The effect of the increase in the monetary base on Japan s economy at zero interest rates: an empirical analysis 1

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1 The effec of he icrease i he moeary base o Japa s ecoomy a zero ieres raes: a empirical aalysis 1 Takeshi Kimura, Hiroshi Kobayashi, Ju Muraaga ad Hiroshi Ugai, 2 Bak of Japa Absrac I his paper, we quaify he effec of he so-called quaiaive moeary easig which he Bak of Japa adoped i March Now ha shor-erm ieres raes are almos zero ad moeary base growh is over 20% year o year, acive debae coiues wih respec o he effeciveess of moeary policy a zero ieres raes. Takig io accou he regime chage i moeary policy ad he possible o-lieariy of moey demad a low (or ear zero) ieres raes, we use a Bayesia vecor auoregressio (VAR), a VAR wih ime-varyig coefficies, o exrac he effec of he icrease i he moeary base a zero ieres raes. The resul of a Bayesia VAR idicaes ha while a icrease i he moeary base previously had a posiive impac o prices, i does o ow a zero ieres raes. I order o ivesigae he possible reaso for his resul, we he esimae a moey demad fucio, ad es wheher a saiaio level i demad for he moeary base exiss a zero ieres raes. The key fidig here is ha he ull hypohesis of he o-exisece of he saiaio level ca be saisically rejeced. This meas ha here may remai room for a icrease i he moeary base o simulae he ecoomy a zero ieres raes. Despie he exisece of he saiaio level of moey demad, why does he Bayesia VAR resul sugges ha a icrease i he moeary base does o have a posiive impac o ecoomic aciviy a zero ieres raes? Oe cosise ierpreaio of hese wo resuls is ha he effec, if ay, of he icrease i he moeary base is highly ucerai ad very small. We cofirm his view by esimaig models ha iclude boh aggregae demad ad aggregae supply fucios ad esig wheher he moeary base eers hese equaios sigificaly. Fially, we discuss reasos why he expasio of he moeary base a zero ieres raes has such a limied ad ucerai effec o he ecoomy. 1. Iroducio O 19 March 2001, he Bak of Japa iroduced ew procedures for moey marke operaios uder which he ousadig balace of curre accous held a he Bak, isead of he overigh call rae, is used as he mai operaig arge. The chage i he operaig arge was closely relaed o he fac ha he overigh call rae had almos reached a zero boud ad he Bak sill eeded o ease moeary policy o comba persise deflaioary pressure. The arge level of he ousadig balace of curre accous held a he Bak exceeded he acual amou of February A he same ime, he Bak decided ha he ew procedures for moey marke operaios should remai i place uil he cosumer price idex (CPI) (excludig perishables; aiowide) regisered sably a zero per ce or a icrease year o year. The Bak also decided o icrease he ourigh purchase of log-erm goverme bods if i cosidered his ecessary o smoohly provide liquidiy. Furhermore, he Bak 1 2 We are graeful for helpful discussios ad commes from Sefa Gerlach, Keeh Kuer, Edward Nelso, Carl Walsh ad Michael Woodford, as well as paricipas a he Auum 2002 Ceral Bak Ecoomiss Meeig held by he Bak for Ieraioal Selemes. We would also like o hak may saff members of he Bak of Japa for heir commes o a earlier draf ad Saori Sao for her excelle research assisace. Ay remaiig errors are our ow. The views expressed herei are hose of he auhors aloe ad o ecessarily hose of he Bak of Japa. All he auhors belog o he Policy Research Divisio (Policy Plaig Office) a he Bak of Japa. addresses: ad 276 BIS Papers No 19

2 esablished a so-called lombard-ype ledig faciliy ha eables fiacial isiuios, uder cerai codiios, o borrow fuds from he Bak a he official discou rae as log as hey have eligible collaeral. This eire policy regime is ofe referred o as quaiaive moeary easig measures. The ew policy regime was iroduced o explore he possibiliy of furher moeary easig eve afer shor-erm ieres raes had falle o zero. The Bak of Japa pursued his policy, while cocurrely examiig he followig effecs heoreically assumed o Japa s ecoomy. Firs, lower ieres raes would sill have a simulaive impac o he ecoomy. I his regard, he aouceme ha he ew policy regime should be maiaied uil CPI iflaio becomes zero or more was ieded o iduce maximum effecs from a raher limied call rae cu o loger-erm raes. Secod, he abuda provisio of liquidiy would make moey marke paricipas feel more secure abou he availabiliy of fuds, hereby preservig fiacial marke sabiliy. Third, a icrease i reserves migh ivie liquidiy saiaio ad, cosequely, somehow iduce porfolio shifs i fiacial asses, resulig i, for example, a rise i sock prices, depreciaio of he ye, or credi expasio. Fourh, decisive moeary policy messages suppored by a icrease i reserves migh have some posiive effecs o expecaios held by corporaios ad households wih respec o he fuure course of he ecoomy ad prices. Oe ad a half years have passed sice he Bak iroduced his ew policy regime. Based o experieces ad relaed daa so far, we aalyse he effecs of quaiaive moeary easig measures a zero ieres raes ad ry o make a eaive evaluaio. The res of he paper proceeds as follows. We begi i Secio 2 by surveyig rece developmes i moeary policy ad he observed reacios of fiacial idicaors. I Secio 3 we survey he rasmissio mechaism of moeary policy a zero ieres raes from a heoreical viewpoi. I Secio 4, akig io accou he regime chage i moeary policy ad he possible o-lieariy of moey demad a low (or ear zero) ieres raes, we use a Bayesia VAR, a VAR wih ime-varyig coefficies, o exrac he effecs of he icrease i he moeary base. I Secio 5, we ivesigae wheher a saiaio level of moey demad exiss a zero ieres raes by esimaig a moey demad fucio. I Secio 6, we he esimae models ha iclude boh aggregae demad ad aggregae supply fucios ad examie wheher he moeary base eers hese equaios sigificaly. I Secio 7, we discuss reasos why he expasio of he moeary base a zero ieres raes has a limied ad ucerai effec o he ecoomy. Secio 8 preses cocludig remarks. 2. Rece developmes i moeary policy i Japa ad he reacio of fiacial idicaors The collapse of asse prices i he early 1990s was he begiig of a log ecoomic slump i Japa, which is characerised as several deep cyclical dowurs wih some modes shor-lived ecoomic recovery. There is a cosesus amog policymakers ad ecoomiss ha oe of he basic srucural problems Japa s ecoomy has faced is he o-performig loa (heceforh NPL) problem of he bakig secor. The impaired balace shee of he bakig secor has preveed he rasmissio mechaism of moeary policy from workig smoohly, hereby dampeig he fiacial ad ecoomic resposes o moeary policy easig. As early as 1995, he Bak of Japa had lile room for furher reducig ieres raes. The Bak maiaied he ucollaeralised overigh call rae as low as aroud 0.5% despie he fac ha Japa s ecoomy recovered a a more ha 3% growh rae of GDP from 1995 o I auum 1997, Japa s ecoomy sared o deeriorae, largely uder he ifluece of fiacial sysem disurbace reflecig he failure of large fiacial isiuios. The Bak successively lowered he overigh call rae o 0.02% i February The period bewee 1999 ad 2000 is ofe called he zero ieres rae period. I Augus 2000, he Bak lifed is zero ieres rae policy ad raised he overigh call rae o 0.25%, sice he ecoomy was showig clear sigs of coiued recovery. However, i lae 2000, he ecoomy sared o deeriorae agai, reflecig adjusme of global IT ad relaed expors, ad cocer over deflaio iesified. The Bak lowered he policy ieres rae oe las ime o 0.15% ad he adoped quaiaive moeary easig i March I sum, while he NPL problem of he bakig secor has bee a serious facor weakeig he effecs of accommodaive moeary policy, he zero boud of ieres raes has become a ever more iracable issue from he viewpoi of moeary policy formulaio. BIS Papers No

