The myth of China’s monetization

ABSTRACT

This article develops a simple model of M2/GDP based on the money demand function of Milton Friedman. This model proves that M2/GDP is positively related to the expected wealth and negatively related to the opportunity costs of holding money. China’s extremely high monetization ratio as measured by M2/GDP is the result of a decades-long rapid economic growth and a depressed financial system. Fast economic growth leads to high expected wealth. A depressed financial system leads to low opportunity costs of holding money. The combination of those two factors increases money demand and leads to very high M2/GDP. The model is verified indirectly by testing two implied testable hypothesizes. The study of this article raises questions on the accuracy of M2/GDP as a measure of monetization.

KEYWORDS:

• Monetization
• M2/GDP
• money demand
• Milton Friedman

JEL CLASSIFICATION:

• E31
• E41
• E51

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ For example, Liu et al. (2015) studies whether high M2/GDP means there is excess liquidity in China.