Monetary policy - United States ; Money supply

Brian Motley

English

Research Papers in Economics

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February 19, 1982 
M-2 as a Monetary Target 
In formulating policy, the Federal Reserve 
System considers more than one monetary 
aggregate. In particular, it pays close atten-
tion to M-1 (the former M-1 B), which consists 
only of  transactions money, and M-2, which 
adds to M-1 a number of other assets which 
are highly liquid butcannot be spentdirectly. 
This month, for example, the Fed announced 
several definitional changes, in an attempt to 
make M-2 a better measure of the growth of 
these high  Iy I  iqu id assets (see the February 12 
Weekly Letter). 
In 1981, M-2 growth exceeded the top of its 
6-to-9 percent targeted growth range. In con-
trast, M-1  B growth fell somewhat below the 
bottom of its targeted range of 3  Y2  to 6 per-
cent (after ad justment for NOW  accounts and 
other "checkable" deposits). Some analysts 
have argued that the rapid growth of M-2 not 
only explains but also justifies M-1's below-
target performance, in the sense that higher 
levels of M-2 can offset the output and infla-
tion effects of lower levels of M-l. However, 
the validity bf this argument depends on how 
monetary variables affect the real side of  the 
economy. 
Unique assets 
In monetary theory, "money" is a unique and 
special asset, first, because it functions as the 
medium of  exchange. As such, money is the 
most liquid asset available, so that an 
increase in the stock of money adds to the 
liquidity of the economy. At a given level of 
interest rates, such an increase in liquidity 
may raise the overall propensity to spend on 
goods and services. For example, a house-
hold faced with an unexpected decline in its 
income is less likely to delay a planned 
expenditure if its assets are in liquid rather 
than in illiquid form. Indeed, empirical 
evidence suggests that households' con-
sumption outlays are positively related to 
their holdings of liquid assets. Similar con-
siderations may apply to the spending 
behavior of  businesses and of state and local 
governments. For these reasons, many econ-
omists believe that an increase in the money 
stock directly stimulates aggregate demand. 
Second, "money" is unique in that it yields a 
zero, or at least fixed, rate of return. This 
characteristic1s significant because, if the 
stock of  money changes, the rates of return on 
non-money assets must ad just u nti I the pu bl ic 
is willing to hold the changed money supply. 
For example, if the stock of money increases, 
interest rates on non-money assets such as 
securities must fall, to induce the public to 
alter its portfolio in order to hold relatively 
more money and fewer non-money assets. 
This interest-rate decline will in turn exert an 
expansionary effect on the demand for goods 
and services. This provides a second reason 
for expecting an increase in the money stock 
to stimulate output, employment and prices. 
However, if money were to yield a return 
which varied in response to changes in supply 
and demand, the effect of an increase in the 
money stock would be less easy to predict. In 
such a case, an addition to the stock of  money 
would be likely to cause an increase in the 
rate of return on money as well as a decrease 
in the rate of return on other assets. Hence, 
although it would have a positive liquidity 
effect, the direction of its influence on the real 
economy would be ambiguous. 
Changing nature of M-2 
All of  the assets included in M-1  possess both 
of  the unique characteristics of money. Until 
recently, almost all ofthe components of  M-2 
also yielded fixed rates of return and were so 
highly liquid that, although not directly 
spendable, they functioned as a "temporary 
abode of purchasing power" (to adopt 
Milton Friedman's phrase). Hence, the above 
arguments about the stimulative effects of an 
increase in the money stock applied not only 
to M-l but also to M-2. Today, however, 
several of  the assets included in M-2 yield 
interest at a market-determined rate. This is Percent 
Opinions expressed in this newsletter do not 
necessarily r!::fiect the views of the managernent 
of tht' Federa! Reserve Bank of ~)an Frarlcisc(}. 
or of the Board of Covernors of the Federal 
Reserve System. 
true, for example, of overnight repurchase 
agreements (RPs) and Eurodollars, of money-
market  mutual  funds,  and  of  the  money-
market and small-saver certificates issued by 
banks and other depository institutions. The 
share of these assets in M-2 has risen dra-
matically in recent years, so that they now 
account for almost half of  the total. In addi-
tion, some M-2 components-such as the 
small-saver (30-month) certificates and the  .i 
new All-Savers certificates and IRA ac-
counts-not only yield a market rate of 
interest but also are not particularly liquid. 
Thus, the characteristics of  the M-2 aggregate 
have changed dramatically, so that a sub-
stantial portion no longer possesses the uni-
que featu res wh  ich separate money from 
other assets. 
Additions  to  the  stocks  of  these  interest-
bearing components of M-2 generally are 
associated with increases in their own-rates of 
return. For example, high rates of return in 
1981  induced households to switch their 
liquid assets into money-market funds on a 
massive scale. Because of this, the effect of 
increases in these components on the de-
mand for goods and services is  not as  clear-
cut as it used to be. 
On the one hand, an increase in the stock of 
these interest-bearing liquid assets frequently 
represents the response of  the public and of 
depository institutions to rising interest rates, 
rather than the direct result of an expansion-
ary action by the monetary authorities. 
Hence, such an increase does not necessarily 
imply that wealth-holders' portfolios are out 
of equilibrium, and hence will not neces-
sarily lead either to a decline in interest rates 
on other assets or to a rise in-the demand for 
goods and services. Rather, an accelerated 
rate of M-2 growth may be an indication of a 
restrictive monetary policy, which is pushing 
up market yields and inducing the public to 
rearrange its assetportfol ios, rather than an 
indication of an expansionary policy. 
On the other hand, the increase in the quanti-
ties of these J"lnear-money" assets probably 
2 
does mean that the economy is more liquid 
than it would be in their absence. Without 
these instruments, high market interest rates 
produced by restrictive monetary policies 
would provoke shifts of funds into less-liquid 
marketable securities, such as Treasury bills 
and commercial paper. Hence the increased 
availability of near-money assets yielding 
market rates of interest probably means that 
the propensity to spend is higher than it 
would otherwise be. Because of this "liquid-
ity effect," the restrictive impact on spending 
of higher interest rates may be reduced. 
Intermediation and policy 
This point may be explained in another way 
by noting that the issuers of "near-moneys" 
perform a financial-intermediation role 
which is similar to that performed by issuers 
of transaction accounts. Hence if restrictive 
Federal Reserve actions reduce the issuance 
of  transaction accounts-and the financial 
intermediation which accompanies it-the 
economic impact may be mitigated by an 
offsetting increase in the amount of inter-
mediation services provided by the issuers of 
non-transaction I  iqu id assets. On the other 
hand, th is offset is not complete, since interest 
rates do rise at the same time. 
This is not a new insight. It was recognized 
several years ago by Nobel Laureate James 
Tobin, who in turned based his analysis of 
financial intermediation on the earlier work 
of  John Gurley and Edward Shaw. Until re-
cently, however, binding deposit-rate 
ceilings limited the ability of issuers of near-
money assets to supply more financial inter-
mediation when monetary policy was tight. 
As a result, rising market interest rates pro-
duced a decline, rather than an increase, in 
the amount of intermediation they could 
provide. But several  recent developments-
the gradual elimination of Regulation Q, and 
the emergence of new instruments and insti-
tutions not subjectto regulation-are 
changing the manner in which the economy 
responds to restrictive monetary policy. 
Specifically, we must expect policies which 
slow  the  growth  rate  of the  low-interest-$  Billions 
460 
450 
440 
430 
420 
410  0  N 
1980 
~~ 
bearing transaction balances included in M-l 
both to stimulate the public's demand for 
other liquid assets and to induce depository 
institutions to supply interest-bearing instru-
ments which meet that demand. 
The offsetting effects on slower M-l growth of 
a more rapid growth of other I  iqu  id assets 
frequently is explained in terms of a shift in 
the demand for transactions money. In this 
view, policies which slow M-l growth, and 
