Research Discussion Paper – RDP 8805 The Relationship between Financial Indicators and Economic Activity: 1968-1987

Abstract

This paper is part of a larger project which looks at monetary policy and the economy. The object of the present paper is to serve as an introduction to and description of some key empirical regularities, without seeking to describe how monetary policy exerts its influence, or how this may have changed under deregulation. Other papers are presently being prepared which will address these issues.

The paper examines the relationship between a number of financial indicators and economic activity over the past two decades. The study focuses on private demand as an indicator of activity, and short-term interest rates and a number of financial aggregates as financial indicators.

The paper examines these indicators both visually (graphically) and using simple correlation coefficients. While it does not claim to be definitive about causality, it does draw some conclusions about the strength and timing of relationships. In particular, it suggests that large movements in real demand are preceded by movements in interest rates. The evidence for monetary and credit aggregates is mixed. M1 consistently leads real demand (though this is probably not independent of interest rates). Other bank-based aggregates sometimes led in the 1970s, but no longer do so; the relationship for these aggregates has at times been unstable. Broader monetary and credit aggregates tend to lag real demand.

In the case of nominal demand, the timimg of relationships is altered. The leading relationship of interest rates and M1 to nominal demand is longer than it is for real demand, and the lag from demand to broader aggregates is shorter. M3 and bank lending performed very well as leading indicators of nominal demand in the 1970s, but have since deteriorated.

One consistent theme which comes through in the results is that interest rates are a reasonably good leading indicator of changes in demand, particularly real demand. This relationship has not weakened with deregulation; indeed, the statistical evidence suggests that it has strengthened.

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