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Asset Exchanges and the Transactions Demand
for Money, 1919-29

surge in transactions demand, a failure unrecognized at the time, was associated with
an antispeculative policy that drove real interest rates to very high levels in 1928-29,
levels not approached again until the early
1980's. This deflationary impulse, larger than
is apparent from a simple examination of
monetary growth figures in relation to GNP
growth, was the proximate cause of the
downturn in real activity generally dated
from August 1929.2

This paper addresses a general theoretical
question—the appropriate specification of
the transactions demand for money—as well
as a particular historical question: what triggered the Great Depression? Theoretically,
fluctuations in the volume and value of asset
exchanges in secondary asset markets can
influence the transactions demand for money
independently of real output and interest
rates, and ought to be integrated into the
analysis of those forces perturbing1 the demand for money and shifting LM curves in
the absence of monetary intervention.
Empirically, I demonstrate that, over the
years 1919-29, monthly fluctuations in the
volume and value of trading on the New
York Stock Exchange did influence the
transactions demand for money independently of fluctuations in real output and
interest rates. Moreover, in the context of
relatively slow post-1925 growth rates of
monetary aggregates, the unprecedented increase in the volume and value of such trading from the beginning of 1925 to October
1929 had the effect of shifting the LM curve
persistently to the left. The failure of U.S.
monetary authorities to accommodate this

I. Asset Exchanges and the Transactions
Demand for Money
The preponderance of transactions in asset
markets involves the conveyance or transfer
from one individual to another of previously
issued securities. This was true in the 1920's
and is true today. A certain base level of
transactions results from the issuance of new
securities, and from life cycle effects, as individuals liquidate their holdings, or rearrange
their portfolios at various stages of their
careers. But the observed volatility in trading
volume in secondary asset markets is largely
driven by other forces, forces related to but
distinct from those that determine asset
prices. At any moment in time individuals
have different expectations about the future
course of particular asset prices. Such
differences themselves may, but do not necessarily, give rise to trades of existing assets.
But when these expectations are changing
rapidly in different ways for different individuals as the result of new information differentially available, or differently interpreted, increases in trading volume are likely
to result. Such trading volume can persist
without necessarily giving rise to changes in
an asset price index. By contrast, new infor-

*Associate Professor of Economics, University of
Santa Clara, Santa Clara, CA 95053. The groundwork
for this project was conducted during 1979-80 at the
Institute for Advanced Study in Princeton. I am grateful
to the Institute for the opportunity afforded to branch
into a new area of research. I thank David Laidler and
Milton Friedman for detailed comments on earlier versions, and also thank participants in the All-UC Symposium on the Great Depression, Berkeley, May 1982,
at which an earlier version of this paper was presented.
Such fluctuations are analogous in their effects to,
but analytically distinct from, volatile shifts in liquidity
preference: both types of disturbances may cause the
demand for money not to be a "stable function" of a
"fairly small" number of variables. It is worth recalling
that Milton Friedman came to identify the volatility of
Keynes' liquidity preference function, not the proposition that the demand for money was interest sensitive,
as the distinctive feature of the Keynesian approach (see
his 1966 article, p. 85).

This is a statement about the origin—not the depth
or duration—of the Great Depression.




mation, widely available and similarly interpreted, may cause asset prices to rise or fall
on very low levels of trading.
In other words, prices in secondary asset
markets, unlike prices in commodity markets,
do not depend for their maintenance on a
continual flow of expenditures. Without such
a flow, commodity prices eventually decline
because of the involuntary accumulation of
inventories that ensues in an environment
where production flows are positive and the
holding of inventories is costly. No such
eventuality necessarily accompanies the cessation or slowing of trading in secondary
asset markets. Yet, when expectations differ
about the appreciation potential of particular
assets, exchanges will take place, sometimes
accompanied by and sometimes not accompanied by price changes.
If individuals simply bartered financial assets when they wished to trade them, a transactions demand for money could never arise
from such exchanges, but for the same reason money serves as a convenience and
temporary repository of value in goods transactions, nonmonetary assets tend to be rendered more liquid before being reconverted
to other assets. As a result, in periods of high
trading volume, a monetary system may experience (at given interest rates and output
levels) an increase in the transactions demand for money, especially in large financial
centers such as New York City. Trading
volume and value, and the resulting transactions demand for money, can therefore be
influenced by forces not directly related to
flows of production, income, consumption,
and saving, and as a result have great potential to move independently of movements in
GNP or even the average price level of traded
The possible consequences of such movements have been only infrequently examined
in the last half century.3 These and related
Franco Modigliani, Robert Rasche, and J. P.
Cooper (1970) found, but did not report, a very small
but positive influence of the value of stock market
transactions on the demand for money. This result
applied to a regression on quarterly U.S. data from
1955:I to 1966:IV, using a ratio specification. A recent
criticism of assuming proportionality between GNP and
total transactions demand is found in Charles Lieber-

MARCH 1984

issues were discussed extensively during the
1920's within the context of a protracted
debate over whether or not stock exchange
"speculation" deprived other sectors of the
economy of stocks of cash balances and/or
flows of saving. Many observers, including
influential decision makers in the Federal
Reserve System, had an intuitive sense that
the existence of the stock exchange, and
the call loan market in which funds were
lent for the purpose of purchasing securities, "drained" funds from the rest of the
economy.4 But advocates of "absorption"
employed impressionistic and sometimes contradictory arguments that left them vulnerable to the criticisms of sophisticated monetary theorists such as Gustav Cassel and
Fritz Machlup.5
The conclusion that the stock market did
not absorb cash balances was based on a
number of irrefutable logical arguments and
scattered bits of empirical evidence. Oppoman (1977), who advocates using total debits, adjusted
for currency transactions, as a measure of transactions
demand. Two other recent reviewers of research on the
demand for money have also noted the potential dangers
entailed by the use of GNP as a proxy for total transactions demand: "This whole line of reasoning, however,
overlooks the large and rapid fluctuations that can take
place in the volume of transactions conducted in the
financial markets," (David Laidler, 1977, p. 58), and "it
is not clear that real GNP is a good measure of transactions..." (Steven Goldfeld, 1973, p. 583). Both of these
remarks occur in footnotes, however, and are not systematically followed up. Somewhat earlier, Tibor Scitovsky issued a similar warning (1969, p. 39). See also
Jacob Enzler, Lewis Johnson and John Paulus, who
recognize asset exchanges as possibly influencing transactions demand (1976, p. 269), but empirically are more
interested in intermediate goods transactions. Friedman
and Anna Schwartz also recognize the possibility that
asset exchanges might influence transactions demand
(1982, p. 39), although this is not incorporated into their
theoretical framework.
See Fritz Machlup (1940, especially chs. 2-4) for a
superior although critical introduction to this literature.
For example, the proposition that stock market
speculation deprived legitimate commerce and industry
of needed capital sometimes coexisted with the proposition that overinflated stock prices made it "too easy" for
businesses to raise expansion capital by issuing equities.
While these claims can be reconciled by differentiating
between those firms that did (because of their size or
reputations) and those that did not have access to the
stock market, most of the discussion lacked this kind of

