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15- O a

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of cLtu^fies

John D. Paulus
January 13, 1978

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After surging to near record levels in the first year of the
current recovery, Ml velocity has grown at a comparatively modest pace
in the last two years.

This return to growth rates more in line with

historical experience raises two questions:

first, why did Ml-velocity

grow very rapidly early in the recovery and then slow down; and, second,
is the slower growth of velocity permanent, or is it likely that velocity
growth will accelerate unexpectedly in the next few quarters.
In order to assess recent growth patterns and prospective growth
in velocity it is necessary to examine the behavior of the narrowly defined
money stock in relation to its principal determining factors.

The average

stock of money desired during a given period generally is thought to be
positively related to the volume of transactions to be undertaken and
negatively related to some measure of the opportunity cost of holding

GNP is often used to approximate the level of transactions, and

a short-term interest rate, usually the Treasury bill or commercial paper
rate, is used to capture the opportunity cost of money.
Before 1975, this relationship, GNP, and interest
rates had proved remarkedly stable.

Studies by Board staff and academic

economists generally indicated that future money growth could be predicted
quite accurately if GNP and interest rate changes were known.

But in

late 1974 the narrowly defined money stock began to grow more slowly than
historical experience would have suggested.

- 2 -

Shown in Table 1 are annual growth rates of Ml and GNP and
percentage changes in the 3-month Treasury bill rate since the beginning
of the current recovery.

The right-hand memo item presents the growth

of Ml-velocity over this-period,
average levels.)

(All figures are based on quarterly

Despite the very rapid growth of GNP and the decline

\ in short-term interest rates, Ml expanded modestly in the first year
of the recovery (1975-1 - 1976-1).
a near record rate.

Ml-velocity in.turn surged upwards at

But in the second and third years of the recovery

GNP expanded at a more moderate pace on average and interest rates,
after declining slightly on balance in 1976, began to move upward
last year.

Ml growth accelerated over this period, and as a consequence,

Ml-velocity began to advance at moderate rates consistent with similar
stages of previous cyclical recoveries.
The pattern and the magnitude of the shift in the relationship
among money, economic activity and interest rates is illustrated in
Figure 1.

The estimated errors shown are based on the money demand

relationship used in the Board*s quarterly econometric model.


^/top panel displays the total short-fall in Ml growth since late 1974.

The short-fall first grew rapidly before slowing sharply in recent quarters.
The cumulative short-fall for any period represents the increase in the
level of Ml since late-1974 that would have been required to achieve
the GNP and interest rate patterns actually observed had the historical
relationship among money, economic activity and interest rates continued
to hold over the period.

For the last 3 years the short fall in Ml

- 3 -

has cumulated to about $40 billion.

Equivalently, Ml growth has been

depressed,by all factors about 4 percentage points per year on average
since late 1974,
The incremental quarterly errors-are -shown in the bottom
panel of Figure 1.

The points shown represent the estimated percentage

point short-fall in the Ml growth rate for each quarter since 1974-IV.
The dashed lines represent average percentage short falls over the
indicated periods.

The largest errors occurred in the six quarter

period from 1974-IV to 1976-1.

Over this period Ml grew on average

about 6 percentage points slower than historical experience would have
j suggested.

In the following year (1976-1 to 1977-1), the average short­

fall was about 3 -1 / 2 percentage points, or just over one-half as great
as that of the previous year and one-half.

In the last three quarters,

the short-fall in money growth has disappeared as Ml has expanded about


■ in line with expectations based on its earlier relationship with economic
activity and interest rates.

This pattern of steadily declining

short-falls in money growth would seem to imply that the demand for
money on the margin has been gradually but steadily returning to the
association with GNP and interest rates that had been well established
before 1975.

Support for the hypothesis that the relationship among changes in
money, GNP, and interest rates has been returning to the alignment prevail­
ing earlier can be found in an analysis of the various factors that
appear to have constrained Ml growth in the last three years.


regulatory actions and innovations:designed to economize on cash balances
have contributed to the short-fall in Ml growth during the current

For the most part, the additional constraining effects

of these factors on the growth rate of Ml seem to have diminished
in the last year or two.
Federal regulators have played an important role in constraining
Ml growth, especially by broadening the class of economic agents that
V are permitted to hold savings accounts and by facilitating the use of
isuch accounts for third party payments.

