Monetary policy - United States ; Money supply ; Interest rates ; Supply-side economics

John L. Scadding

John P. Judd

English

Research Papers in Economics

IP~cdl~lf©\ll  TI«~~~lfW~ 
IBs~ffi\~  (G) IT 
~  ©\ffi\  IP  If  ~\ffi\  (C n  ~  CC (G) 
September 3, 1982 
Volatility in Money and Interest 
Starting in the early 1970's, the Federal Re-
serve began to shift the focus of its monetary 
policy from the level of interest rates to con-
trol of  the supply of money. This change was 
spurred primarily by the accumulation of 
much evidence linking inflation with exces-
sive money growth. The' Fed has achieved 
considerable success reducing the growth of 
the monetary aggregates on an annual basis 
since 1979, with the resultant benefit of a 
downward turn in the rate of inflation, but it 
has been less successful at controlling the 
su pply of  money over shorter periods of  ti me. 
Some of  the Fed's critics, including leading 
monetarists like Milton Friedman and Allan 
Meltzer, have charged that variability in 
monetary growth contributes to uncertainty 
about inflation, high interest rates and 
the poor performance of  the economy. But 
the Federal Reserve has countered that tight 
short-run monetary control could further in-
crease the variability in interest rate.s and, 
besides, would not contribute measurably to 
economic stability. 
The critical assumption in the Fed's argument 
is that short-run changes in the quantity of 
money represent differences in the underly-
ing desire of  the publiC to hold money, that is, 
changes in the demand for money. This view 
is often used by the Fed to justify accom-
modating rather than resisting deviations of 
the quantity of money from its target. 
The alternative view posits that the observed 
changes in the quantity of money result from 
changes in the supply of  money which do not 
necessarily correspond to changes in the 
demand for money. According to this view, 
the Fed shou Id not accommodate money 
control deviations as often. 
Accommodating demand 
To illustrate why accommodating changes in 
money demand can be appropriate, assume 
that the pu bl ic sudden Iy wanted to hold more 
of its wealth in the form of money (at given 
levels of income and prices).lfthe Fed did not 
supply the extra money, interest rates would 
rise because the demand for money would 
have risen relative to the supply. The higher 
interest rates would exert a depressing effect 
on the economy, perhaps going as far'as to 
cause a recession. To avoid this result, the Fed 
bel ieves it must provide the additional money. 
M1  growth between October 1981  and April 
1982 provides a good example of accommo-
dating perceived increases in money de-
mand. In this period, M1  (the chief definition 
of money used by the Fed) grew relatively 
rapidly to a level above the upper boundary 
of its annual target range. This growth was 
thought mainly to reflect the desire of the 
public to hold more money as a precaution 
against the uncertainties of a recession. The 
Fed reasoned that if  monetary pol icy were not 
to be tighter than intended, then th is apparent 
change in the demand for money would have 
to be accommodated. 
Supply-side influences 
An alternative view often attributes rapid M1 
growth to factors affecting the supply of 
money rather than its demand. This view 
emphasizes two important features of  money 
in the u.s. economy. 
Buffer stock. The first is the widely accepted 
idea of money as a "shock absorber" or buf-
fer stock between the public's receipts and 
spending. In this view, short-run variations in 
the observed stock of money may represent 
independent changes in the quantity of 
money supplied by banks to which the public 
has not had time to adjust completely. 
The view of money demand as largely pas-
sive in the short run, accommodating itself 
to changes in the supply of money, reflects 
the transactions costs of managi ng money 
balances closely. Unanticipated inflows or 
outflows of  funds cause inventories of  money If  CE ((ll ~~  If  ~\.11  rr:« ~  ~~  lfW  ~ 
TQl '5'  ~"'-'\ )l,  ((\"\ ~~  lQ)  (9~\  lft~  ,0,\::"  "'\)) 11 
§  ~:\\. "f'\  ~  ~;:7  ,~5\. 1('\\ (tv  11 ~~  «('\1 (t\\  0J  lS~  \.L\ D,  H  11  &;,  ,:.; D.  ,-~,. ~ \;2) ~4  ~ 
()pinions cxpn-'ssed in  lhi~ IH:,vvslt.,tit'i" do not 
necessarilv rellect  the View') of tilt'  rlldni:H~t:)IIl(:llt 
of the Federal I<c'servf' Bank of San  Fr;m(~i';c(). 
en 01  the Roard  01  Covernors of 1h<'  Federal 
R(,~;t, I've  S ys t  E' 11'1. 
balances to wander away from their desired 
levels in the short-run because it is too costly 
for some money holders to make the neces-
sary purchases and sales of securities (or 
goods and services) to bring money balances 
back to their desired levels quickly. 
This view does not dispute the effectiveness 
of sophisticated cash management tech-
niques and new instruments, like repurchase 
agreements, that emerged in the 1970s. These 
developments significantly lowered transac-
tions costs for large corporations and, per-
haps, wealthy households. But for most 
households and small corporations, with 
relatively low money balances on average, 
the costs of managing money more closely 
using the new techniques may still be too 
high. Therefore, it remains optimal for these 
groups to leave their inventories out of bal-
ance in the short-run. 
If money finds its way into these "loosely" 
managed portfol  ios, it may stay there for a 
while. Moreover, as one money holder tries 
2 
to bring his balances into line, he may throw 
the portfol io of  other holders out of balance. 
For this reason, the system as a whole takes 
longer to ad just than does anyone household 
or corporation. 
Recent empirical evidence at this bank sug-