VOL. 74 NO. 1


nents of absorption pointed out correctly
that purchases and sales of existing securities
in secondary markets did not extinguish cash
balances any more than did purchases and
sales of a rare painting or a loaf of bread.
Critics of absorption went on to emphasize
the lack of a close connection between asset
prices and the transactions balances necessary to sustain them. Although Machlup
waffled on this point,6 he did claim that there
could be in principle no limit to the rise in
asset prices over time consistent with a given
money supply, so long as new information
was interpreted similarly by most investors.
He neither emphasized nor denied that the
opposite extreme was also possible: high
levels of trading among individuals with different and changing expectations about the
appreciation potential of different securities
in the absence of major movements in individual stock prices and their average.
The central issue, recognized as early as
1916 by such German writers as Herbert von
Beckerath,7 and in the 1920's by some of the
English and American writers, was whether
fluctuations in the volume and value of exchanges of existing securities could have
measurable influences on the stock demand
for cash balances for transactions purposes.
This was never denied as a theoretical possibility. But after extensive debate among
monetary theorists in the 1920's, a consensus
was reached: such trivial amounts of cash
relative to the volume of transactions were


involved in the transfer of securities, and the
variance in the demand for such balances
was so small, due to highly (inexpensively)
flexible velocity, that the empirical impact of
fluctuations in the volume of asset exchanges
on the transactions demand for money had
to be insignificant.8 Even John Maynard
Keynes, towards the end of the first volume
of the Treatise, expressed skepticism as to
the empirical importance of a theoretical
mechanism he had outlined in some detail at
its beginning.9
The consensus reached by economists in
the late 1920's and early 1930's that fluctuations in asset exchanges had little or no effect
on the demand for cash balances has not
been systematically reexamined since then, at
least insofar as it applies to the 1920's. By
the early 1930's, a decade of consistently
collected data were available (now assembled
in Banking and Monetary Statistics, 1976a),
but inexpensive statistical techniques for their
analysis were not. Applying multiple regression analysis to data from the 1920's, it is
now possible to show that over the years
1919-29, the volume and value of trading on
the New York Stock Exchange did have an
economically important impact on the transactions demand for money in New York and
in 100 major commercial and industrial
centers, as well as on the demand for more
broadly defined national monetary aggregates.
II. Asset Trading and Transactions Demand,

Compare Machlup " N o additional money capital is
necessary for a rise in securities prices" (p. 46) with
p. 92, where he claims that a lasting stock market boom
can result only from inflationary credit supply. Machlup
and others dismissed the phenomenon of margin buying
as simply an increase in the number of layers of financial intermediation—without real consequence—and
pointed to the use of clearance mechanisms and brokerage deposits by regular customers as evidence that velocity was costlessly, or at least very inexpensively, flexible
in financial transactions.
"The money which is withdrawn from expenditure
on the markets for goods and labour, and used as a unit
of account for business on the stock exchange, leads to a
temporary reduction in the demand for goods and for
labour. That is to say that the money is held up on its
way and for the time being can neither be spent nor lent
in the economic process proper" (Beckerath, p. 162,
cited in Machlup, p. 68).

According to conventional analysis, the
position of an economy's LM curve is conditional on a number of parameters, the most
important of which are 1) the stock of nominal cash balances in the system, 2) the price
level of GNP-related transactions, and 3) a
given state of liquidity preference. If asset
exchanges require fluctuating levels of transactions balances, then at least two additional
parameters need to be added: 4) the volume
Machlup (p. 94); Seymour Harris (1933, p. 611);
Charles Hardy (1932, p. 167).
Keynes (1934, I. pp. 44 and 249); see my 1983



of asset exchanges in secondary markets, and
5) the average volume-weighted price of
traded assets. A contractionary open market
operation, a change in liquidity preference
leading to a higher demand for money as an
asset, or a surge in the desired level of asset
exchanges can now all, ceteris paribus, be
interpreted as shifting the LM curve to the
left, resulting in higher interest rates and
lower levels of real GNP in the short run.
Eventually, price declines in GNP-related
transactions might lead to counterbalancing
shifts in both IS and LM schedules. In most
business cycle episodes, however, various
kinds of expectational and institutional inertia keep goods and services prices from
moving sufficiently rapidly to prevent quantity movements.10 Such price movements, and
their consequences, will be treated in this
paper as of a second order of importance.
Two conclusions follow from these assumptions. A major change in the level of
asset exchanges must in the short-run result
in some combination of (a) nominal money
stock changes, (b) interest rate changes, or
(c) changes in real GNP. Absent accommodation, the effect will be (assuming the change
to be an increase) some combination of higher
interest rates and lower real output, depending on the shape of the IS curve. With total
accommodation, nominal money supply
would be higher, with unchanged interest
rates and real output. How accommodative
can we assume the System to have been?
The Federal Reserve System was set up in
part to satisfy temporary seasonal variation
in the demand for credit or money associated
with such events as fall harvests or December retail sales. The effect of the introduction
of the System was to reduce substantially the
seasonal variability in interest rates that had
previously characterized the American economy.11 Through a combination of open
market operations, foreign exchange transactions, and discount window policy, the Fed's
operations permitted the nominal money
Examples include overlapping contracts for the delivery of output as well as the purchase of inputs,
including labor, or the failure of inflation expectations
to adjust downward (upward) until several periods of
lower than (higher than) expected inflation have elapsed.
See Friedman and Schwartz (1963, pp. 293-95).