3 Tha was he backgroud leadig o he Bak of Japa s decisio o fially discard he orhodox operaig framework ad adop a ew framework uder which i se he ousadig balace of curre accous a he Bak, isead of he ucollaeralised overigh call rae, as he mai operaig arge. Whe he Bak adoped his ew regime, i raised he arge level of he curre accou balace o aroud JPY 5 rillio (March 2001), abou JPY 1 rillio larger ha ha immediaely prevailig before he chage (Graph 1). Afer ha, i raised he arge level o aroud JPY 6 rillio (Augus 2001), more ha JPY 6 rillio (Sepember), ad JPY 10 o 15 rillio (December). Also, o 28 February 2002, o secure fiacial marke sabiliy owards he fiscal year-ed, he Bak decided o provide more liquidiy o mee a surge i demad irrespecive of he arge of curre accou balaces, aroud JPY 10 o 15 rillio. Jus before he year-ed, he Bak provided a maximum JPY 27 rillio, ad, followig his year-ed requireme, he curre accou balace has bee ruig aroud JPY 15 rillio. Graph 1 Curre accou balaces a he Bak of Japa I rillios of ye Curre accou balaces a he Bak held by isiuios o subjec o reserve requiremes Excess reserves Required reserves CY Zero ieres rae policy period Quaiaive easig period Noe: Each moh idicaes a reserve maieace period (from he 16h of oe moh o he 15h of he followig moh). Source: Bak of Japa, Fiacial ad Ecoomic Saisics Mohly. Meawhile, i order o smoohly provide liquidiy, he Bak icreased is ourigh purchases of logerm goverme bods from JPY 400 billio o JPY 600 billio per moh i Augus 2001, ad hereafer o JPY 800 billio i December, ad furher o JPY 1 rillio i February Afer adopig quaiaive easig, he growh rae of he moeary base sared o markedly rise from he secod half of 2001, reachig some 30% year o year i March-April 2002, he highes rise sice he firs oil shock i he 1970s (Graph 2). This has refleced he Bak s ample provisio of reserves 3 I Ocober 2002, he Bak of Japa decided o aim a a ousadig balace of curre accous held a he Bak of aroud JPY 15 o 20 rillio, ad o icrease is ourigh purchases of log-erm goverme bods from JPY 1 rillio o JPY 1.2 rillio per moh. 278 BIS Papers No 19

4 Graph 2 Moey, prices ad oupu Aual perceage chages (1) Moeary base, M2+CDs, ledig M2+CDs Moeary base -4-8 CY Ledig by domesic commercial baks CPI (2) CPI, GDP deflaor, real GDP Real GDP -1-2 GDP deflaor -3 CY Noe: CPI, GDP deflaor ad real GDP are adjused o exclude he effecs of he cosumpio ax hike i April Sources: Bak of Japa, Fiacial ad ecoomic saisics mohly, Pricipal figures of fiacial isiuios; Miisry of Public Maageme, Home Affairs, Poss ad Telecommuicaios, Cosumer price idex; Cabie Office, Naioal accous. BIS Papers No

5 Graph 3 Call raes (overigh) I perceages CY CY Source: Bak of Japa, Fiacial ad ecoomic saisics mohly. 280 BIS Papers No 19

