How Large is the Demand for Money at the ZLB? Evidence from Japan

This paper estimates a money demand function using Japanese data from 1985 to 2017, which includes the period of near-zero interest rates over the last two decades. We compare a log-log specification and a semi-log specification by employing the methodology proposed by Kejriwal and Perron (2010) on cointegrating relationships with structural breaks. Our main finding is that there exists a cointegrating relationship with a single break between the money-income ratio and the interest rate in the case of the log-log form but not in the case of the semi-log form. More specifically, we show that the substantial increase in the money-income ratio during the period of near-zero interest rates is well captured by the log-log form but not by the semi-log form. We also show that the demand for money did not decline in 2006 when the Bank of Japan terminated quantitative easing and started to raise the policy rate, suggesting that there was an upward shift in the money demand schedule. Finally, we find that the welfare gain from moving from 2 percent inflation to price stability is 0.10 percent of nominal GDP, which is more than six times as large as the corresponding estimate for the United States.