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The financial crisis of 2008/09 and the national governments’ endeavours to stimulate the economy has rekindled interest in the Japanese experience with fiscal stimulus plans. Like in the ongoing economic crisis, many elements of the Japanese crisis and fiscal stimulus responses share similarities. During the 1990s, a period frequently referred to as the "lost decade", economic growth in Japan declined sharply to an average of 1.2 percent from an average growth rate of 3.9 percent in the decade earlier. The economic slowdown was precipitated by a bursting of the asset and credit bubble as the stock market declined by 41 percent and credit flow declined by 71 percent between 1989 and 1991. In response, the Japanese government introduced numerous stimulus packages which were continued over the course of the decade. Yet, despite large and repeated fiscal stimulus packages, the cost effectiveness of these packages has been questionable. Growth remained stagnant amidst deflationary pressures and public deficits and debts rose rapidly reflecting both tax revenue slowdown and the increase in government expenditures.

We contribute in this paper to the debate on whether government expenditures are effective in stimulating economic activity during times of crisis by exploiting a rich dataset of regional government expenditures in Japan during the 1990-2000 period to estimate from within-prefecture variation the multiplier effects that government investment and government consumption expenditures have on output. The use of regional data allows us to circumvent important identification issues that arise in country-level VAR analysis of the effects that fiscal policy has on output due to the non-passiveness of monetary policy as well as other "big shocks" that are often difficult to control for. We deal with these issues by using panel fixed effects regressions that account for both prefecture-specific unobservables as well as time-specific shocks that are common across prefectures in a given year.