6 Graph 4 Forward raes of goverme bod yields I perceages Call raes (overigh, ucollaeralised) 1-year forward raes sarig 1 year laer 1-year forward raes sarig 2 years laer 1-year forward raes sarig 3 years laer 10-years remaiig mauriy CY Source: Bak of Japa, Fiacial ad ecoomic saisics mohly. ad he icrease i demad for cash caused by he declie i he opporuiy cos of holdig moey. As a resul, he raio of he moeary base o omial GDP has icreased o 17%, he highes figure sice he Secod World War period. While he moeary base has posed double digi perceage growh year o year, wha has bee he reacio of fiacial markes sice quaiaive easig was adoped? 4 Firs of all, amid he uprecedeed abuda supply of liquidiy, o surprisigly he ucollaeralised overigh call rae was furher lowered o 1 or 2%, lierally almos zero (Graph 3). Aoher eleme of he ew policy regime is a commime o coiue i uil uderlyig CPI iflaio urs posiive. Currely i Japa, give ecoomic weakess ad persise dowward pressure o prices, mos marke paricipas do o see CPI iflaio urig posiive ay ime soo. Reflecig such a expecaio, he decisive easig sace of he Bak of Japa exered some dowward effec o medium-erm forward ieres raes (Graph 4). Secod, as he parial removal of blake deposi isurace (for ime ad savigs deposis, ec) approached, shifs from ime ad savigs deposis o liquid deposis, ad deposi shifs amog fiacial isiuios were widely see uil he ed of fiscal 2001 (Graph 5). However, he subsaial provisio of reserves by he Bak succeeded i dispellig he liquidiy cocers of fiacial isiuios a he ed of he fiscal year. Graph 6 shows he premium o he implied forward euroye rae seppig over he ed of he fiscal year, providig evidece of his siuaio. Third, a curre accou balace icrease does o seem o have a srog effec o he corporae fiacig evirome i capial markes such as he corporae bod ad commercial paper (CP) 4 See Shirakawa (2002) for deails. BIS Papers No

7 Graph 5 Deposis of domesically licesed baks Aual perceage chages Ciy baks Regioal baks Regioal baks 2 Shiki baks CY Source: Bak of Japa, Ecoomic ad fiacial daa o CD-ROM. 0.5 Graph 6 Premium of euroye raes maurig beyod he ed of he fiscal year I perceage pois Maurig beyod he ed of FY 1998 Maurig beyod he ed of FY 1999 Maurig beyod he ed of FY 2000 Maurig beyod he ed of FY May 31 May 30 Ju 30 Jul 29 Aug 28 Sep 28 Oc 27 Nov 27 Dec 26 Ja 25 Feb Noe: Premium here is he rae icrease i fudig liquidiy whe he mauriy seps over he ed of he fiscal year. Premium = (implied forward raes from March o April) (oe moh implied forward raes whose coracs expire wihi he same fiscal year : average of hose from February o March ad hose from April o May). Source: Japaese Bakers Associaio. 282 BIS Papers No 19

8 Graph 7 Yield spreads of corporae ad public bods I perceage pois (1) Yields o corporae bod less yields o goverme securiy Ba Baa A Aa Ju 97 Sep 97 Dec 97 Mar 98 Ju 98 Sep 98 Dec 98 Mar 99 Ju 99 Sep 99 Dec 99 Noe: Yields o bods wih five-year mauriy. The idicaed raigs are Moody s. Mar 00 Ju 00 Sep 00 Dec 00 Mar 01 Ju 01 Sep 01 Dec 01 Mar 02 Ju 02 Source: Japa Securiies Dealers Associaio, Over-he-couer sadard bod quoaios, Referece price (yields) able for OTC bod rasacios (2) Yields o CP less yields o fiacig bills CY Noe: Yields o FB uil March 1999 are replaced wih yields o TB. Source: Bak of Japa, Fiacial ad ecoomic saisics mohly. BIS Papers No

9 markes. Facig he weakeig role of baks as fiacial iermediaries, ehacig he fucio of capial markes could be a impora roue for moeary easig. I his regard, he corporae fiacig evirome has parly improved. The differeial (credi spread) bewee ieres raes o corporae bods ad CP ad yields o risk-free goverme bods declied margially afer March I should be oed, however, ha firms which reap he beefis of moeary easig effecs are limied o hose wih high credi raigs. The effecs have o fully permeaed hrough o firms wih low credi raigs ad hose uable o access capial markes. Credi spreads o low-grade corporae bods have bee risig sice Ocober 2001, because ivesors have become more coscious of credi risk. Fourh, he prices of oher fiacial asses do o seem o be respodig o quaiaive easig. From March 2001, equiy prices emporarily rose uil aroud May because of he aicipaed favourable impac of srucural reform, bu declied hereafer due o a deerioraio i he ecoomic oulook (Graph 8). Afer a shor recovery from March 2002, equiy prices gradually declied agai, maily reflecig he pluge i US equiy prices. While equiy price flucuaios reflec various facors, he mos impora facor seems o be prospecs for ecoomic fudameals, o a icrease i he moeary base. As for foreig exchage raes, he ye rae agais he dollar mosly moved i he lower 120s bu emporarily rose o 116 i Sepember 2001 (Graph 9). The ye depreciaed rapidly from November 2001 uil February This seems o be aribuable o o moeary easig bu raher o a chage i he ecoomic oulook, as ypically refleced i Japa s equiy prices; while expecaios for recovery of he US ecoomy sregheed, uceraiy over prospecs for Japa s ecoomy iesified, icludig fiacial sysem sabiliy. Thereafer, reflecig he pluge i US equiy prices, he ye appreciaed agai o he 115 level i July 2002, ad has recely see lile chage aroud 120. So far, i is o clear wheher he exchage rae ad moeary base appear o move i a same way. Graph 8 Equiy prices ad he moeary base 2,800 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 CY TOPIX (1968 = 100; lhs) Moeary base (aual perceage chage; rhs) (2) 02 Sources: Tokyo Sock Exchage, Mohly saisics repor; Bak of Japa, Fiacial ad ecoomic saisics mohly. Fially, as for credi ad broad moey idicaors, bak ledig has kep decreasig, while he growh rae of M2+CDs has bee sable a aroud 3% (Graph 2). The declie i bak ledig ad moderae growh i deposis should resul i a icrease i some oher ivesmes. So far, baks have icreased ivesme i goverme bods ad Bak of Japa curre accous, boh of which are free of credi risks. 284 BIS Papers No 19

