The role of financial assets in the quantity theory.

Abstract

The purpose of this study is to expand the quantity theory of money, and the equation of exchange, to include credit market assets in the monetary transmission mechanism. This expansion will help instructors of college-level economics to present the transmission mechanism more in line with the current research in monetary economics.

Three alternative groups of financial assets are constructed for the 1959:1-1994:2 period, and compared with the current definitions of money (M1 and M2). The Engle-Granger cointegration procedure is employed to determine if any of these variables has a stable long-run equilibrium relationship with nominal income and interest rates. The results suggest that one variable, namely total credit market assets held by private domestic nonfinancial sectors, has a stable long-run relationship with short-term interest rates and nominal GDP.

The empirical findings have several implications for monetary policy. First, credit market assets explain the monetary transmission mechanism better than money. Second, if the monetary authority can control credit market assets, then it can control the level of nominal GDP. Third, the monetary authority can influence the supply of credit market assets by using open market interest rates or capital requirement ratios, though capital requirements hold more promise.

Several recommendations emerge from this study for class presentations of the monetary transmission mechanism. First, the change in credit market assets of the domestic private nonfinancial sectors induces a diversification into real assets. As with the traditional view of the quantity theory, this induces a change in nominal GDP. Second, the markets for bank loans and for marketable securities can be used to present the influence of open market interest rates on credit market assets, a process akin to the Keynesian view of the monetary transmission mechanism. Third, capital requirement ratios can be employed by policy makers to influence the level of credit market assets in the economy.