Bank deposits ; Interest ; Checking accounts ; Money

Gary C. Zimmerman

Michael C. Keeley

English

Research Papers in Economics

FRBSF WEEKLY LETTEA
November 21, 1986
InterestChecking and Ml
Over the past two years, the M1 monetary
aggregate has grown at a historically high
anllLJalfateolaOoLJf T2percerit,yet there has
not been a resurgence ofthe inflation that would
normally be associated with such rapid money
growth. Many economists argue that this sig-
nifies that the traditional relationship between
M1 and the economy no longer holds. One the-
ory posits that the deregulation ofdeposit rates
on personal checking accounts, which came
about through the authorization of NOW (Nego-
tiable Order of Withdrawal) and Super NOW
accounts at banks and thrifts, has altered the
behavior of M1.
In last week's Letter, we showed how the
deregulation of deposit rates on personal check-
ing accounts resulted in interest being paid on
over 70 percent of personal checking account
deposits-orover 30 percent of M1. We also
argued that, although the new NOW and Super
NOW accounts attracted a large fraction of their
deposits from pre-existing checking accounts,
they also attracted funds from nontransaction,
savings-type, accounts.
The shift of nontransaction balances into NOWs
and Super NOWs and the payment of interest on
balances in the two accounts raise the possibility
that deregulated deposits will behave less like
. transactions money and more like other finan-
cial assets, and thereby change the behavior of
M1. In this Letter, we examine the behavior of
the NOW and Super NOW components of M1
along with that ofM1 to see whether deregula-
tion can explain the aggregate's recent unusual
behavior.
Deregulation of personal checking
The deregulation of personal checking accounts
began in earnest with the nationwide authoriza-
tion of NOW accounts on December 31, 1980.
NOW accounts could pay interest up to a max-
imum of 5V4 percent. The Super NOW account
was authorized about two years later on January
5, 1983 and was ceiling-free, although it was
subject to regulatory minimum balance require-
ments. On January 1, 1986, both the minimum
balance requirement on Super NOWs arid the
ceiling on NOWs were eliminated. Thus, there
are now no regulatory deposit rate or minimum
balance restrictions on interest-bearing personal
checking accounts, although institutions are free
to impose their own minimum balance
reqUiremellt5.
Even though all demand deposit accounts are
still prohibited from paying interest, individuals
can easily avoid this restriction by.choosing a
NOW or Super NOW account. Businesses,
however, are still limited to holding non-interest
bearing demand deposits.
Behavior of deregulated accounts
Some economists expected balances in these
new deregulated accounts to respond much dif-
ferently to economic changes than balances in
regulated accounts and thereby change M1's
behavior. In fact, the behavior of NOWs and
Super NOWs has differed markedly from that of
the other components of M1 (mainly currency
and demand deposits).
As shown in Chart 1, in each year since 1982
(well after the initial large shift into NOWs was
completed in early 1981), NOWs plus Super
NOWs have grown much faster than the regu-
lated components of M1. Ifthe new accounts
had behaved more like traditional checking
accounts (demand deposits) before deregulation,
M1 's growth would have been much lower over
the same period. Thus, on the surface, it appears
that deregulation has increased M1's rate of
growth.
Lowered opportunity·costs
One explanation for the interest-bearing
accounts' different behaviors is the higher effec-
tive yields they offer depositors. Deposit rate
deregulation had the effect of increasing this
effective yield by eliminating the inefficiencies
of nonprice competition. Even though depositors
received some implicit interest in the form of
free or underpriced services on their demand
deposits (which were and still are prohibited
from paying explicit interest), the implicit plus
explicit interest on NOW accounts was signifi-
cantly higher.
Similarly, since Super NOWsi unlike NOWs,
were completely free of interest ceilings, they
offered even higher total yields than NOWs.
Indeed, it is the higher yields that explain the
massive shifts offunds, first from demandFABSF
Chart 1
