Business cycles ; Money supply ; Monetary policy - United States

Frederick T. Furlong

John P. Judd

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 91~33, September 27, 1991
M2 and the Business Cycle
1.6
1.7
1.8
Ratio
1.9
Chart 1
Income Velocity of M2
(GNP/M2)
1.5
1960 1965 1970 1975 1980 1985 1991
period M2 has led GNP on average. These tests
also suggest that the other monetary aggregates
(M1, M1A, and M3) have not had such stable
long-run relationships (Miller, 1991).
In the past few years, interest in the aggregates,
especially M2, has resurged. Two factors seem
to have led to this development. First, recognition
has grown that deregulation may not have in-
terfered with the stable long-run relationship
between M2 and total spending on goods and
services (and thus with the price level). Second,
the slow growth in M2 that preceded this reces-
sion has led some to argue that the Fed should
have paid more attention to that signal.
The role of the monetary aggregates as indicators
or targets of monetary policy has waxed and
waned over the past fifteen years. Emphasis on
monetary targeting reached a high in 1979-1982,
when the Federal Reserve explicitly targeted M1
in implementing its anti-inflation policies. After
that, the aggregates were de-emphasized, based
largely on the view that deregulation ofthe
financial system had rendered the relationship
between money and the economy unreliable,
at least for an extended transition period.
In this Letter, we review the evidence on the
reliability of M2 as a guide for monetary policy
in general, and then assess the implications of
the recent slowdown in M2 for future economic
activity.
In the long fun. ..
Is the relation between M2 and nominal GNP
(that is, total spending on goods and services)
stable in the long run? Chart 1 shows the velocity
of M2 (referred to here as V2) over the past 30
years. V2 is measured as the ratio of nominal
GNP to M2, and thus indicates how many times
in a year a given stock ofM2 is spent and re-
spent on goods and services. As the Chart shows,
V2 fluctuates widely in the short run, but in the
long run, the series exhibits a stable trend, al-
ways returning to a constant level since the late
1950s. This suggests a stable long-run relation-
ship between the levels of M2 and nominal
GNP; specifically, the stock of M2 tends to be
spent and re-spent about 1.64 times per year on
goods and services. Statistical analyses (tech-
nically called cointegration tests) confirm this
conclusion, and suggest that over the post-war
What do these results mean for monetary policy?
They suggest that if the central bank knows the
average level of M2 over a long period of time, it
can predict nominal GNP over the same period
fairly accurately. How long a period is required
for this relationship to hold? Empirical estimates
suggest that nominal GNP adjusts to a new level
of M2 with very long lags. In fact, it appears to
take around 4Y2 years for one-half of this adjust-
ment to be completed.
Moreover, over periods this long, adjustment
of nominal GNP translates into adjustment of
the price level. In the long run, the level of out-
put produced by the economy is determined by
underlying supply conditions (such as the labor
force and productivity) and is unrelated to M2.
Thus the influence of M2 on nominal GNP trans-
lates fully into an influence on the aggregate
price level.
In sum, the fact the V2 is stable in the long run
means that persistent, excessive M2 growth will
lead to excessive inflation. Or, putmore positively,FRBSF
effect of an M2 impulse on output easily could
be swamped by the effects of other factors.
Two categories of explanations have been put
forth. First, the decline in M2 could reflect a
portfolio shift into other assets. For example, the
o
20
60
80
40
Percent
100
12 8
Quarters
4
... with current
information on all variables.
1
Chart 2
Reai GNP Forecast Error:
How Much Is Accounted for by M2 ...
In the current cycle•••
The analysis so far applies to the long-run and
short-run relationships observed on average over
the past 30 years. Undoubtedly, business cycles
differ, and M2 is more important in determining
real GNP in some cycles than in others. Is it
likely that M2 is having a larger than average
effect on economic activity in this cycle? Does
the decline in M2 in recent months threaten to
abort the business cycle recovery?
... with current
information only on M2. ,
To answer these questions, we consider the possi-
ble sources of the recent decline in M2, and what
they may imply for real GNP in the future. First,
the weakness in M2 is not entirely explained by
past and current movements in output, prices,
and interest rates. Over the past several quarters,
M2 has been well below the level predicted
based upon its historical relationship with these
other variables (see Chart 3). M2 moved outside
the error band early last year, and since then the
gap has widened. There is only a 5 percent chance
that M2 would have fallen outside the error band
if the historical relationship were still in place.
This suggests that unusual factors most likely
have accounted for the weakness in M2.
!n the short nm...
The wide fluctuations in V2 around its average
level (Chart 1) show that there is no simple rela-
tionship between money and output, so M2 is a
much less useful indicator of economic activity
in the short run. Some of these fluctuations can
be explained by the effects of interest rates and
the lags in the response of GNP to money. For
