Abstract

Towards a New Monetary Paradigm: A Quantity Theorem of Disaggregated Credit, with Evidence from Japan

Three important "anomalies" that have occurred in the 1980s in several countries, including Scandinavia and Japan, have challenged the traditional monetary model: (1) the observed velocity decline and consequent instability of the money demand function; (2) significant asset price rises, often referred to as "bubbles" and (3) enormous capital outflows from Japan in the 1980s and a sudden reversal in the early 1990s. In this paper, a simple model is proposed that encompasses traditional theory and manages to explain the three main anomalies. It centres on a "quantity theory" framework of credit-money circulation, which is disaggregated into "real" and financial transactions. Excess credit creation in the "financial circulation" is shown to be responsible for asset price booms, the observed velocity decline and, in an open economy extension, foreign investment. Empirical evidence from Japan supports the model. Implications for theory, further research and policy are explored.