Money ; Velocity of money ; Monetary policy - United States ; Bank deposits ; Interest

Brian Motley

English

Research Papers in Economics

FRBSF WEEKLY LETTER
September 5, 1986
Should Money Be Redefined?
Since 1981, the rate at which money changes
hands in the purchase of goods and services has
trended downward in contrast to its steady
growth over the previous two decades. Econo"
mists describe this rate as the velocity of money
and measure it by the ratio of the value ofthe
nation's output (or GNP) to the stock of money.
For example, during the 1960s and 1970s, the
velocity of M1, which consists of currency and
fully checkable deposits, increased quite steadily
at an average annual rate of around three per-
cent, but since mid-1981, M1's velocity has
declined at an average annual rate of more than
two percent. Also, as shown in Chart 1, M1 's
velocity has been more variable in the 1980s
than in earlier years.
The unexpected decline and greater variability
of velocity have made it more difficult for the
Federal Reserve to set targets for monetary
growth that are consistent with acceptable rates
of growth of GNP. Partly in response, the
Federal Reserve has permitted quite rapid M1
growth in recent years. Compared to the
1979-82 period, however, it also has de-empha-
sized the role ofthe monetary aggregates,
especially M1, in setting policy, and has paid
more attention to other indicators of economic
activity.
Some economists have argued that the unusual
behavior ofM1 velocity has been due to a
change in the nature of this monetary aggregate
since the nationwide introduction ofinterest-
bearing checkable deposits (or NOW accounts)
in 1981 and the subsequent deregulation of rates
on these deposits in 1983 and 1986. According
to this argument, balances in M1 prior to the
changes were held primarily for transactions
purposes, whereas NOW accounts may contain
a mixture oftransactions and savings balances
and hence may not be closely related to spend-
ing on goods and services.
Some proponents of this view that the nature of
M1 has changed recently suggested that M1 be
redefined to include only currency and demand
deposits which, because they bear no explicit
interest, are more likely to contain only transac-
.tions funds. This narrower definition of money
was termed M1A prior to 1983. As shown in
Chart 1, the trend of M1A velocity has changed
less in recent years than that ofM1. This Letter,
however, will argue that other evidence indi"
cates that the narrower aggregate would not be a
superior indicator for monetary policy in the
future.
Are NOWaccounts spent less often?
In 1985, the annual turnover rate of demand
deposits at banks outside New York City was
about 300 times. That is, each dollar in these
deposits was transferred about 25 times each
month. In contrast, NOW accounts were trans-
ferred less than 17 times per year. These num-
bers suggest that moneyholders treat demand
deposits differently from NOW accounts and
that the latter may contain a large volume of
nontransactions funds.
Much of this apparent difference in activity
between the two types of accounts, however, is
due to the composition oftheir holders. NOW
accounts are held only by households, who use
their money holdings less intensively than busi-
nesses. Although there are no separate direct
measures ofthe turnover rates of deposits owned
by individuals and corporations, indirect esti-
mates made in the early 1970s (before NOW
accounts existed) suggested that, at that time,
corporations turned over their accounts three to
five times more rapidly than did households. In
addition, evidence on the number of payments
from various types of accounts suggests that
households use NOW accounts about as inten-
sively as they do personal demand deposits.
Thus, the lower turnover rates of NOW accounts
compared to demand deposits appear to be due
to differences in the holders of these accounts
rather than differences in the nature of the
accounts.
Moreover, a majority of transfers of business
demand deposits represent either financial trans-
actions or purchases of intermediate products,
which do not enter into the demand for GNPFABSF
and hence do not affect money's measured
velocity. Of course, households also engage in
financial transactions, butthey do so to a
smaller extent. Paul Spindt ofthe Federal
Reserve staff has estimated that, in 1982, the
annual turnover rates ofdemand deposits and
NOW accounts in the purchase of final products
only were 7V2 and 4 times, respectively. The dif-
ference between these rates clearly is much
smaller than that between the 300 and 17 times