example. as market interest rates rise relative to
those paid on M2 accounts, people economize on
their holdings of M2 and its velocity increases.
However, even after accounting for interest rate
spreads and lagged responses, large errors remain
in explaining V2.
In order to be more precise about the usefulness
of ~A2 as a short=run, or cyclical indicator, \V€
estimated a model of M2, prices, real GNp, and
a market interest rate that incorporates the short-
run relationships among changes in these vari-
ables, as well as the long-run relationships among
their levels. This model (called a vector-error-
correction model) is similar to the one estimated
by Miller (1991). It is used to estimate the relative
importance of M2 impulses to the short-run
behavior of real GNP. (An M2 impulse can be
thought of as an unexpected one-time movement
in M2 growth.)
We asked two questions of this model. First, what
does M2 tell us about future movements in real
GNP if we have information about contempora-
neous interest rates, prices, and real GNP? The
answer is: Not much. As shown in Chart 2, M2
impulses historically have accounted for a very
small percentage ofthe total uncertainty (predic-
tion error) in real GNP in our model. In other
words, M2 does not contain much additional
information about future real GNP over and
above that contained in contemporaneous
interest rates, prices, and real GNP.
if monetary policy keeps M2 growth under con-
trol over a period of several years, it simultane-
ously would keep inflation under control.
The second question is, what does M2 tell us
about real GNP when information on M2 is all
we have? The answer is: A little more, but still
not a lot. In this case, unexpected movements in
M2 account for no more than about 16 percent of
the overall uncertainty in real GNP. Thus, even if
the "deck is stacked" in favor of a role for M2, theyield curve has steepened recently, meaning that
rates of return on longer-term assets have risen
relative to those on the comparatively short-term
assets in M2. This may be why funds invested in
stock and bond mutual funds have risen sharply
while M2 has declined. It is generally agreed that
such portfolio shifting should have little or no im-
plication for future economic activity, and would
therefore not call for a monetary policy response.
banks, and other factors, and that reduced credit
has restricted both M2 and economic activity.
However, this view suggests that M2 may not
be playing an independent role in the current
business cycle. In other words, whether or not
weak M2 is likely to precede weakness in the
economy may depend more on whether or not
these is a credit crunch than on the behavior
of M2 itself.
Chart3
Actual and Predicted M2
Standard Error
Band
Billions $
3.7
3.5
3.3
3.1
In summary, M2 has not been a very reliable
or significant cyclical indicator in the past. It is
possible that its correlation with economic ac-
tivity has been strengthened in the present cycle
by a credit crunch. However, to the extent that
this is the case, the real issues have to do with
developments in the credit markets, not neces-
sarily with M2.
The role of a credit crunch in the recent reces-
sion is an open issue, which will be discussed in
a future Letter.
1989 1990 1991
Monthly Estimation from Oct. 1978 to Dec. 1988.
Frederick T. Furlong
Research Officer
John P. Judd
Vice President and
Associate Director
of Research
The second category, which has received the
most attention, has to do with the role of reduced
credit availability in determining M2 and eco-
nomic activity: in other words, the so-called
"credit crunch:' It has been argued that credit
availability has been restricted by the downsizing
of the thrift industry, tougher capital standards for
Reference
Miller, Stephen J. 1991. "Monetary Dynamics: An
Application of Cointegration and Error-Correction
Modeling." Journal ofMoney, Credit and Banking
(May) pp. 139-154.
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
3/22 (91-12) Inflation and Economic Instability in China Cheng
3/29 (91-13) Banking and Commerce: The Japanese Case Kim
4/5 (91-14) Probability of Recession Huh
4/12 (91-15) Depositor Discipline and Bank Runs Neuberger
4/19 (91-16) European Monetary Union: Costs and Benefits Glick
4/26 (91-17) Record Earnings, But... Zimmerman
5/3 (91-18) The Credit Crunch and The Real Bills Doctrine Walsh
5/10 (91-19) Changing the $100,000 Deposit Insurance Limit Levonian/Cheng
5/17 (91-20) Recession and the West Cromwell
5/24 (91-21 ) Financial Constraints and Bank Credit Furlong
5/31 (91-22) Ending Inflation JuddlMotley
6/7 (91-23) Using Consumption to Forecast Income Trehan
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7/5 91-25 Is the Prime Rate Too High? Furlong
7/19 91-26 Consumer Confidence and the Outlook for Consumer Spending Throop
7/26 91-27 Real Estate Loan Problems in the West Zimmerman
8/16 91-28 Aerospace Downturn Sherwood-Call
8/30 91-29 Public Preferences and Inflation Walsh
9/6 91-30 Bank Branching and Portfolio Diversification LadermanlSchmidt!
Zimmerman
9/13 91-31 The Gulf War and the u.s. Economy
Th.~~~
1IIIVVtJ
9/20 91-32 The Negative Effects of Lender Liability Hermalin
The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December,

Monetary Dynamics: An Application of Cointegration and Error-Correction Modeling.&quot; Journal ofMoney, Credit and Banking

M2 and the business cycle

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M2 and the business cycle

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