Discussion Papers In Economics
And Business

THE EFFECTIVENESS OF NONTRADITIONAL MONETARY POLICY:
THE CASE OF JAPANYuzo Honda

Discussion Paper 13-25

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHE EFFECTIVENESS OF NONTRADITIONAL MONETARY POLICY:
THE CASE OF JAPANYuzo Honda

Discussion Paper 13-25

September 2013

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHE EFFECTIVENESS OF NONTRADITIONAL MONETARY POLICY: THE
CASE OF JAPAN*1

Yuzo Honda (Kansai University)
The effectiveness of nontraditional monetary policy is controversial at least in Japan.
Making use of data from the quantitative easing monetary policy period, this paper
presents statistical evidence on the effectiveness of nontraditional monetary policy. We
empirically demonstrate that quantitative easing monetary policy, adopted by the Bankof Japan for the period from March 2001 to March 2006, had a stimulating effect on
investment and production at least through Tobin’s q channel. We also provide a simple
and operational model in which an injection of base money lowers the interest rate on
bonds, reduces the required rate of returns from capital stocks, and depreciates the valueof domestic currency.
Key Words: Quantitative Easing, Vector Autoregressions, Stocks, Tobin’s q, Asset
Markets
JEL Classification Number: E51.

*1 I thank Yoshihiro Kuroki and Minoru Tachibana for their generosity in allowing me to use the results ofour joint research in this paper. I am also grateful to Kazumi Asako, Koichi Hamada, Hiroshi Ohta, andKazuyuki Suzuki for helpful discussions on earlier versions. The present version was read as the presidential
address of the Japanese Economic Association at Kanagawa University on the 2013 Autumn Meeting of the
Association. Preliminary versions were presented at seminars at Aomori Public University, Kansai
University, Kobe University, the Conference on “Frontiers in Macroeconometrics” at Hitotsubashi
University, and the Spring Meeting of the Japan Association of Applied Economics at Ritsumeikan
University. I greatly appreciate the discussions with participants at these meetings. Keiko Makino and Junko
Ohnishi also helped me with the data analysis.

11. Introduction

As soon as the new governor Haruhiko Kuroda and vice-governors took office at the
Bank of Japan (BOJ) in April 2013, they started a new “quantitative easing” (QE)monetary policy in order to attain the targeted rate of inflation of 2% in around two
years. Prior to this, the BOJ also adopted a QE strategy for the period from March 2001
to March 2006. We define “QE monetary policy” as injection of more newhigh-powered money into the economy by the central bank than is required for the
short-term interest rate to reach 0%.
In an attempt to reverse the rapid deterioration of the US economy in December
2008, the Federal Reserve Board (FRB) also set the federal funds rate at 0–0.25%, andpurchased large amounts of agency debt and mortgage-backed securities to support the
US housing market. Ben Bernanke, chairman of the FRB, called this policy “Credit
Easing (CE)”, as the FRB’s operating target was on the asset side, rather than theliability side, of its balance sheet. However, when the FRB purchases large amounts of
securities, it expands not only the asset side but also the liability side of its balance
sheet. Hence, the effect of the US CE policy obviously also includes the impact of QE.
The relevant question confronting central bankers is how effective QE or CE is instimulating the real economy. If QE or CE is not effective, central bankers obviously
want to avoid taking the risk of implementing unprecedented measures and incurring
unpredictable disastrous side effects in the future.
Indeed, the former governor of the BOJ (Shirakawa, 2008) and the director in chargeof monetary policy, Amemiya (Japanese Economic Association (JEA), 2012) areskeptical about the effectiveness of nontraditional monetary policy on macroeconomic
variables. Kimura et al. (2002) and Fujiwara (2006), BOJ officials, also express the2skepticism about the effectiveness of QE on macroeconomic variables, though the datain their empirical studies do not cover the entire QE period.
In the academic literature, there are two alternative views on the effectiveness of QE.
The first view dates back to at least Hicks (1937). Hicks shows that, when the interest
rate reaches the lower bound, money becomes a perfect substitute, and that pumping
money into the economy under this condition has little effect in stimulating the
economy. Eggertsson and Woodford (2003) and Curdia and Woodford (2010) also
analyze dynamic general equilibrium models and reach similar conclusions.
Under a different set of assumptions, however, Bernanke and Reinhart (2004),
Bernanke et al. (2004), and Clouse et al. (2003) argue that the central bank, even whenfacing very low interest rates, has at least three alternative monetary policy measures tostimulate the economy. The first measure is through “expectations” of the future path ofshort-term interest rates. Under normal circumstances, the central bank has a strong
influence on the short end of the term structure of interest rates. Hence the central bank
may make explicit or implicit commitments on the future path of monetary policy (someexamples might include statements such as “The FRB will keep the current QE strategy
until at least the end of year 2014” or “The BOJ will keep the current zero interest
policy until concerns about possible deflation disappear”). By committing to
expansionary monetary policy, the central bank may change market “expectations” ofthe future path of short-term interest rates, and lower longer-term interest rates today
through arbitrage between short-term and the longer-term rates of interest. This is called
the “time duration effect”.
The second alternative measure is through changes in the composition of assets on
the balance sheet of the central bank. In general, the long-term interest rate may be3taken as the sum of the short-term interest, liquidity premium (premium paid for lack ofliquidity), term premium (premium paid for the length of maturity), and risk premium(premium paid for default risk). Should a financial crisis occur, the risk premium on
long-term interest rates would rise sharply. If the central bank should purchase large
quantities of private securities, for example, as the FRB did in the face of the collapse of
Lehman Brothers in September 2008, the central bank accepts the default risk of theprivate sector, mitigates the sharp rise in the risk premium, and thus lowers longer-term
interest rates today.
The third alternative measure is a QE strategy, which has effects through changes inthe size of the balance sheet of the central bank. While the second measure above
focuses on the effects of changes in the asset side of the central bank’s balance sheet,this third method pays close attention to the effects of changes in the liability side.
Expanding the quantity of base money on the liability side of the balance sheet, thecentral bank induces the private sector to change their portfolios (called “portfolio
rebalancing effects”) and/or “expectations” of the future path of short-term interest rates(called “signaling effects”). When the central bank injects large quantities of basemoney into the economy, private investors holding the extra base money mightpurchase imperfect substitute assets, raise the price of these assets, and thus stimulate
the real economy (“portfolio rebalancing effects”). The massive injection of base money
into the economy by the central bank may signal an expansionary monetary policy
stance to the market, lower expectations of the future path of short-term interest rates,
and thus reduce longer-term interest rates today (“signaling effects”).
The QE or CE monetary policy actually adopted in the US, UK, and Japan combines
the above three alternative measures. An example of the second alternative measure is4the adoption of a CE policy in December 2008 by the FRB involving the purchase oflarge amounts of private financial assets; however, it is also an example of the third
measure in part as it involved the injection of a large quantity of high-powered money
into the economy, expanding the size of the FRB balance sheet. The QE monetary
policy that the BOJ adopted from March 2001 to March 2006, on the other hand, is an
example of the third alternative measure; however, it is also an example of the second
alternative in part as the BOJ purchased short- or long-term government securities,
which might have different effects on the real economy.
Whether nontraditional monetary policy measures have real effects or not is
controversial and still an ongoing question, largely because of a lack of sufficient data
to identify the impacts of nontraditional monetary policy measures.
The JEA organized a panel discussion on the “Evaluation of Nontraditional
Monetary Policy” at the 2011 Autumn Meeting of the Association, a summary of which
was published as chapter 7 of JEA (2012). Some panelists were skeptical about theeffectiveness of the nontraditional monetary policy measures on the macroeconomy.
One panelist asserted that the QE monetary policy adopted by the BOJ for the period
from March 2001 to March 2006 was effective in promoting the stabilization of thefinancial system rather than in stimulating the macroeconomy through portfolio
rebalancing effects. Another panelist also asserted that it was nothing more than aplacebo effect on the macroeconomy, should there be any, from nontraditional monetary
policy measures.
However, these assertions were made with no or little empirical evidence. The
purpose of this paper is to show that these assertions are in conflict with statistical data.
Rather, the data suggest that QE monetary policy by the BOJ had significant impacts on

