RDP 8805: The Relationship Between Financial Indicators and Economic Activity: 1968–1987 5. Financial Indicators and Nominal Private Demand: Graphical Comparisons

It might be objected, with respect to Sections 3 and 4, that financial aggregates measured in nominal terms should not really be compared with real magnitudes for activity. Traditional notions of the demand for money, for example, typically explain the demand for real money balances in terms of real income and the opportunity cost of holding money. Alternatively, the real quantity of credit extended by intermediaries might be a determinant of real expenditure. Under this sort of framework, nominal financial variables should be compared with nominal measures of activity. This approach is taken in this and the following section.

Part (a) of this section looks at a nominal series for private demand and compares it with the real series used in Sections 3 and 4. Part (b) looks at the relationship between interest rates and nominal demand, while part (c) examines the banking aggregates. The final part compares nominal demand with the broader financial aggregates.

(a) Growth in Nominal Demand

Figure 9 compares (smoothed) growth in nominal and real private demand over the period 1968 to 1987. Several features stand out.

Firstly, for much of the period under consideration, the rate of inflation is considerably less volatile than the rate of growth of real demand. As a result, the nominal and real series for demand exhibit similar patterns. The major exception was during 1974 when real private demand fell quite sharply. With inflation rising, growth in nominal private demand fell only slightly, after the fall in real growth, and recovered before real growth became positive again.

In each of the four “recessions” identified using growth in real private demand, growth in nominal demand also fell, on three occasions quite noticeably, though nominal demand never actually fell in absolute terms.

Most turning points of nominal demand were coincident with or lagged those of real demand. The exception was during the mid 1970s when nominal demand turned prior to real demand in two instances.

(b) Interest Rates

Figure 10 shows the bill rate, in both nominal and real terms,^[14] and growth in nominal private demand. In the second half of the period, the relationship between the nominal bill rate and nominal demand was similar to that found for real demand: rises in interest rates preceded falls in the growth of demand, and falls in interest rates preceded pick-ups in demand.

The relationship is more complex in the first half of the graph. It is clear that nominal interest rates did not perform well as an indicator of nominal demand in this period. Up to 1971, the general upward trend in growth of nominal demand was matched by a rise in nominal interest rates. The major acceleration in demand in 1972–73 was preceded by a slight fall in interest rates, but was followed by a very large rise in nominal interest rates. The subsequent slowing in nominal demand was much more subdued, relative to the size of the rise in nominal interest rates, than the slowing in real demand. At about the same time as nominal interest rates came down very quickly in the second half of 1974, growth in nominal demand rose again, to annual rates of around 20 per cent in 1975.

During this period, movements in real interest rates were sometimes quite different to those in nominal rates. Real rates fell noticeably from about the end of 1970 as inflation gathered pace. Even though nominal rates were rising, there was no rise in real rates until the middle of 1974 and that was only temporary. In fact, a very strong visual impression is that the bulge in nominal demand growth at this time broadly corresponded to negative real interest rates.

Of course, it is difficult to be definitive about what borrowers and lenders perceived real interest rates to be at the time. One result which is clear, however, is that for this period, the dynamics of the interaction of interest rates, real activity and inflation were complex, too much so to be described easily on a graph.

(c) Banking Aggregates

Figure 11 shows growth in M1 and nominal demand. Broadly speaking, they appear to be positively related – expansions in M1 were associated with increased growth in nominal demand and falling growth in M1 was associated with downturns in growth of nominal demand. In most cases, growth of M1 tended to lead growth in nominal demand, except in the late 1970s.

Again, there is some evidence of a breakdown in what was otherwise a pretty good relationship in the very recent period. In 1987, growth in M1 was at its strongest since the mid 1970s, but growth in nominal demand much lower.^[15]

Figure 12 shows growth in nominal private demand, M3 and bank lending. For much of the period, the actual rate of growth of both aggregates was little different from that of demand. During the 1970s, growth in M3 also had a good cyclical relationship with growth in nominal demand. Growth in M3 appeared to lead growth in nominal demand on some occasions. The relationship was not always uniform, however. The sharp fall in growth of M3 in 1974 was only associated with a slight downturn in growth of nominal demand, and demand subsequently picked up only slightly when M3 growth increased rapidly. In the following episode, by contrast, M3 and demand growth were much more closely related.

As was the case for real demand, there was not much of a relationship between M3 and nominal demand from 1976 to 1983. M3 showed no indication of the downturn in nominal demand in 1982/83. A fairly close relationship between M3 and nominal demand was reestablished in the most recent cycle, but it was coincident rather than leading.

Bank lending, like M3, had a strong cyclical relationship to nominal demand in the 1973–74 period, but its performance seems to have worsened after that. A stronger relationship was re-established from about 1985, although the most recent upturn in nominal demand appeared to lead the upturn in bank lending by around four quarters. Further, a shift in the relationship is apparent: the trough in the growth of bank lending was much higher than the average growth of bank lending at any time since the mid 1970s, despite a sizeable fall in nominal demand growth in 1985.

(d) Broader Aggregates

Figure 13 shows growth in nominal demand and growth in the broader financial aggregates – broad money, lending and credit. All three aggregates have a strong positive relationship with growth in nominal demand, although they appear to lag it.

Broad money had a good association with both major downturns in nominal demand. It also had a clear positive relationship with the smaller downturn in 1979. In most cases, turning points in broad money tended to lag those in nominal demand. There were a few cases which were arguably coincident. Credit and lending also exhibited a positive relationship with nominal demand, although they appeared to lag nominal demand by more than broad money.

While all three aggregates grew at rates a little above that of nominal demand in the late 1970s and early 1980s, lending and credit have grown at rates considerably higher than demand since 1985. This suggests some structural change in the relationship between activity and lending and credit.

Footnotes

The real bill rate is defined in footnote 5. [14]

This is another case where the use of the GDP cycle provides slightly different conclusions, as nominal GDP growth has been substantially stronger, in the recent upturn, than growth in nominal demand. It should be noted, however, that although the exchange rate has not been considered in this paper, it would have an important influence since 1984. [15]