Monetary policy - United States ; Money ; NOW accounts

Brian Motley

John P. Judd

English

Research Papers in Economics

September 18, 1981 
Innovation and Monetary Policy: II 
Two important institutional changes affecting 
the Federal Reserve's monetary pol icy have 
occurred this year-a sharp rise in the use of 
money-market mutual funds, especially by 
households, and the nation-wide introduc-
tion of NOW accounts. As we pointed out in 
the last Weekly Letter, these innovations may 
have reduced the public's demand for 
money. Such a shiftwould change the impact 
of Fed monetary policy, making any given 
growth target for the monetary aggregates less 
restrictive in its effect on inflation. 
Monetary policy 
In pursuing its policy objectives, the Federal 
Reserve System seeks a money-supply 
growth rate which allows for real growth in 
the economy but which also curbs the rate of 
inflation. But to make this general policy 
operational, the Fed must select a precise 
statistical definition of  the "money supply." 
Despite the availability of a number of 
alternative definitions, the Fed places 
considerable emphasis on a definition which 
stresses money's role as a medium of 
exchange and hence includes only funds 
which are used for making payments. The 
aggregate wh  ich most closely corresponds to 
this "transactions" definition of money is 
M-l B, which consists of currency, traditional 
checking accounts at banks, and the newer 
interest-bearing checkable deposits (e.g., 
NOWs) at banks and thrift institutions. 
Economic theory and considerable empirical 
research suggest a close and stable relation 
between the demand for transaction balances 
and the levels of nominal income and interest 
rates. As a result, control of the supply of 
transaction money enables the Fed to exert 
pressure to bring down the inflation rate by 
influencing spending-both directly and 
indirectly via interest rates. However, the 
Fed's ability to predict the impact of its 
policies on the economy depends on the 
maintenance of a constant relationship 
between'those variables and the public's 
demand to hold (M-l B) money. For example, 
with a decline in the average amount of 
money which the public wishes to hold at 
given income and interest-rate levels, any 
particular monetary growth rate will become 
less restrictive. Essentially, this occurs 
because a given stock of money wi  II be able 
to finance a greater number of transactions if 
each transactor holds on to money for a 
shorter period of time before spending it on 
goods and services or exchanging it for 
another type of asset. 
Hence, in formulating its monetary growth 
targets, the Fed must always be on the 
look-out for shifts in the demand for money, 
since any such shift changes the effect of a 
given rate of money growth on the economy. 
However, in an uncertain and changing 
financial environment, a shift in money 
demand may not be recognized until after it 
has actually occurred. 
NOW Accounts: New Fed Problem 
Since the beginning of 1981, banks and thrift 
institutions have been able to issue NOW 
accounts to their household and non-profit 
customers, in accordance with one of  the key 
provisions of the Depository Institutions 
Deregulation and Monetary Control Act of 
1980. NOWs are accounts at banks and thrift 
institutions which may be used to make 
third-party payments but which -unlike 
traditional bank demand deposits-also 
yield interest. Between December 1980 and 
July 1981, the volume of  these accounts 
outstanding increased from $28 billion to 
$69 billion. Most of these new accounts 
represent fu nds transferred from either 
demand deposits or saving accounts. 
As we have seen, the Fed's best estimate of 
the stock of transaction money -M-1 B-
includes NOW accounts in addition to 
currency and traditional demand deposits. 
However, a significant proportion of new 
NOW accounts represents funds shifted out W~cdl~1f©'n TI«~~e1fw~ 
ra  (§\ fffi 1k  (G) IT 
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Opinions expressed in this newsletter clo  not 
necessarilv reflect the views of the management 
of the Feeleral  Reserve Bank of San  Francisco, 
or of the Board of Covernors of the Federal 
Reserve System. 
of  savings deposits and other non-transaction 
instruments, which yield about the same as 
NOWs but are not checkable. As a result, 
M-l B's growth rate has been inflated this year 
because it  contains a comlXlnent which it  did 
not include in earlier years. Moreover, 