10 I sum, a firs sigh moeary ad fiacial idicaors provide o clear evidece ha quaiaive easig has produced discerible effecs wih some excepios a zero shor-erm ieres raes. However, i order o judge carefully he full effecs of quaiaive easig, we eed o evaluae hem quaiaively by coducig empirical aalyses based o ecoomic heory. Graph 9 Exchage rae ad he moeary base CY Ye depreciaio Ye appreciaio JPY/USD (lhs) Moeary base (aual perceage charge; rhs) Source: Bak of Japa, Fiacial ad ecoomic saisics mohly. 3. Moeary policy rasmissio a zero ieres raes 3.1 Moeary base chael The ieres rae chael is he primary mechaism i coveioal Keyesia macroecoomic models, which works hrough he chage i he shor-erm ieres rae. If his were he oly chael, he ecoomy would be uder a liquidiy rap whe he shor-erm ieres rae is zero. 5 However, moeariss criicise such a Keyesia view sayig ha coveioal macroecoomic models sigificaly oversimplify he srucure of he ecoomy. I he radiioal moearis accou, for a full liquidiy rap o be effecive, he composie asse - moey plus bills - mus be a perfec subsiue for all oher asses (Melzer (1999a)). I pracice, however, moey is a imperfec subsiue for a wide rage of fiacial ad real asses, icludig log-erm bods, corporae bods, equiies, foreig fiacial asses, physical capial, ad durable goods. 6 A chage i moeary policy iduces a rebalacig of porfolios i geeral, affecig omial demad boh hrough wealh ad subsiuio effecs o real asses, ad hrough adjusmes i a wide rage of fiacial yields releva o expediure decisios. From a heoreical viewpoi, eve a zero ieres raes he chage i he moeary base is expeced o cause his rebalacig effec hrough he followig chaels. 5 6 A liquidiy rap was suggesed by Keyes i he Geeral Theory ad revived recely by Krugma (1998, 1999). Some represeaive quoes of moeariss views: Melzer (1999b): Moeary policy works by chagig relaive prices. There are may, may such prices. Some ecoomiss erroeously believe [ ] moeary policy works oly by chagig a sigle shor-erm ieres rae. Friedma ad Schwarz (1982, pp 57-8): Keyesias regard a chage i he quaiy of moey as affecig i he firs isace he ieres rae, ierpreed as a marke rae o a fairly arrow class of fiacial liabiliies [ ]. We isis ha a far wider rage of markeable asses ad ieres raes mus be ake io accou [ ]. [We] ierpre he rasmissio mechaism i erms of relaive price adjusme over a broad area raher ha i erms of arrowly defied ieres raes. BIS Papers No

11 The firs chael is a relaive asse supply effec. A ope marke operaio by a ceral bak causes a opposie chage i he socks of he moeary base ad securiies held by baks, firms or households. Sice he moeary base is o a perfec subsiue for various oher asses, chages i he ousadig balace of he moeary base due o moeary policy may lead o chages i he relaive prices of asses. This relaive asse supply effec ca be realised by chages i he risk premium of asse prices. For example, Melzer (2001) ad McCallum (2000) argue ha moeary auhoriies ca use he moeary base o egieer exchage rae depreciaio eve whe shor-erm omial ieres raes are zero. Implicily, hey view he risk premium i he ucovered ieres pariy relaioship as subjec o moeary policy maipulaio i he shor ru. 7 The risk premium ca also be reduced by he secod chael, which would work hrough he reducio of rasacio coss by providig ample moey. 8 The fricios which moey helps o overcome i fiacial markes are relaed o is role i providig liquidiy services. Whe ecoomic ages aicipae a liquidiy shorage regardig heir fuure reveues, hey will boos demad for liquid asses o avoid borrowig due o cash flow cosrais. Such asse demad i preparaio for a liquidiy shorage leads o he higher evaluaio of liquid asses. Tha is, liquidiy demad migh subsaially raise he raes of illiquid asses relaive o hose of liquid asses due o a liquidiy premium. 9 I such circumsaces, he icrease i moey will reduce he probabiliy of liquidiy shorage, ad cosequely affec he liquidiy premium ad relaive asse reurs. The relief from cocer over he liquidiy of fiacial isiuios, meioed above uder he secod poi of he reacio of fiacial markes (p 6), ca be udersood as such a example (Graph 6). From a differe perspecive, i migh be expeced ha ivesors ake risks more because of a decrease i he liquidiy risk premium. Fiacial isiuios migh be cadidaes for such ivesors, ad if hey chaged heir aiude o ledig, i would have a posiive impac o aggregae demad. I his way, recogisig he role of moey i reducig fiacial fricios may provide a more sigifica role for moey i he rasmissio mechaism. The expecaio effec is aoher chael. A ceral bak ca lower loger-erm ieres raes eve whe shor-erm raes are zero. Because loger-erm raes are formed as averages of expeced shor-erm raes plus some risk premium over heir mauriy, commiig o maiaiig he zero ieres rae policy loger will lower expeced fuure shor-erm ieres raes. As he sregh of his chael relies o he expecaio of firms ad households wih respec o fuure moeary operaios of he ceral bak, curre chages i marke operaio, realised as a icrease i he moeary base, may be expeced o ehace he credibiliy of he ceral bak. 10 If his coribued o dimiishig uceraiy over fuure shor-erm ieres raes, he erm premium would be reduced ad hece loger-erm raes would be lowered furher. The above-meioed declie i medium-erm forward raes i Japa ca be regarded as a ypical example (Graph 4). I should be oed, however, ha his expecaio effec ca also be classified as par of ieres rae chaels wih loger-erm mauriies. As a variey of logic argues a variey of chaels, i is difficul o crysallise all io a simple chael. Hereafer, his paper eaively calls hem he moeary base chael. As meioed above, he moeary base chael depeds o various chages i yields (or relaive prices), raher ha moey per se. 11 Melzer (1995, 1999a) argues ha a measure of moeary codiios based o real moey However, empirical sudies seem o have cocluded i geeral ha chages i he relaive supply of dollar ad foreig currecy bods have lile or o lasig impac o exchage raes. I addiio, alhough may useful sudies have aemped o measure he degree of subsiuabiliy bewee dollar ad foreig currecy bods, here are sill o geerally acceped esimaes of hese crucial parameers. These fidigs sugges ha porfolio rebalacig effecs o he exchage rae are probably egligible for small o medium-sized chages i he relaive quaiies of dollar ad foreig currecy bods. Of course, hey do o preclude he possibiliy ha he Bak of Japa could cause a depreciaio of he ye eve a he zero boud. However, very large purchases of foreig currecy bods would be required o achieve a sigifica resul. See, for example, Kig (1999, 2002). Saio ad Shirasuka (2001) poi ou ha Japa s fiacial isiuios faced severe liquidiy cosrais durig he fiacial crises ha occurred i 1997 ad 1998, ad ha he serious liquidiy cosrai prevailig i he bakig secor resuled i depressed loa aciviies, limied arbiragig, ad poor dealig amog fiacial markes. See, for example, Meyer (2001). There is aoher view ha focuses o moey per se: he real balace effec (Pigou (1943)). However, he moeary base, amely ouside moey, accous for oly a very small fracio of fiacial wealh i developed couries. So he quaiaive impac of he real balace effec is ieviably small. 286 BIS Papers No 19

