likely to further constrain aggregate demand by reducing permanent income.

Ageing will continue to have wide-ranging effects on the Japanese economy and Japanese society; the priority is to manage the policy changes needed to continue to lift the productivity of a declining workforce and maintain and improve living standards.