RDP 8805: The Relationship Between Financial Indicators and Economic Activity: 1968–1987 1. Introduction

This paper examines the relationship between movements in various financial indicators and movements in measures of economic activity. The financial indicators include interest rates and a range of financial aggregates; the measures of activity are confined to changes in real and nominal private final expenditure. The study is based on quarterly Australian data over the past two decades. It is, therefore, mostly concerned with short to medium-term relationships.

The relationship between financial variables and economic activity can be examined in a variety of ways. One common approach has been to estimate simple demand functions for money, or to examine various measures of the velocity of circulation. Other approaches involve more sophisticated single-equation techniques, or full-system econometric modelling. Most of these have been used in the Bank over recent years.[1]

The present paper is less ambitious than those studies. It is essentially an exercise in data exploration and description, and it uses two simple and direct empirical techniques: graphical comparison of the movements in financial variables (interest rates and financial aggregates) with movements in private demand, and simple correlation coefficients of the same variables. The aim is to see which variables have had a reasonably reliable relationship with private demand over the four business cycles that have occurred over the past two decades, and to see the degree to which movements in financial variables lead or lag movements in private demand. The paper focuses first on the extent to which changes in real private demand are associated with changes in financial conditions. While traditional monetary theory suggests that changes in, for example, the nominal quantity of money have no lasting effect on real activity, it is widely accepted that financial variables can affect real demand in at least the short run.

To complete the analysis, the same set of comparisons and tests are also conducted for nominal private demand. This allows for the possibility that the timing of the relationship between financial variables and private demand might be different for the quantity and price components.

The paper does not, however, attempt to explain how financial institutions react to varying financial conditions or to changes in monetary policy. Nor does it spell out the transmission mechanism by which a change in monetary policy affects financial variables, and real activity and prices. These subjects will be covered in later papers which draw on the data and empirical evidence contained in the present study. In fact, the paper says very little about causality. The aim is more limited: to examine the properties of the financial variables as indicators of economic activity.

As well as looking at average relationships over the two decades, the paper also looks at whether the relationships have changed. Over the past two decades, the Australian financial system has moved from being heavily regulated to being largely deregulated. Many of the relationships which held during the early, heavily-regulated part of the period might have changed by the end of the period, when substantial deregulation had taken place.

The paper is in seven sections. The next section describes the variables examined in the paper. Section 3 contains graphical analysis of how the financial variables have moved relative to real private demand. Section 4 supplements this with some simple statistical correlations. Sections 5 and 6 repeat this analysis for nominal private demand. The conclusions are given in the Section 7. An appendix gives details of data and material not covered in the text.


Recent Reserve Bank work examining the stability of the demand for money includes Stevens, Thorp and Anderson (1987), and Blundell-Wignall and Thorp (1987). Recent work on the timing of the relationships between financial aggregates and economic activity has used vector-auto-regression techniques, such as in Bullock, Stevens and Thorp (1988). A generation of large-scale econometric models developed in the Bank gave an important and direct role to money in the determination of spending. The structure of the RBA82 version of the model is set out in Fahrer, Rankin and Taylor (1984). More recent development work is detailed in Edey, Kerrison and Menzies (1987). [1]