5

production through changes in stock prices. Furthermore, Tobin’s q was operating as achannel through which monetary policy shocks were transmitted to investment in thereal sector.
The organization of the paper is as follows. In Section 2, we present the results of ourvector autoregressions (VAR) models. Finding that stock prices play a key role in theempirical results, in Section 3 we briefly explain the four possible channels throughwhich changes in stock prices are transmitted to the real macroeconomy. In Section 4,
we examine the relationship between stock prices and the volume of newly issued
stocks and the value of fixed investment, during the QE period. In Section 5, we discuss
the impacts of QE monetary policy on bank lending and prices. In Section 6, we
propose a simple and operational model that is consistent with the observed data.
Section 7 summarizes our findings.

2. Vector autoregressions

This section summarizes the results of vector autoregression analysis in our two joint
papers, Honda, Kuroki and Tachibana(2007; HKT hereafter), and Honda and Tachibana(2011; HT hereafter).
In assessing the effectiveness of monetary policy, it is common to include variables for
production, prices, and the short-term interest rate in the VAR. During the QE period
from March 2001 to March 2006, however, the BOJ used the total balance of bankreserves (TBBR) as their operating target, because the overnight call rate (the standard
operating target) was stuck at virtually zero percent. Hence, if we restrict our data to theperiod March 2001 to March 2006, and if we replace the short-term interest rate by

6

TBBR, we can directly apply the above standard VAR method to analyze theeffectiveness of nontraditional monetary policy during the QE period.
The problem with this approach is that the sample period is very short with only 60
months of data. Hence, we have to be parsimonious in our model specification. We startwith the simplest three variable VAR model with indices of industrial production (y),consumer price index (p), and TBBR. All variables are in levels. The Akaike
Information Criterion (AIC) suggests a lag of two months.
With the above three-variable VAR, the results are clear. TBBR affects production y.
Then, we examine through which channel the variation in TBBR affects y. To beparsimonious in our model specification, we add just one variable at a time. As a fourthvariable, we use various variables, including government bond rates of different
maturities, stock prices, exchange rates; we found that stock prices have a significant
influence on production. Therefore, we include stock prices as the fourth variable in our
four-variable VAR model. As for the data on TBBR, the results are virtually the same,
whether we use the realized balances of bank reserves or the target numbers officiallyannounced by the BOJ.
The results for the four-variable VAR model indicate that changes in the TBBR
target by the BOJ immediately lead to changes in stock prices and then to changes in
production with a time lag. That is, changes in the operating target of TBBR aretransmitted to production via changes in stock prices. Granger causality tests, impulse
response analysis, and variance decompositions unanimously support these results.
These are the main results in our first paper, HKT(2007). Our results largely agree withthose in Wieland (2009). The weakness of HKT is that our sample size was so smallthat the results may not be robust.

