Money, Credit and Economic Activity*

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MONEY, CREDIT AND ECONOMIC ACTIVITY'

M.S. Monadjemi, Sclwol of Economics, University ofNew SOUlh Wales. POBox 1, Kensington. NSW 2033.

The pUrJX>se of lhis paper is to examine the effect. of deregulation on the relationship between financial aggregates and economic activity. Various empirical tests are applied to examine the stability of the relationship between monetary/credit

aggregates and Gross Domestic Product (GOP). The results of this study show that the traditional relationships between the growth ralc of GOP and the growth rates of financial aggregates have been affected by the recent rapid deregulation of financial markets. Therefore, these aggregates may not serve as a satisfactory target and indicator for monetary policy. Some discussion of oilier strategies for monetary

policy is also included.

1.

Introduction

Targeting monetary aggregates became popular in the 1970s when innation appeared to be a major economic problem. However, inflation forced financial

institutions to bypass existing regulations and engage in financial innovations which, in turn, reduced the meaning of monetary aggregates. In addition, deregulation of financial markelS caused problems in interpretation of monetary aggregates. These developments led the cenlIal banks to de-emphasise monetary aggregates and rely on a wide range of aggregates as indicators of monetary policy. Monetary targeting is based upon a stable and predictable relationship between

money and economic activity. In addition, movemenlS of aggregates should reflect changes in the financial conditions rather than merely a shift from one form of asset to another. Recently, in AuslIalia, as a result of deregulation,the M3 aggregate has grown rapidly without any significant change in economic activity.l This developmenl

changed the traditional relationship between M3 and economic activity and caused difficulty in intcrpreting the movements of M3. In January 1985, the "conditional

• I

The author expresses his gratitude to Dr C. Kearney and Dr L. Perry for useful comments. and Mrs Penny Neal and Mrs Lucy Carrozzi for helpful assislaflcc. M3 is defined as currency plus bank deposits of the private non-bank sector.

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projection" of M3 was suspended for the rest of the financial year. The government emphasised the importance of looking at a wide range of aggregates in the transitional period of deregulation. The purpose of this paper is to examine the suitability of monerary and credit aggregates as an alternative indicator of changes in the financial conditions.

2. Which Credit Aggregate? Various studies in Auslralia and overseas have used dirrerent approaches for

measuring credit aggregates. The works of Friedman (19820, 1982b, 1982e) and Kaufman (1978) arc among the pioneers in the United States (US), Friedman considered the total indebtedness of the non-financial sectors. Kaufman looked at the debt proxy which measured holdings of financial claims by the private sector, In AUSlratia, Horne and Monadjemi (1985) estimated the total outstanding indebtedness of the non-financial sector and examined the relationship of this aggregate with Gross Domestic Product (GOP). Their empirical results did not show a significant relationship between the growth of credit and economic activity and the authors explained the weakness of the relationship on the lack of reliable debt data. In a separate study, Valentine (1983) investigated the relationship between bank credit and gross national expenditure and suggested that a range of aggregates including bank credit is preferable to a single M3 targct. Marzouk (1987) showed that the broader measures of money and credit moved more closely with the implicit price deflator of GOP than the more narrow aggregates. Marzouk also argued that the broader aggregates have fewer fluctuations around their averages,

Mohl (1985) and the staff of the Research Depanment of the Reserve Bank of Australia have measured total indcbtedness of the non-financial sector (1...) and have suggested that L provides useful additional information about changes in the financial conditions. L includes borrowings by the non-finance sectors from all financial inlClTIlcdiaries plus direct financing through equities, industrial debentures,. trade credit and borrowings from overseas. This aggregate is similar to the US "domestic non-financial debt" except that the US measure of debt excludes equities. The Research Report consU'Ucted a series on L based on the data in the financial flow accounts from 1953 to 1984. Since there arc no official published data on the outstanding debt of the non-finance sector, the constructed series estimated a figure for 1953 and used flows to derive the levels in the following years. Recently the Reserve Bank started publishing a regular series on L similar to the series on monetary aggregates. Figures I and 2 show the velocity of L and the growth of GOP and L. The velocity of L was relatively stable during the past decade and its growth moved closely with the growth of economic activity.

