PRELIMINARY DRAFT: PLEASE DO NOT QUOTE WITHOUT PERMISSION Working Paper No. <xxx> UK broad money growth in the long expansion – what can it tell us about the role of money ? Michael McLeay(1) and Ryland Thomas(2) Abstract This paper looks at the behaviour of UK money growth during the long expansion of activity between the mid 1990s and the start of the financial crisis in mid-2007. The relationship between money and other variables over this period throws up several puzzles. Money grew significantly less than credit growth over this period suggesting it was not just a simple reflection of the expansion of bank balance sheets. Yet money grew more strongly than nominal activity over this period but this did not lead a significant pick up in inflation. To analyse these puzzles we review the role of the broad money supply in the transmission mechanism both in terms of what it can tell us about the source of the shocks hitting the economy over this period and the role of money in the propagation of those shocks. Using empirical models that embody a role for money and credit, we find that a key driver of credit growth over this period was a shift in the willingness of wholesale investors to provide funds to the UK banking system and a shift in the supply of credit by the banking system. We attribute this to a general increase in risk taking behaviour as a result of the ‘search for yield’ by wholesale investors and increased risk taking behaviour by the banking system. The expansion of credit resulting from those shocks boosted money growth but to a smaller degree given the increase in non-deposit funding over this period. Asset prices and demand were also boosted by these shocks but there also appears to have been a beneficial effect on the supply side of the economy which partly explains the lack of an inflationary response. A sectoral analysis of money holdings suggests that corporate money holdings provided some incremental information about the pattern of asset prices and domestic spending we saw over this period. Key words: Money supply, Financial and macro linkages, SVARs, long-run restrictions. JEL classification: C11, C32, E51, E52 __________________________________________________________________________ (1) Bank of England, Monetary Strategy and Assessment Division. Email: [email protected] (2) Bank of England, Monetary Strategy and Assessment Division. Email: [email protected] The views expressed in this paper are those of the authors, and not necessarily those of the Bank of England. This paper was finalised on <Press Office clearance date>. The Bank of England’s working paper series is externally refereed. Information on the Bank’s working paper series can be found at www.bankofengland.co.uk/publications/workingpapers/index.html Publications Group, Bank of England, Threadneedle Street, London, EC2R 8AH Telephone +44 (0)20 7601 4030, Fax +44 (0)20 7601 3298, email [email protected]. © Bank of England 2013 ISSN 1749-9135 (on-line) Contents Summary 3 Introduction – the behaviour of money during the long expansion: what are the puzzles ? 6 1 Recent literature on the role of money in the transmission mechanism 10 1.1 Conventional and unconventional theories of money 10 1.2 A simple monetarist framework for analysing money 13 1.3 Money and standard macroeconomic shocks 15 1.4 Money and shocks to the banking sector 17 1.5 Money as a propagation mechanism – how do monetary disequilibria unwind ? 20 1.6 An empirical approach for addressing the propagation role of money 22 2 A model for investigating the role of the monetary sector as a source of shocks 24 2.1 An aggregate co-integrated SVAR model 24 2.2 Data choices 24 2.3 Stationarity of the data and cointegration 27 2.4 Identification of structural shocks 30 2.5 Validating the shocks 34 3 Analysing the long expansion period – to what extent was the monetary sector the source of shocks driving the economy ? 37 3.1 Why explains the movements in money and credit over the long expansion period 37 3.2 The impact of shocks on GDP and inflation 38 4 The role of money as a propagation mechanism 44 4.1 . Linking the sectoral models together 47 4.2 Quantifying the propagation role of money in driving asset prices and GDP during the run up to the financial crisis 51 5 Conclusions 53 Appendix References Working Paper No. <xxx> <month> 2013 2 Summary The recent financial crisis has re-focused attention on the role of money and credit in driving macroeconomic fluctuations. Prior to the crisis much of macroeconomic analysis was typically interested in explaining movements in macroeconomic variables in terms of only a small number of aggregate level shocks, such as aggregate supply, aggregate demand and monetary policy shocks. Movements in money were largely on the periphery of macroeconomic analysis and many economists doubted the relevance or information content