MARCH 1984

supply to be endogenously determined by
allowing the commercial banking system to
satisfy, at least in part, the transactions demand forthcoming, at targeted interest rates,
during different months.12
The Fed's philosophy with respect to cyclical fluctuations in the demand for credit was
less clear. Some argued for accommodating
all legitimate "needs of trade," while others
maintained that the System should tighten
up towards the end of an expansion to prevent speculative "overaccumulation" of inventories.13 In spite of these and other differences, however, there was fundamental
agreement within the System on two propositions: first, that the ultimate source of
fluctuations in desired money holdings, be
they seasonal or cyclical, werefluctuationsin
real, GNP-related activity, and second, that
the responsibility given the System to regulate the supply of money entailed a responsibility to safeguard its purchasing power.
This obligation to maintain the purchasing
power of money meant that although the
System was willing in the short run to
accommodate unexpected cyclical as well as
seasonal fluctuations in desired money holdings, originating in perturbations in the IS
schedule or the money demand function, the
willingness to make such accommodation
could, over time, come into conflict with the
implicit longer-run objective. Periodically, the
Open Market Investment Committee, consisting in 1929 of five bank governors with
the New York governor as chair, responded
to current economic conditions including (at
least implicitly) observed longer-run changes
in the nominal money supply (Mt - Mt-1)
by ratcheting up or down the interest
rate/credit conditions targets. Appropriate
changes in discount rate and/or open market
purchases or sales consistent with these
targets were then made.
" Transactions demand for money" is used here in
the sense of desired money holdings. Such fluctuations
could have their origins in the perturbations in the
demand for money function (i.e., influences on desired
money holdings other than changes in Y or r), or in
changes in theflowdemand for credit, as reflected in the
position of the IS schedule.
See Friedman and Schwartz (1963, p. 263). Support
for both of these positions is to be found in the System's
Tenth Annual Report. See Hardy, pp. 79-81.

VOL. 74 NO. 1


Ceteris paribus, monetary growth rates
would change as a result of such changes.
Although primarily concerned with credit
conditions and interest rates, policymakers
could not help keeping an eye on monetary
growth rates, both for what such rates told
them about the health of the real side of the
economy, and for the warning they might
give of longer-run inflationary dangers. Accommodating short-term seasonal or cyclical
fluctuations in the desired money holdings
was an important objective of the system,
but so too was price stability or mild deflation over the longer term, and most central
bankers believed the implications of the
quantity theory of money: that control of the
longer-term growth rate of the money supply
in relation to the growth rate of real GNP
was the necessary means to this end.
In normal times, then, the System can be
viewed as having a short-run (accommodative) interest rate target, and a longer-run
(less accommodative) monetary growth
target, with a feedback mechanism linking
the two. The problem was that the late 1920's
were not "normal times." In particular, the
regressions and simulations discussed below
demonstrate that an empirically important
increase in transactions demand resulted
from the rising volume of asset exchanges in
the post-1925 period. Because this increased
demand was unrecognized, it short-circuited
a feedback mechanism that otherwise would
have led to a moderation of the high interest
rate policy that pushed the economy into
recession in 1929. Before the logic of that
argument is developed, however, the influence of asset exchanges on the transactions demand for money must be established
The regressions reported in Table 1 test
the fundamental empirical question at issue
in this paper. Using monthly data, they ask
whether, when one holds the level of nominal
income and interest rates constant, the level
of trading on the New York Stock Exchange
exercised a statistically significant and economically important impact on the demand
for and holdings of nominal cash balances.
Six monetary aggregates serve as the dependent variables in Table I. These include demand deposits in New York City, demand
deposits in 100 major centers (excluding New


York City), demand deposits in 101 centers
(including New York City), currency plus
demand deposits in commercial banks (Ml),
currency plus demand and time deposits in
commercial banks (M2), and M2 plus deposits in mutual savings banks and the postal
savings system (M3). All dependent and independent variables (excluding dummies)
have been transformed into natural logarithms to facilitate the calculation of elasticities. Two short-term interest rates are used:
that on prime commercial paper, 4-6 month
maturity (PCP46), and the rate in the call
money market for loans on new securities

Nominal income data is not available on a
monthly basis for the 1920's, and three measures have been used to estimate it. One
(YINT) is a simple linear interpolation from
annual data, with endpoints centered in midyear. The second proxy (YIND) is constructed using a two-stage procedure. Annual
nominal income is regressed on an annual
index of industrial production. The resulting
regression coefficients are then used to construct predicted monthly income data based
on this annual relationship, and monthly seasonally adjusted industrial production data.
The third proxy (YM) is constructed by multiplying monthly seasonally adjusted industrial production data times a monthly
wholesale price index, less farm products.
The choice of income proxy does not materially affect any of the conclusions of the
paper. To conserve space, only the results
using the third proxy are reported, but regressions have been run using each of the
The asset exchange variable (TRAD1) consists of the monthly volume of trading on the
New York Stock Exchange in millions of
shares, round lots times an index of common
stock prices (1935-39=100). The volume
series is based on the Exchange ticker, and
excludes odd lots, stopped sales, private sales,
split openings, crossed transactions and/or
"errors of ommission."14
TRAD1 is an imperfect estimate of trading value,
inasmuch as the weights used in the stock price index
may not have reflected the relative trading volumes of
different securities. On the trading volume series, see
U.S. Bureau of the Census, Vol. II, p. 999, note on series



MARCH 1984


Log of
Demand Deposits:
(1) R2 =.980, D-W = 1.87
p =.200 (2.20)
(2) R2 =.985, D-W = 1.85
p =.264 (2.99)
Outside NYC:
(3) R2=.996, D-W = 1.97
p =185 (2.06)
(4) R2 = .996, D-W = 1.97
p =.174 (1.93)
101 Centers:
(5) R2 =.994, D-W = 1.83
p =.164 (1.73)
(6) R2 =.996, D-W = 1.82
p =.267 (2.95)
(7) R2=.9996, D-W =2.19

p =-.512 (-6.52)

(8) R2=.9997, D-W =2.19
p = - . 5 3 3 (-7.21)
(9) R =.9997, D-W= 2.01
p = - . 3 9 3 (-4.72)
(10 R2 =.998, D-W= 2.09
p = - . 4 7 7 (-5.92)
(11) R2 = .9998, D-W = 2.03
p = - . 4 0 4 (-4.90)
(12) R2=.9999, D-W =2.12
p = - . 4 8 5 (-6.08)

Log of
Log of
Trading Nominal

Log of Short-Term
Interest Rate

Commercial Seasonal Dummies
January August Constant











































Sources: Federal Reserve System (1976a): Demand Deposits: Tables 49 and 50, pp. 164-74; 196-206; Prime
Commercial Paper Rates: Table 120, p. 450; Call Loan Rates, New Loans: Table 120, p. 450; Index of Common
Stock Prices: Table 133, pp. 480-81; Volume of Trading on NYSE: Table 135, p. 485. Federal Reserve System
(1976b): Seasonally Adjusted Industrial Production: p. S-27. Friedman and Schwartz (1963): M1, M2, M3: Appendix
A, pp. 710-12. U.S. Bureau of the Census (1975): Volume and Value of Trading on NYSE, 1935-39, Series
X-525—526, Vol. II, p. 1007. U.S. Department of Commerce (1940): Wholesale Prices, All Commodities other than
Farm Products, p. 18.
n =131 observations (February 1919-December 1929.) The method of estimation was ordinary least squares with
first-order autocorrelation coefficient selected by a maximum-likelihood procedure. Durbin-Watson (D-W) statistics
are biased towards 2 in such models. However, an approximation of the Durbin h-statistic, h = (1 - d/2)
(N/(l - N(vara)))1/2, where d is the D- W statistic, N is sample size, and a is the estimate of the coefficient on the
lagged endogenous variable, enables us to reject at the 5 percent level the hypothesis that the errors in the estimated
equation are serially correlated. The t-statistics are shown in parentheses. The t-statistic for p is to its right.
Trading volume, millions of shares X asset price index (see text).
Industrial production index, seasonally adjusted, X WPI, other than farm products, X a scaling factor (.0518) to
make estimates comparable to annual GNP estimates.

This study employs a widely used, although sometimes criticized,15 partial-adjust-

ment model estimated through the use of a
Koyck transformation. Including the lagged
dependent variable on the right-hand side of


See Goldfeld (1973, pp. 581-83). Criticisms center
around the proposition that demanders of money never
actually hold their desired cash balances, and on the

econometric difficulties of constructing a confidence interval around the long-term elasticity estimates.

VOL. 74 NO. 1


the equation implies that previous month's
cash balances (Mt_1) adjusted only partially
to current month's desired level (Mt*). Because regressions are run on demand deposits in New York City as well as in 100
centers outside New York City, this specification facilitates the comparison of the speeds
of adjustment of different monetary aggregates.
A maximum-likelihood procedure is used
to estimate the autocorrelation coefficient p.16
In addition to the above mentioned variables, two seasonal dummies were introduced in the demand deposit regressions to
deal with systematic variation in the
deposit-currency ratio over the year. One
might anticipate the need for a positive
dummy for December to take account of the
large fraction of retail sales that take place
during the Christmas season, and the resulting increased demand for money. In the
1920's, however, almost all of the impact of
the Christmas season shows up in an increase in the demand for currency, as opposed to demand deposits. It is in January,
which typically experiences the largest
month-to-month drop in the amount of currency in circulation, that demand deposits
rise to unusual levels. As merchants deposit
their cash receipts from the Christmas season, and consumers cut back on their currency withdrawals, the deposit-currency ratio
rises, and so, temporarily, does the amount
of demand deposits. By the end of January,
demand deposits begin to fall, as the Fed
traditionally contracts the money supply. But
average weekly January demand deposits
tend to be higher than would otherwise be
the case, as the result of this seasonal variation in the deposit-currency ratio. As the
regressions show, this increase is statistically
independent of variation in the other righthand variables discussed above. The sign of
the coefficient on the August dummy can be
explained as the result of a shift in the
deposit-currency ratio in the opposite direction.17
See Charles Beach and James MacKinnon (1978).
This procedure is a variant on the original CochraneOrcutt technique.
For all years except the recession year of 1921, the
end-of-month currency in circulation figures are higher
for August than July (and continue at higher than



New York City
100 Major Centers
101 Centers



Based on Table 1 estimates. Industrial production
index X WPI less farm products as nominal income
proxy; call loan rate as short-term interest rate.

Note in Table 1 that all the regression
coefficients, with the exception of that on
nominal income in equation (1), are statistically significant and carry the predicted signs.
Regressions including a time trend have been
run, but are not reported. Adding a time
trend does not greatly change the values or
significance levels of any of the reported
coefficients, and such a time trend is not
itself significant when controlling for the
other variables.
Statistical significance is not the same, of
course, as economic importance. Table 2
calculates long-run elasticities of money demand with respect to trading value, dividing
the estimated coefficient by the implied
estimates of 18 Setting aside the combined
average levels throughout the rest of each year). The
beginning of these cash withdrawals, in the absence of
immediate compensatory accommodation, leads to a
drop in the deposit-currency ratio which results in particularly low demand deposit holdings in August, independently of variation in nominal income, trading value,
or interest rates. The August effect is weaker than the
January effect, and is statistically significant for New
York and for the combined regressions, but not for the
100 major centers outside New York. See Federal Reserve System (1976a, Table 110, pp. 410-11).
y is the complement of the estimated coefficient on
the lagged dependent variable: 1n Mt - 1 n Mt_1 =
y(ln Mt* -1n Mt-1), where 1n Mt* represents desired
money holdings. The long-run elasticity of nominal income, calculated using a similar procedure, is considerably less than 1 for all of the monetary aggregates. The
main explanation for this is that monthly GNP is proxied imperfectly, another way of saying that it is measured with error. This tends to bias downward the
estimated coefficient on income. Improvements in transactions " technology" due to experience effects over the
decade, during which nominal income trended upward,
may also contribute.



demand deposits in 101 centers, one can
rank the remaining five monetary aggregates
in the order of their cumulative sensitivity to
trading value fluctuations, as estimated by
long-run elasticity: M3, M2, demand deposits in NYC, demand deposits outside of
NYC, and Ml. However, the speed of adjustment implied by the coefficient on the
lagged endogenous variable tends to rise the
more narrowly one defines the monetary aggregates, and is the highest for demand deposits in New York City. Although Ml and
M3 eventually experience a larger percentage
increase in response to a given percentage
increase in trading value, the impact coefficient is approximately three times larger for
demand deposits in New York than it is for
any of the Friedman-Schwartz monetary aggregates.
Over the period in question, annual nominal income fluctuated from a low of $69.9
billion in 1921 to a high of $102.1 billion in
1929, while trading value on the New York
Stock Exchange fluctuated from an annualized low of $1.6 billion a year (July 1921) to
a high of an annualized rate of $97.8 billion
(October 1929).19 Whereas nominal income's
1921 low was 68.5 percent of its 1929 high,
trading value's 1921 low was 1.6 percent of
its 1929 high. Almost all of the rise in trading value from its July 1921 trough to its
October 1929 peak took place in the post1925 period. One way to consider the economic importance of the Table 2 elasticities
is to ask how much the post-1925 growth in
asset trading changed money growth rates, as
compared with a hypothetical scenario in
which interest rate policy and GNP growth
took their historical levels, but asset trading
remained at its pre-1925 levels. The counterfactual posited, therefore, is one in which
trading value remained constant throughout
the period at the average of its level during
the first 72 months of the sample, but inter19
These estimates are obtained by taking the minimum and the maximum value of the TRAD1 series
(constructed by multiplying a common stock price index
by the volume of trading), multiplying them by the
average price during the base years (1935-39) of the
index, ($26.95) and dividing by 100. Average annual
stock prices calculated from U.S. Bureau of the Census,
Vol. II, p. 1007, Series X-525 and X-526.

MARCH 1984

est rates and nominal income had their actual values.
Dynamic simulations of monetary stocks
(i.e., simulations in which the lagged dependent variables are simulated rather than actual values) using the regression coefficients
reported in equations (1) and (7) were conducted for demand deposits in New York
City, as well as Friedman and Schwartz Ml.
These simulations indicate that, absent the
post-1925 surge in asset exchanges, average
holdings of New York City demand deposits
over the 24-month period 1928-29 would
have been 20.3 percent lower than they actually were. Holdings of Ml would have been
on average 17 percent below their actual
levels.20 These results have important implications.
The decision to raise discount rates as a
means of controlling speculative activity on
the stock market engendered substantial disagreement within the System.21 Experience
in 1920-21 had led to the advocacy of discount policy to control speculation in commodities, where speculation was understood
to mean excessive holding of inventory stocks
in anticipation of future price rises. Such
holdings made an economy particularly
vulnerable to downturns in real activity
inasmuch as a change in expectations regarding future price levels or rates of increase could rapidly change the stock of involuntarily held inventories, leading to an
immediate downturn in production. The
sharp rise in the discount rate in January
1920, and the economy's response to it, gave
ammunition both to those opposed to such
countercyclical policy, who argued that the
rise was too severe, and those in favor, who
argued that the rise should have come
In 1928-29, however, debate concerned
the use of discount policy to combat speculation not in commodities (whose prices were
dropping), but in financial assets, in particu20

New York City demand deposits' actual 24-month
average was $5,379 million. The average for the simulation over the same period was $4,286 million. For M l ,
the corresponding figures are $26,300 million and
$21,824 million.
Friedman and Schwartz (1963, p. 254).
Friedman and Schwartz (1963, p. 231).

VOL. 74 NO. 1


lar, equities. Although there are some similarities between commodity speculation and
speculation in equities, the potential effect of
such speculation on real activity is more
attenuated, and therefore the rationale for
attempting to use monetary policy to control
it is less compelling. In proposing to use high
interest rates to moderate an explosion in
asset prices in a deflationary environment
characterized by rapid real growth, the System was moving into uncharted waters, a
fact recognized both by proponents and opponents of such policy. There were concerns
among opponents—in retrospect, legitimate
—that such higher rates would adversely
affect real economic activity, much as discount rate policy in 1920 had helped plunge
the economy into one of the shortest but
most severe recessions in U.S. history. However, opponents of higher interest rates did
not disagree with proponents regarding the
desirability of some Federal Reserve action
to deal with developments on the stock
market: they simply believed that asset prices
could somehow be deflated through the use
of direct pressure (selective controls on loans
for speculative purposes) without affecting
real activity. Moreover, both opponents and
proponents lacked an awareness of the additional source of transactions demand resulting from asset exchanges.
A plausible case can be made that this
ignorance resulted in a tighter monetary
policy than otherwise would have obtained.
Suppose there had in fact been no such
additional source of transactions demand (or,
alternately, no rise in the value of exchanges).
The simulations described above indicate that
had asset exchanges remained at their pre1925 level, the Fed would have been confronted, already in 1928, with the beginnings
of a fairly precipitous decline in monetary
aggregates (or, in the case of the broader
aggregates, their rate of growth). One cannot
predict exactly what the System's response to
this would have been, but there is good
reason to believe that such developments
would have strengthened the hand of those
who opposed the high interest rate policy,
and that the policy would have been moderated, thus avoiding, or at least making less
severe the downturn, centered in construc-


tion and automobiles, that was gathering
momentum already in the second quarter of
In the event, there was a complete failure
to understand the nature or dimensions of
the transactions demand for cash arising from
the rising volume of asset exchanges. One
can, with the benefit of hindsight, argue that
observers should have been puzzled by the
fact that the rise in interest rates in 1928-29
had little effect on monetary growth rates.
Optimists apparently looked at this evidence
and concluded that, in the context of the
Wall Street mania, high interest rates were
not adversely affecting the real side of the
economy, since holdings of cash balances,
which they implicitly assumed to be entirely
GNP related, continued to grow at approximately the same rate as before, contrary
to what one would have expected in more
normal times.
Unfortunately, real activity was being adversely affected. The steady growth in monetary aggregates did not, according to these
regressions, reflect a steady growth in GNPrelated transactions demand. The interpretation suggested by these regressions is that the
rise in interest rates, as theory predicts, led
to a general decline in desired money holdings, but that this decrease was more or less
compensated for by the surge in transactions
demand coining from the stock market, leaving Ml, for example, virtually unchanged
from September 1925 to September 1929.
III. Further Econometric Issues
If the transactions demand for money were
almost exclusively associated with GNPrelated transactions, then it would be reasonable to speak of a CPI, WPI, or GNP deflator as approximating its "price," and deflate
both nominal income and the monetary aggregate by such a index. But, if the argument
of this paper is correct and transactions in
secondary asset markets exercised a nonnegligible impact on the transactions demand
for money, this procedure for generating a
series of real cash balances is subject to
criticism. The income proxy can be deflated
by the WPI to give us industrial production,
and the trading value index can be deflated



