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BOARD OF G OV E R N OR S

or TH
E
FEDERAL R ESERVE SYSTEM

Office Correspondence
r _____ Chairman
£o_
From

Date

Subject:

Burns

July 31, 1973

Demaud and.Supply. .Factors
in the Growth of

Lyle E, Gramley

You asked for a brief memo explaining the reasoning which led .
view that shifts in the money demand function occurred in the
and second quarters of this year.

The reasoning is as follows:

(1)

Demand for
is thought to be determined by the volume
of transactions (for which nominal GNP may be used as
a proxy) and interest rates, especially short-term
rates. Money demand is positively related to GNP
and negatively related to diort-term interest rates.

(2)

In the first quarter, nominal GNP growth rose, and
thereby increased the demand for money. Rising
interest rates during the first quarter, and also
late in 1972, were acting to reduce money demand.
The quarterly econometric model predicted that,
given the actual levels of GNP and interest rates that
prevailed,
should have increased at an annual rate
of about 6 per cent.

Sv°




I (3)
I
l
1
1

(4)

We take the shortfall of actual
growth from that
predicted by the model as evidence of a downward
shift in the money demand function. This is not
to say that supply factors (e , g ., Federal Reserve
policy) had nothing to do with the slow growth of
M^. If the Fed had set out singlemindedly to keep
growing at (say) 6 per cent, it could have done so--or
at least it could have accomplished a higher annual
growth rate than 1.7 per cent. But it would have had
to drive down interest rates substantially below actual
levels to accomplish this.
In the second quarter, GNP growth declined and interest
rates rose further. Both factors should have acted
to reduce the demand for M^. Growth in M^, however,
accelerated. An upward shift in money demand evidently
occurred, probably a reaction to the early decline, at
least in part.
The quarterly model predicted that, given actual GNP
and interest rates,
should have risen at an annual
rate of about 5 per cent.

GOVERNORS

To:




Chairman Burns
(5)

OF TH E

FEDERAL

RESERVE

- 2 -

Again, this is not to say that th$ Federal Res e r v e 1s
willingness to let bank reserves grow rapidly during the
second quarter had nothing to do with the rapid growth
of M - . But given the surge in demand, an effort to
hold
growth to 5 per cent would have meant a huge
rise in interest rates.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102