for demand deposits and NOW accounts,
respectively, mentioned earlier. It is these "final
demand" turnover rates that determine average
velocity.
NOW accounts and Ml demand
More importantly, the lower turnoverrate of
NOW accounts compared to demand deposits
does not necessarily imply that M1 is somehow
"contaminated" by the inclusion of NOW
accounts, or that M1A would consequently be a
"purer" and more reliable indicator of monetary
policy.
For the nature of M1 to have changed, today's
NOW accounts mustcontain a significant vol-
ume of funds that previouslywere outside M1.
But since Money Market Deposit Accounts
(MMDAs) and other liquid accounts that are out-
side M1 provide higher yields than NOW
accounts, and have grown rapidly since 1982, it
does not seem likely that households have
switched a largevolume of savings funds into
NOWaccounts. Moreover, since it is likely that
M1A included a certain amount of low-turnover
funds before 1981 that have since been shifted
into interest~bearingNOWaccounts, M1A today
probably is notthe same aggregatethatit was
before 1981.
Thus, the relationship between the quantity of
M1 thatthepublic desires to hold.andthe levels
of income, prices and interest rates that they
face islesslikelytohave been affected by
deregulation since 1981 than the corresponding
relationship for.M1A. Economists describethis
relationship as the demandfunctibn for a mone-
tary aggregate.
Empirical evidence supports the idea that the
demandfunction has been much more stable for
M1 than forM1A.Chart 2 compares actual M1
and M1A withvalues from simulating astatisti-
cal MfA demandequation estimated at this
Bank using pre-1981 data - before NOW
accounts were widely available. Up to the end
of 1984, this equation tracks M1 (including
NOWs) quite closely, but it seriously overesti-
mates both the level and the growth rate of
M1A. This result suggests that the introduction of
NOW accounts did not affect the relation of M1
demand to its principal determinants but that it
did reduce the demand for M1A as households
switched transactions funds from demand
deposits into NOW accounts. Had M1 been
"contaminated" by an inflow of nontransactions
funds from other sources, this equation would
. have understated the growth of M1 after 1981 .
Velocity and money demand
In setting annual targets for growth in the mone-
tary aggregates, the Federal Reserve must make
three principal judgments. First, it must judge
what rates of growth of real output and inflation
are feasible and acceptable for the year ahead.
Second, the central bank mustestimate the lev-
els of interest rates consistent with these eco-
nomic projections. Finally, given projections of
economic activity and interest rates, the Federal
Reserve must estimate how much money the
public will want to hold and set money growth
targets accordingly.
Clearly, ifthe demand for an aggregate becomes
more difficult to forecast, the third stage would
become more difficult as well. For example, if
the demand to hold M1 were to increase more
rapidly than suggested by its historical relation-
ship with income, prices and interest rates/the
aggregate would tend to exceed the Fed's target
even though economic activity was evolving as
the Fed had projected. These developments
would show up as a decline in M1 velocity. If
the central bank were to attempt to keep the
supply of M1 within its target range despite the
increase in demand, interest rates would be
driven up and economic activity would tend to
slow.
Although an increase in the demand to hold
money will, other things equal, lead to a decline
in its velocity, unexpected movements in
velocity do not necessarily mean that the
demand for money has shifted. Between the
middle of1981 and the middle of 1983, for
example, M1's velocity declined seven percent,
but the public's demand to hold money - given
the levels of interest rates, income and prices
prevailing - appears to have remained stable.
As Chart 2 shows, our money demand equation
was able to explain the behavior of M1 during
1982-83 reasonably accurately. Thus, this epi-
sode of declining M1 velocity apparently
reflected the sharp and unexpected drop in
interest rates resulting from the slowing in theChart 1
Monetary Velocity
10
9
8
7
6
5
4
MiA /"'- ,
/r"f\"
,
!
i'!
/",,-
Chart 2
$ Billions Actual and Simulated Money Growth
700
600
500
400
3 LL.Ll-..L.L-'--J.--'-LL.Ll-..L.L-'--L-'-'--'-LL.Ll-..L.L--'-'--'
1959 1962 1965 1968 1971 19741977 1980 1983 19S6
inflation rate in 1982 rather than a shift in M1
demand,
The situation with respect to M1A since 1981
has been the opposite of that for M1. Although