7

To improve statistical inference, Honda and Tachibana(2011) extend the sample
period: from March 2001–March 2006 to January 1996–March 2010, thereby increasing
the sample size from 60 to 171 months. Introducing dummy variables into VAR, wefully exploit prior information that the central bank changed their operating target fromthe short-term interest rate to TBBR for the QE period. With the larger samples, theAIC leads us to choose four-month lag models.
We consider three kinds of VAR models in Table 1. Model (i) is a simple
five-variable VAR, including prices (p), production (y), the overnight call rate (r), stock
prices (s), and the actual TBBR (m) multiplied by the dummy variable (d1), where d1
takes the value 1 during the QE period, and 0 otherwise. In ordinary times, the BOJ set
its operating target at the overnight call rate. With the overnight call rate at close to zero
percent during the QE period, however, the BOJ used TBBR as their operating target.
This is why we include the variable TBBR (m) during the QE period only in model (i).
“c”, “c1”, and “c2” in Model (i) denote (5  1) vectors of intercept parameters.
<Table 1 around here>
Model (ii) is a six-variable VAR, including two dummy variables, d1 and d2, where
the second dummy variable d2 takes the value 0 during the QE period, and 1 otherwise.
Model (i) has the shortcoming of treating the QE period and other time periods
asymmetrically, because the variable (d1  m) takes the value m during the QE period,
and 0 otherwise. With the second dummy variable (d2  m) included, Model (ii) treats
the QE period and other time periods symmetrically, and allows the variable TBBR (m)to have different dynamic effects on other variables during the QE period comparedwith the other time periods. Model (ii) has an advantage over Model (i) in that we can8treat the QE period and other time periods symmetrically, but at the cost of reduced
efficiency of estimation with an increased number of parameters.
Model (iii) assumes that the effects of TBBR on the other variables might bedifferent between the three periods, the QE period, before the QE period, and after the
QE period. Model (iii) includes three dummy variables, d1, d3, and d4, where d3 takes
the value 1 during the pre-QE period only and 0 otherwise, and d4 takes the value 1
during the post-QE period only and 0 otherwise.
By increasing the sample size from 60 in HKT to 171 in HT, we can obtain more
precise estimates of the relationships between the macroeconomic variables, andthereby increase the statistical power of the hypothesis tests on the effectiveness of QE.
The qualitative results in HT (2011) are virtually the same as in HKT (2007).
Figure 1 reports the responses of prices (p), production (y), and stock prices (s) to a
one standard deviation shock in TBBR (m). The dotted lines indicate the 90%
confidence bounds, obtained by Monte Carlo simulation using 500 repetitions. In all
three models, the responses in prices (core CPI) are negligible, but those in production(IIP) and stock prices are significantly different from zero. Stock prices react
immediately but production reacts with a time lag, as expected.
<Figure 1 around here>
Bernanke and Reinhart (2004), and Bernanke et al. (2004) suggest that the central
bank has at least three alternative monetary policy measures even when facing the zerobound constraint of short-term interest rates.
During the QE period, the BOJ set the operating target at TBBR, but at the same time
took full advantage of other means explained by Bernanke and Reinhart (2004) andBernanke et al. (2004). Therefore, the main message in HKT (2007) is that9

nontraditional monetary policy as a package has significant impacts on production
through changes in stock prices.
Table 2 shows our estimates of an increase of 1 trillion yen in TBBR on prices,
production, and stock prices evaluated at the mean value of TBBR. Although theimpacts of policy shocks on stock prices and production are statistically significant,estimates vary across models probably because of the small samples in the QE period.
The original estimates by HKT (2007) are much larger than those by HT (2011). The
estimates in Model (iii) are the largest, while those in Model (i) are the smallest of thethree models.
<Table 2 around here>

3. Alternative transmission channels through stock prices

HKT (2007) and HT (2011) suggest that stock prices play an important role intransmitting monetary shocks to the real sector even when short-term interest rates arevery low. There are at least four possible channels through which financial shocks aretransmitted to the real sector. The first is the channel of the well-known Tobin’s q.
Second, increases or decreases in the value of stocks or real estate change the valueof collateral when agents borrow money from markets. Higher stock prices make iteasier for potential borrowers to obtain external funds from markets, and thus tend toincrease investment (see, for example, Bernanke and Gertler (1989, 1995) and Kiyotaki
and Moore (1997)).
Third, Japanese banks are allowed to hold up to 5% of the existing stock of acorporation. The difference between the purchase price and the market price of stocks is
hidden reserves (fukumi-eki in Japanese). Tier II bank capital includes 45% of hidden
10reserves. Therefore, rises in stock prices increase banks’ hidden reserves and thus Tier
II bank capital. Increased bank capital in turn enables banks to make more loans, andthus tends to increase investment.
Finally, rises in stock prices make households wealthier, which increases
consumption (called “wealth effects”).

4. Transmission channel via Tobin’s q

4.1 Stock prices and newly issued stocks
There are at least four possible channels through which changes in stock prices affectthe real sector. Among these four channels, this paper only focuses on the first, theTobin q channel, and finds that it plays a crucial role in transmitting financial shocks to
the real sector. In particular, we demonstrate that firms are very sensitive to the value ofstocks in issuing new stocks. That is, when stock prices rise, firms tend to issue larger
amounts of new stocks, and are likely to spend more, which in turn increases physicalinvestment.
4.1.1 Correlation
Figure 2 shows the changes in stock prices (Nikkei 225) and the corresponding amountsof newly issued stocks (including convertible bonds and warrants) during the QE
period, March 2001 to March 2006.
<Figure 2 around here>
The Japanese government injected bank capital of about 1.8 trillion yen to Resona
Bank in March 2003. The government rescued the bank to avoid the possibility ofcontagion effects spreading to the rest of the Japanese economy. March 2003 is clearly11an outlier in our dataset, and we exclude this outlier from Figure 2 and also from ourstatistical analysis.
Figure 2 shows a downward trend in stock prices before March 2003, but an upward
trend after that. Comparing the former period of 24 months (March 2001 to February2003) with the latter period of 36 months (April 2003 to March 2006), we observe thetendency that the amount of newly issued stocks for the latter period is clearly larger
than that in the former period. The average amount of newly issued stocks increased
from 213 billion yen in the former period to 356 billion yen in the latter period, a rise of
67%. With a t-value of 2.55, we reject the null hypothesis at the 1% significance levelthat the means of the amounts of newly issued stocks are equal between the two
subsamples.
Since the average stock price (Nikkei 225) increased from 10,699 yen in the former
period to 11,608 yen in the latter, the data suggest that there is a positive correlation
between stock prices and the amount of newly issued stocks. This assertion is also
supported by the data. The correlation coefficient is 0.34 between stock prices and theamount of newly issued stocks.
4.1.2 Causality from stock prices to newly issued stocks
A comparison between the two subsamples shows that the rate of increase in the
average amount of newly issued stocks of 67% is far greater than the corresponding rateof increase in stock prices of 8.5%. This finding supports Tobin’s q, suggestingcausality from stock prices to newly issued stocks. That is, the higher stock prices
induce firms to issue larger amounts of stocks. The ordinary least squares (OLS)
estimates of the relationship between stock prices st and the amount of newly issued
stocks at are:12

at = –188,975 + 43.366 st.
(1.06)(1)(2.77)

