Optimal Liquidity and Economic Stability. By Linghui Han & Il Houng Lee

Optimal Liquidity and Economic Stability. By Linghui Han & Il Houng Lee
IMF Working Paper No. 12/135
May 2012

Summary: Monetary aggregates are now much less used as policy instruments as identifying the right measure has become difficult and interest rate transmission has worked well in an increasingly complex financial system. In this process, little attention was paid to the potential spillover of excess liquidity. This paper suggests a notional level of "optimal" liquidity beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a gap between the face value and the real purchasing value of financial assets and widen the wedge in income between those with capital stock and those living on salaries. Such divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector.

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Excerpts

Introduction

The definition of money has evolved but is still anchored on the notion that money provides ready access to current and future goods and services, i.e., cash value. Liquidity is often defined as assets that can be easily converted into cash, and now includes most financial assets as financial innovations and financial deepening have enabled them to be readily converted into money. In this regard, the definition of money can be broadened to equal liquidity.

The traditional conceptual framework of money and price dynamics, however, has not kept up with the expanding concept of money. The formalization of the conceptual framework of the role of money M probably started with the infamous Fisher’s “equation of exchange” MV = PT, where M is money, V is velocity, P the price level and T the level of transactions.  Since it assumes that V and T are fixed and M is exogenous, an increase in M will lead to an exact proportional increase in the price level. The Cambridge school highlights money’s role as a store-of-wealth (including for precautionary motive) and defines M/P = kY where k is the Cambridge constant capturing the opportunity cost of money (interest). Thus, k is not institutionally fixed but changing. This is equivalent to Fisher's equation if one recognizes that real income (Y) and transactions (T) are identical and k=1/V.

Keynes further enriched the Cambridge equation by providing three motives for money, i.e., transaction, precautionary, and speculative. Money demand is affected by income and interest rates, so that Md = L(r, Y) where r is the average of rate of return on illiquid assets.  The basic propositions are L’(r) < 0 due to the opportunity cost, and L’(Y) > 0. These motives provide the basis for holding a larger amount of money within the economy. In Milton Friedman’s general form of money demand Md introduces the generalized portfolio constraint (Md - Ms) + (Bd - Bs) + (Yd - Ys) = 0 which connects the goods market with the money and bond markets. A monetary expansion (Ms) can be offset by an excess demand for goods. Then output Ys will rise and money demand Md will rise so that the goods market and money market are brought back into equilibrium.

Increasingly less attention is paid to the interconnectedness between money and the real sector, and thus on a mechanism for correction if money exceeds a notional optimal level. In large part, this is because the relationship between money in the classical sense and the real economy has weakened with the expansion of financial market instruments. Money M as used in Fisher’s equation is now only a fraction of instruments of transaction and as a store of value. Similarly, Friedman’s generalized portfolio constraint no longer captures the complexity of the current financial system. Indeed, M (narrowly defined money) is only relevant in influencing short term liquidity condition, and hence the short term interest rate.

Accordingly, in several countries monetary aggregates are now playing a relatively minor role in monetary policy formulations. The former Federal Reserve Governor L. Mayer noted that “money plays no role in today’s consensus macro model.” Consistent with this view, the Federal Open Market Committee does not specify a monetary aggregate as a target. Indeed, Bernanke (2006) stated that targeting monetary aggregates have not been effective in “constraining policy or in reducing inflation.” He attributes this to the recurrent instability in the relationship between money demand framework associated with deregulation and financial innovation. While the Federal Reserve continues to monitor and analyze monetary developments, he argued against heavy reliance on monetary aggregate in policy formulation.

These views are supported by Woodford (2007), who reviewed inflation models with no roles for money and suggested that these models are not inconsistent with elementary economic principles. Using a basic new Keynesian model, he showed (implicitly) that central banks’ inflation target credibility and their reaction function (policy rate) are adequate in setting a path for the price level without explicitly modeling a role for money.

In Europe, on the other hand, monetary aggregates are not fully dismissed in policy formulation. As noted by Kahn and Benolkin (2007), the European Central Bank continues to regard money as one of the factors determining inflation outlook over the medium term.  Even then, its focus is more on identifying an appropriate money demand framework and less on redefining money that better captures the growing complexity of the financial market.

These said, studies on the role of monetary aggregates have evolved but with focus on their relations with asset prices, especially in light of the disruptive boom and bust cycles of the latter on growth. Borio and Lowe (2002) identified gaps in credit, asset price, and investment, respectively, as periods when the actual deviates from the trend by a sizable amount. They found that the credit gap is the best indicator of an impending financial crisis.  The importance of credit to equity and property boom/bust episodes is supported also by Helbling and Terrones (2003) where they found the monetary aggregate to be more relevant for equity, rather than, for housing prices.

Gerdesmeier and others (2009) found asset price booms to follow rapid growth in monetary aggregates (money and credit) and eventually lead to asset price busts. They do so by constructing an asset price indicator composed of stock price and house price markets, similar to the work by Borio and others (1994) where the index was compiled using residential property, commercial property and share prices. Gerdesmeier found that changes in their composite index were consistent with the rapid increase in credit growth that followed the relaxation of constraints in the wake of financial liberalization during the 1980s.

Against these developments, this paper suggests an expanded definition of money, i.e., liquidity, which includes all financial assets held by the nonfinancial private sector. Then a notional level of “optimal” liquidity is proposed beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a “Gap” between the face value and the real purchasing value of financial assets. Such a divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector. This work provides value added by identifying a monetary aggregate the optimal value of which can be targeted at a level consistent with real sector fundamentals. These in turn are defined as the economy’s capacity to produce goods and services. When the Gap widens, it will not only lead to a boom/bust cycle, but also worsen income disparity between those holding capital stock and those who rely on income flows.


Summary and conclusion

Although money in the narrow sense matters less in an increasingly complex financial system, the quantity of a broader measure of monetary aggregate is still very relevant to the real economy. We find that the liquidity defined as the total financial assets held by the nonfinancial sector is an important determent of the value of the physical capital. This is because those who issue a financial asset must have corresponding earnings, including valuation gains, on the liability side that match the value of the issuance. The value of the earnings of a physical asset in turn is the real net present value of return of the capital stock, which depreciates over time, multiplied by the price of the capital stock.

The optimal amount of liquidity is attained at the level where it equals the real earnings times the GDP deflator. This is because the nominal earnings (income flows) of capital by default are measured as a scale to nominal GDP (i.e., relevant because of purchasing power). A Gap is created if the amount of liquidity exceeds this optimal level, which will be reflected through a fall in the GDP deflator/price of capital ratio. In other words, if the Gap arises due to a rapid expansion in liquidity, this will push up the price level of the capital stock at a much faster pace than the GDP deflator. As a result, this gap will (i) lead to a boom and bust cycle if left unchecked, which is disruptive to the economy, and (ii) worsen income inequality by rewarding those with capital stock more than those who depend on flow of income.

While it is true that interest rate transmission mechanism has become an effective monetary policy instrument aimed at controlling inflation, monetary aggregate is also still relevant to providing economic stability. By broadening the definition of money to include all financial assets held by the nonfinancial private sector, and then targeting the total to a level that is consistent with the optimal level liquidity as discussed in this paper, economic and price stability can be achieved. To achieve this desired outcome, monetary policy will have to use a combination of interest rate and monetary aggregate as the intermediate target.