MARCH 1984


Log of
Log of
Log of
Call Money







-.393 (-4.71)




- .0144


- . 3 8 4 (-4.600)






P = - . 5 1 7 (-6.619)
D-W = 2.128




P =
D-W =

Instruments include lagged dependent variable, constant, and lagged values of logs
of trading value, nominal income, and call money rate. Correction for serially correlated
errors has been made.

by the asset price index to give us trading
volume, but what is the appropriate deflator
to use for the stock of money? That obviously depends on how important is the asset
exchange component of the transactions demand for money. The more important this
component, the larger should be the weight
attached to the asset price index in the
monthly composite deflator. Were asset prices
and goods prices positively correlated over
the period in question, the relative weighting
of such price indexes would not be empirically of great concern. But, for the 1920's, a
series of real balances calculated using a
composite deflator is very sensitive to the
weighting procedure used, because monthly
goods prices (the WPI) and asset prices (a
stock price index) were negatively correlated
(r = — .384) over the 132-month sample.
Small changes in the prior specification of
the weighting scheme will produce major
changes in the calculated series of real balances. Moreover, that weighting scheme cannot adequately be specified without first
reaching conclusions regarding the fundamental questions at issue in this study. These
considerations argue, I believe, for a nominal
specification, not because people necessarily
suffered from money illusion and exhibited
demand for nominal balances, but rather
because such a specification permits testing
of an important hypothesis in a manner that
does not require prejudging the outcome of
that test.

Regressions were nevertheless run on New
York demand deposits, deflating all nominal
variables (demand deposits, trading value,
and nominal income) by the WPI less farm
products. These still show economically important and statistically significant estimates
of the elasticity of the monetary aggregate
with respect to deflated trading value.23
However, the results are somewhat weaker,
and, as indicated, I do not feel that this
procedure is theoretically satisfactory, because it assumes that asset prices have no
weight in the nominal balance deflator.
The assumption of monthly interest rate
pegging is an abstraction—a defensible one
—but nevertheless an abstraction. There
are legitimate reasons for worrying about
whether disturbances in the amount of nominal balances demanded and supplied were
totally uncorrelated with interest rates, or
indeed with the other right-hand side variables. Table 3 reports instrumental variable
estimates, conducted using a procedure suggested by Ray Fair (1970). The instruments
For the entire sample, the impact elasticity of deflated demand deposits in New York City with respect
to deflated trading value =.023 (t = 2.94). If one restricts the sample to the 1921-29 period (108 observations), the elasticity estimate and t-statistic are higher:
elasticity = .036 (t = 4.29). Right-hand variables in the
equations were the lagged endogenous variable, the log
of deflated trading value, the log of industrial production, the log of the call money rate, and the two seasonal

VOL. 74 NO. 1


include the lagged dependent variable, and
lagged values of all other right-hand variables. The estimates in Table 3, designed to
correct for possible simultaneous equation
bias, do not markedly affect the conclusions
of this paper. For example, the elasticity of
M3 with respect to trading value is .111
using ordinary least squares; the instrumental variable estimates imply an elasticity of
Econometric issues aside, there remain alternate interpretations of these results. There
is no necessary connection between the
volume of stock market trades and the asset
price index, but, as an empirical matter, they
were closely correlated in the 1920's (r =
.937). Given this empirical relationship, one
alternate interpretation emphasizes the influence of wealth on the demand for transactions balances. Since wealth grew with the
value of securities, these regressions might
reflect the fact that people demanded and
paid the opportunity cost of carrying higher
transactions balances at given (Y, r) combinations, but higher levels of wealth. The statistical results would be due to a spurious
correlation of the value of asset exchanges
with the value of assets. A second alternate
interpretation argues that the spurious corre24
In recent years, a number of papers have been
published utilizing econometric procedures to test for
"causality," where the direction of causality cannot be
specified on a priori grounds and the assumption of
instantaneous joint determination, reflected in the use of
simultaneous equation methods, is rejected as inapplicable or unrealistic. The results of such causality tests
seem to be quite sensitive not only to the choice of lag
truncation, but also to the prefilters applied to the data.
Such sensitivity seems to be particularly acute in the
case of the Sims tests, although the conclusions of Edgar
Feige and D. K. Pearce (1979) cast some doubt on the
procedures in general. Nevertheless, I did run a multivariate Granger test on the Friedman and Schwartz M1
data, logging and first differencing the logs of all variables, and using lags of 18 months. Two regressions
were run, the first including 18 lagged values of the
dependent variable, income (YM), trading value, and
interest rates (call money rate) and a constant, and the
second minus the trading value variables. The F-ratio

((RSS- URSS)x(n - k))/(URSS x q) = 2.07
where n =113, k = 12 and q = 18. The upper 5 percent
point for F(18,41) = 1.87. This result is consistent with
the Table 1 results.


lation is with the volume of exchanges rather
than the value of assets. Suppose that a
growing volume of asset exchanges reflected
increased uncertainty, and that increased uncertainty gave rise to an increased demand
for liquidity (shift in liquidity preference).
These regressions would then be picking up
the fact that the demand for money as an
asset, not its demand for transactions purposes, had increased due to increased uncertainty, which also affected the volume of
The best available measure of transactions
velocity is the debit-deposit ratio—the ratio
of the total monthly flow of debits to deposit
accounts to the average stock of deposits
held. Both of the above hypotheses imply
that high levels of asset trading would have
been associated (at any interest rate) with
higher holdings of stocks of transactions balances (the denominator of a debit-deposit
ratio) without being associated with higher
flows of debits (the numerator). Therefore,
both of these alternate hypotheses imply that
fluctuations in the value of asset exchanges
should, ceteris paribus, have been inversely
associated with transactions velocity.
IV. Exchange Trading and Deposit-Turnover
Econometric work on short-term variations in velocity is relatively rare, and that
which has been done has primarily considered income velocity as the dependent variable. Such work has concluded that income
velocity tends to vary procyclically, and the
most widely accepted explanation for this is
that interest rates vary procyclically and
velocity is positively sensitive to interest
rates.25 Interest rates influence velocity because the higher the rate of return on alternate financial assets, the higher will be the
individual and aggregate ratio of expenditures to non- or low-interest-bearing cash
balances.26 This hypothesis should also apply
Over the 1919-29 period, the monthly prime commercial paper rate is negatively correlated with industrial production, although the call money rate does
vary procyclically in this sample.
A second hypothesis, advanced by Friedman, calls
less attention to interest rates. During the cyclical up-



to regressions using a measure of transactions velocity.
If the results of Table 1 are to be explained using either of the two alternate interpretations suggested above, one would in
addition expect to find a negative coefficient
on trading variables in a velocity regression.
Such a negative coefficient would result from
the posited association of asset trading with
a growth in the denominator, but not the
numerator of the debit-deposit ratio, due in
the first instance to the growth in transactions balances at given (Y,r) combinations
related to higher wealth levels, for which
asset prices were a proxy, and in the second
instance to the growth in the asset demand
for money associated with uncertainty (for
which trading volume was a proxy). In contrast, if the argument of this paper is correct,
velocity should covary positively with the
volume of trading on the New York Stock
swing, he argues, measured income is greater than permanent income (which largely determines the stock demand for money) so that measured income velocity
(GNl/M) is high during expansion. Similarly, in the
cyclical downturn, measured income is less than permanent income, so GNI/M is low. The stock demand for
cash balances is more stable over the business cycle than
measured income, leading to procyclical movements in
measured velocity. Friedman's hypothesis suggests that
income should be positively associated with velocity,
independently of interest rates. This hypothesis has been
criticized by Laidler on the grounds that transitory
increases in income increase wealth, and that "elementary notions" of liquidity preference suggest that money
balances might receive a portion of it. See Friedman and
Schwartz (1963, pp. 642-43); Laidler (1966, p. 56).
= the elasticity of the stock demand for
money with respect to trading value, and
elasticity of the flow of debits with respect to trading
values. If
then trading value will not affect
velocity. Two extreme cases would be (a)
and (b)
. In case (a) neither debits nor
deposits held are affected by trading value, and in case
(b), equally unrealistic, deposits held rise dollar for
dollar with debits. The two alternate interpretations of
the Table 1 results discussed at the end of Section II
imply that
and in particular that
close to 0. The arguments and evidence of this paper,
however, suggest the contrary, that
, which
implies positive elasticity of velocity with respect to
trading volume, as Table 4 shows. Nevertheless, the
Table 4 results cannot discriminate between
= 0 and
In the former case, that of
costlessly flexible velocity in the financial circulation,
there would be little reason to expect any impact of



MARCH 1984

The regressions reported in Table 4 have
as their dependent variable the debit-deposit
ratio. The regressions are run for New York
City, for 100 centers outside New York,28
and for 101 centers, including New York. All
three series exhibit strong seasonal regularity, (generally strongest in the outside New
York City series), and six monthly dummies
are included to capture these effects. A partial-adjustment model is again estimated, although without an autocorrelation correction
in equation (2), where it is not needed. The
call loan rate is used as the short-term interest variable, except for the outside of New
York regressions, where an equation using
the prime commercial paper rate (3) is also
reported. As before, instrumental variable
estimates, using a procedure similar to that
described for Table 3, result in only minor
variations in coefficient estimates, and in this
case are not reported. Calculations of Durbin
h-statistics, conducted as described in the
note to Table 1, again reject at 5 percent the
hypothesis of serial correlation in the estimated equations.
The results in Table 4 show unambiguously that trading volume as well as interest
rates exercised a positive influence on transactions velocity in the 1920's. They also show
that the immediate impact of a surge in
trading volume on deposit turnover was three
to five times higher in New York City than
outside of New York City, depending on
which of equations (2) and (3) one uses as
comparison. The long-run elasticity of deposit turnover with respect to trading volume
trading on the real side of the economy. The arguments
of this paper, therefore, depend on both the velocity
(Table 4) and the stock demand for money (Table 1)
Regressions run on data for the 100 centers outside
of New York required some transformation of the series
presented in Banking and Monetary Statistics, because
the debit data is reported for 140 centers outside of New
York (Table 51), whereas the deposit data is for 100
cities outside of New York (Table 50). However, in
Table 55, Federal Reserve Board statisticians have adjusted downward the debit data to make them comparable to the deposit data in order to calculate annual
debit-deposit ratios. The implicit annual downward adjustment factors applicable to the debit data were extracted from Table 55 and these annual factors were
multiplied by the monthly observations to create a
monthly debit series comparable to the monthly deposit

VOL. 74 NO. 1



New York City

1919-29 b

100 Centers
Outside NYC

Right-Hand Variable


Log of Lagged
Endogeneous Variable
Log of Trading
Volume, NYSE
Log of Industrial
Log of Prime
Commercial Paper Rate
Log of Call
Money Rate, New Loans
Monthly Dummies:









(.606) (-2.19)

101 Centers,
Including NYC

Sources: (in addition to those for Table 1): Federal Reserve System, Banking and
Monetary Statistics, 1919-1941 (1976): Debits to Deposit Accounts, Table 51, p. 234;
Annual Deposit Turnover Rates, Table 55, p. 254.
The monthly sum total of debits to deposit accounts divided by the average weekly
(Wednesday) stock of demand deposits. Debit figures for 140 centers outside of New
York City have been adjusted downward to make them comparable with deposit figures
(see fn. 28).
= 131 observations (February 1919-December 1929). The method of estimation
was ordinary least squares, with first-order autoregressive correction in equations (1),
(3), and (4). The t-statistics are shown in parentheses.

displays a similar multiple: .31 in New York
City, according to equation (1), vs. .072-.074
outside of New York, according to equations
(2) and (3). These results cast doubt on the
two alternate explanations considered for the
Table 1 results.

Discussions in this section must be viewed as
more speculative than the conclusion reached
in Sections II and III. Nevertheless, preliminary results for the entire 1919-41 period
(275 observations) do show statistically significant although somewhat smaller elasticities of M3 with respect to trading value.29

V. Conclusions
These findings naturally lead one to ask
whether such relationships can be generalized to other periods, and one must move
cautiously in extrapolating, without adequate
empirical work, an effect that I believe can
be convincingly demonstrated for the 1920's.

