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This paper explores the business cycle dynamics of nominal money growth, inflation, nominal and real interest rates and the velocity of money. Accounting for the observed relationships among these variables has proved to be difficult in a variety of monetary models, such as cash-in-advance models, models with sticky prices or with segmented markets (Hodrick, Kocherlakota, and Lucas (1991), Cooley and Hansen (1995), King and Watson (1996)). In particular, accounting for the negative correlation of inflation and nominal interest rates with nominal money growth, for the high volatility of money velocity and the weak correlation of inflation and nominal interest rates is still a challenge. Moreover, there are large and persistent deviations of the model-predicted money demand relationship from its counterpart in the data. Certainly, a monetary model, which can successfully account for these empirical observations, would raise the confidence in the conclusions drawn from policy experiments.
I show that it is possible to overcome these shortcomings in a model with strong liquidity effects (Increases in nominal interest rates decrease real money demand and increase real interest rates). I find that these liquidity effects imply that the estimated model can closely match the business cycle facts that standard models have not been able to replicate. An important assumption in the theoretical model is that households are hit by idiosyncratic preference shocks, which determine their demand for money in a model with cash and credit goods. This assumption generates a significant precautionary demand for money and I demonstrate that it also induces strong liquidity effects.
In the turmoil in global financial markets and financial crisis after the summer of 2007, several overseas financial institutions failed. The financial institutions were forced to fail because liquidity became tight despite the fact that those institutions had maintained a sufficient regulatory capital adequacy ratio. Moreover, some financial institutions located here in Japan, including foreign financial institutions, faced funding difficulties at home and abroad and were forced to reduce the size of balance sheets. Through such experiences, the importance of liquidity risk management has been recognized again. Namely, it is critically important for financial institutions to have both a sufficient capital base and an appropriate liquidity risk management system in order to ensure the soundness of management and thereby exert the stable financial intermediation function.
Against such a backdrop, central banks and the regulatory and supervisory authorities have been strengthening monitoring financial institutions' liquidity risk management. In addition, the review of the framework for financial regulation and supervision is underway. For example, the Basel Committee on Banking Supervision (hereafter the Basel Committee) presented in December 2009 a proposal on new capital adequacy requirements and also proposed the introduction of liquidity regulations. The Committee plans to finalize specific requirements after the process of public consultation and impact assessment.