although funds transferred from savings to 
NOWs may be used to make payments, their 
owners probably will continue to treat them 
as savings rather than transaction accounts. 
This poses a problem for the Fed because it 
wishes to control the rate of growth of 
transaction balances. Therefore, the Fed has 
attempted to construct a statistical magnitude 
comparable to the earl ier M-1  B series by 
adjusting the data to exclude balances shifted 
to newly opened NOW accounts in 1981 
from sources other than demand deposits. 
However, it is difficult to obtain information 
on the proportion of new NOW accounts 
which are not truly transaction balances. The 
Fed views its estimates of  this prolXlrtion as 
being subject to rather wide margins of  error. 
Sources of NOW data 
The Fed obtains its information, first, from 
surveys of banks and thrift institutions 
regarding sources of new NOW accounts. 
However, an institution receiving a new 
NOW account has no sure way of knowing 
the source of the funds except for those 
transferred from another account within the 
same institution. For example, although a 
customer opens a NOW account with a 
,check drawn on a bank checking account, 
this does not necessarily mean that that 
account was the original source of  the funds, 
which may have been shifted from some 
other type of account only to permit the 
switch to the other institution. 
The Fed also obtains information from a 
statistical analysis of weekly changes in 
demand deposits and NOW accounts at 
about 9,000 commercial banks nationwide. 
This analysis attempts to measure the extent 
to which increases in NOW accounts are 
associated with the loss of traditional 
checking accounts. This approach fails to 
capture shifts of funds from bank checking 
accounts into thrift-institution NOW 
accounts-or movements of funds between 
and within thrifts. The result is an 
under-estimation of the share of new NOWs 
. coming from savings accounts. Other data 
sources, however, provide some indication 
of  shifts of funds between banks and thrifts. 
2 
The Fed finally obtains information 
from a series of  surveys of households 
conducted by the Survey Research Center at 
the University of Michigan. These surveys, 
however, are designed to gain information 
about a variety of household decisions and 
attitudes, so that a random sample of 
households at.large may not be 
representative of NOW account-holders. 
Relatio.i toM~  1  B'  .. 
These various estimation procedures provide 
similar results, despite all the statistical and 
conceptual problems involved. They suggest 
that time and savings accounts provided 
between 20 and 25 percent of  the NOWs 
opened in January 1981, and 25 to 30 
percent of  those opened in later months. 
Using the midpoints of  these estimated 
ranges, the Fed now publishes data on 
"shift-adjusted M-1 B," which represents 
M-1 B minus the portion of new NOW 
accounts estimated to have come from 
non-demand delXlsit sources. Each month, 
the total increase in NOW accounts (apart 
from a small "trend" increase) is split into 
two parts, depending on the source of  the 
original funds. The portion estimated as 
coming from non-transaction sources is 
deducted from the total increase in M-l B for 
that month to yield an estimate of  the increase 
in shift-adjusted M-1 B. The level of adjusted 
M-1 B then equals the cumulative sum of 
these monthly increases. 
This adjusted aggregate rose from $415.6 
billion in December 1980to  $423.9 billion in 
April 1981, but then declined to $420.2 
billion in July. For the entire December-July 
period, this represented only a 1.9-percent 
annual rate of  growth, so that adjusted M-l B SBil/lons 
445 
Money  Supply (M-1B) 
M-1B 
6% 
.  Growth 
3.5% 
.  Growth 
440 
435 
430 
425 
420 
415 
__ M-1 B  Adjusted 
410  0  N  0  J  F  M  A  M  J 
1980  1981 
tell below the lower bound of  the Fed's 1981 
target range. By contrast, M-1 B without a shift 
adjustment increased at a 6.0-percent annual 
rate between December and July. 
Many analysts attribute the recent rise 
in interest rates, deceleration of inflation 
and reduction of real growth to this 
slowdown in M-1 B. Nonetheless, nominal 
GNP has risen substantially faster in 1981 
than might have been expected from past 
relationships of money, income and interest 
rates. As we argued in the last Weekly Letter, 
statistical tests using shift-adjusted M-1 B data 
suggestthat equations explaining this relation 
were much less successful in 1981 than in 
