Monetary policy - United States ; Money supply

Bharat Trehan

John P. Judd

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 92-30, September 4, 1992
Money, Credit, and M2
The Federal Reserve is required by law to estab-
lish target ranges for the "monetary and credit
aggregates:' However, in conducting policy it
generally has eschewed credit in favor of mone-
tary aggregates, on both theoretical and empiri-
cal grounds. Since about 1983 the Fed has placed
greatest emphasis on a broad measure of money,
M2, which includes currency, checkable depos-
its, liquid savings instruments and small time
deposits at commercial banks and savings and
loans. M2 was selected for an important role be-
cause over the past three decades its relationship
with total spending on goods and services has
been relatively stable and predictable. However,
over the past three years, this relationship has
deteriorated, casting doubt upon M2's usefulness
as a monetary policy indicator. In this Letter we
argue that these difficulties are the result of con-
tinuingfinancial innovation, in whichM2 has been
strongly affected by changes in the way that
credit is channeled through the economy.
From Ml to M2
When the Fed began targeting money in the
1970s, it focused mainly on a narrow measure of
money, M1, which includes only currency and
(fully) checkable deposits. (For complete details
on the composition of M1 and the other mone-
tary aggregates, see any issue of the Federal
Reserve Bulletin.) M1 predicted spending in a
fairly reliable manner and performed well as an
intermediate target for monetary policy because
it had two important virtues. First, it had a stable
money demand function-that is, a stable rela-
tionship with certain important macroeconomic
variables. In particular, given a certain level of
income, prices, and interest rates, M1 behavior
was fairly predictable. Second, the supply of M1
was affected mainly by the monetary authority,
and relatively little by commercial banks.
Both virtues essentially stemmed from the fact
that banks were prohibited from paying explicit
interest on the deposits in M1. Since consumers
were not earning interest on these deposits, they
tended to use them as transactions balances,
keeping only as much in them as they needed for
their transactions; therefore, these deposits were
closely linked with spending. Furthermore, banks
could not affect the supply of M1 very much in
the short run. Thus, the Fed's control of M1 was
not compromised by bank behavior.
By contrast with M1, the broad aggregates, M2
and M3, contained time and savings deposits,
which do earn interest, and therefore tended to
be investment-oriented balances. Savings bal-
ances are affected by changes in investment
incentives that may be hard to predict, like inter-
est rate spreads and risk, so they are less reliably
related to spending. In addition, while deposit
accounts in the broad aggregates were subject to
interest rate ceilings, banks had relatively more
freedom to vary rates on these accounts than on
checking accounts.
The deregulation of deposit interest rates in the
early 1980s blurred the distinction between
transactions and savings balances. Consumer
checkable deposits (NOW accounts) were al-
lowed to pay explicit interest nationwide in 1981,
and the public began to leave some of its savings-
type balances in Ml. As a consequence, its rela-
tionship with nominal GOP began to deteriorate.
These problems culminated in 1983 with the
Fed's de-emphasis of M1 in favor of M2. The ra-
tionale was that M2 was broad enough to inter-
nalize many of the portfolio substitutions that
had disrupted M1; for example, when interest
rates on small time deposits rose, consumers
would substitute from checking to time deposits,
which would cause M1 to decline, but not affect
M2.
Another factor in favor of M2 was that it ap-
peared to have a stable long-term relationship
with GOP since the early 1960s. But this evi-
dence may have been a statistical artifact. The
current definition of M2 came into existence only
in 1980, when the Fed redefined all of its aggre-
gates. In the process of determining how to
group various accounts into different aggregates,
researchers looked at the stability ofthe money
demand function of each potential aggregate.
Thus, the stable relationship between M2 and
GOP in the years prior to 1980 should not beFRBSF
considered independent verification of M2's de-
sirability as an intermediate target. For indepen-
dent verification we need to look at the period
since the aggregate was defined.
Unfortunately, we find that over the past three
years, M2 has fallen well below expected levels
givencurrent levels of income, prices, and inter-
est rates; in other words, the public has chosen
to hold less M2 than it did previously. This has
been a principal reason that in 1990, 1991, and
so far in 1992, M2 has come in near the bottom,
or even below, the target ranges established by
the Fed.
Increased substitutability and M2
The problem with M2 seems to have arisen from
the same deregulation and financial innovation
that made movements in M1 so difficult to pre-
dict, and it reflects behavior changes both by the
public, in its demand to hold M2, and by banks,
in their supply of M2 deposits.
On the demand side,the growth of alternative
assets, such as bond mutual funds, as wellas
reductions in the costs of moving from one asset
to another, have made people more sensitive to
changes in interest rates on assets both inside
and outside M2-in other words, assets outside
M2 have become closer substitutes for assets
inside M2. For example, the recent sluggish
growth in M2 has been accompanied byexplo-
sive growth in bond mutualfunds. It appears that
individuals have reacted to an unusually steep
yield curve (the spread between long-term and
short-term interest rates) by moving out ofac-
counts held in M2 and into long-term assets.
Statistical analysis supports the explanation of
substitutability, because models that incorporate
this behavior improve our ability to explain
movements in M2.
Close substitutability on the demand side implies
that developments on the supply side will have
a greater effect on the quantity ofM2. Because
individual's demand for M2 has become more