The impact elasticity of M3 with respect to trading
value is estimated = .002 (t = 2.98) over the entire period.
Long-run elasticity = .0525, based on a y of .0387. The
economic history of the 1930's is so unusual, however,
that much more empirical work is necessary before
meaningful statements can be made about the impact of
asset exchanges on the macroeconomic history of that



Analogous mechanisms may today exercise
perturbing influences on the transactions demand for money. For example, maturation
of large numbers of All-Savers Certificates in
October of 1982 was associated with an unexpectedly large increase in monetary aggregates, presumably the result of an accommodated increase in the transactions demand
for cash to be used in exchanging these assets for other assets. A plausible demonstration of such effects for the 1920's opens the
door to more sophisticated investigations of
such possibilities.
Current claims in the 1980's that financial
takeovers, such as that of Conoco by Dupont,
absorb cash balances have an air strongly
reminiscent of the 1920's, both in the quality
of the analysis evident, and in the opposition
to such ideas generated among monetary
economists. Yet, if the arguments of this
paper are accepted, one must conclude that
proponents of absorption in that earlier decade were partially correct in their intuition,
although for reasons they did not always
(especially in the United States) articulate
well. The same may turn out to be the case
with respect to these current discussions.
Similarly, this analysis of the 1920's provides
a perspective on the influence of international asset exchanges on the transactions
demand for dollars, an influence that was
underlined by the rise in monetary aggregates associated with the transfer of assets to
Iran under the term of the hostage release
agreement.30 More generally, currency substitutability between dollar, mark, and yen
may play a role analogous to that of the New
York Stock Exchange in introducing instability in the demand for dollar balances in the
Setting aside the research opportunities
opened up for subsequent decades, this paper
does suggest a number of new interpretations
of some key aspects of the macroeconomic
history of the 1920's. It explains the Friedman-Schwartz puzzling result that income
velocity rises hardly at all towards the end of
the 1920's, in spite of record high interest

Wall Street Journal, August 17, 1981, p. 20.
I base this remark on discussion with Ronald
McKinnon. See his 1982 article.

MARCH 1984

rates.32 It suggests a way of understanding
the relationship between trading on the New
York Stock Exchange and the downturn in
the German economy in 1928, a relation that
has been rejected by those who deny that
stock market "speculation" could have
"absorbed" funds previously loaned in
Germany.33 Finally, it provides some insight
into the proximate causes of the downturn in
real economic activity in the United States,
usually dated from August 1929.
The U.S. monetary authorities allowed the
money stock, by any number of definitions,
to grow quite rapidly after the recession of
1920-21. The Ml stood at $20.5 billion in
January 1922, then rose to $26.2 billion four
years later (September 1925), approximately
the same level recorded for September 1929.
Ml and M3 also grew at slower rates after
1926. Beginning in 1925, and picking up
steam in late 1927, however, trading volume
and value on the New York Stock Exchange
began to rise to historically unprecedented
levels. Confronted by pressure at the discount window to provide more reserves, the
See Friedman and Schwartz (1963, Chart 16, p.
197). The resolution is that transactions velocity, which
was not proportional to income velocity, rose quite
dramatically toward the end of the decade, as one might
have expected. This emphasis on the potential influence
of fluctuations in the transactions-income ratio may also
provide insight into a current macroeconomic issue.
Many macroeconomists are puzzled by why velocity has
grown so slowly since 1981, more slowly than periods in
the 1970's characterized by nominal interest rates in the
same range (see Wall Street Journal, May 24,1983). The
problem again may be that income velocity is not the
right variable. The April 1983 Federal Reserve Bulletin
(p. A-16) indicated that between 1980 and 1982, debitdeposit ratios in all insured banks rose from 198.7 to
324.2, a 63 percent increase in the space of two years. As
of February 1983, that figure had risen even further, to
361.3. This evidence suggests that the demand to hold
cash balances for transactions purposes may be higher
than policymakers would normally expect, given current
levels of real output and interest rates, perhaps explaining policymakers' tolerance of a money growth rate
exceeding 12 percent (at an annualized rate) in the first
half of 1983.
In a recent discussion of this episode Peter Temin
briefly entertained the possibility that the "increased
volume of activity on the New York Stock Exchange
required an increased quantity of money for transactions purposes..." before rejecting it on the grounds
that "it is hard to believe [transactions demand] rose
very much" (1976 p. 154).

VOL. 74 NO. 1


Fed first tried to clamp on selective credit
controls, threatening to refuse discount if
loans were for "speculative" purposes.34
By and large, the System viewed such loans
solely with regard to their impact on asset
prices, apparently maintaining that asset
prices, like goods prices, required a continual
flow of expenditures to sustain them. There
was little discussion of the possible role
played by such credit expansion in satisfying
(if this paper is correct) the rise in demand
for transactions balances associated with the
unprecedented rise in the volume of financial
transactions, an accomodation that was
essential if such trading volumes were to
continue along with normal GNP related
transactions. Eventually, the System determined that selective controls were arbitrary and discriminatory, and permitted interest rates to rise to very high levels—the
only course of action (outside of major institutional changes) consistent with maintaining a policy of virtually no annual growth in
Ml in the last three years of the decade.
Some corporations benefited from the ability to raise long-term expansion capital
cheaply in the inflated stock market. But
many other firms and households began to
curtail their investment and consumption demand, especially that for consumer durables
such as automobiles,35 thus helping to precipitate the downturn in real GNP signified
by the drop in industrial output starting in
August. It is reasonable to believe that part
of this decline was in response to the very
high prevailing interest rates. The persistence
of those rates, in turn, can be linked to the
System's failure to understand the contribution of the rising volume and value of stock

Friedman and Schwartz (1963, pp. 254-66).
See Temin (pp. 64; 171-72) for a discussion of the
importance of consumption declines in 1930. However,
Temin attributes the decline in consumption to the
effect of the stock market crash on household wealth.
Yet seasonally adjusted automobile production peaked
in June 1929, several months before the crash. I attribute part of the decline in consumer durables production and consumption, as well as the failure of construction to continue to recover after mid-1928, to the tighter
credit conditions associated with the Fed's antispeculative policies. See Survey of Current Business (January
1930, pp. 2-3, 7, 12, 17, 49, 65). For a more extensive
discussion, see my 1984 article.


trading to the transactions demand for money.36 It was in this sense, and really in this
sense alone, that one can speak of stock
market speculation absorbing cash balances,
thereby adversely affecting the real side of
the economy.
This argument does not deny the possibility that
autonomous forces were generating concurrent contractionary shifts in the IS schedule. Nevertheless, high real
interest rates prevailing in 1928-29 do suggest that the
deflationary impulse came primarily from movements in
the LM not the IS schedule.

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