RDP 8903: The Relationship Between Financial Indicators and Economic Activity: Some Further Evidence 1. Introduction

The role of money and credit in the economy, and particularly the empirical relationships between monetary and credit aggregates and measures of economic activity, have attracted much attention in the macroeconomics literature. Many prescriptions for monetary policy have arisen as a result of strongly-held beliefs about these relationships.

The aim of this paper is to explore whether a range of financial indicators – short-term interest rates, and various monetary and credit measures – have useful leading relationships with measures of economic activity.

An earlier paper by Bullock, Morris and Stevens (1988) (BMS) has already considered this issue. Its tentative conclusions were that the narrow monetary aggregate M1[1] and the level of short-term interest rates had a reasonably good relationship with private final spending, and had the added advantage of being leading indicators. Broad monetary and credit aggregates tended to be at best coincident with activity, if not lagging. The intermediate aggregates, M3 and bank lending, were useful indicators at times, principally in the early and mid-1970s, but had since been subject to considerable disturbance in their relationship with activity.

These conclusions were drawn on the basis of fairly simple methodology – graphs and correlation coefficients. The approach adopted in this paper is to take the same data set as in BMS (updated and revised for re-basing of the national accounts to 1984/85 prices) to see whether the earlier preliminary conclusions draw support from more sophisticated tests.

In recent years in particular, questions of statistical methodology have tended to dominate the empirical literature. While it is not our intention to dwell on these issues, Section 2 of the paper, which gives a brief (and far from exhaustive) review of the empirical literature, highlights some of the methodological issues. Section 3 discusses data.

New empirical work is reported in Section 4. The tests used confirm that the broader aggregates do tend to be lagging indicators of activity, but are unable to detect any systematic leading or lagging relationship between interest rates and activity. The evidence on the narrow and intermediate monetary aggegates is mixed.

Section 5 broadens the scope of the analysis by allowing for the foreign sector. In an open economy, a floating exchange rate means that changes in monetary policy can affect output of the tradeable goods sector, through the link between interest rates and the exchange rate. The data set is expanded to allow for this, and the preliminary results reported are consistent with such an effect.


BMS conjectured that the interest-sensitivity of M1 meant that the information conveyed by it was likely in fact to be the same information as conveyed by short-term interest rates. In this case, perhaps these two cannot really be viewed as independent indicators. [1]