Figure 3 shows a scatter plot and the fitted OLS line. The sample period covers
March 2001 to March 2006 with the outlier of March 2003 excluded. The t-values ofthe estimates are in parentheses and indicate that stock prices st affect the amount of
newly issued stocks at at the 1% significance level, consistent with the hypothesis that
Tobin’s q is working as a transmission channel from the financial to the real sector.
<Figure 3 around here>
4.2 Stock prices and investment
Was the increase in newly issued stocks the cause of the increased investment in thelatter half of the QE period? In this subsection, we address this question, making use ofboth monthly and quarterly data. We use “Machinery Orders”, a prominent leading
indicator for monthly data, and “Fixed Investment” data for quarterly data.
4.2.1 Stock prices and machinery orders
Figure 4 is a scatterplot diagram of stock prices and machinery orders for the period
from March 2001 to March 2006, excluding March 2003. The estimated equation is:bt = 868,548 + 105.16 st,(1.75)(2)(2.40)

where bt denotes machinery orders, and the t-values are in parentheses. Equation (2)shows that a rise in stock prices increases machinery orders significantly at the 1%
level.
<Figure 4 around here>13

To avoid possible simultaneous equation bias, we also regress machinery orders on
stock prices with a lag of one month, st–1, and find results similar to those of equation(2) with the t-value of the coefficient estimate of st–1 significant at the 5% level.
4.2.2 Stock prices and fixed investment
Now we turn to quarterly data. Using three-month-average data of stock prices, St, andregressing fixed investment It+4 on stock prices, St, we obtain the following OLS
estimates and t-values:
It+4 = 12517.13 + 0.42 St.
(5.74)(3)(2.18)The sample period covers the first quarter of 2001 to the first quarter of 2006, for asample of only 21 observations. The sample size is too small to identify the effects ofother variables accurately. Hence, we should be cautious about the interpretation of
estimation results in equation (3). Nevertheless, the t-value of the estimate of stock
prices St is statistically significant at the 5% level.
The results for both the monthly data and quarterly data above are consistent with the
hypothesis that higher stock prices induced firms to issue larger amounts of new stocks,
which in turn lead to increases in fixed investment and production.

5. Deleveraging and prices

In the previous sections, we analyzed firm behavior in the stock market for the QE
period. In this section, we now examine firm and bank behavior in lending markets forthis period.

14

Figure 5 depicts the total amount of bank loans for the QE period. The total balanceof bank loans starts at around 469 trillion yen in March 2001 and declines almost
monotonically until January 2004 at a rate of 21.4 trillion yen per year. Over this period,
it was believed that there were three excesses in the economy, excess capital stock,
excess stock of labor, and excess debt balance. Banks were collecting money back from
customers and firms were repaying loans. The lending channel had virtually shut down.
The impacts of this deleveraging were enormous. The decline in bank loans of 21.4
trillion yen per year is large relative to 3.9 trillion yen of newly issued stocks per year
(monthly average of 61 samples, from March 2001 to March 2006 with an outlier ofMarch 2003 included, multiplied by 12). They had contractionary and deflationary
effects on the national economy. The QE strategy adopted in March 2001 and the sevensubsequent increases in the operating targets by the BOJ could not prevent thisdownward trend in bank lending immediately. However, pumping large amounts ofbase money into the economy seems also to have had effects in bank loan markets, andraising the operating target to 30–35 trillion yen in January 2004 seems to have stopped
the downward deleveraging trend.
<Figure 5 around here>
As shown in Figure 5, the total balance of bank loans reached a low of about 388
trillion yen in June 2005, and subsequently increased slightly. However, the BOJ
suddenly abandoned its QE strategy in March 2006. We believe that this sudden exitfrom QE was probably too early for lending markets to return to normal, and for theJapanese economy to commence a strong recovery. This is why we find that
expansionary nontraditional monetary policy during the QE period had no significant
impact on prices in our VAR analysis in previous sections.

15

6. A simple analytic model

In this section, we propose a simple and operational model that is consistent with thestatistical evidence presented in previous sections. The model we employ is anextension of Tobin (1969) and Yabushita (2009).
Before we proceed to our model, recall that bank loan markets were virtually not
operating during the QE period. Taking this fact into account, we assume for purely
analytic convenience that there are no bank loan markets. That is, we discard bank loans
and deposits from our analysis in the following model. “Money” is the central bankmoney and does not include deposits in our discussion in this section.
6.1 Four-asset model
Following Tobin, for analytical purposes we regard the income account variables as
exogenous data for portfolio choice behavior, and find equilibrium in the markets forstocks of assets conditional upon assumed values of outputs, incomes, and other flow
variables. This strategy is the same as the one we employ when constructing the “LMcurve” in macroeconomics. The key behavioral assumption here is that spending
decisions and portfolio decisions are independent.
Yabushita (2009) constructs two types of financial market models, both of which arecomposed of three asset markets. Given the importance of stock prices, as we see inprevious sections, and given the significance of foreign exchange rates, as we find in
Hamada et al. (2010), we extend Yabushita’s models to one with four assets; money,
bonds, capital stocks, and foreign assets.

16

6.2 Demand for assets
The respective demand for money (M), bonds (B), stocks (V), and foreign assets (F)depends on their relative asset yields, GDP (Y), and wealth (WS):Money:

M = M(i, r, z, Y, WS)

Bonds:

B = B(i, r, z, Y, WS)

Stocks:V = V(i, r, z, Y, WS)

Foreign Assets: F = F(i, r, z, Y, WS).

