Use of Money Supply in the Conduct of Japan's Monetary Policy: Reexamining the Time Series Evidence

Japan's money supply and its role in monetary policy have drawn considerable attention especially since the Bank of Japan adopted its "quantitative easing" scheme in March 2001. This paper focuses on the role of money supply as an information variable and reexamines the empirical relationship between money and economic activity with recent data extending through 2003. We show that the linkage between M2+CD and income or prices largely disappeared in the 1990s and explore possible reasons for this breakdown. The evidence suggests that (i) time deposits lost their predictive content for future economic activity in the 1990s, which seems a primary reason for the breakdown in the M2-income relationship, (ii) bank loans also became no longer useful in forecasting subsequent movements in output in the late 1990s, and (iii) there has been a close link between time deposits and bank loans throughout the period examined. We argue that Japan's persistent non-performing loans problem and ongoing efforts by firms and banks to trim excessive and inefficient bank loans may have caused the breakdown in the bank loan-income relationship and accordingly the breakdown in the M2-income relationship by way of time deposits over the last decade.