the velocity of M1A has behaved much as it did
in the preceding decades, the demand for this
aggregate has not been related in a stable way to
income, prices and interest rates. In fact, the
lesser variability of MIA's velocity appears to
have been largely fortuitous. For example, the
failure of M1 A velocity to decline in 1982-83 in
response to the fall in interest rates apparently
was caused by the simultaneous reduction in the
demand for M1A as the public continued to
move funds into higher-yielding NOWs. Hence,
the stability ofM1A velocity in that episode does
not provide grounds for believing that M1 A
would be a useful monetary policy indicator in
the future.
The 1985-86 experience
Chart 2 suggests that the demand for M1 has
changed since early 1985 since the simulation
underpredicts its growth since then, The reasons
for this shift in the demand for M1 are not well
understood.
It appears likely that deposit rate deregulation
has played a role in shifting M1 demand by
effectively raising the return that depository
institutions pay on their checkable deposits and
thus making the public willing to holdmore of
their financial wealth in the form of these
deposits, A disproportionate amount ofthe
recent increase in M1 has been in NOW
accounts.
30.0 LL..__L-_---'-_---JL-_-L__L-_-'
1981 1982 1983 1984 1985 1986
But it is unclear why this effect was felt in 1985
and not in earlier years since there were no reg-
ulatory changes in that year. If deposit rate
deregulation were to cause a major shift in M1
demand, one would have expected this to occur
in 1983 when Super-NOW accounts bearing
fully deregulated interest rates were authorized,
or in 1986 when rate ceilings on regular NOW
accounts were removed.
The greater-than-expected increase in M1
growth since early 1985 has coincided with a
decline in market interest rates. As a result, the
differential between the returns available on
other highly liquid deposits, such as MMDAs,
and that on fully checkable NOW accounts has
become extremely narrow.This small spread
may explain why the public apparently has
taken to holding larger NOW account balances
relative to their incomes.
In the future, the impact of changes in interest
rates on M1 demand may become more difficult
to predictbecause it will depend on the speed
and extent to which banks alter thedepositrates
they pay on both NOW accounts and otherliq-
uid deposits. As a result, it seems likely that the
central bank will find it necessarytocontinue its
recent practice of monitoring other economic
indicators as well as the monetary aggregates
when setting policy. It also seems likely that
M1A will not offer a solution to theproblems
created by the unusual behavior of M1that
began last year.
Brian Molley
Opinionsexpressed in this newsletterdo not necessarily reflectthe views ofthe managementof the Federal Reserve Bank ofSan
Francisco,orofthe Board of Governorsofthe Federal Reserve System.
Editorial commentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....Free copiesof F~eralReserve publications
can be obtainedfrom the Public Information Department, Federal Reserve BankofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n U060JO OpOfl0U
040PI !!omoH O!UJoJ!l0) ouoz!J1:J o~solI:J
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
8/13/86
Change
from
8/6/86
Change from 8/14/85
Dollar Percent7
Loans, Leases and Investments1 2 200,148 87 6,295 3.2
Loans and Leases1 6 182,044 11 6,844 3.9
Commercial and Industrial 50,381 - 385 - 610 - 1.1
Real estate 67,351 205 3,064 4.7
Loans to Individuals 39,175 - 176 2,504 6.8
Leases 5,501 - 15 92 1.7
U.S. Treasury and Agency Securities2 10,383 - 53 - 1,264 -10.8
Other Securities2 7,721 129 714 10.1
Total Deposits 205,681 - 897 7,522 3.7
Demand Deposits 51,964 - 768 5,143 10.9
Demand Deposits Adjusted3 37,029 615 - 5,853 -13.6
OtherTransaction Balances4 16,825 - 251 2,822 20.1
Total Non-Transaction Balances6 136,892 121 - 441 - 0.3
MoneyMarketDeposit
Accounts-Total 46,827 75 1,796 3.9
Time Deposits in Amounts of
$100,000 ormore 35,163 - 43 - 2,833 - 7.4
Other Liabilities for Borrowed MoneyS 23,351 1,726 - 197 - 0.8
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)jDeficiency(-)
Borrowings
Netfree reserves (+)jNet borrowed(-)
Penod ended
8/11/86
3,582
13
3,569
Penod ended
7/28/86
79
35
43
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 NOW and 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 percent change

Should money be redefined?

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Should money be redefined?

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