(4)

We assume that bonds, stocks, and foreign assets yield returns of interest rate (i),stock returns (r), and foreign asset returns (z), but that money yields no return.
The expected rate of return from holding foreign assets z is the sum of two
components, the interest rate on foreign bonds and the expected rate of change in theexchange rate E[e/e], where E[*] denotes the expectation operator. We assume z isexogenous throughout the paper.
We also assume that the assets are “gross substitutes” in standard microeconomics
terminology: the demand for each asset varies directly with its own rate of return andinversely with other rates. In symbols, the own derivatives of the respective demand
functions:(B/i, V/r, F/z),
are positive and the cross-derivatives are nonpositive.
Just as there is a budget constraint in standard microeconomics, we have a balance
sheet constraint: the total demand for the four assets sums to the total demand for wealthin the economy W:
W = M(i, r, z, Y, WS) + B(i, r, z, Y, WS) + V(i, r, z, Y, WS) + F(i, r, z, Y, WS).

17

(5)

When any one of the returns (j = i, r, z) changes, the demand for each asset reacts tothis, but the sum of the changes in the demand for each asset is assumed to be zero. Thatis:
Mj + Bj + Vj + Fj = 0 for j = i, r, z,(6)where subscript j denotes partial derivatives with respect to j = i, r, z.
When exogenous total wealth increases, we have:
MW + BW + VW + FW = 1,

(7)where subscript w denotes a partial derivative with respect to total wealth WS.
6.3 Supply of assets
The central bank exogenously supplies the money stock, MS. The government and firms
jointly determine the supply of bonds, PBBS, where PB and BS denote the price and thequantity of bonds outstanding, respectively.
Firms provide the supply of stocks, qKS, where q and KS denote the market-value
price of one unit of physical capital and the stock of physical capital, respectively, or
alternatively, the stock price and the total number of stocks outstanding, respectively.
The reproduction cost of one unit of physical capital is assumed to be one, and remains
constant throughout the discussion.
We denote the supply of foreign assets by eFS, where e and FS are the exchange ratemeasured in yen per unit of foreign currency, and the total balance of foreign assets
measured in foreign currency, respectively. The exchange rate e is endogenous, but FS is
assumed to be determined exogenously.
6.4 Inverse relations between market prices and returns
We assume that there is an inverse relation between bond price, PB, and interest rate, i:
18

dPB/di < 0.

(8)

Similarly, we also assume that an inverse relation:
dq/dr < 0,(9)also holds for capital stocks.
One simple intuitive explanation for inequalities (8) and (9) is as follows. Consider
consols that produce one yen per year. The market value of these consols PB is given by
PB = 1/i. There is indeed an inverse relation between the price of bonds PB and theinterest rate i.
In a similar manner, consider one unit of physical capital that produces real return R(assumed to be exogenous) per year. Then, the market value of this physical capital q is
given by q = R/r. An inverse relation holds again in this case between stock prices q andthe rate of return on capital stocks r, where r is the rate of return on stocks required formarket investors to be induced to hold capital stocks in their portfolios.
6.5 Market equilibrium
The market equilibrium conditions are given by the four equations:
MS = M(i, r, z, Y, WS),

(10)

PBBS = B(i, r, z, Y, WS),

(11)

qKS = V(i, r, z, Y, WS),

(12)eFS = F(i, r, z, Y, WS),(13)

but one of these conditions is automatically satisfied when the other three conditions are
met because of the balance sheet constraint:
MS + PBBS + qKS + eFS = WS = W,

19

(14)

where WS denotes the total supply of wealth. Therefore, we only have to consider any
three equations of the above four; we choose equations (10), (11), and (13). The three
endogenous variables are the interest rate i, returns on capital stocks r, and the foreignexchange rate e. Variables PB, q, and WS are also endogenous because of conditions (8),(9), and (14), respectively. The remaining variables in the system (10) through (13) areexogenous.
Substituting equation (14) into equations (10), (11), and (13), we have:
MS = M(i*, r*, z, Y, MS + PB(i*)BS + q(r*)KS + e*FS),(15)

PB(i*)BS = B(i*, r*, z, Y, MS + PB(i*)BS + q(r*)KS + e*FS),(16)

e*FS = F(i*, r*, z, Y, MS + PB(i*)BS + q(r*)KS + e*FS),(17)

where superscript * indicates the equilibrium value.
6.6 The effects of an increase in money supply
We are interested in the effects of an exogenous increase in money supply MS on theequilibrium endogenous variables (i*, r*, e*). We consider two kinds of comparative
statics. The first is the examination of the effects of a simple exogenous increase inmoney supply MS. In this case, the government and the central bank collaborate andprint the new money, and distribute it to individuals in the nation, similar to the case oftax cuts. The most primitive case corresponding to this in the real world is the casewhere the government issues new government bonds, and purchases goods and services
with the newly printed money. As we are interested in the pure effects of an increase in
the money supply, we consider the situation where the government reduces its spending
on other activities by the same amount as the newly printed money.

