Quantitative Easing to Accelerate Nominal Economic Growth

Seiji SHINPO (Advisor, Daiwa Research Institute)

Recently, quantitative easing in monetary policy has attracted much attention in Japan. However, there are differences in opinion on the effect of quantitative easing. Generally speaking, overseas observers, including some U.S. government officials such as Undersecretary of the Treasury Department Taylor, tend to emphasize the importance of money supply in the Japanese economy more than Japanese observers. In fact, a majority view in Japan is that monetary policy in general is not very effective in stimulating the economy. It is often said that the ineffectiveness of monetary policy was proved by the experience in the U.S. during the Great Depression.

In Japan there exists an image that too much money is already supplied and flooding the economy. However, when we calculate the deviation of the "velocity" (the ratio of nominal GDP to money supply) from its declining trend line, we find that it consistently deviated upward throughout the 1990s. That means that money was scarce.

Also there is a very influential view in Japan that quantitative easing would not increase money supply because of malfunctioning of the lending mechanism of financial institutions. This view appears to be supported by the fact that although the monetary base that the Bank of Japan is trying to increase has been actually increasing, money itself remains stagnant. However, this view is not correct, because it was not until March 2001 that the Bank of Japan started to raise the growth rate of the monetary base, and now it is about to increase money supply. It takes time to deliver a full impact.

The Bank of Japan decided to adopt a "quantitative easing" policy last March and increase the annual growth rate (compared to the same period last year) of the monetary base from 1.2% in March to 14.2% in September and, as a result, the growth rate of money supply increased from 2.6% to 3.7% during the same period. This increase in money supply must be a result of the increase in the growth rate of the monetary base, since the demand for money has been declining as nominal GDP is slowing down substantially. In any case, it is well known from our experience that it takes time to have a full effect of increases in the monetary base.

Our empirical study on the money supply function, using data from April 1974 through August 2001, shows that although money supply can be suppressed by its general downward trend and the severe lending attitude of financial institutions, which we have actually observed since 1991, it is possible to accelerate money supply by increasing the growth rate of the monetary base.

Our simulation, using this money supply function, indicates that if the Bank of Japan had kept the growth rate of the monetary base at 10 percent from the November of 1998 through the end of fiscal year 1999 (March 2000) and at 15 percent since then, by actively purchasing government bonds and foreign exchange the growth rate of money supply would have increased to 3.6 percent in fiscal year 2000 and up to 4.9 percent in fiscal year 2001.

Then, increases in money supply can raise the nominal rate of economic growth, as monetarists insisted in the 1970s and the 80s. The author has estimated a nominal growth rate function and found that one percentage point increase in the growth rate of money supply in a certain year leads to a 0.46 percent increase in the nominal GDP growth rate in the following year.

Regrettably, Japan's nominal growth is likely to be close to minus 2 percent in fiscal year 2001, as government investment and exports are expected to decrease by 3.8 percent and 10 percent or so, respectively. If, however, the Bank of Japan had kept the growth rate of the monetary base at 10-15 percent since the end of 1998 and the growth rate of money supply had been increased to 3.6 percent in fiscal year 2000, then the negative growth rate would have been much less than 2 percent, as the nominal growth rate would have been 0.7 percentage point higher in fiscal year 2001 and 1.2 percentage point higher in fiscal year 2002 than otherwise, according to our simulation.

In conclusion, it seems clear that even though there are various obstacles for lending money from financial institutions, increases in the monetary base is expected to increase the growth rate of money supply and thus to accelerate nominal GDP growth significantly. However, it takes considerable time to have a full impact of such a policy. Therefore, we need to maintain a double-digit growth rate in the monetary base for a substantial period of time.

(A larger paper on this subject has been published in Japanese in the October 17, 2001, issue of Nihon Keizai Shimbun.)