gests that buffer stock effects are significant 
-that  the monetary aggregates can depart 
Significantly from levels desired by the public 
for up to six months at a time. This departure 
has, however, only modest effects on interest 
rates. In other words, over a period as long as 
half a year, it is possible for money supply 
factors to influence movements in the money 
stock as the public's demand for money ac-
commodates independent changes in supply. 
Bank loans. The second feature in the supply 
view is the relationship between changes in 
the public's demand for credit, and changes 
in the stock of money. Essentially, distur-
bances in the market for credit-for  equities, 
bonds, and money market instruments like 
commercial paper-may filter through the 
banking system and affect the stock of  trans-
actions deposits which are an important 
component of money. 
The critical variable connecting money and 
credit is the stock of commercial bank loans. 
From the public's point of  view, bank loans 
are an alternative form of financing to bor-
rowing in open financial markets such as the 
commercial paper market. The rate that 
banks charge on their loans (prime rate) rela-
tive to open market rates therefore helps 
determine the amount of  bank loans the pub-
I  ic wants to take out. A lower spread between 
prime and commercial paper rates encour-
ages the public to borrow more from banks. 
The resulting rise in bank loans causes the 
supply of money to increase as the loan pro-
ceeds are paid out to the borrowers in the form of newly created transactions deposits. 
As we have seen, the transactions costs of 
cash management mean that part of  these 
new deposits may stay in the economy for 
up to six months with but slight effect on 
interest rates. 
An important implication of this view of the 
money supply process is that "disturbances" 
in the credit markets can influence the money 
stocle For example, an unexpected decrease 
in the public's demand for bank loans would 
cause a decrease in the money stocle The 
credit control program of March 1980 is a 
dramatic example of  a credit market "shock" 
that influenced the money supply, having 
contributed to its sharp decline in the spring 
and its rebound in the summer and fall. An-
other example is the collapse ofthe bond 
market in early 1980, which suddenly shifted 
borrowing into banks and caused M1  to ac-
celerate. Finally, developments in the real 
sector, such as inventory cycles, can' influ-
ence bank loans and Ml. 
Policy Implications 
The supply side view provides an alternative 
to the traditional explanation of the observed 
positive association between money and in-
terest rates in the short run. In the supply 
view, the positive relationship between 
money and interest rates is explained by shifts 
in the demand for credit. An increase in the 
demand for short-term credit (including bank 
loans), perhaps because of high cost and 
uncertainty in the long-term bond market, 
would lead to both an increase in deposits as 
banks provided more loans and an increase 
in interest rates as banks competed for addi-
tional reserves to support the new deposits. 
This appears to have been one of  the influ-
ences in the October 1981-Apri  11982 period 
of high Ml growth when fast growth in bank 
loans contributed to an increase in money 
growth and interest rates. 
3 
The impl ications for policy ofthe supply-side 
analysis are quite different from that of  the 
demand view. The latter, as we have seen, 
would argue that accommodating increases 
in money demand would prevent interest 
rates from rising orfalling and, thus, mone-
tary policy from being inadvertently too tight 
or too loose. 
In contrast, the supply view would argue that 
the increase in money, thoughtto be a change 
in demand, actually represents an incipient 
excess supply of money. If not removed, this 
excess supply would cause spending to rise. 
In other words, policy would turn out to 
be more expansionary than intended if  the 
increase in money were accommodated. 
Hence, policy should resist the increase 
in money. The supply view argues for keep-
ing relatively tight control over the stock 
of money in order to prevent money "sur-
prises" from exerting a destabilizing effect 
on the economy. 
John P. Judd and John L. Scadding ·me::> lo:>spueJ:I ues 
ZSL. ·ON llWH:Jd 
mVd :J!:>VlSOd ·s·n 
llVW SSVl::> lSHI:I 
OUHOS:JHd 
SS"1:> .lSI:II:J 
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICf 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial Banks 
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. 
Amount 
Outstanding 
8/18/82 
161,049 
140,979 
44,337 
57,297 
23,408 
2,722 
6,454 
13,616 
38,663 
26,901 
30,801 
99,934 
90,212 
37,924 
Weekended 
8/18/82 
28 
4 
24 
Change 
from 
8/11/82 
337 
334 
- 248 
20 
18 
206 
2 
1 
628 
- 672 
- 60 
1,116 
754 
870 
-
-
Weekended 
8/11/82. 
- 212 
79 
- 291 
U01~U!4st?M. 4t?ln  •  Uo~aJO •  t?pt?AaN  •  o4t?PI 
!!t?Mt?H  •  t?!UJOl!It?:)  t?uoz!l'v'.  t?>j 5 t?1'v' 
CG)~<§y~\\Jr\2?JJ~ ~~~ 
~  CG)  ~\ill~C@I 
@.&JJ@<§@@  TI~JJ@~@~ 
{1 \ill ~  \illlJ{1Jr\2?((iI ~(ffi  \\{[ ~  Jr \2? ~~  ~CQI 
Change from 
year ago 
Dollar  Percent 
9,478  6.3 
10,336  7.9 
4,915  '12.5 
3,264  6.0 
475  2.1 
1,365  100.6 
478  8.0 
1,336  - 8.9 
970  - 2.4 
104  - 0.4 
939  3.1 
13,945  16.2 
12,351  15.9 
2,497  7.0 
Comparable 
year  -ago period 
16 
32 
16 
Editorial comments may be addressed to the editor 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 
Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Volatility in money and interest

http://www.frbsf.org/publications/economics/letter/1982/el82-36.pdf

Volatility in money and interest

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics