Inflation (Finance) ; Money supply ; Monetary policy - United States

Brian Motley

John P. Judd

English

Research Papers in Economics

JF~cdl~1f@n JJ«~~~1fW~ 
JTh @\Jl~  Jk  (G) 11 
~  ©\ffi\  JF if  @\1ffi  CC 11 ~  CC (G) 
September 11, 1981 
Innovation and Monetary Policy: I 
The Federal Reserve increasingly has focused 
its monetary pol icy on the problem of 
bringing inflation under control. The Fed's 
anti-inflation plan involves gradually 
reducing the rates of growth of the monetary 
aggregates-especially M-1 B, the measure of 
transaction balances -over  a number of 
years. However, innovations in the financial 
markets over the past decade (and especially  -
in 1975-76) have distorted the influence of 
monetary policy, thereby making it more 
difficult for the Federal Reserve to achieve its 
goals for the economy. In 1981, two such 
changes in the financial markets again 
threaten to distort policy-the rapid growth 
i~ money-market mutual funds, and the 
introduction of NOW accounts on a 
nationwide basis. 
Financial innovations complicate monetary 
policy by making the public's demand to 
hold money balances less "stable" or 
predictable. Money demand is important to 
monetary policy because a lower growth rate 
in the money supply can ultimately reduce 
inflation only if supply decelerates relative to 
demand (at current prices, income, and 
interest rates). When this happens, the public 
finds itself with smaller money balances than 
it wishes to hold. It then tries to accumulate 
more money by selling securities (such as 
Treasury bills or money-market fund shares) 
and by purchasing fewer goods and services. 
The latter course means a direct reduction in 
the aggregate demand for goods and services, 
eventually leading to lower rates of inflation. 
The former approach-selling securities-
causes interest rates to rise, thereby 
increasing borrowing costs and restraining 
spending and (ultimately) inflation. 
What will happen, however, if the public's 
demand for money -at  given levels of 
income and interest rates-decelerates by an 
amount equal to the slowdown in the money 
supply? The public then will be left with the 
amount of money it wants to hold, and will 
have no reason to adjust its financial portfolio 
or spending patterns. Hence, future inflation 
will not be affected. 
Money management 
Thus before it can choose the appropriate 
growth rate for the supply of money, the Fed 
must have a good idea of  what will happen to 
the demand for money. Before discussing 
evidence of possible problems with money 
demand today, we should outline briefly 
what factors determine the public's demand 
to hold money in general. First, the volume of 
transactions defines the size of the job to be 
done. With more transactions to conduct, a 
larger quantity of money will be held. 
However, there is a limit to the amount of 
money a household or business will want to 
hold, because money generally does not earn 
a market rate of return. In August 1981  a 
household cou Id earn 5 % percent on a NOW 
account, which is checkable, compared to 
more than 15 percent on a 6-month bank 
money-market certificate (MMC). Of course, 
an instrument like an MMC is not checkable 
and cannot be used directly for transactions. 
However, as rates of return increase on such 
instruments, the public is induced to squeeze 
its money holdings in favor of  higher-yielding 
but less-I iqu id alternatives. 
The problem of  not being able to write checks 
on a high-yielding alternative investment 
could be overcome if funds could be easily 
and inexpensively transfered between that 
investment and the checkable account just 
prior to a spending transaction. With a fixed 
fee for such transfers, the investor would, in 
effect, choose to hold a volume of NOW 
accounts which balanced the cost of  frequent 
transfers against the interest foregone by 
holding the NOW account. A lower fee for 
transfering funds would make a larger 
number of transfers economical and thus 
reduce the demand to hold money balances. 
A final determinant of the public's money 
holdings is the available knowledge and IF~cdl~if©\ll  ~~~~ifW~ 
IP1 ©\1ffi 1k  CD) IT 
~©\1ffi IF  if  SlIm (C Ii ~cc  CD) 
Opinions expressed in this newsletter do not 
necessarilv reflect the views of the management 
of the Fc.,cleral  Reserve Bank of San  Frandsco, 
or of the Board of Governors of thp Federal 
Reserve System. 
technology of, managing money. Some 
households may not manage thei r money 