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Figure 1 Velocity or Debt (end or June)

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Delay in the availability of data imposes serious limitations on the use of Las an indicator of changes in the economy. The data on L arc available only annually, and with a considerable time lag. and hence they cannot provide advance infonnation about the economy. In addition, the relationship between L and GDP is less stable than the relationship between monetary aggregates and GOP. The coefficient of variation (standard deviation divided by mean) of the velocity of l was 13.7 per cent compared to 0.6 per cent for both velocities of M3 and broad moncy.2 The advantage of L or any other fonn of broad credit aggregate over the monetary aggregate is that the fonner is less affected by strucluml changes which arc nol relaled 10 changes in spending. Any form of credit aggregale will not grow unless there is some intention of spending by the borrower. Therefore, during periods of rapid deregulation and financial innovations, movements of credit may provide more reliable information about changes in the economy than the movements of monetary aggregates. That is. when shifts occur within the monetary aggregates and the growths of aggregalcs provide misleading signals, the movements of credit aggregates may compensate for this deficiency. As mentioned above, the main disadvantage of credit is its controllability, and availability of advance infonnation. Davis (1979) argues that due to the delay in availability of data and unpredictability of the relationship between variables under the control of the central bank, the control of the credit aggregates is more difficult than the monetary aggregates.

3. Narrow Credit Aggregates A narrow credit aggregate may be defined to include lending by financial intermediaries lO the non-fmancial sector. This aggregate includes loans, advances and bills discounted, and holdings of private and government securities by banks and non-bank financial intermediaries (NBHs).

3.1 BaJ1kCremr The data on bank credit are available in advance of the data on GOP and the Reserve Bank may control the volume of bank credit by controlling the liquidity of the banks. This means that bank credit is as controllable as M3.

2

Broad money is M3 plus borrowings from the private sector by non-bank financial intennediaries (NBFI) less holdings of currency and bank deposils by NBAs.

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Figure 3 Velocity or Bank Credit

, :',ft

Z.6 :,.~

>

,., , '.' -

, ..'.'' !

~

\.Z

0.' 0.' 0.'

-

0'

Figure 4

MJ and Bank Credit (percentage change over four quarters)

",-------------------------;,--------,

.. " • " " " s

0

~

J

$ D

1979

~

J

S D W J S D WJ 1981

o

0,

sou

J 5 0 1983

9A~K

CREOIT

w

J 5 D W J 5 0

1985

w ) 5

w

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The stability of the velocity of bank credit is shown in Figure 3. 3 The coefficient of variation of the velocity of bank credit over the period is 0.06. Figure 4 shows that the growth of M3 and bank credit moved closely together. This relationship should not be surprising as M3 includes all of the banking system's deposits. A simple approach to examine the relationship between economic activity and financial variables is to regress the growth of nominal GOP on the growth of financial variables. Tables 1 to 3 show the regression results of the growth rate of

GDP and current and lagged growth rates of M3, broad money and bank credit

TABLE 1 REGRESSION RESULTS: 1964(1) • 1987(1) Dq
Equotion

Constant

m3

mJ.I

mJ.2

Y·I

NlI'1lber

2.04 (2.22)

Growth Rate of

Adj.

Durbin h

R2

SLltistic

0.66 (8.71)

0.61

0.65 (8.39)

0.60

0.17

0.61

0.59

(2.27)

(8.2')

0.19 (2.70)

-0.56

GOP

Grow",

2

2.16 (2.37)

3

2.27 (2.48)

Rate of

0.18 (2.55)

GOP

"'owIh Rile of GOP

0.23

Note: m3 and y are percentage changes in m3 and nominal GOP over four quarters respectively. The values reported in parenlheses are "t" statistics. Further lagged values of independent variables appeared to be insignificant and are not reported. Where the lagged endogenous variables are included in the regression. the' Durbin/Watson statistic wiD be close to 2. In this case the Durbin h statistic is useful to test for the presence of serial correlation. If the value of the Durbin h statistic is less than 1.645. at the 5 per cent significance level. the nuD hypothesis of no serial correlation cannot be rejected.

3

Quarterly data on bank and non-bank crcdit are only available since 1976-77.

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TABLE 2 REGRESSION RESULTS: 1978(4) - 1987(1)

D' Variable

Equation N""bo<

G,ow
4

Growth

S

Rate of

Constant

3.69 (1.23)

bm

""-,

Y·I

0.33

0.35

(1.41)

(2.09)

7.66

-o.rn

(2.29)

(-0.26)

0.44 (263)

Adj.

Durbin h

R'

Statistic

0.19

4.55

0.19

3.65

GOP

Note: bm is percentage change in broad money over four quarters.

TABLE 3 REGRESSION RESULTS: 1979(3) - 1987(1)

Dependent Variable

Growth Rate of

Equation NlEber

6

COOst....t

"'·1

Durbin h Stuistic

Y·I

6.73

-oms

0.47

(2.10)

(-0.27)

(2.14)

0.18

1.41

0.18

1.28

GOP

G,ow
7

6.70 (2.2S)

-0.37

0.48

(-0.27)

(28S)

Note: be is percentage change in bank credit over four quarters.

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The regression results of the growth of monetary aggregates are superior to the results of the growth of bank credit. However, Lhe stability of these relationships has to be examined in the recent period when deregulation caused rapid growth of monetary aggregates.

3.2 Financial In/ennediaries' Credit (FIC) Financial intermediaries' credit includes the credit extended by banks and NBFls. This measure of credit does not include direct financing between the non·financial sector and hence it is not as broad as the Reserve Bank's measure of debt which was discussed earlier. The growth of FIC is closely related to the growth of broad money since these two aggregates reflect the major portion of assets and liabilities of financial intermediaries. The relationship betwccn the growlh of FIC and broad money and the stability of the velocity of FIC are shown in Figures 5 and 6. Table 4 shows the regression results or growth or GDP and FIe.

Figure 5 Broad Money and FIe (percentage change over four quarters)

",-------------------------,

" " "

•

" "

. " "

• sow

J S

W J

1979

sow

J S D W J S

IoIJSOWJS

1985

1981 []

IIRO,/,(} WONEY

j.

riC

•

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Vol. 18 No. 02, September 1988

Figure 6

Velocity or Fie

......, ••• .....,.., u

t

g " ~

.... ,

,..• 0.'

0.' 0.' o.~

0.' 0.'

-

~ ~ ~ ~"........ ~"-e-....,.,-=...

0.' 0.'

o+'rr-~rr~--r~ ...~"rr-~rr~"rr-rr~,.,--r~r SO" J S

1918

L~

J 5

6..

J

~

6..

J 5 II t.I J

1980

~

6

M J

1982

~

t ..

J

~

t ..

J

~~

1':0184

.. J

~

tM

1986

TABLE 4 REGRESSION RESULTS: 1979(3) • 1987(1)

Dq>ond
Growth Rate of

Equation Number

Constanl

8

4.S9 (LSI)

9

1,10 (2.3S)

roo

ftq

0.11 (0.6S)

'-I

Adj.

Durbin h

R2

Statistic

0.47 (2.86)

0.19

1.40

0.50 (2.99)

0.19

0.81

GDP Gn>W1h Rate of

-0.08 (-0.46)

GDP

Note: fie is percenlage change in fmancial intermediaries' credit over four quaners.

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Comparison of the above results with the results of monetary aggregates indicates better overall performance of money over credit This result is in contrast with that of Friedman (1982b) who found no support for the preference of money over credit in the US. Friedman's measure of credit was defined as the tOlal indebtedness of the non-financial sector which is broader than the above measure of credit.

4. Stability or the Relationships There is strong evidence to suggest that the stability of the relationship between money and income has changed as a result of the recent rapid deregulation of financial markets. The growth of M3 accelerated in 1984-85, despite finn financial conditions. On a JUlle-to-June basis, M3 grew 17.4 per cent in 1984-85, compared to 10.8 per cent in 1983-84. The major contributing facLors to lhis rapid growth were a shift in the pattern of financing within financial intennediaries and a move away from direct financing. A Reserve Bank discussion paper summarised the discussions of a "meeting on monetary issues" and attempted Lo isolate any significant change in the demand for money in recent periods [Reserve Bank of Australia (1985)]. The paper updated regression results of several studies and compared the actual and predicted growth rates of M3. Generally. the updated regressions under-predicted the growth of M3 in

1984·85. The report suggested that under-prediction by various models of demand for M3 may indicate rapid growth of the actual values of M3 in 1984-85. This method will be used to examine the seability of the relationships between growth of GDP and financial aggregates which were presented in Tables ll0 4. Figures 7 to 10 show the residuals of regressions 1,2,4 and 8 from Tables I to 4. In every case the regressions tended to under-predict in 1983-84 and overpredict in 1984-85 and 1985-86. These results appear to be consistent with the rapid growth of monetary and credit aggregates in recent periods. The rapid growth of the acLual values of the independent variables lead to large forecast values. of dependent variables. This causes the residuals to become negative and large in absolute value. The usual tests of stability (such as the Chow lest) require sufficient numbers of observaHons before and after the shift. One possible test is the usc of dummy variables. Dummy variables may be used to identify any significant change in the slopes or interccpL tenns of the regression equations. This test was applied to the regression equations 1, 2 and 8 (in Tables 1 to 4) in order to examine the possibility of any significant change in the slope over the period beginning 1984·

85(1). The results are reponed in Table 5.

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Figure 7 Residuals of Equation 1

• •

, ,

Iv

r-~

o

1\ 11

-,

11

-, -,

-.

-,

,.~J

I

',.:..I

I

a

,~J

om.".,

' I

,~J

' I

,:.l

I!{SlOu.o.u

Figure 8 Residuals of Equation 2

• •

,

, 1""\

o

I~

'A ),;'\j

-,

~

-,

-. -

-,

, I 1918

,-

'J

'M'

' I

'M.

' I

'M'

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Vol. 18 No. 02, September 1988

Figure 9 Residuals of Equation 4

• • <

, ,

}

1"-1

,

V\j

-.

\

'"

('

VI

-, -, -<

-.

I

V

.-

,, , ,, , ,, , , , , , , , 1

,,, ,,, ,,,

,

Figure 10 Residuals of Equation 8 <

• <

, ,

111

~

,

\

)1

~J\.

•

., -,

V

-, -<

-'

,

.1 o

llUAI!T(JIS

II(SIOUAlS

,

.. '

V 'M'.. '

241

TABLE 5

Oq>
a",".n'

m3

m3. 1

fie

D

Y·l

Ad'

R~

Durbin h Slalistic

0,,1

from:

Growlh

2.09

0.22

~.11

0.53

(2.31 )

(3.09)

(-1.61)

0.64 (8.33)

0.61

Rate of

198485(3)

-0.12 (·1.65)

0.62 (7.92)

0.60

0.15

1985-

-0.15 (-2.40)

0.30 (1.94)

0.26

GDP

2.21 (2.47)

Growlh Rate of GDP

3.07 (0.99)

0.2.2 (2.99)

0.43 (1.97)

86(1)

1.86

1984· 85(1)

Note: The sample periods for the above regressions are as the same as those repe)Jted in Tables 1 to 4.ln the equation = a + bX + cDX. D = a from lhe beginning of the sample period up to the quarter specified in this table. and = 1 from the beginning of thal quarter to the end of the sample period.

b

Vol. 18 No. 02, September 1988

Growlh Rate of GDP

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REGRESSION RESULTS: INCLUDING DUMMY VARIABLES

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Significant coefficients for the dummy variables in Table 5 may indicate that the relationship between economic activity and financial variables has changed. This development has caused the financial aggregates to become a misleading indicator of changes in the economy.

5. Alternative Targets and Indicators Poole (1970) showed that interest ·rate targets are preferable when the source of instability originates from the financial sector and monetary targets are preferable when the real sector was unstable. In Poole's analysis the preference of one policy target over another was determined by the minimisation of variation in GOP. With widespread deregulation of financial markets in Australia and with instability in the relationship between financial variables and GDP, interest rates may be an appropriate choice of target. The difficulty with interest rate targeting is detennining the real interest rate, i.e. the nominal interest rate adjusted for the expected inflation. Since expected inflation is not observable, real interest rates may not be known precisely. However, nominal interest rates may be used as an indicator of monctary policy. Recently the Reserve Bank of Australia has suggested looking at a "check list" for detcnnining the stance of monelary policy. The "check list" includes a wide range of financial and economic variables such as monetary aggregates, interest rates, the exchange rate, the external account, asset prices, inflation and inflationary expectations. By introducing the "check list" the Reserve Bank has left the actors in markets to use their own judgments about the stance of the policy. The direction of change in the variables included in the check list may indicate the degree of finnncss of the monetary policy. Phillips (1985) argued that changes in shoft-tenn interest rates are important in indicating any significant change in financial conditions. A rise in short-tenn interest rales, other factors remaining constant, may indicate a tighter monetary JX>licy. However, interest rates may also be affected by other variables. Phillips stated that " ... accepting the need for care in interpretation, changes in interest rates (or lack of change) arc valuable indicators of changes in financial condition and of the impact of the Bank's operations" (Phillips (1985) p.13]. These statements may indicate that since the suspension of monetary targeting the Bank has relied on the movements of short-tenn interest rates as a guide to its stance of monetary policy.

6. Conclusions Deregulation of financial markets caused rapid growth of M3 and changed the relationship between M3 and economic activity. This development has led to the suspension of the conditional projection of M3 in January 1985. The Reserve Bank emphasised the irnJX>rtance of relying on a wide range of aggregates as an indicator of the stance of policy. This requires a substantial amount of judgment for deducing any conclusions based upon movements of several aggregates. In addition the staff

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of the Research Department of the Reserve Bank. introduced a measure of the indebtedness of the non-financial sector which attempts to provide useful information about changes in financial conditions. Unfortunately the data on the proposed measure of debt are not very reliable and are only available annually with a long delay.

The growth of monetary and credit aggregates appears to have a significant influence on the growth of economic activity. However, the empirical results of this study show a significant change in the relationship between financial aggregates and GDP in recent periods. These results do not provide suppon for choosing a single aggregate as an indicator and 13.rget in the transitional period of deregulation. There is some evidence that the Reserve Bank. has emphasised the movements of shan-term interest rates as an indicator of the changes in financial conditions. However, in interpreting the movements Of shan-term rates one must use judgment to isolate the extent to which rates are affccted by factors other than the Bank's monetary policy.

Rderences Davis, R.G. (1979) "Broad Credit Measures as Targets for Monetary Policy", Quarlerly Review, Federal Reserve Bank of New York. VolA No.2, pp.13-22.

Friedman, 8.M. (1982a) "Time to Re-examine the Monclary Targets Framework.", New England Economic Review, March/April, pp.15-23. Friedman, B.M. (1982b) "Monetary Policy with a Credit Aggregate Target", National Bureau of Economic Research, Working Paper No.989. Friedman, B.M. (1982c) "Money, Credit and Non-Financial Economic Activity, an

Empirical Study of Five Countries", National Bureau of Economic Research, Working Paper No.1033. Horne, J. and Monadjemi, M. (1985) "Debt, Credit and Monetary Targeting in Australia", Economic Record, Vol.61 No.173, pp.522-34. Kaufman, H. (1978) Testimony Before the House of Representatives Committee on the Budget, February 6. Marzouk, G.A. (1987) The Flow of Funds and Monelary Policy in Australia, (Australian Professional Publications, Sydney). Mohl, A. (1985) "Changing Pallerns of Financing", Reserve Bank of Australia Bullelin, May, pp.737-43.

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Phillips, M.J. (1985) "Monetary Policy from the Inside", Reserve Bank of Auslra/ia Bu//elin. November, pp.9-13. Poole, W. (1970) "Optimal Choice of Monetary Policy in a Simple Stochastic Macro Model", Quarterly Journal of Economics. Vol.84 No.2, pp.197-216.

Reserve Bank of Australia (1985) "Meeting on Monetary Issues", Discussion Paper No.8502, November. Valentine, T. (1983) "Monetary Targeting Revisited", Bulletin of Money. Banking

and Finance, No.2, pp.I-41.