in money holdings given the poor experience with targeting monetary aggregates in the 1980s. Movements in credit were not ignored over this period but they were typically treated within the umbrella of aggregate demand shocks. And little attention was paid to the potential for credit to have allocative effects that boosted the supply potential of the economy. This paper goes back to the long period of expansion from the mid-1990s leading up to the financial crisis in 2007 to examine what movements in money and credit were telling us about the UK economy. We ask two particular questions: (i) What was the role of the money-creating sector as a source of economic shocks over this period ? We know the financial sector and money expanded rapidly over this period. And Chadha et al. (2013) have recently highlighted the need to understand the extent to which the supply of credit by the banking system is the source of shocks to the economy rather than technology and other macroeconomic shocks. So what did drive that expansion and how did that affect macroeconomic outcomes over this period ? . (ii) What was the role of money in propagating shocks to the economy ? Did money play a role in amplifying or dampening the impact of shocks in the economy. And, as a result, was there information in money that would have allowed us to help predict what happened to asset prices, activity and inflation in the UK economy. We use these questions to help explain various features and puzzles about the behaviour of money and credit in the lead up to the crisis: (i) Why did credit grow faster than money ? In the 1980s the expansion of money largely matched that of credit. In the long expansion period credit grew substantially faster than deposit liabilities, opening up an aggregate ‘funding gap’. What drove the expansion of credit and non-deposit liabilities over this period ? (ii) Why did all measures of money generally grow faster than nominal spending over this period ? All measures of money – narrow, broad and weighted Divisia indices – grew faster than nominal spending over this period. Indeed money velocity declined at rates similar to that observed in the 1980s. So there appeared to be no diminishment in the role of traditional measures of Working Paper No. <xxx> <month> 2013 3 money either as a form of transactions or as a store of value despite continued technological progress in payments systems and the rise of shadow banking. Did this reflect increased competition in the banking system and a continuation of the trend of financial liberalisation in the 1980s onwards or did it reflect increased risk taking behaviour in financial markets that was channelled through the banking system ? (iii) Why did the expansion of money not eventually lead to a large pick up in inflation? Despite double-digit money growth this did not ultimately lead to any significant pick up in inflation although real output growth did pick up to above historical trends. Why was this ? Does this suggest that the shocks driving money and credit may have had beneficial supply side effects ? (iv) Does the behaviour of sectoral money holdings matter over this period ? Household money growth was fairly stable over this period whereas the money holdings of non- financial companies (PNFCs) and non-bank financial companies (NIOFCs) such as pension funds and asset managers were more volatile. What are the implications of this and how does this feature help explain puzzles (i) to (iii) ? To address these issues we use a range of econometric models where money and credit are modelled jointly with other macroeconomic variables. We first look at an aggregate model to investigate role of the monetary sector as a source of shocks. We use a cointegrated (SVAR) to identify the role of different shocks emanating from the banking sector alongside traditional aggregate demand, supply and monetary policy shocks. Underlying this system is a long-run money demand equation that means we can explicitly incorporate how deviations of money holdings from long-run equilibrium respond and play out in response to different shocks. Although an aggregate SVAR analysis is useful in identifying and quantifying the role of different structural shocks on macroeconomic variables it can reveal little about the transmission mechanism of such shocks at a deeper level. So to investigate the role of money as a propagation mechanism we use a set of sectoral money demand systems. Previous research has suggested that the linkages between money, asset prices and spending have tended to be clearer at a sectoral level in the UK data. In these systems the money holdings of a particular sector are modelled jointly with other relevant sectoral variables, such as asset prices in the case of the financial company sector and consumption and investment in the case of the household and corporate sectors.