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We would like to thank our IMF colleagues, especially Timothy Callen, Charles Collyns, Patricia Reynolds, and participants in an APD Departmental Seminar, for valuable comments, and Fritz Pierre-Louis for excellent research assistance.
By contrast, the wealth channel may be relatively unimportant in Japan given the limited ownership of equities by individuals.
Two different views of the banking crisis are contained in the literature. Krugman (1998) argues that bank weakness has had little impact on the effectiveness of monetary policy as impaired banks tend to lend too much, not too little. By contrast, Bayoumi (1999) finds that the negative shocks to bank lending, either autonomous or caused by falling asset prices, have provided a major deflationary impetus over the 1990s.
The inclusion of the exchange rate yielded unstable and often perverse results, such as a positive and significant output response to an exchange rate appreciation. The omission of such a variable for Japan is in line with the empirical literature on the United States, which is another large, advanced economy which is not very open.
An alternative interpretation is that the multiplier on government spending is unity, a value used in other IMF work (Lipworth and Meredith, 1998), although recent empirical work has pointed to a somewhat lower value (Bayoumi, 1999).
The data sources are provided in the data annex. Real output and broad money are measured as ratios to potential output, prices are in logarithms, and the nominal interest rate is a ratio, so a change of 0.01 represents a 1 percentage point change in the relevant variable.
See also Singleton (1993) and Ueda (1993) in the same volume. Kasa and Popper (1996), who use a structural VAR approach to study the objectives and operating procedures of the BOJ, also conclude that short rates are important.
As the reduced-form errors are typically correlated, the Choleski decomposition isolates the underlying structural errors by recursive orthogonalization, with the innovation in the first equation untransformed, the innovation in the second equation taken as orthogonal to the first, and so on. This identification scheme is common in the empirical literature on monetary policy, though other approaches have also been used.
Given the planning processes involved in setting output and prices, these variables are assumed to react slowly. The monetary authorities are assumed to set the call rate with some information abut the contemporaneous behavior of output and prices, but without a full picture of the behavior of quickly-changing financial variables. In the extended VARs, decisions about lending and borrowing are assumed to reflect all current information.
The stock price index for the banking sector from the Tokyo Stock Exchange is available starting in 1983, truncating the sample period. The variable is normalized to unity over the sample period, so that changes have the interpretation of percentage deviations. This variable was ordered last in the VAR, given that market prices generally respond quickly to all types of shocks.
Detailed results for this VAR and the others reported in the paper are contained in Annex II, including standard errors around the impulse responses.
This multiplier is similar to that obtained by Bayoumi (1999), who uses a VAR methodology with a different set of variables, although only about half of that obtained by Lip worth and Meredith (1998), who use the Japan block of the IMF’s MULTIMOD model, and at the lower end of the range of estimates from large econometric models presented by Krugman (1998).
The introduction of commodity prices reduces this source of bias in empirical work on the United States (see, for example, Christiano, Eichenbaum, and Evans, 1996). However, neither commodity prices nor stock prices resolved the price puzzle in Japan.
Since broad money is roughly equivalent to the liabilities of the banking system, this result also suggests that banks in particular may play an important role in the transmission mechanism. This is further supported by other results (not reported for the sake of brevity) in which M2 was divided into Ml and quasi-money. The results from this model indicate that it is quasi-money (time and savings deposits) rather than Ml (currency and demand deposits) which primarily affects real demand.
The equation for base money is ordered second to last (before broad money but after the short-term interest rate to account for the impact of interest rate changes on base money). The results are similar if base money is ordered last.
The components of private demand being consumption, business investment, residential investment, exports, and imports.
Note that the sum of these components—0.3 percent of potential—is very close to the result found for total private demand in the basic model, indicating that the decomposition into separate components of demand is broadly consistent with the aggregate results.
These data come from the flow of funds accounts. The securities markets series aggregates funds from bonds, corporate paper, and equities.
Responses of short-term interest rates are not reported as they were small and insignificant in the main model, as discussed earlier.
When the VAR is run without broad money, the impulse responses of private demand to innovations in bank loans and securities are somewhat larger, consistent with the view that these variables to some extent capture money shocks.
Balance-sheet-based measures of bank strength, such as a bank’s reported capital adequacy ratio, are suspect. For example, Long-Term Credit Bank reported a capital adequacy of over 10 percent for March 1998, just a few months before it was found to have negative net worth equivalent to over 14 percent of risk assets.
The results of the decomposition are similar if the VAR is reordered with the financial variables preceding the real variables.