Monetary policy - United States ; Money supply

Bharat Trehan

John P. Judd

English

Research Papers in Economics

FRBSF WEEKLY LEtIEA
October 2, 1987
How Reliable is Ml A?
M 1 grew at a very rapid 13V2 percent average
annual rate in 1985 and 1986. Under normal
circumstances, such rapid growth would have
preceded a surge in ()utputand inflation, but
output growth has remained moderate and infla-
tion relatively subdued. Prior to this episode, the
Federal Reserve had often relied heavily on M1
in the conduct of monetary policy. In 1987, for
the first time, the Fed decided not to establish an
M1 target range. The breakdown in the relation-
ship between M1 and macroeconomic develop-
ments has since spurred the search for other
monetary aggregates that might provide useful
information about the future course of the
economy.
The authorization of interest-bearing checkable
deposits (NOW accounts) in the 1980s is a com-
monly cited reason for M1 's aberrant behavior.
As a result, some observers have argued that
M1A, which includes only noninterest-bearing
currency and demand deposits, should be
affected less by deregulation than M1, which
includesNOWs. In fact, they have argued that
M1A behaves like M1 prior to deregulation, and
that M1A may therefore be a rei iable alternative
to M1 as a monetary policy indicator.
This Letter discusses the conceptual basis for this
view and also looks at the available evidence.
We can find no compelling reason for expecting
M 1A to behave like M1 did prior to deregula-
tion. Moreover, our empirical evidence supports
an even stronger inference: that movements in
M 1A provide little useful information about the
future course of the economy.
Is M1A like Ml used to be?
An important reason for the stable and s.imple
relationship between M1 and GNP that persisted
for a substantial portion of the post-war period
appears to be that interest on checkable deposits
was prohibited by law. This prohibition appar-
ently induced individuals to keep most of their
savings-type balances in interest-bearing small
time and saving deposits, as well as open market
securities. In other words, the regulation of inter-
est on checkable deposits effectively separated
transaction balances from those held for savings
purposes, and thus set M1 apart from the
broader monetary aggregates, M2 and M3.
The introduction of interest-bearing checkable
deposits ~ NOW accounts, which are included
in M1 appears to have changed all that.
Households use NOW accounts to store both
savings and transactions balances. As a conse-
quence, variations in the growth rate of M1 are
likely to reflect not only planned changes in
transactions (spending), but also the diverse set
of factors that determine saving and portfolio
allocation - such as changes in interest rate dif-
ferentials between alternative liquid assets,
uncertainty about future returns, and changes in
investors' preferences for various maturities and
liquidity characteristics. Such portfolio adjust-
ments can interfere at various times with the
relationships between M1, income, and prices.
This conclusion about the source of problems
with M1 makes it tempting to look at narrower
monetary aggregates, which exclude interest-
bearing instruments, as monetary policy indica-
tors. M 1A is a natural candidate since neither of
its components - demand deposits and cur-
rency in the hands ofthe public - bear interest.
One might conclude, then, that M1A primarily
contains transactions balances, and thus may
have a stable relationshipwith GNP and prices.
Unfortunately, such a conclusion does not
appear to be warranted by conceptual Or empiri-
cal considerations. NOW accounts have
attracted a substantial amount of household
transaction balances that are excluded from
M 1A. There is no reason to expect that the
behavior of M1A, which contains most business
transaction accounts but only a fraction of those
held by households, would bear much of a
resemblance to the behavior of M1, which con-
tained most business and household transaction
accounts, prior to deregulation.
Furthermore, interest-sensitive households are
more likely to have moved their transactions
accounts into NOWs. Consequently, the nature2-j-nC"T""fTTTT'""'""'TTTT1~rrn,,-r""""C"T""fT""""""-T"T"T""J"T""T"T"rrn~
\ ,?>(Q~,?>(Q(,?>(Q~,?>(Q~,?>(Q~,?>1 ~,?>1(,?>1 ~,?>1~,?>1 ~,?>'O~,?>'O(,?>'O~,?>'O(Q
FABSf
of household transactions accounts still held in
M1A is likely to differ from those that were held
in M1 prior to deregulation. Deregulation may
have affected the behavior of demand deposits
held by firms as well, since it has provided firms
with a variety of close substitutes.
Indicator value of M1A
Even though conceptual considerations by them-
selves do not suggest thatM1A would be a reli-
able monetary policy indicator, we cannot rule
out the possibility on theory alone; For example,
if the portion of household transaction accounts
that remains inM1A bore some consistent rela-
tionship with that in NOW accounts, M1A might
prove useful for the Federal Reserve in conduct-
ingmonetary policy. The available empirical
evidence, however, suggests otherwise.
8
7
6
5
4
3
Chart 1
Velocity
,..0'""
.....1 't
t'
I
M1A :
," " ..:
First, even though M1A growth has been
noticeably less volatile than M1 growth over the
past few years, it has been fadrom stable. A
4V2 percent average M1A growth rate over
1983-84 (fourth quarter to fourth quarter) was
followed by an average rate of 10 percent in
1985~86. Real income grew strongly in 1983
and 1984, but atmodest rates over the following
two years, when M1 A growth was rapid; nor did
inflation show any signs of picking up in
response to the acceleration in M1A.
Thus, as shown in Chart 1, the velocity of M1A
(measured as the ratio of GNP in current dollars
to M1A) increased in both 1983and 1984 (simi-
lar to its behavior over the·1960s and 1970s) but
declined dramatically in 1985 and 1986. M1A's
