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On the Relationship between Monetary Aggregates and Economic Activities in Japan: A Study Focusing on Long-Term Equilibrium Relationships

  • The full text is on the November 1997 issue of the Quarterly Bulletin.

November 1997
Bank of Japan
Research and Statistics Department

Introduction

This paper empirically analyzes the relationship between monetary aggregates and economic activities in Japan using actual data and focusing on long-term equilibrium relationships. Long-term time-series data from the 1960s to 1996 are used in the analysis in order to observe long-term relationships between the most commonly used monetary aggregate, M2+CDs, and macroeconomic indicators, such as GDP, rather than limiting the analysis to short-term relationships during the past year or two.1 In addition to long-term relationships, the stability of the money demand function and also the lead/lag relationships between monetary aggregates and other macroeconomic indicators are tested.

The conclusions of the paper can be summarized as follows.

(1) When developments in M2+CDs and other macroeconomic indicators are viewed in the long term, fluctuations in nominal M2+CDs have a relatively stable relationship with movements in nominal GDP. This can also be confirmed by applying an econometric technique called "cointegration analysis," which suggests that there is a long-term equilibrium relationship between the two.

On the other hand, the relationship between M2+CDs and prices -- which along with real GDP make up nominal GDP -- has changed since the latter half of the 1980s, in the sense that fluctuations in prices have clearly diminished relative to those of M2+CDs.

(2) A relatively stable money demand function can be estimated, based on the above long-term equilibrium relationship and incorporating factors for short-term fluctuations. At least in the sample period, the mechanism of short-term fluctuations has been relatively stable in M2+CDs, GDP, interest rates, and asset factors, as represented by the money demand function.

(3) An analysis in terms of lagged cross correlation on the lead/lag relationships between M2+CDs and other macroeconomic variables reveals that M2+CDs basically leads nominal and real GDP, domestic private demand, and prices. However, there are differences in results across sample periods that cannot be ignored.

(4) Similar analyses are conducted, from the standpoints of conclusions (1)-(3) above, on selected monetary and credit aggregates other than M2+CDs, and on monetary aggregates obtained by partially changing the components of M1 and M2+CDs. The results show that these aggregates did not have more stable relationships with macroeconomic indicators than did M2+CDs.

(5) The above results suggest that, in analyzing monetary aggregates, it would be effective to use the long-term equilibrium relationship between M2+CDs and GDP as well as the money demand function incorporating the relationship. In interpreting the empirical results using the statistical techniques, however, it is necessary to bear in mind the following limitations:

  1. (a) Long-term equilibrium relationships indicate only the average relationship in the long run, and hence considerable deviations from equilibrium values may arise in the short term; and
  2. (b) There still remains a possibility that the long-term equilibrium relationships or money demand functions derived from the previously observed data may change, as a result of a large shift of funds caused by deregulation and other structural changes in the financial markets in the future.
  1. Note that the sample period includes the period when M2+CDs underwent large fluctuations, i.e. from the latter half of the 1980s to the early 1990s.