20

The direct purchase of government bonds by the central bank is of course prohibitedby law in Japan today. If the government issues new bonds, and if the central bankpurchases the same amount of older bonds from the markets, however, the result is thesame as in the case of the direct sale of government bonds by the government to thecentral bank.
Furthermore, note that this case of a simple exogenous increase in the money supply
corresponds to the case of an increase in the money supply in the well-known IS–LM
model.
Appendix A shows that an increase in the money supply lowers the interest rate,
di*/dMS < 0, reduces the required rate of returns from stocks, dr*/dMS < 0, anddepreciates the value of the domestic currency, de*/dMS > 0.
The second case is the effects of an open market operation (OMO). What are theeffects if the central bank purchases government bonds from the market? Appendix B
shows that an increase in the money supply by OMO lowers the interest rate, di**/dMS <0, reduces the required stock return, dr**/dMS < 0, and depreciates the value of thedomestic currency, de**/dMS > 0.
6.7 Limitations of the model
6.7.1 Banks
There are neither deposits nor bank loans in our model. This is clearly a bold
simplification. However, the significance of our model lies in the demonstration of theexistence of the transmission mechanism of nontraditional monetary policy even in sucha primitive model as one with no bank loans. We have shown in our model that anincrease in the money supply MS lowers the interest rate on bonds i, reduces the21required rate of return from stocks r, and depreciates the exchange rate of the domestic
currency e. This implies that even if lending channels are completely shut down, there
are still other channels through which monetary policy shocks may be transmitted to thereal sector. Indeed this was what happened in Japan for the QE period, as we saw in
Sections 4 and 5.
6.7.2 Expectations
Variables in financial markets are forward-looking, and expectations play an importantrole in the real world. However, our model ignores the role of expectations for the sakeof simplicity.
For example, our model shows that the purchase of government bonds by the central
bank reduces the equilibrium interest rate. However, this might not be the case in thereal world because of expectations among market participants. When the central bankpurchases government bonds, and when portfolio managers believe that such a policy
stimulates the economy and that the inflation rate will be higher in the future, thenportfolio managers are likely to increase the share of stocks and decrease that of bondsin their portfolios. (This is because stocks are believed to be a better device than bonds
for hedging against future inflation.) The decline in the demand for bonds might raise
the equilibrium rate of interest, contrary to the prediction of the above simple model.
When expectations change as in the above example, they might shift demand for
assets in the equations in (4). Strictly speaking, therefore, when we wish to analyze theeffects of OMO, we should specify demand for bonds B and stocks V as:
B = B(i, r, z, Y, WS, B(MS)),(18)

V = V(i, r, z, Y, WS, V(MS)),

(19)

22

instead of the corresponding equations in (4), where B(MS) and V(MS) denote theimpacts of an increase of the money supply on the demand for bonds and stocks,
respectively, through changes in expectations among market participants. In such acomplicated model with expectations, our standard results obtained, di*/dMS < 0 or
di**/dMS < 0, may no longer hold. This is all the more likely to happen under a lowinterest rate environment, where the liquidity effect is weak, or almost disappears.
As in the above example, our simple model with no expectations has some
limitations for analyzing the real world. Nevertheless, our simplified model is still
relevant because people form their expectations carefully. They usually base their
expectations on logical thinking or a simple operational model such as the one in thispaper. In this case, our simple model with no expectations might still be a good
approximation to the real world in many situations.

7. Concluding remarks

We summarize our findings in this paper. First, the two different VAR analyses, HKT(2007) and HT (2011), provided the same qualitative results. That is, changes in the
TBBR target affect IIP through changes in stock prices. Second, the estimates of the
impacts of nontraditional monetary policy in HT (2011) are smaller than those in HKT(2007). Third, monetary policy shocks during the QE period increased IIP at least
through the Tobin q channel. However, our empirical results do not exclude possible
effects through changes in foreign exchange rates.
Why did stock prices rise when the BOJ raised their operating targets for TBBR
during the QE period? There are at least two reasons. The first is a simple substitution
effect between money and stocks, as shown in our simple model in the previous section.
23

The second is that the “expected rate of inflation” in the market rises. Indeed, thebreak-even inflation rate (the nominal yield on standard government bonds with a
10-year maturity minus the real yield on the corresponding government bonds of thesame maturity adjusted for future rates of inflation) rose from about 0.2% in March
2004 to nearly 1.0% in August 2004, and remained roughly there for the rest of the QE
period (data were obtained from Nihon Sogo Securities in Japan).1 Taking into accountthat there is an upper bound on the returns from bonds, whereas there is no such boundon the returns from stocks, some market investors might have shifted their portfolios
from bonds to stocks, and stock prices increased.
A rise in stock prices in turn induces corporate managers to collect more funds fromstock markets and to spend more on their physical capital investment. Hence,
investment, and thus production increase.
Why, then, has the Japanese economy been trapped with deflation even after the QE
monetary policy from March 2001 to March 2006? We conjecture there are at least two
reasons for this. One, the strength of the recovery from the serious recession was weak
and slow. Two, it was too early for the BOJ to abandon nontraditional monetary policy
and send a contractionary financial shock to the market. This contractionary monetary1

Some doubt about the reliability of the break-even inflation rate in Japan as an indicatorof future inflation due to the thinness of the market. However, the total balance of inflationindexed bonds outstanding at that time roughly corresponds to the total issued stocks
outstanding of one of largest corporations listed at Tokyo Stock Exchange, and we conjecturethat the market was thick enough for arbitrage to fully work. (Sekine et al.(2008) report thatthe total balance of inflation indexed bonds was 8.4 trillion yen at the end of March 2008.)

24

policy shock in March 2006 might have hampered the strong recovery of the real
economy.
Fourth, the impacts of deleveraging were enormous. Lending channels were virtually
shut down during the QE period. Fifth, raising the operating target of TBBR to 30–35
trillion yen at January 2004 seems to have halted the trend of deleveraging.
Sixth, this paper has an implication for analytic economic models. The well-known
IS–LM model is based on the assumption that there are two asset classes, money andbonds. Arguments regarding the “liquidity trap”, which Hicks (1937) discussed, break
down if there are more than three assets in the model. Our empirical findings suggestthat stock prices play a crucial role in transmitting financial shocks to the real sector.
Therefore, it is not the two-asset model, but the n-asset model, as in Tobin (1969), thatis relevant for describing the real world today. It is not the interest rate alone as in the
IS–LM model that transmits financial shocks to the real sector. Changes in the central
bank’s policy stance are transmitted to the real sector through the prices of all assets,
including the term structure of interest rates (prices of bonds), stock prices, and foreignexchange rates (prices of foreign currencies).2

2. Kiyotaki

and Moore(2012) also discuss the role of monetary policy in a framework ofmultiple assets.
25Appendix A: Effects of an exogenous increase in money supply

There are three endogenous variables, (i, r, e), and three equations. Differentiating
equations (15), (16), and (17) with respect to MS, we have:
1