sensitive to changes in interest rates paid on M2
accounts, the quantity of M2 is more responsive
to banks' behavior in supplying deposits. Interest
rates paid on instruments that are substitutes for
M2, like bond funds, have a larger effect as well.
One reflection of the increased importance of
supply factors is that M2 demand equations are
now commonly specified in terms of the spreads
between the interest rates banks pay on the myr-
iad components of M2 and rates available on
open market instruments. Changes in these
spreads will reflect developments in the banking
sector, as well as other sectors that issue sub-
stitutes for M2 instruments.
For example, available evidence suggests that the
slow growth in M2is related to a decline in the
volume of bank loans. For various reasons, banks
are playing a smaller role in the process of chan-
neling credit in the U.S. economy. With a smaller
volume of loans to finance, banks have reduced
deposit rates and issued fewer deposit liabilities,
and this has depressed M2 growth. A rather
spectacular case in point is provided by develop-
mentshaving to do with the Resolution Trust
Corporation (RTC). Recent sluggish growth ofM2
is at least partly due to the RTC's takeover and
resolution of sick thrifts (Duca 1992). Thus the
shrinkage of bank and thrift assets associated
with the resolution of "bad" loans has led to a
reduction in M2.
Other evidence of the behavior of M2 reflecting
developments in credit markets is available as
well. In the 1980s, small time deposits began to
respond to (unexpected) changes in market inter-
est rates more like the large time deposits in M3
(Judd and Trehan 1987). Large time deposits are
widely regarded as credit market instruments
rather than money. In fact, the Fed has tradi-
tionally shied away from M3 as a policy indicator
in part because it was thought to be too much of
a credit aggregate. Thus, banks' more active
management of accounts in M2 isevidencethat
it may have some of the same problems thought
to beset M3; in other words, this suggests that
M2 will be significantly affected by develop-
ments on the asset side of banks' balance sheets.
Increasedsubstitutabilityandmonetarytargeting
The evidence that M2 (and M3) are susceptible
to variations in bank lending activity, as well as
to how banks choose to fund these loans has
important implications for monetary targeting. If
these factors dominate the behavior ofthe broad
aggregates, then controlling them may really
amount to a roundabout way of controlling
credit.
Is there any reason to believe that credit would
be a useful variable for the Fed to focus on in
conducting monetary policy? While an authorita-
tive answer does not appear to be available in
the economics literature, some observations canIn summary, when the Fed shifted its emphasis
from Mlto M2, the hope was that we were get-
ting a monetary aggregate that would internalize
the portfolio shifts that had plagued M1However,
the passage of time and continuing financial
innovation have revealed that M2 is susceptible
to portfolio shifts resulting from a wide variety of
sources. These developments have created a
number of serious empirical challenges in trying
to obtain useful information from movements in
M2. Conceptually, these problems flow from the
fact that targeting'M2 has become more like tar-
geting credit, rather than money.
be made. First, since credit is only one method of
financing expenditures, the relationship between
credit and economic activity is relatively loose.
In addition, bank credit is only a fraction of total
credit, and this fraction has varied widely over
historical periods. In the last few years, it has
declined rapidly.
Controlling the fraction of total credit that banks
extend may be desirable if banks tend to have
loan customers with few alternative' sources of
loans, as has often been argued. Proponents of
this view argue that banks have an advantage in
gathering information and monitoring the activi-
ties of borrowers, and thus tend to make loans to
small firms that do not have access to national or
secondary credit markets. A reduction in bank
loans may thus have the effect of directly limiting
spending by these small firms. However, the size
of this effect in the national economy remains an
open question.
John P. Judd
Vice President and
Associate Director
of Research
Bharat Trehan
Senior Economist
Even if special attention in the conduct of mone-
tary policy should be paid to lending by banks,
is control of M2 the way to do it? Or should we
be thinking of a broader monetary aggregate like
M3, or even of bank loans themselves? In any
event, the logic and evidence required to justify
such a procedure are very different from those
that are put forward to justify the use of money
as an intermediate target.
References
Judd, John P., and Bharat Trehan. 1987. "Portfolio Sub-
stitution and the Reliability of M1, M2 and M3 as
Monetary Policy Indicators." Federal Reserve Bank
of San Francisco EconornicRevie\tv (Summer)pp.
5-30.
Duca, John. 1992. "The Case of the Missing M2." Fed-
eral Reserve Bank of Dallas Economic Review
(Second Quarter) pp. 1-24.
MONETARY POLICY OBJECTIVES FOR 1992
On July 21, Federal Reserve Board Chairman Alan Greenspan presented a mid-year report to the Congress on
the Federal Reserve's monetary policy objectives for the remainder of 1992. The report reviews economic
and financial developments in 1992 and presents the economicoutlook heading into 1993. For single or multiple
copies of thereport, 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.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor ortothe author.·•.. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San FranciscQ 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
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Portfolio Substitution and the Reliability of M1, M2 and M3 as Monetary Policy Indicators.&quot; Federal Reserve Bank of San Francisco EconornicRevie\tv (Summer)pp.

The Case of the Missing M2.&quot; Federal Reserve Bank of Dallas Economic Review (Second Quarter)

Money, credit, and M2

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Money, credit, and M2

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