very much atall, simply allowing their NOW 
or checking acount balances to rise and fall as 
they pay bills and receive income. But as the 
cost of foregone interest increases, more and 
more money holders will be induced to find 
ways to keep their balances down to 
minimum levels. 
However, high interest rates apparently are 
not enough to induce closer money 
management -rates generally must rise to 
new peaks to induce such behavior on a large 
scale. Business firms and others apparently 
will be willing to incur the start-up costs-
time, trouble, and out-of-pocket expenses-
of  a new money-management method only if 
interest rates are likely to be permanently 
higher. But new techniques, once instituted, 
are likely to be used even if interest rates 
subsequently subside below their peak 
levels. Once start-up costs have been 
incurred, the new technique may be little (if 
any) more expensive to use than the old one. 
The 1975-76 shift 
The preceding discussion provides an 
explanation for a good part of the sizeable 
downward shift in business demand for 
money which occurred in 1975-76. A large 
part of this shift can be explained by two key 
factors affecting corporate money manage-
ment. First, regulatory changes in 1974-75 
allowed corporations and others to hold 
passbook-savings deposits, which cost little 
to transfer into transaction balances-and 
thus provided them with an efficient new 
money-management tool. Secondly, short-
term interest rates reached a new post-war 
peak in 1973-74: for example, the three-
month Treasury-bill rate surpassed 8 percent 
for the first time in the post-World War II 
period. This development apparently raised 
corporations' perceptions of the long-run 
retu rns to closer money management, 
encouraging them to use new financial 
instruments and new technologies in 
managing their money. 
2 
Security repurchase agreements (RPs) pro-
vide an example of a financial instrument 
which also increased in importance as a 
means of keeping money balances low. An 
RP is a contract that combines the sale of  a 
security (such as a Treasury bill) and an agree-
ment  to repu rchase that security at a specified 
future date and price. RPs generally carry 
short maturities, often one day, and can be 
arranged at very low transaction costs. These 
low costs permit frequent transfers between 
each RP and a checking account, facilitating 
a lower checking-account balance. 
The cash-concentration account provides a 
good example of  the technological innova-
tions of the 1975-76 period. This type of 
account involves the transfer of excess 
balances from a corporation's local banks to 
its regional banks. Thus, unexpected 
decreases in one local account can, in effect, 
be covered by unexpected increases in 
another local account by the poolingoffunds 
in the cash-concentration account. This 
procedure allows a firm to reduce its overall 
money balance while still handling the same 
level of  transactions. 
Another shift? 
Another downward shift in the demand for 
money may now be underway-probably 
because of closer money management by 
households rather than corporations. The 
evidence comes from statistical analysis of 
equations used by economists to describe the 
public's demand for money, as well as recent 
developments in money-market mutual 
funds and regulatory changes. 
In money-demand equations, the public's 
holdings of money are determined by prices, 
real GNP and a short-term rate of interest. 
Equations of this type detected the money-
demand shift of the 1975-76 period. More 
recent statistical analysis indicates-for 
given levels of prices, income, and interest 
rates-a significant drop in 1981  in the 
public's demand for M-1 B (adjusted for the 
impact of  nationwide NOW  accounts). Thus, 
the public appears to be handling,a given Money Market  Mutual Fund Shares Outstanding 
$ Billions 
120 
100 
80 
60 
40 
20 
O~~~~~~~~~~~~~~~~ 
J  F  M A M J  J  A SON D  J  F  M A M J  J 
1980  1981 
volume of  transactions, at a give,n cost of 
foregone interest, with lower money 
balan<;:es than it did prior to 1981. Further 
testing indicates thatthis apparent downward 
shift could be statistically explained by 
1980's peak interest rates, when (for 
example) the three-month Treasury bill rate 
exceeded 16 percent. 
The recent growth of NOW accounts, how-
ever, makes the statistical tests on money-
demand equations less reliable than they 
would otherwise be. NOWs were authorized 
on a nationwide basis in January 1981, and 