Growth Rates of M1 and Its Components
Annual
Percent
Growth
35
deposits to NOWs, and then from NOWs to
Super NOWs when the latter were introduced.
With a much higher yield, the foregone interest,
or opportunity cost, of holding funds in the new
accounts (instead of in higher-yielding nontrans-
action assets) wasmuch smaller than thatof
holding funds in traditional demand deposits,
which paid no explicit interest at all.
30
25
20
15
II
I!lIII M1
~ Currency
[SI Demand Deposits
[iii Interest
Checking
Moreover, even though the deposit rate on the
fully deregulated Super NOW was free to move,
it did not vary closely with the open market
interest rate, at least in the short run. As a result,
a given percentage change in the open market
rate would cause a much larger percentage
change in the opportunity cost of these new
accounts than that oftraditional zero-interest
checking accounts. For example, ifthe Super
NOW rate were constant at 9 percent, a 10 per~
cent increase in the open-market rate from 10 to
11 percent would translate into a 100 percent
increase in the opportunity cost (from 1 to 2 per-
cent) of holding a Super NOW but only a 10
percent increase in the opportunity cost of hold-
inga zero-interest account (from 10 to 11
percent).
To illustrate this point, the monthly percentage
changes in opportunity costs for the Super NOW
and demand deposits are plotted in Chart 2. The
opportunity cost is defined as the difference
between the 3-month Treasury bill yield and the
explicit yield on the-deposit account (as reported
in the Bank Rate Monitor). This chart shows that
the typical monthly percentage change in the
opportunity cost of holding Super NOWs was
several times as large as that of demand
deposits. Although not shown in the chart, the
percentage change inthe opportunity costs of
NOW accounts was between that of demand
deposits and Super NOWs because the total
yield on NOWs was between that on demand
deposits and Super NOWs.
According to the inventory theory of money
demand, percentage changes in account bal-
ances are inversely related to percentage
changes in the opportunity cost of holdingthem.
Thus, one might expect deposit balances in
deregulated accounts to be much more variable
than balances in regulated accounts.
In fact, we found that balances in deregulated
accounts were several times more sensitive to
changes in open-market interest rates than bal-
10
5
o
1982 1983 1984 1985 1986'
* Preliminary estimates using first 9 months of 1986
ances in regulated accounts. Specifically, we
found that the percentage change in Super
NOW deposits to a given percentage change in
the 3-month Treasury bill rate was several times
larger than the response of demand deposits
prior to the nationwide authorization of NOW
accounts. That is, when short-term interest rates
fell, deposits in Super NOWs increased propor-
tionately several times more than funds in
demand deposits. NOW deposits were less sen-
sitive than Super NOWs but still more sensitive
than demand deposits. And, as other researchers
have found, currency was the least sensitive.
Implications for Ml
It appears that as one moves across the spectrum
oftransactions media from the most regulated
(currency) to the least regulated (Super NOWs),
one finds an increasingsensitivity to changes in
the open market rate. This pattern has several
implications for the behavior ofM1. First, during
periods when open market interest rates are
declining (and for some time thereafter because
of lags in depositors' responses), the growth rates
of NOWs and Super NOWs should exceed
those of either demand deposits or currency.
This partly explains the more rapid growth of
NOWs plus Super NOWs depicted in Chart 1.
Second, as deregulated accounts grow in popu-
larity over time, we would expect the M1 aggre-
gate to behave more like them and less like its
traditional components (mainly currency and
demand deposits) simply because deregulated
accounts would constitute a greater share ofM1.
Asimulation
One way to see just how much the behavior of
M1 has been altered by deposit rate deregula-Chart 3
Actual vs. Simulated M1 *
Chart 2
Super NOWs' Opportunity Costs*
are More Variable than
b~~;;~ Demand Deposit Accounts'
50
40
30
Super NOW
-40
Billions
of Dollars
700
650
600
550
500
450
400
350
300
I
Now accounts
authorized nationwide
12-31-80