velocity grew at an average annual rate of
approximately 3.5 percent over 1983-84, but fell
at a 4.5 percent average annual rate over
1985-86.While this behavior was less volatile
than that of M1's velocity, the sharp fall in M1 A
velocity over the past two years represents a
major departure from past trends.
Even though M1A by itself does.notappear to
contain very much information about future
movements in GNP and prices, it still is possible
that this aggregate contains information overand
above that contained in other variables. If this
were the case, a combination of M1A and these
other variables could be used as an indicator of
future developments in the economy.
To test for this, we used a technique called vec-
tor.autoregression to examine the relationship
between real personal income, the price level,
the six-month commercial paper rate, the non-
M1A components of M3, and M1A itself. First,
we used all these variables to predict M1 A. We
then looked at how M1A velocity would be
affected by an increase in M1 A that could not be
predicted on the basis of these variables. For
M1A to be a useful indicator for monetary pol-
icy, such a positive "surprise" in M1A should be
followed by an increase in income. Since
velocity is defined as the ratio of income to
money, the increase in income implies that
velocity should tend to return to its original
level.
We present the results ofthis exercise for two
different time periods in Chart 2 - the pre-
deregulation period from the beginning of 1974
to mid-1979 and the post-deregulation period
from mid-1981 to the end of 1986. The chart
shows the average cumulative changes in M1A
velocity thatoccurred in response to an unpre-
dictedJ-percent increase in M1A.ltis useful to
keep in mind that over most ofthe 1970s, M1 A
was virtually identical with M1. Thus, a com-
parison ofthe two panels shows how M 1A today
cornpares with M1 prior to deregulation.
In the pre-deregulation period, velocity tended
to return to its original level shortly after a sur-Chart 2
Response of M1A Velocity to a 1 Percent M1A Surprise
-0.8 -+--~r----r-----.--~.,.-"----r~~-,
4 8 12 16 20 24
Months After 'Surprise'
B. July 1981 to December 1986
Percent
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
4 8 12 16 20 24
Months After 'Surprise'
A. January 1974 to June 1979
-0.4
-0.2
-0.6
Percent
0.0
prise increase in M1A. Thus, a permanent
1-percent change in M1A would have been fol-
lowed by an equal permanent increase in
income. By contrast, during the 1980s, the sur-
prise in M1A is followed essentially by no
change in income because a 1-percent increase
in M1A leads to a 1-percent decrease in
velocity. This evidence suggests that, during the
1980s, changes in M1A do not provide useful
information about future changes in income.
Conclusion
A breakdown in recent years in the relationship
between M1 and GNP has forced the Fed to rely
more heavilyon its broader monetary aggre-
gates, M2 and M3, which include savings-type
balances. Nevertheless, there remain strong the-
oretical reasons to believe that a properlymea-
sured transactions aggregate would be a more
useful monetary policy indicator. Thisconsid-
eration has stimulated analysis of alternative
transactions aggregates, such as M1A. Unfor-
tunately, our analysis suggests that M1A does
not seem to bear a very close relationship with
macroeconomic developments. More study is
therefore needed to find a useful alternative to
M1 as the primary guide to conducting mone-
tary policy.
johllP. juddand Bharat Trehan
MONETARY POLICY OBJECTIVES FOR 1987 AND 1988
On July 21, Federal Reserve Board Chairman Paul Volcker presented a mid-year report tothe
Congress on the Federal Reserve's monetary policy objectives for the remainder of 1987 and
1988. The report reviews economic and financial developments in 1987 and presents the
economic outlook heading into 1988. For single or multiple copies ofthe report, write to the
Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San
Francisco, CA 94120, or phone (415) 974-2246.
Opinionsexpressed in this newsletterdo not necessarily reflect the.views ofthemanagementofthe Federal Reserve Bank of San
Francisco,oroftheBoard of Governorsofthe Federal Reserve System.
Editorial commentsmaybe addressedtotheeditor(GregoryTong) ortotheauthor.•.•FreecopiesofFederal Reserve publications
can be obtainedfrom the Public Information Department, Federal Reserve Bank ofSan Francisco, .P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.uo~6U!ljsom ljo~n U060JO 0POl\0U
oljoPI HomoH O!UJoJ!l0) ouozP8 o~sol8
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BANKING DATA-TWELfTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and liabilities
Large Commercial Banks
Amount
Outstanding
9/9/87
Change
from
9/2/87
Change from, 9/1 0/86
Dollar Percent?
Loans, Leases and Investments1 2 204,811 - 685 1,620 0.7
Loans and Leases1 6 180,987 - 735 - 2,555 - 1.3
Commercial and Industrial 51,057 - 123 441 0.8
Realestate 69,738 104 2,537 3.7
Loans to Individuals 37,038 - 91 - 4,175 - 10.1
Leases 5,410 - 5 - 130 - 2.3
U.S. Trea.sury and Agency Securities 16,899 73 5,458 47.7
OtherSecurities2 6,925 - 23 - 1,284 - 15.6
Total Deposits 207,922 388 - 475 - 0.2
Demand Deposits 53,147 199 228 0.4
DemandDepositsAdjusted3 35,736 - 638 - 13,016 - 26.6
OtherTransaction Balances4 20,553 262 2,871 16.2
Total Non-Transaction Balances6 134,221 - 74 - 3,575 - 2.5
MoneyMarketDeposit
Accounts-Total 44,854 - 51 - 2,318 - 4.9
Time Deposits inAmountsof
$100,000 or more 31,087 - 83 - 3,895 - 11.1
Other Liabilities for Borrowed MoneyS 24,558 586 - 1,543 - 5.9
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
9/7/87
45
6
39
Period ended
8/24/87
186
24
162
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

How reliable is M1A?

http://www.frbsf.org/publications/economics/letter/1987/el87-40.pdf

How reliable is M1A?

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