according to Federal Reserve studies, 20-30 
percent of  the subsequent increase represents 
transfers from passbook savings, small time 
deposits and other non-transaction instru-
ments. As a consequence, these NOWs 
should be subtracted from M-1 B to obtain a 
measure of transaction balances more con-
sistent with the pre-1981  levels of  that 
aggregate. The money-demand tests used 
these adjusted numbers, and therefore 
depend on the accuracy of the adjustments, 
as we shall see in our next Weekly Letter. 
However, another important financial-
market development  -money-market 
mutual funds (MMFs) -appear  to be consis-
tent with a downward sh ift in money demand 
this year. Outstanding shares of MMFs have 
grown from $76 billion in December 1980 to 
$134 billion in July 1981, for a 131-percent 
annual rate of  increase (see chart). Most of  the 
increase went  to funds with low initial-invest-
ment requirements-funds that tend to be 
used by households, rather than by corpora-
tions and other institutions. 
The rapid expansion of MMFs does not 
necessarily mean a shift in money demand, in 
view of  the fact that such funds are more 
closely related to savings deposits than to 
demand deposits. However, we could argue 
that 1980's historically high interest rates 
3 
induced some households to manage their 
money balances more closely through trans-
fers between checking or NOW accounts 
and money-market fu nds. These fu nds are the 
best money-management tool available to 
many households. They pay a market rate of 
return, require small initial and incremental 
investments, and offer a checking option. The 
checking option is limited, however, by a 
minimum-denomination requirement of 
about $500. Even so, money-market funds 
make it relatively easy for small savers to 
economize on money balances by' writing a 
few checks a month on the fund and deposit-
ing them in a checking or NOW account 
prior to transactions. 
Monetary policy 
M-1 B (adjusted for the impact of  nationwide 
NOW  accou  nts) now  stands below the lower 
bou  ndary of  its 3 %-to-6 percent target growth 
range for 1981. This might suggest an unduly 
tight pol  icy, especially si nce the real output of 
goods and services in the u.s. economy 
declined at an annual rate of 2.4 percent in 
the second quarter of 1981. 
However, if  money demand is currently shift-
ing down -as  statistical evidence suggests-
then monetary policy is currently more 
expansionary than indicated by (NOW 
adjusted) M-1 B. Consequently, it seems to 
make sense to aim for the lower part of  the 
longer-run range for 1981, as Federal Reserve 
Chairman Volcker indicated in his July 
Congressional testimony. 
How expansionary actually is monetary 
policy? The answer depends crucially on 
how M-l B is adjusted for nationwide NOW 
accounts. But as discussed in the next Weekly 
Letter, this factor tends to reinforce the 
money-demand shift, with both suggesting 
that policy in 1981  may really be more ex-
pansionary than indicated by adjusted M-l  B. 
John P. Judd and Brian Motley ·J!I~J IO:lSpU~J:I u~S 
lSL ·ON llWHld 
OIVd 
l!)V  lSOd ·s·n 
11VW SSV1J lSHI:I 
SS\11~  J.St:lI.:I 
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
uo~8U!4SPM •  4p~n • uo8aJO •  ppPl\aN  •  04PPI 
!!PMPH  •  P!UJoJ!IP:)  •  PUOzpV  •  P>jsPIV 
CG)~~  ~~~JTW?  Jr d[ .  \\]WJCS 
~  (C»  ~\illWJ~ 
~AJr~~~CQ( ITWJJr~tp)~d[ 
{t \ill~m{tcU~cdI~<m \\{f~cU~~~~CQI 
Change from 
year ago  Selected Assets and liabilities 
large Commercial Banks 
Amount 
Outstanding 
8/19/81 
Change 
from 
8/12/81  Dollar  Percent 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. 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. 
151,337 
130,453 
39,369 
53,719 
23,118 
1,364 
5,965 
14,919 
39,553 
26,921 
29,799 
85,854 
77,742 
35,427 
Weekended 
8/19/81 
n.a. 
32 
n.a. 
145  12,535  9.0 
303  13,372  11.4 
- 208  5,594  16.6 
110  6,231  13.1 
37  - 744  3.1 
30  461  51.1 
- 171  - 349  - 5.5 
13  484  3.1 
686  - 4,331  9.9 
-1,860  4,875  -15.3 
- 140  230  0.8 
688  22,898  36.4 
760  23,014  42.1 
421  12,050  51.5 
Weekended  Comparable 
8/12/81  year-ago period 
60  38 
60  36 
0  2 
Editoriarcomments 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 Bal)k of San Francisco, P.O. Box 7702, San Francisco 94120. Phone {415) 544-2184. 

Innovation and monetary policy: I

http://www.frbsf.org/publications/economics/letter/1981/el81-37.pdf

Innovation and monetary policy: I

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics