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The Role of the Money Stock in Conducting Monetary Policy *

  • This is an English translation of the original paper released in Japanese on December 24, 2002. Opinions presented here are based on data and information available when the original was written.

May 6, 2003
Bank of Japan
Policy Planning Office

Click on ron0305a.pdf (374KB) to download the full text.

Summary

1. Introduction

Examining economic and financial developments since the 1990s, this paper discusses (1) the role of the money stock within the Bank of Japan's monetary policy and (2) why the relationship between the money stock and economic activity has been unstable in Japan.

2. The Characteristics of the Money Stock

The money stock is conceptually defined as the total amount of money circulating in the whole economy. Although specific components vary depending on the time and the country, money is generally composed of financial assets with high liquidity (where liquidity refers to the convenience with which an asset may be used to make payment). Movements in the money stock depend on the interaction between the credit creation behavior of financial institutions that take deposits, make loans, and invest in securities and the money demand of firms and households. A central bank implements market operations, targeting the short-term interest rate or current account balances at the central bank, and these influence the money stock as financial institutions, firms, and households change their respective financial portfolios.

3. Historical Changes in the Role of the Money Stock within Monetary Policy in Major Countries

In the 1970s, many major central banks in Europe and North America used the money stock as an intermediate monetary policy target; however, this type of policy was abandoned during the 1980s and the 1990s. The currently accepted wisdom is that it is operation on the short-term interest rate that influences the real economy, and thereby achieves price stability.

Although the money stock may no longer be adopted as an intermediate target of monetary policy, it is nevertheless used as an "information variable" for the following reasons. First, conceptually, the money stock may be considered to offer a reasonable reflection of the overall level of economic activity in the sense that all economic transactions involve the transfer of funds. It is also widely accepted that "inflation is a monetary phenomenon" in the long run. Second, in an environment in which there exists some uncertainty about the economic structure and the transmission mechanism of monetary policy, analysis of the money stock is generally considered useful in cross-checking assessments of the economic situation generated using other economic variables.

The importance attached to the money stock as an information variable in conducting monetary policy depends on the extent to which the money stock contains useful information regarding future price developments that cannot be derived from other financial and real economic indicators. Where the money stock contains such unique information, it is considered to have a certain role to play within monetary policy. Specifically, the economic outlook formed on the basis of the money stock is especially effective as a cross-check of outlooks that depend mainly on developments in the real economy and other financial indicators. In the alternative case, in which the money stock merely tracks movements in the real economy and prices induced by central bank operation on the short-term interest rate, the money stock is treated as just one of many economic indicators. While the European Central Bank (ECB), adopting the former view, attaches relatively high importance to the money stock, the Board of Governors of the Federal Reserve System (FRB) considers the money stock just one of many economic indicators because the relationship between the money stock and economic activity has been unstable in the United States.

4. Relationship between the Money Stock and Economic Activity in Japan

During the 1970s and the early 1980s, in spite of two oil shocks, long-run relationships that evince both stability and causality may be observed between the money stock and the real economy and between the money stock and prices in Japan. However, with the emergence of the bubble in the latter half of the 1980s, the relationship between the money stock and economic activity became harder to discern. Taking an overview of the whole period of the emergence and bursting of the bubble, movements in asset prices ultimately had a significant impact on the real economy, albeit with a long lag, so that the observation that large fluctuations in the money stock imply large fluctuations in economic activity still holds. In contrast, however, during the period since the mid-1990s, although movements in the money stock have been relatively small, economic activity has fluctuated considerably. For this reason, it is currently impossible to detect a long-run stable relationship (a long-run equilibrium relationship) between the money stock and economic activity.

In Japan's economy since the 1990s, there are two factors in particular that are deemed responsible for the failure of corporate demand for loans to rise in spite of the aggressive monetary easing. These are reductions in the excess liabilities of firms; and downward pressure on financial institutions' capital due to the disposal of nonperforming loans (NPLs), both of which have been seen since the early 1990s. Both are thought to have suppressed the growth rate of the money stock.

The first reason why the long-run stable relationship between M2+CDs and economic activity has broken down springs from the reductions in the excess liabilities of firms and from the NPL problems that stemmed from the emergence and bursting of the bubble. These have continuously influenced Japan's economy, and the anxieties over the financial system emerged through late 1997 and 1998, causing a large increase in precautionary demand.

The second reason is the large shifts of funds from assets outside the money stock to those within the money stock, which has occurred as a result of the extremely low level of short-term interest rates since 1999. The Bank adopted the so-called "zero interest rate" policy in 1999, and since 2001 has maintained the so-called "quantitative easing" policy where the main target of market operations has been the outstanding balance of current accounts at the Bank. As a result of this, large shifts of funds to deposits from other financial assets have been observed because short-term interest rates have declined to virtually zero and money demand has been very elastic vis-à-vis the opportunity cost.

Moreover, it is highly likely that such fund-shifts have been encouraged by the increasing demand for risk-free assets, which has reflected various factors including financial system problems.

5. Current Role of the Money Stock in Conducting Monetary Policy

As mentioned above, the relationship between the money stock and economic activity has recently been unstable in Japan.

While the growth rate of the monetary base has risen substantially since the adoption of the "quantitative easing" policy, that of the money stock has not risen correspondingly. For the money stock to increase in line with increasing economic activity presupposes, at the very least, that the financial intermediation function of financial institutions is restored, that the transmission mechanism of monetary policy is fully functional, and that the private sector resumes its fund-raising activities, while it also depends to a certain extent on the operation and effectiveness of fiscal policy.

In the current situation, it is difficult not only to collect important information about current and future economic developments from movements in the growth rate of the money stock, but also to see the effects of monetary policy. In order to evaluate the effects of monetary policy, it is therefore deemed appropriate to look closely at the prices of various financial assets, real economic variables, price developments, and also the fund-raising behavior of firms and households.

The money stock, however, is considered to have the characteristic of being a comprehensive indicator that reflects activity in the economy as a whole. The relationship between the money stock and economic activity may be expected to stabilize in the future if the financial intermediation function of financial institutions is fully restored and short-term interest rates rise significantly above zero. No one could deny that, in such a case, the price information contained in the money stock would once again become important in conducting monetary policy, given that uncertainty exists regarding the economic structure and the monetary policy transmission mechanism. Bearing these possibilities in mind, the Bank intends not only to carry on analyzing movements in the money stock, but also to continue examining the appropriateness of individual components of the money stock and updating the role of the money stock in the conduct of monetary policy.