"" Iii
~ ....' :1,iI ,
f! ,"" /\...'
,-'Simulated M1 based
on behavior before
12-31-80
-50 '--__ ---l... ...l.-__----'- --'
1983 1984 1985 1986
250 '----'------'_--'------'-_-'-----'--_L---'------'-_...L----'
1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
,. Three·month Treasury bill yield minus
explicit yield on deposit account.
tion is to compare how M1 would have been
predicted to behave based on its relationship to
economic factors before the nationwide author-
ization of NOWs with how it has actually
behaved since then.
In Chart 3, we compare M1 's actual behavior
with its predicted (simulated) behavior for the
period January 1975 through June 1986. The
simulation of M1, based on its historical rela-
tionship to economic factors prior to the intro-
duction of NOWs, seriously underpredicts M1's
actual behavior beginning in early 1982. This
underprediction coincides with the dramatic
drop in interest rates that began in November
1981, and is thus consistent with the notion that
the interest-sensitivity ofM1 began to increase
after NOWs were authorized nationwide.
Moreover, estimates based on M1 's historical
relationship to economic factors between Janu-
ary 1981 and June 1986 - after NOWs were
introduced - indicated that M1 had become
three times more sensitive to interest rates (in the
short run).
Together, these results suggest that deregulation
increased the interest-sensitivity of M1. They
also suggest that, beginning in early 1982,
deregulation caused M1 to grow much faster
,oNot seasonally adjusted.
than it otherwise would have, largely in
response to the decline in interest rates that
began in late 1981.
Conclusions
The payment of interest has reduced the cost of
holding checking accounts and simultaneously
increased the percentage variation in their
opportunity costs. The latter has, in turn,
increased the responsiveness of balances in
interest-paying checking accounts to changes in
the open-market interest rate.
Because interest-bearing accounts now comprise
over 30 percent of M1, deposit rate deregulation
has changed the behavior of M1 by making it
more sensitive to interest rate changes. More-
over, the continuing shift offunds into deregu-
lated accounts may continue to increase the
interest-sensitivity of M1.
These changes raise questions for monetary pol-
icy under virtually any view of what money is
and how money is related to the economy. In
particular, they raise the question of whether a
monetary aggregate comprised of both interest-
bearing and noninterest-bearing components
with different behaviors and changing returns is
useful for policy purposes.
Michael C. Keeley and Gary C. Zimmerman
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of themanagementof the Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsof the Federal Reserve System.
Editorial commentsmaybe addressed totheeditor(GregoryTong) ortotheauthor..•.FreecopiesofFederal Reservepublications
can beobtainedfrom the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6u!4S0m 4o~n U060JO 0POl\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
10/29/86
Change
from
10/22/86
Change from 10/39/85
Dollar Percent?
Loans, Leases and Investments' 2 201,558 - 1,070 4,506 2.2
Loans and Leases' 6 181,027 - 1,005 2,920 1.6
Commercial and Industrial 49,312 - 759 - 1,557 - 3.0
Real estate 66,842 - 189 1,351 2.0
Loans to Individuals 39,636 172 1,731 4.5
Leases 5,588 4 185 3.4
u.s. Treasury and Agency Securities2 12,639 - 13 926 7.9
OtherSecurities2 7,892 - 53 660 9.1
Total Deposits 202,830 - 566 3,311 1.6
Demand Deposits 50,682 - 466 3,089 6.4
Demand Deposits Adjusted3 35,473 - 510 - 8,158 - 18.6
OtherTransaction Balances4 17,448 -'- 182 3,503 25.1
Total Non-Transaction Balances6 134,699 81 - 3,281 - 2.3
MoneyMarket Deposit
Accounts-Total 46,344 144 947 2.0
Time Deposits in Amounts of
$100,000 or more 33,153 36 - 5,359 - 13.9
Other Liabilities for Borrowed MoneyS 25,944 - 491 2,433 10.3
TwoWeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)jDeficiency(-)
Borrowings
Netfree reserves (+)jNet borrowed(-)
Period· ended
10/20/86
59
12
48
Period ended
10/06/86
36
24
12
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Interest checking and M1

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Interest checking and M1

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