M
B
F
M

M B dP /di
BB
1 B dP /diF
F B dP /di

M
BF

M K dq/dr
B K dq/dr
F K dq/dr

M F
B F
F
1 F

di∗ /dM
dr ∗ /dMde∗ /dM, A1

where Mj, Bj, Vj, and Fj (j = 1, 2, 3, 4, 5) denote the partial derivatives of demand formoney M, bonds B, stocks V, and foreign assets F, with respect to the j-th argument,
respectively. Solving this system of equations, we obtain:
∗

F

B 1

F

M

B M
dr ∗
dM

B 1

M

F

B

B M

F

F

B K dq/dr /∆,

(A2)

F
B

B

F

M

1 B dp /di /∆,
(A3)

∗

F

M B

F M B

M B

B F K dq/dr

B 1
F 1

M

F B 1
M

B

M

B

B V

F B

M

B dp /diF B K dp /di dq/dr /∆,

26

F
B F
(A4)

where  denotes the determinant of the (3  3) matrix on the right-hand side of equation(A1), and is given by:∆

F M B F

1
M

B F
B F

B

B M

M B F
B F

B 1
F

B M K dq/dr

F M B F

1

M B F

B F

M

B F

B

B M

B M K dq/dr

F

M B

B F

1 B dp /diM B K dp /di dq/dr

B F

B F

M B F

F

M B F

F

B

B dp /diM

M B K dp /di dq/dr .

A5Making use of equations (6), (7), and the assumption of gross substitutes among thedemand for assets, we can show that the terms in square brackets are positive on theright-hand side of equation (A2), positive on the right-hand side of equation (A3), andnegative on the right-hand side of equation (A4), respectively. Noting that10,

we also obtain an inequality   0. Therefore, we have:
∗

0,

∗

0,

27

de∗ /dM

0.

Appendix B: Effects of an open market operation

In mathematical terminology, the central bank’s purchase of government bonds is anincrease in the money supply MS with a simultaneous decrease in the supply of bonds
BS. In this appendix, therefore, the supply of bonds BS is endogenous and a function of
the money supply MS. The system is now composed of the following four equations:
M i∗∗ , r ∗∗ , z, Y, M

M

p i∗∗ B Me∗∗ F

p i∗∗ B M

B i∗∗ , r ∗∗ , z, Y, M

F i∗∗ , r ∗∗ , z, Y, M

d p i∗∗ B M
dMM

q r ∗∗ Ke∗∗ F ,

p i∗∗ B M

p i∗∗ B M

q r ∗∗ K

q r ∗∗ K

A6e∗∗ F ,

(A7)e∗∗ F ,

A8

0,

A9

where superscript ** denotes the equilibrium value. Equation (A9) expresses that anincrease in the money supply MS is equal to the simultaneous reduction in the supply ofbonds PBBS in absolute value.
There are four endogenous variables (i, r, e, BS) in the model. Solving equation (A9)for (dBS/dMS), we have:dB
dM

1/p i∗∗

B /p i∗∗dp i∗∗ /di∗∗ di∗∗ /dM .

A10

Substituting equation (A10) into equations (A6), (A7), and (A8), we have the systemof three equations:
M
B
F

1
1
o

M
B
F

M K dq/dr
B K dq/dr
F K dq/dr

M F
B F
F
1 F

di∗∗ /dM
dr ∗∗ /dM .
de∗∗ /dM

A11

Solving this system of equations (A11), we have:
di∗∗
dM

F

M

B

F

1

B

M F
∆

28

B

M K

,

A12

dr ∗∗
dM
de∗∗
dM

F

VF

V 1

F

,

∆
VF

VF

A13

VF

1

V F K

,

∆

A14

where o is the determinant of the (3  3) matrix in the right-hand side of equation(A11), and is given by:∆

F M B F

1
M
M B

M B F

M B F

V

B M

B M

M B F
V

M B KF dq/dr .

A15

Using conditions (6), (7), and the assumption of gross substitutes among the demand
for assets, we can show that the terms in square brackets are positive on the right-handside of equations (A12), positive on the right-hand side of equation (A13), negative on
the right-hand side of equation (A14), and negative on the right-hand side of equation(A15), respectively. Therefore, we obtain:
∗∗

0,

∗∗

0, and29∗∗0.

References

Bernanke, B. S. and M. Gertler (1989) “Agency Costs, Net Worth, and Business
Fluctuations”, American Economic Review, Vol. 79, No. 1, pp. 14–31.
________ and ________ (1995) “Inside the Black Box: The Credit Channel ofMonetary Policy Transmission”, Journal of Economic Perspectives, Vol. 9, No. 4,
pp. 27–48.
________ and V. R. Reinhart (2004) “Conducting Monetary Policy at Very Low
Short-Term Interest Rates”, American Economic Review, Vol. 94, No. 2, pp.
85–90.
________, ________ and B. P. Sack (2004) “Monetary Policy Alternatives at the ZeroBound: An Empirical Assessment”, Brooking Papers on Economic Activity, Vol.
35, No. 2, 1–100.
Clouse, J., D. Henderson, A. Orphanides, D. H. Small and P. A. Tinsley (2003)“Monetary Policy When the Nominal Short-Term Interest Rate is Zero”, Topics inMacroeconomics, Vol. 3, No. 1.
Curdia, V. and M. Woodford (2010) “The Central-Bank Balance Sheet as an Instrumentof Monetary Policy”, NBER Working Paper No. 16208. July 2010.
Eggertsson, G. B. and M. Woodford (2003) “The Zero Bound on Interest Rates andOptimal Monetary Policy”, Brooking Papers on Economic Activity, Vol. 34, No.
1, pp. 139–233.
Fujiwara, I. (2006) “Evaluating Monetary Policy When Nominal Interest Rates are
Almost Zero,” Journal of the Japanese and International Economies, Vol. 20, No.
3, pp. 434–453.