earl ier periods. 
This phenomenon may perhaps be explained 
in terms of a falling demand for money, 
which has permitted the economy to finance 
a substantial rise in the volume of 
transactions with only a modest increase in 
the stock of  transaction balances. Last week, 
we argued that recent financial innovations, 
such as the growth of money-market mutual 
funds, might be involved in such a reduction 
of money demand. 
Alternatively, this phenomenon may result 
from a faulty NOW-shift adjustment-in 
other words, less NOW-account money has 
come from non-transaction sources than is 
currently assumed. As we noted, the Fed's 
estimate of  this proportion is subject to error, 
as shown by the fact that the Fed bases its 
adjustment on the midpoint of an estimated 
range. This suggests that the "true" stock of 
transaction balances may be greater than 
currently estimated-and that M-1 B may 
have grown faster this year than the estimated 
1.9-percent annual rate. That is, rather than a 
falling demand for money, we may be 
experiencing a higher supply of money than 
suggested by the official data. However, this 
argument is weakened by the fact that the 
error may go in either direction. 
3 
Implications for policy 
These two alternative explanations may have 
different implications for monetary policy in 
1982. This reflects the fact that most of  the  . 
shift of funds into NOW accounts will 
probably be completed by the end of 1981, 
whereas high interest rates could continue to 
induce financial innovations and reduce 
mqney demand for some time into  the future. 
Once the shift into NOWs is complete, this 
factor will no longer affect the observed 
monetary growth rate. Even a too high esti-
mate of  the share of NOW accounts coming 
from non-transaction balances would not 
significantly affect the estimated growth rate 
of  M-1 B once the shift is complete, so that the 
Fed would have no need to alter previously 
announced targets for monetary growth in 
1982. On the·other hand, a downward shift in 
money demand, if continued into 1982, 
would imply not only less restrictiveness than 
projected in past targets, but also a continua-
tion of  that situation in the future. This would 
imply a need for downward adjustment of 
future targets. 
At present, there appears to be no rei iable 
way of  judging which of  these explanations is 
the correct one. However, both imply  thatthe 
Fed should lower its targets for 1981. Federal 
Reserve Chairman Volcker recently 
announced that the Fed planned to aim for 
the lower bound of its 1981 target during the 
remai nder of  th is year. Such a move wou  Id be 
dictated either by a downward shift in money 
demand or by a finding of error in the 
NOW-account adjustment. In the former 
case, any adjusted M-1 B growth rate is less 
restrictive than wou  Id have been true in the 
past. In the latter case, the appropriately-
adjusted supply of (M-1 B) money is growing 
more rapidly than currently estimated. 
Brian Motley and John P. Judd '.J!II!:l/O:)SPUI!J:I UI!S 
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) -total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securitie's loans 
US. Treasury securities* 
Other securities* 
Demand deposits - total # 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weekly Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (+ )/Deficiency (-) 
Borrowings 
Net free reserves (  + )/Net borrowed (  -) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
Amount 
Outstanding 
9/2/81 
152,555 
131,426 
39,766 
53,845 
23,195 
J,375 
5,906 
15,223 
40,692 
27,890 
29,771 
86,538 
78,302 
35,535 
Weekended 
9/2/81 
- 204 
10 
- 214 
Change 
from 
8/26/81 
938 
901 
430 
69 
18 
113 
- 52 
89 
1,990 
718 
225 
597 
516 
147 
-
-
-
-
Weekended 
8/26/81 
102 
195 
93 
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Change from 
year ago 
Dollar  Percent 
12,387  8.8 
13,129  11.1 
5,497  16.0 
6,204  13.0 
744  - 3.1 
373  37.2 
609  - 9.3 
129  - 0.8 
7,071  14.8 
5,205  15.7 
65  0.2 
23,108  36.4 
23,126  41.9 
11,758  49.5 
Comparable 
year-ago period 
79 
133 
54 
Editorial comments may be addressed to the editor (William Burke) or to the author ..  , . Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Information Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Innovation and monetary policy: II

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Innovation and monetary policy: II

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