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How Should the Recent Increase in Japan's Monetary Base Be Understood? *1

  • *1This is an English translation of the Japanese original paper released on August 2, 2002. Opinions presented here are based on data and information available when the original was written.

September 5, 2002
Bank of Japan
Policy Planning Office

Click on ron0209a.pdf (400KB) to download the full text.


Monetary Base

  • Monetary base is generally defined as 'all central bank liabilities to the financial corporations and other sectors'. In Japan, it is the quantitative monetary indicator which represents 'the amount of currency supplied by the Bank of Japan (the Bank)' and consists of the current account balances held at the Bank (accounting for 10-20%) and cash in circulation (banknotes and coins, 80-90%). These two components share the common features: (i) both are currency with the highest liquidity (convenience as a method of payment); (ii) both are liabilities of the Bank or the government; (iii) both are supplied through the Bank; and (iv) neither bear interest rates.
  • In supplying monetary base, the Bank purchases financial assets with relatively lower liquidity in exchange. In other words, the supply of monetary base does not mean 'the supply of income, ' but 'the supply of liquidity'.
  • The recent rate of increase in monetary base is the highest since the first oil shock. As a result, the ratio of monetary base to nominal GDP is now the second highest figure in the last 100 years, following the Second World War period. In order to understand such a phenomenon, it is useful to divide the whole period into two sub-periods: one of short-term interest rates significantly above zero and one of nearly zero short-term interest rates.

Current Account Balances at the Bank

  • During a period when the Bank guides short-term interest rates to a level significantly above zero, the current account balances held at the Bank are almost equivalent to required reserves, which are legally required to be held by financial institutions subject to reserve requirements. This is because, required reserves are sufficiently large, and as a result, liquidity in excess of such required reserves is not usually demanded unless interest rates are extremely low.
  • On the other hand, during a period of nearly zero short-term interest rates, the Bank can realize current account balances exceeding required reserves. In fact, after adopting the current account balances at the Bank as the main operating target in March 2001, the Bank raised its target amount several times with the result that the outstanding balance of the current accounts at the Bank has greatly increased. The fact that the Bank was able to increase the provision of massive amount of funds implies that there was corresponding demand for such funds on the part of financial institutions. The decline in short-term interest rates, which arose from an ample fund provision, and various expansions of fund provision methods by the Bank contributed to the increase in demand for current account balances. Also, precautionary demand for liquidity increased following the September 11 terrorist attacks and uncertainty over financial system. In addition, under extremely low interest rates, many market participants stopped dealing funds and started holding excess reserves because they could not obtain sufficient returns in the money market when taking into account transaction costs. The situation of a fund surplus has become the usual condition, and this tendency has been strengthened due to inactive funds transactions. This contributed to the phenomenon whereby, once the current account balances at the Bank increased, they did not tend to decrease even after direct causes disappeared.

Cash in Circulation

  • Demand for cash is usually affected by interest rate and transaction levels. In daily operations, the Bank passively pays or receives cash according to demand determined by economic transactions. However, over the medium and long term, the determinants of demand for cash (interest rates and transaction levels) are influenced by monetary policy.
  • Since the beginning of 2002, the year-on-year rise in cash in circulation has been over 10%. Background to this phenomenon is a drop in deposit rates to nearly zero and fewer customer visits to deposit at banks, avoiding transaction costs. In addition, the partial removal of blanket deposit insurance (for time deposits, etc.) in April 2002 heightened the relative attractiveness of holding cash by slightly raising the risk premium on deposits, which is recognized by economic agents (households, firms, etc.), and by lowering risk-free deposit rates excluding premiums.
  • Under nearly zero interest rates, the slope of the cash demand curve has become flatter. Therefore, the decrease in deposit rates and change in recognition of risks have shifted a part of funds from deposits to cash, contributing to a big increase in the growth rate of cash, even though each change itself was small.

Money Multiplier

  • The ratio of money stock to monetary base is termed the 'money multiplier,' and it is often used to argue the influence of monetary base on money stock. The money multiplier depends on the ratio of current account balances at the central bank to bank deposits, and the ratio of cash to bank deposits. These ratios are determined from portfolio selection by economic agents, and such selection is determined especially by the levels of interest rates.
  • Since March 2001, while the increase tempo of monetary base has significantly accelerated, the increase in money stock has been limited and the money multiplier has shrunk considerably. This is because, under nearly zero interest rates, both the ratio of current account balances at the central bank to bank deposits and the ratio of cash to bank deposits tend to fluctuate sharply, as the above explanation of the current account balances at the Bank and cash in circulation shows. In such an environment, the relationship between monetary base and money stock becomes unstable and highly uncertain. It should be noted that further multi-faceted investigation is needed in order to analyze the relationship between monetary base and economic activity.