30

Hamada, K., W. Masuzumi and K. Katsuma (2010), Learn from the Legend Professor,
Tokyo: Toyokeizai Shinposha Publishing. (in Japanese)
Hicks, J. R. (1937) “Mr. Keynes and the ‘Classics’: A Suggested Interpretation”,
Econometrica, Vol. 5, pp. 147–159.
Honda, Y., Y. Kuroki and M. Tachibana (2007) “An Injection of Base Money at Zero
Interest Rates: Empirical Evidence from the Japanese Experience 2001–2006”,
Osaka University, Discussion Papers in Economics and Business, No. 07–08(reprinted in the Japanese Journal of Monetary and Financial Economics, Vol. 1,
June 2013).
________ and M. Tachibana (2011) “Financial Crisis and the Quantitative Easing
Monetary Policy in Japan”, Osaka University, Discussion Papers in Economics
and Business, No. 11–18 (in Japanese).
Japanese Economic Association (JEA) (2012) “Evaluation on Nontraditional Monetary
Policy”, Chapter 7, in M. Ohgaki, K. Ogawa, H. Konishi and T. Tabuchi, eds.,
Current Economics 2012, Tokyo: Toyokeizai Shinposha, pp. 193–235. (inJapanese)
Kimura, T., H. Kobayashi, J. Muranaga and H. Ugai (2002). “The Effect of the Increasein Monetary Base on Japan’s Economy at Zero Interest Rates: An Empirical
Analysis”, Bank of Japan, IMES Discussion Paper Series No. 2002-E-22.
Kiyotaki, N. and J. Moore (1997) “Credit Cycles”, Journal of Political Economy, Vol.
105, No. 2, pp. 211–248.
________ and ________ (2012) “Liquidity, Business Cycles, and Monetary Policy”,
Clarendon Lecture at the University of Oxford.

31

Sekine, T., Yoshimura, K., and C. Wada (2008) “On Inflation Expectation” , Bank ofJapan Review, 2008-J-15, December. (in Japanese)
Shirakawa, M. (2008) “Modern Monetary Policy in Theory and Practice: Central
Banking and Financial Markets”, Nihon Keizai Shinbun Publishing Co, Tokyo.
(in Japanese)
Tobin, J. (1969) “A General Equilibrium Approach to Monetary Theory”, Journal of
Money, Credit and Banking, Vol. 1, No. 1, pp. 15–29.
Wieland, V. (2009) “Quantitative Easing: A Rationale and Some Evidence from Japan”,
NBER Working Paper No. 15565.
Yabushita, S. (2009) Monetary Economics, Minerva Publishing Co., Kyoto (inJapanese)32

TABLE 1
VAR models
VAR Model (i)Y = (p, y, r, d1  m, s), c = c1 + (c2  d1)
VAR Model (ii)Y = (p, y, r, d1  m, d2  m, s), c = c1 + (c2  d1)
VAR Model (iii)Y = (p, y, r, d1  m, d3  m, d4  m, s), c = c1 + (c2  d1) + (c3  d4)

HT (2011)

33

TABLE 2
Effects of an increase of one trillion yen in operating target
Model (i)Model (ii)

Model (iii)

HKT (2007)

Core CPI

0.004%

0.005%

0.003%

0.021%

IIP

0.031%

0.067%

0.177%

0.303%

Stock Prices

0.200%

0.341%

0.918%

2.142%HKT (2007)
HT (2011)

34Model (i)Model (ii)

Model (iii)Core CPI

Core CPI

Core CPI

0.03

0.08
0.06
0.04
0.02
1E-17
-0.02
-0.04
-0.06
-0.08

0.04
0.03

0.02

0.02

0.01

0.01
0

0

‐0.01

‐0.01

‐0.02
0

6

12

18

24

30

36

42

0

48

6

12

18

24

IIP

30

36

42

0

48

IIP

0.4

0.8

0.1

0.3

0.6

0.2

0.4

0.1

0.2

0.05
0
‐0.05

0

0

‐0.1

‐0.2
‐0.4

‐0.2

‐0.1
6

12

18

24

12 18 24 30 36 42 48

IIP

0.15

0

6

30

36

42

0

48

Stock Prices

6

12

18

24

30

36

42

0

48

6

Stock Prices

12

18

24

30

36

42

48

Stock Prices

0.8
0.6
0.4
0.2
0
‐0.2
0

6

12

18

24

30

36

42

48

3

1.4
1.2
1
0.8
0.6
0.4
0.2
0
‐0.2
‐0.4

2
1
0
‐1
0

6

12

18

24

30

36

42

48

0

6

12

18

24

30

36

42

48

FIGURE 1. Impulse responses to a quantitative easing policy shock
Notes: Solid and dotted lines are the point estimates and 90% confidence bounds,
respectively. The horizontal axis measures months after the policy shock. The units ofmeasurement on the vertical axis are the natural logarithm of the variable in levels
multiplied by 100.
HT (2011)35

36

Figure 3: Scattered Diagram on Stock Prices and Newly Issued
Stocks(2001/3 to 2006/3 with data of 2003/3 Excluded as an
Outlier)
Amounts of Newly Issued Stocks;
12,00010,000

8,000

6,000

4,000

2,000

0
6000

8000

10000

12000

14000

16000
18000
Nikkei Average; Yen

Tokyo Stock Exchange

37

Figure 4: Stock Prices and Machinery Orders(2001/3-2006/3)(Cabinet Office)Machinery Orders: Billion Yen
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
7000

9000

11000

13000

Nikkei Average: Yen

38

15000

17000

200103
200105200107
200109200111
200201
200203
200205200207
200209200211
200301
200303
200305200307
200309200311
200401
200403
200405200407200409200411
200501
200503
200505200507
200509200511
200601
200603Figure 5: Total Bank Lending from 2001/3 to(trillion yen; Kinyu Keizai Tokei Geppo(Monthly Statistical Reports on Finance and Economy))

2006/3

480

470

460

450

440

430

420

410

400

390

380

39