Last year the Board staff estimated

that NOW accounts, business and State and local government savings accounts,
telephone transfers from savings to demand deposits and pre-authorized
payments from savings accounts depressed Ml growth by about 1-1/2 per­
centage points from late-1975 to late-1976.

Principally reflecting

slower NOW account growth and the completion for many firms of the stock
adjustment from demand to business savings accounts, these factors
probably depressed Ml growth by about 1 percentage point or less in the
last year.

In general, the constraining effects of these regulatory

factors, which account for perhaps one-third of the short-fall in Ml
growth in the last two years, appear gradually to be disappearing as
the public has adjusted its stock of financial assets to the new
regulatory environment.

While regulatory changes help to explain a part of the short-

1 fall in money growth, the unusually high interest rates in 1973 and
\ 1974 produced a more general impetus to the shift in money demand by

- 5 -

providing businesses and individuals with an incentive for updating
and improving cash management techniques and for adopting more efficient
payment practices.

Though the cost of implementing more efficient

cash management practices is largely unaffected by interest rates,
the potential savings from reducing demand balances increases when
interest rates rise.

The trade-off between the cost of implementing

new cash management devices and the savings from reduced demand balances
thus improves with higher interest rates.

Moreover, as interest rates

exceed past peak levels, this tradeoff should become favorable for
increasing numbers of firms and individuals, and the rate of adoption
of financial innovations should accelerate.

Short-term interest rates rose steadily throughout 1973 and
reached record levels in the summer of 1974.

Financial officials of

many major U.S. corporations have indicated to Board staff that the
extraordinary levels that short-term interest rates reached in 1974
greatly stimulated efforts to trim demand balances.

Indeed, officials

of many large firms indicated that demand deposit balances of their
firms have been about unchanged over the last three years even though
sales have advanced substantially.

Increased use of remote disbursing

techniques, balance reporting and cash concentration accounts, wire
transfers, depository transfer checks, zero balance accounts, lock
boxes and other devices have enabled these corporations to effect
a significant reduction in demand balances.

Staff research on business

demand deposits based on the Board's Demand Deposit Ownership Survey


tends to support the hypothesis that nonfinancial businesses have
significantly lowered their demand balances relative to business
sales and interest rates in the last three years.
Implementation of more efficient cash management practices,
whether by businesses or individuals, would, of course, tend to
lower the desired stock of demand balances associated with a given
level of economic activity and interest rates, and would help to
explain the short-fall in Ml growth in 1975 and 1976.

However, after

the lower desired stock of money balances has been reached, the effects
of previous financial innovations on rates of growth of money should
tend to disappear.

Thus, if a series of innovations designed to

economize on demand balances is introduced, rates of growth in Ml during
and immediately after the period of introduction should slow.


unless further innovations follow, the rate of growth of Ml should
return to a range more consistent with historical experience.
Businesses and individuals, having learned of the cost saving
potential of economizing on cash balances, no doubt continue to implement
techniques designed to maintain lower demand balances.

However, with

interest rates significantly lower over the last three years than their
1974 peak values, the incentives for introducing further cash management
practices have diminished.

Diminished rates of innovation, coupled with

an absence of further regulatory actions, would imply that the money
stock should continue to expand more in line with historical experience,


given GNP and interest rate changes.

These developments further imply

that Ml velocity, although likely to advance rapidly with interest
rates this year, will on balance grow significantly slower in the
future than earlier in the recovery.

T a b le 1

(Per cent change)


Growth 1/

Growth 1/

1975-1 to 1976-1



1976-1 to 1977-1


1977-1 to 1977-IV



Pet Change
3-Month Bills

Velocity Growth 1/




- 5.9





Growth rates are SAAR (based on quarterly average levels for Ml).

Figure 1
($ billions)
* 5 0 " -----






Percentage points






















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