12 sock ca be regarded as a beer summary of he various chages i yields ha a measure based o a specific real ieres rae. Oe reaso he offers for his is ha moey demad migh, like aggregae demad, be a fucio of may ieres raes, as i Friedma (1956). 3.2 Review of he lieraure o empirical aalyses Whe he moeary base chael works ad he real moey sock serves as a beer summary of he various chages i yields releva for ecoomic aciviies, he moeary base eers he aggregae demad equaio for a give shor-erm ieres rae. Tha is, moey could play a role i srucural equaios for aggregae demad, or i VARs, as a proxy for chaels which are o summarised by he real ieres rae o shor-erm securiies. Koeig (1990) ad Melzer (1999a) show ha real moey growh is a sigifica deermia of cosumpio growh i he Uied Saes, corollig for he shor-erm real ieres rae. Nelso (2000) also shows ha he same propery of base moey holds for oal oupu (relaive o red or poeial) i boh he Uied Saes ad he Uied Kigdom. However, do hese aalyses idicae ha he moeary base chael works a zero ieres raes? While ecoomeric models ha are esimaed usig daa from ormal periods whe he ecoomy operaes safely away from he zero boud ca provide useful esimaes of moeary rasmissio hrough he ieres rae chael, hey are ulikely o capure he effecs of he moeary base chael ha may remai operaive whe omial ieres raes are cosraied a zero wih cosiderable precisio. Takig his poi io accou, we cao ecessarily regard he empirical aalyses of Koeig (1990), Melzer (1999a) ad Nelso (2000) as evidece of he exisece of he moeary base chael a zero ieres raes, sice heir aalyses do o iclude ay samples from he zero ieres rae period. As for Japa s case, Baig (2002), usig he VAR based o he daa from 1980 o 2001, shows ha expasio of he moeary base has posiive effecs o boh price ad oupu eve wih he ieres rae icluded i he VAR as a separae variable. The, Baig (2002) argues ha Japa s daa suppor he exisece of he moeary base chael eve a zero ieres raes. However, we have o examie wheher his aalysis really idicaes he effeciveess of he moeary base chael a zero ieres raes i Japa. Alhough Baig (2002) uses Japa s daa icludig he sample period of zero ieres raes, his aalysis is based o a VAR model which does o allow for ime-varyig parameers. I oher words, his empirical resuls do o reflec he effec of he moeary base chael a zero ieres raes, bu he average effec of ha chael durig he whole sample period. This is a problem which arises from usig a log sample which icludes differe policy regimes. Therefore, we cao ecessarily recogise ha he aalysis of Baig (2002) suggess he effeciveess of he moeary base chael a zero ieres raes i Japa. Ideed, he resuls of Baig (2002) do o seem o be cosise wih Japa s rece ecoomic performace. Alhough he growh rae of he moeary base has remaied very high for several years, deflaio persiss i he ecoomy, albei a low raes (Graph 2). If his resuls were righ, deflaio would have sopped. Needless o say, moey affecs he ecoomy wih log ad variable lags. We may have o wai jus a bi loger. However, he usual rage for he lag i he effecs of moeary policy o he ecoomy lies somewhere bewee half a year ad approximaely wo years. Cosequely, we seem o be wiessig somehig very uusual i he relaioship bewee moey ad he ecoomy. 4. Empirical aalyses based o a ime-varyig VAR I he previous secio, we poied ou he problem regardig he empirical mehod of ivesigaig he effec of he moeary base chael a zero ieres raes. We should o exrac he average effec of he moeary base chael durig a log sample period, bu ha reflecig he sample period of zero ieres raes oly. A Bayesia VAR, a VAR wih ime-varyig coefficies, is oe way o solve his problem. 12 Usig a ime-varyig VAR, we allow for possible chages i he ieres rae elasiciy of moey demad ad chages i he rasmissio mechaism a (ear) zero ieres raes. Sice he 12 See Doa e al (1984) for deails of a Bayesia VAR. BIS Papers No

13 Bak of Japa has faced he zero ieres rae boud, is policy reacio fucio has clearly chaged. The regime chage i moeary policy, from ieres rae argeig o quaiaive easig, will brig shifs i he resposiveess of ecoomic aciviy o he icrease i he moeary base. A ime-varyig VAR ca capure hese chages i ecoomic srucure ad leads o impulse respose fucios ha vary over ime. 4.1 VAR Before esimaig a ime-varyig VAR, we begi by esimaig a VAR as a bechmark, usig Japa s quarerly daa over he sample period 1980:Q1-2002:Q1. The sample period is chose o be he same as ha i Baig (2002). The specific VAR ha we cosider coais four variables: iflaio rae, oupu gap, moeary base (growh rae) ad overigh call rae. 13, 14 Clearly, his VAR provides a very simple or simplisic descripio of he ecoomy, bu i coais a leas he miimum se of variables ha are crucial for ay discussio of moeary policy. 15 We iclude four lags i he VAR accordig o AIC. The VAR is ideified by usig he Cholesky decomposiio, wih he order beig iflaio, oupu gap, ieres rae ad moeary base. The choice of orderig is made, accordig o Baig (2002), o he basis of he speed wih which he variables respod o shocks, ie iflaio is assumed o respod las, ad he moeary base o be he mos resposive. Graph 10 displays impulse respose fucios based o he esimaed VAR. The basic resuls are he same as hose of Baig. Tha is, boh iflaio ad he oupu gap respod posiively o iovaios i he moeary base. Alhough hese resposes are o saisically sigifica, usig a loger sample period, 1971:Q2-2002:Q1, resuls i a sigifica respose (Graph 11). 16 As oed earlier, however, his resul does o reflec he effec of he moeary base chael a zero ieres raes, bu he average effec of he chael durig he whole sample period. I ca be guessed ha he experieces of he 1970s coribued o his resul. Therefore, i is o ecessarily appropriae o regard he resuls based o he VAR as evidece of he exisece of he moeary base chael a zero ieres raes. 4.2 Time-varyig VAR Now, we esimae a ime-varyig VAR o properly aalyse he effecs of he moeary base chael a zero ieres raes. Wrie he jh equaio i a VAR as: = (1) x, j X 1 β, j + u, j where x,j is a jh edogeous variable, X 1 is a vecor of lagged variables, ad u,j is a error erm. β, j is a vecor of ime-depede parameers ad is assumed o follow a radom walk process. β, j is updaed accordig o a Kalma filer algorihm, based o a prior disribuio o he iiial value of a parameer vecor β 0, j. 17 Sice β, j is ime-depede, he impulse respose fucios vary over ime. We focus o he impulse respose fucios a 1985:Q2 ad hose a 2002:Q1. The former fucios are based o he parameer β 1985:Q2, while he laer are based o he parameer β 2002:Q1. These parameers are esimaed by a Kalma filer over sample periods 1971:Q2-1985:Q2 ad 1985:Q3-2002:Q1, respecively. The parameer β 1985:Q2 reflecs he propagaio mechaism of he period jus See he daa appedix for a deailed descripio of he daa. To check he robusess of our resuls, we have re-esimaed he VAR by replacig oupu gap wih oupu growh. While we repor oly he resuls obaied from he VAR wih oupu gap, he VAR wih oupu growh yields very similar resuls. To limi he exe of a price puzzle (see Sims (1992), Chari e al (1995) ad Berake ad Mihov (1998)), we re-esimae he VAR icludig commodiy price iflaio (or he wholesale price idex), bu he mai resuls do o chage. The origial available daa se rus from 1970:Q1 o 2002:Q1. Because of daa rasformaio (firs differeces ad lags), he aalysis is performed o he 1971:Q2-2002:Q1 period. We se he hyperparameers of prior disribuio a he values which Doa e al (1984) recommed for a ypical ecoomic ime series. To check he robusess of our resuls, we re-esimaed he ime-varyig VAR based o he opimised hyperparameers. While we repor oly he resuls obaied from he ime-varyig VAR wih he hyperparameers which Doa e al (1984) recommed, he ime-varyig VAR wih he opimised hyperparameers yields very similar resuls. 288 BIS Papers No 19

14 BIS Papers No Graph 10 Impulse respose fucios based o VAR (sample period: 1980:Q1-2002:Q1) Y: oupu gap ON: ucollaeralised overigh call rae (level) P: iflaio rae MB: moeary base (growh rae) Respose of P o P Respose of P o Y Respose of P o ON Respose of P o MB Respose of Y o P Respose of Y o Y Respose of Y o ON Respose of Y o MB Respose of ON o P Quarers Quarers Quarers Quarers Noe: The graph shows a 16-quarer respose of variables o a oe sadard deviaio iovaio. The dashed lies represe ± 2 sadard deviaio bads Respose of ON o Y Respose of ON o ON Respose of ON o MB Respose of MB o P Respose of MB o Y Respose of MB o ON Respose of MB o MB

15 290 BIS Papers No Respose of P o P Respose of P o Y Respose of P o ON Respose of P o MB Graph 11 Impulse respose fucios based o VAR (sample period: 1971:Q2-2002:Q1) Y: oupu gap ON: ucollaeralised overigh call rae (level) P: iflaio rae MB: moeary base (growh rae) Respose of Y o P Respose of Y o Y Respose of Y o ON Respose of Y o MB Respose of ON o P Respose of ON o Y Respose of ON o ON Respose of ON o MB Respose of MB o P Respose of MB o Y Respose of MB o ON Quarers Quarers Quarers Quarers Respose of MB o MB Noe: The graph shows a 16-quarer respose of variables o a oe sadard deviaio iovaio. The dashed lies represe ± 2 sadard deviaio bads.