hence raise interest rates, tend also to induce 
financial innovations which cause a down-
ward shift in the demand for M-l. The conse-
quence is a reduction in the impact of  the 
policy on interest rates and aggregate de-
mand. This mode of argument reflects the 
emphasis placed by monetary theorists on the 
asset "money," and especially on money in 
its role as the medium of exchange. 
However, essentially the same point may be 
made by pointing out that the issuers of  trans-
action money (banks) are also suppliers of 
intermediation services. When restrictive 
policies reduce banks' ability to issue check-
ing accounts, they simultaneously decrease 
the supply of intermediation services, which 
in turn raises interest rates. However, if banks 
respond to this situation by issuing other, non-
transaction, liabilities, and if  other institutions 
come into existence to supply intermediation 
services through the issue of new financial 
instruments, there is less effect on the supply 
of financial intermediation. As a result, the 
effect on interest rates and on aggregate de-
mand is less than it otherwise wou  Id be. 
Policy implications 
The above discussion suggests that M-2 is 
unlikely to be a good indicator ofthe  thrust of 
Federal Reserve policy. This is because the 
components  of M-2  which  yield  a  market-
3 
$Bllllon8 
1B40 
1800 
1760 
16 
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JJASOND 
1981 
determined rate of return affect the real 
economy in a different way than do the com-
ponents (including M-l) which yield a fixed 
rate. Unfortunately, the relation of M-l to the 
principal macroeconomic variables-out-
put, prices and interest rates-also has been 
subject to a good deal of uncertainty as a 
result of  the recent spate of financial innova-
tions (see our January 1 Weekly Letter). Inter-
estingly, the erApirical relation between M-2 
and national income has been quite stable 
through this period, leading some commenta-
tors to argue that the broader aggregate might 
be a better indicator in practice despite the 
theoretical objections raised against it above. 
The weakness of this argument is that it 
ignores the dramatic changes taking place in 
the composition of M-2. The stability in the 
average velocity of  the aggregate conceals the 
sharp changes occurring in the velocity of its 
components and, in particular, the shift of 
funds from fixed- to variable-yield instru-
ments. As a result, the past empirical regular-
ity may be a less reliable guide to the future 
than economic theory. 
If Federal Reserve policy reduces the supply 
offixed-rate assets, the effect is unambiguous-
ly restrictive-since interest rates rise, the 
economy becomes less liquid, and the supply 
of financial intermediation declines. On the 
other hand, such a pol icy may tend to 
increase the amount of  variable-interest-rate 
liabilities which are issued by intermediaries. 
This in turn supplies additional liquidity and 
more financial-intermediation services, and 
partially offsets the effects of  the policy on 
aggregate demand. As a result, the growth of 
the combined fixed- and variable-rate com-
ponents may convey little information regard-
ing the economic impact of policy. 
Brian Motley BANKING DATA-TWELfTH fEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
.  Selected Assets and Liabilities 
large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total # 
Comniercial 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) 
Amount 
Outstanding 
2/3/82 
157,235 
136,003 
41,937 
56,090 
23,646 
1,989 
6,181 
15,051 
40,879 
27,349 
30,690 
90,757 
81,665 
36,435 
Change 
from 
1/27/82 
638 
688 
371 
98 
- 61 
77 
14 
- 64 
2,407 
- 111 
479 
- 88 
165 
- 121 
-
-
Weekly Averages  Weekended  Weekended 
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. 
2/3/82 
414 
237 
177 
1/27/82 
69 
171 
- 102 
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Change from 
year ago 
Dollar  Percent 
10,048  6.8 
11,411  9.2 
4,937  13.3 
5,215  10.3 
26  - 0.1 
607  43.9 
695  - 10.1 
647  c- 4.1 
1,969  e- 4.6 
2,472  f- 8.3 
1,307  4.4 
14,108  18.4 
14,530  21.6 
6,539  21.9 
Comparable 
year-ago period 
114 
46 
68 
Editorial comments 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 Infonnation Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

M-2 as a monetary target

http://www.frbsf.org/publications/economics/letter/1982/el82-08.pdf

M-2 as a monetary target

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