16 before he Plaza Accord, while β 2002:Q1 reflecs ha afer he adopio of quaiaive easig. The reaso why we compare he impulse respose fucios a 1985:Q2 wih hose a 2002:Q1 is ha 1985:Q2 is ear he midpoi of he whole sample period 1971:Q2-2002:Q1. I order o examie wheher he propagaio mechaism differs bewee 1985:Q2 ad 2002:Q1, we calculae he impulse resposes o he commo iovaios whose covariace marix is esimaed over he whole sample 1971:Q2-2002:Q1. 18 Tha is, sice he covariace marix of iovaios is kep cosa, he differece of he impulse respose fucios provides a measure of a chage i he propagaio mechaism i he face of uchaged disurbaces. The resul, which is show i Graph 12, is clearly differe from ha of he VAR. This graph idicaes ha he icrease i he moeary base has a posiive effec o iflaio a 1985:Q2, bu o a 2002:Q1. This fidig implies ha, beyod he ieres rae chael, he moeary rasmissio process ook place hrough he moeary base chael i he 1980s, bu such rasmissio does o work ow a zero ieres raes. This seems o reflec he rece observaio ha he high growh rae of he moeary base does o lead o a idicaio of iflaio (Graph 2). 4.3 Implici assumpio of he moeary base chael Why does he uderlyig mechaism of he moeary base chael o work well as heoreically assumed? Here, i should be oed ha he moeary base chael a zero ieres raes is based o he implici assumpio ha moey demad is saiaed a a fiie level. Tha is, whe ieres raes are zero, households ad firms become saiaed wih moey balaces, ad ay icrease i he moeary base beyod ha level leads o chages i heir porfolios wih coseque chages i relaive yields o differe fiacial ad real asses, ad direc ad idirec effecs o spedig. 19 I coras wih such a view, here is aoher view. Whe ieres raes are zero, households ad firms have a ifiiely elasic demad for moey balaces. A icrease i he moeary base is absorbed passively i higher balaces, ad here are o implicaios for broader measures of moey or demad ad oupu. Moeary policy is impoe; here is a liquidiy rap. Which view is cosise wih he resul of our aalysis? As backgroud o he resul of he imevaryig VAR, we ca se wo hypoheses: Hypohesis I: As he ieres rae eds o zero, demad for moey balaces eds o ifiiy. Therefore, moeary policy has o effec o ecoomic aciviy a zero ieres raes, because ay addiioal moey creaed is simply absorbed passively i moey holdigs. Hypohesis II: Moey demad exhibis saiaio such ha he demad is fiie a zero ieres raes. Therefore, he moeary base chael works eve a zero ieres raes, bu is effec is very small or egligible. I order o es which hypohesis is acceped, we mus esimae he moey demad fucio ad examie wheher here is a saiaio level of moey demad a zero ieres raes. 20 The ex secio deals wih his issue The shock is calculaed as follows. We firs calculae he residuals from he coefficies i each period, he he covariace marix ad make he orhogoal shock usig he Cholesky decomposiio. The orderig is chose o be he same as ha of he VAR: iflaio, oupu gap, ieres rae ad moeary base. The lag legh is also chose o be he same as ha of he VAR, ha is, four lags are icluded i he ime-varyig VAR. We mus oe ha if here are oly wo fiacial asses, moey ad bods, i he ecoomy, he exisece of a fiie saiaio level of real balaces does o mea he exisece of a moeary base chael a zero ieres raes. Moey demad is ifiiely elasic a a saiaio level i he sese ha o furher ieres rae declies are eeded o make people willig o hold larger real balaces, eve if he elasiciy of moey demad is bouded a all ieres raes greaer ha zero. For a example of a simple model i which he moeary base chael is ieffecive a a zero ieres rae, ad i which here is saiaio i real balaces a a fiie level, see he discussio of real balace effecs i Woodford (2002). Baig (2002) uses he moeary base (expressed as a raio of poeial oupu) ad he level of ieres rae i he VAR wih a fixed parameer, which implicily assumes ha here is a saiaio level of moey demad a zero ieres raes. Isead of he level of ieres raes, if a logarihmic specificaio for ieres raes is used as a variable of he VAR, i implicily assumes ha moey demad eds o ifiiy as he ieres rae eds o zero, ha is, here is o a saiaio level of moey demad a zero ieres raes. However, a cosrai abou wheher here is a saiaio level of moey demad a zero ieres raes should o be imposed o he moey demad fucio a priori, bu be esed saisically. BIS Papers No

17 292 BIS Papers No Graph 12 Impulse respose fucios based o ime-varyig VAR 2002:Q :Q2 Y: oupu gap ON: ucollaeralised overigh call rae (level) P: iflaio rae MB: moeary base (growh rae) Respose of P o P Respose of Y o P - Respose of P o Y Respose of Y o Y - Respose of P o ON Respose of Y o ON - Respose of P o MB Respose of Y o MB - Quarers Quarers Respose of ON o P - - Respose of ON o Y - - Respose of ON o ON - - Respose of ON o MB - - Quarers Respose of MB o P Respose of MB o Y Respose of MB o ON Respose of MB o MB Quarers Noe: The solid lie shows a 16-quarer respose of variables a 2002:Q1. The dashed lie shows a 16-quarer respose of variables a 1985:Q2.

18 5. Saiaio level of moey demad 5.1 Geeral moey demad fucio As i Friedma (1956), he demad for real balaces depeds o o a sigle ieres rae bu o may differe ieres raes, or, more geerally, o he prices of asses relaive o he prices of ew producio of he same asses. These relaive prices sele dow as he ecoomy adjuss o a equilibrium a which all asses sell a replaceme cos. I a full, geeral equilibrium, prices of bods ad real capial, of domesic ad foreig asses, of ew ad used houses ad auomobiles, ad may oher relaive prices, ca be usefully summarised by a sigle ieres rae. I rasiio, however, his does o hold rue, ad he demad for real balaces differs from log-ru desired real balaces. Based o such logic, Melzer (1999b) argues ha he differece bewee acual ad log-ru desired moey balaces is a measure of he excess supply of moey, he amou by which prices ad oher omial variables mus chage o resore equilibrium i markes for asses ad oupu. 21 Here, we assume ha log-ru desired real balaces ca be modelled as follows: M P γ = e Y α i 1+ i + δ β α > 0, β > 0, δ 0 where M, P, Y ad i are he moeary base, price level, real icome ad call rae, respecively. α, β, γ ad δ are parameers. I equaio (2), i is assumed ha he relaive prices of various asses ca be usefully summarised by he call rae i i he log ru. Equaio (2) is cosise wih a rasacios-ime approach ad iveory-heoreic approach o moey demad. The iveory-heoreic approach says ha maagig a iveory always requires ime, ad a larger real balace of moey ca reduce rasacio ime. A variaio of he rasaciosime approach is ha cosumpio requires shoppig ime, which ca be decreased by holdig a larger real balace. I order for he rasacios-ime approach o be cosise wih saiaio, i mus be such ha, a some posiive real balace amous, furher icreases i ha raio would o decrease rasacios-ime. 22 I should also be oed ha equaio (2) ess wo familiar moey demad fucios as special cases: he log-log fucio ad semi-log fucio. Cosider he case whe he call rae i is low eough for he approximaio i /(1 + i ) = i o be reasoable. Takig logs of equaio (2) whe δ = 0, we obai he log-log fucio: m p = αy βlog( i ) + γ (3) where all lower-case leers, excludig he ieres rae i, refer o logarihms of he variables i uppercase leers. The elasiciy of moey demad wih respec o ieres raes is a full elasiciy, which shows he perceage chage i moey demad i respose o a 1% chage i ieres raes. O he oher had, akig logs of equaio (2) whe δ > 0 ad δ >> i, we obai he semi-log fucio: 23 m p = αy βlog( i + δ) + γ i = αy βlog 1+ βlogδ + γ δ β α y i + ( γ βlogδ) δ ( Q log(1+ x) x for small The respose of moey demad o ieres rae chages is a semi-elasiciy, which idicaes he perceage chage i cash holdigs as a resul of a 1 perceage poi chage i ieres raes. x) (2) (4) A aleraive view is ha he ecoomy adjuss o reduce his gap by spedig o reduce he real balace of moey, whe real balaces are larger ha desired, or o icrease he gap by reducig spedig whe real balaces are less ha desired. This so-called real balace effec is geerally cosidered small, sice real balaces are a small par of real wealh i developed couries. See Bakhshi e al (2002) ad Wolma (1997). Whe codiio δ >> i is o saisfied, his approximaio does o hold rue eve if δ > 0. BIS Papers No

19 I equaio (2), he saiaio level of moey balaces (expressed as quasi-cambridge k) a zero omial ieres raes is: M β γ k = = δ e (5) α PY i = 0 which is fiie if δ > I coras, if δ = 0, his raio k is ifiie, which implies ha here is o saiaio level of moey demad. Regardig log-log ad semi-log moey demad fucios, he former does o have a saiaio, whereas he laer does. The figure below illusraes he moey demad curve ad he locaio of he saiaio level. i 1+ i Saiaio level: β δ e γ 0 M k = P Y α δ Wheher δ is zero or sricly posiive gives a raher differe policy implicaio. I he case of δ = 0, moeary policy would have o effec o real demad ad oupu, because ay addiioal moey creaed would simply be absorbed passively i moey holdigs. I coras, i he case of δ > 0, he moeary base chael works eve a zero ieres raes, because he creaio of moey beyod he saiaio level would be raslaed io demad for oher asses ad, ulimaely, via effecs o relaive yields, io omial spedig. 5.2 Esimaio resul Now, we esimae a moey demad fucio ad examie wheher here is a saiaio level of moey demad. Before esimaig equaio (2) ad esig he hypohesis ha here is o saiaio level (δ = 0) i equaio (2), we firs aemp o examie wheher eiher of he fucios, he log-log fucio (3) or he semi-log fucio (4), is appropriae for he log-ru desired real balace. If equaio (3) or (4) is appropriae for he log-ru demad fucio, we will fid a coiegraig relaioship amog real moey (m p ), icome (y ) ad ieres rae (i or log(i )). Usig Johase s (1988) maximum likelihood esimaio procedure, we coduc a coiegraig es over he sample period 1978:Q1-2002:Q1. The sample period is chose o avoid he high-iflaio period of he firs-roud icreases i oil prices, sice he behaviour of holdig cash balaces i he privae secor may have chaged afer rasiio o a moderae- or low-iflaio period. I addiio, he policy sace of he Bak of Japa migh also have chaged afer he firs oil shock. Ideed, i 1978, he Bak bega aoucig quarerly forecass of moey supply. 24 Here, we call M /(PY α ) quasi-cambridge k because α is o ecessarily uiy, while α is se a uiy for origial Cambridge k. 294 BIS Papers No 19

20 Table 1 shows he resuls of he maximum eigevalue ad race es saisics of he Johase es for log-log ad semi-log fucios. Boh ess sugges ha, for boh specificaios, here is o coiegraig vecor amog real moey (m p ), icome (y ) ad ieres rae (i or log(i )). This implies ha eiher he semi-log or he log-log fucio is appropriae for he log-ru moey demad fucio. A more geeral moey demad fucio is desirable; herefore esimaig equaio (2) is he ex sep. Table 1 Johase s coiegraio es (1) Series: m p, y, i Null hypohesis: rak = r Maximum eigevalue saisic Trace saisic r = (21.0) r (14.1) r (3.8) 22.7 (29.7) 9.8 (15.4) 1.0 (3.8) Null hypohesis: rak = r (2) Series: m p, y, log (i ) Maximum eigevalue saisic Trace saisic r = (21.0) r (14.1) r (3.8) 25.7 (29.7) 11.3 (15.4) 3.0 (3.8) Noes: 1. The sample period is 1978:Q1 o 2002:Q1. 2. Numbers i pareheses are criical values a he 5% sigificace level. 3. The lag legh of he VECM is se o 4, obaied from he likelihood raio es. For esimaio purposes, we rearrage equaio (2) as follows: 25 M P γ e Y γ e Y α α i 1+ i i 1+ i + δ + δ β β = e γ ( ii + δ) k β 1 = ε (6) where k M = α PY ad ii i = 1+ i 25 Whe δ > 0, we cao use Johase s (1988) maximum likelihood esimaio procedure o esimae he parameer δ i equaio (2), sice akig logs of equaio (2) does o lead o a liear sysem. BIS Papers No

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