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Federal Reserve Bank of Minneapolis
1985 Annual Report
The Fed's Money Supply Ranges:
Still Useful After All These Years

Contents
President's Messege

The Fed’s Money Supply Renges:
Still Useful After All These Years

Statement of Condition

Earnings and Expenses

Directors

Officers

President's Message

The economic essay which comprises this year’s Annual
Report addresses a subject that is, in my judgment, a critical
issue in monetary policy determination. Specifically, it
attempts to identify and to explain the valuable roles of
growth ranges for the monetary aggregates and to contrast
those roles with some popular misconceptions about the
appropriate use of the aggregates in the policy process.
While the immediate provocation for this essay was the
pronounced overrun in M l growth last year and some of the
commentary that ensued, it seems to me that far broader
concerns are raised by discussion and assessment of the 1985
experience. Thus, we argue here that in conducting policy, it is
inappropriate to take the money supply measures as targets in
the sense that policymakers ought to react to them irrespec
tive of other developments in the economy and in financial
markets. Such an approach is inefficient and, more impor
tantly, runs the risk of interfering unnecessarily with attain
ment of the ultimate objectives of policy-high employment,
sustainable economic growth, and stable prices.
Growth ranges for the monetary aggregates, although not in
our judgment legitimate policy targets, are valuable to policy
makers and the public in other ways. To my mind, the ranges,
if appropriately established, effectively add discipline to policy
determination and simultaneously provide a mechanism for
Congress and the public, as well as Federal Reserve policy
makers, to monitor and review performance. The ranges are
also an effective means of communicating to a broad and
diverse audience the stance of monetary policy on the assump
tion that the economy performs about as the policymakers
expect. Finally, behavior of the monetary aggregates provides
policymakers useful information about their ultimate objec
tives, a role played, of course, by a wide range of economic
time series.
In most respects, the views we are presenting here are based
on principles derived from economic theory. This does not
say, however, that they are universally accepted within the
economics profession or by policymakers generally. In this
sense, they represent a personal perspective on the role of the
aggregates in policymaking, and I need to emphasize that we
are not speaking for others in the Federal Reserve on these
issues.
Preparation of this essay was a team effort. I very much
appreciate the contributions of Bob Litterman, Preston Miller,
Kathy Rolfe, Art Rolnick, and Phil Swenson.

Gary H. Stern
President

Federal Reserve Bank of Minneapolis
1985 Annual Report
The Fed's Money Supply Ranges:
Still Useful After All These Years

The past year was a difficult one for the
Federal Reserve as a monetary policymaker.
Although the U.S. economy continued to
expand and inflation remained subdued, the
Fed’s narrow measure of the money supply
(M l) leaped far above its announced range.
The Fed thus had to choose between trying
to bring this measure back within its range,
which could jeopardize the recovery, and
ignoring the money measure’s faster-thanexpected growth, which could lead to
higher inflation. The Fed chose the latter
course.
The Fed’s situation did not go unnoticed.
Many seemed to blame the Fed for allowing
the money supply to grow so fast; they criti
cized the Fed for a lack of commitment to
its own strategy of targeting the money
supply and thus to its own long-run goal of
reducing inflation. Others seemed to blame
the Fed for its choice of targets; they criti
cized the use of money measures and called
for a look at other variables that might be
more controllable.
While public scrutiny of monetary policy is,
of course, appropriate, such criticisms are
not. They seem to be based on a misunder
standing of the role that money ranges play
for the Fed. It uses these ranges as economic
theory says is best, and that is not as targets.
That is, they are not meant to be goals
which the Fed will aim to achieve regardless
of what else is happening. The only things
the Fed treats that way are things like the
price level, employment, and output; infor
mation on anything else— including

money— is only useful for what it can tell
the Fed about whether or not those goal
variables are on target. What the money
ranges are meant to be are indicators to the
public of the general course of monetary
policy if the economy performs as expected.
The ranges give the public a simple, short
hand form of the complicated policy rule
which the Fed implicitly uses to decide when
and how to act given its goals, the econo
my’s interrelationships, and uncertainties.
Any specific ranges tell the public just what
the Fed’s actions will imply for the growth
of money during that period if the usual
economic patterns persist. The ranges also
provide a simple, though not infallible, way
for the public to monitor the Fed’s
performance.
From this perspective, the experience of
1985 should look quite different to Fedwatchers. The exceptionally rapid growth in
M l was good reason for the public to ask
for an explanation, since it could have indi
cated a change in the Fed’s policy. But the
M l growth surprised the Fed as much as
anyone. It turned out to be due to a change
not in Fed policy but in the economy, in
particular, in the way the public was manag
ing money. While this change increases the
uncertainty about the relationships between
money and the rest of the economy, it does
not make the money ranges useless for their
role as indicators of Fed policy. Instead, it
simply suggests that M l ’s range for 1986, to
reflect the increased uncertainty, should
probably be somewhat wider than those for
recent years.

The Best Way to Make
Monetary Policy
The situation of a U.S. policymaker is not
easy in any year. The Fed has a somewhat
vague general objective of maximizing the
current and future welfare of society, which
all public policy institutions share. Congress
has translated that into a few broad operat
ing goals— stable prices, high employment,
and economic growth, for example— but
these are not necessarily compatible goals,
the Fed has no direct control over them, and
they are measured only infrequently. The
Fed does have direct control over a few
financial instruments— bank reserves and
the discount rate, for example— which it
can change as often as daily, but these are
far removed from the goals; movements in
the instruments can influence the goal varia
bles only through a long chain of other vari
ables. The Fed has data on these other
variables— including various measures of
the money supply— some of which are
available more frequently than data on goal
variables. But these it can’t control directly
either. It can only influence them to varying
degrees, with varying degrees of uncertainty,
by adjusting its instruments.
W hat’s a policymaker to do? The Fed does
what economic theory says is best for a
decisionmaker in this situation: It uses all
the information available at each point in
time to move as close as possible to its
broad goals. This means not targeting
anything except those goals. (See the list at
the end of this essay for suggested reading
about the economic theory behind this opti
mal strategy.)
Targeting in this context means just what
one might guess: aiming to hit particular
values. Again, the Fed targets the variables
that represent its broad goals (variables like
a price index, the unemployment rate, and

the gross national product). For any period,
the Fed aims at its targets by determining as
best it can— using everything it knows
about the past and current values of all vari
ables and their relationships— paths for the
goal variables which for that period repre
sent the best possible outcome, the closest
the goal variables can get to their targets
from where they currently are. This involves
ranking the various possible outcomes that
the various settings of its instruments can
achieve, since movement toward one target
can unavoidably interfere with movement
toward another. The Fed then sets its instru
ments as is consistent with the best (the
highest-ranked) possible outcome. As new
information becomes available, the Fed uses
it to take aim again— to determine how far
from the targets the goal variables now
seem to be and how close they might be able
to get— and adjusts its instruments
accordingly.
In this strategy, the Fed’s money measures
are not targeted. They are instead among
the many variables the Fed uses to deter
mine how next to aim at its goals by adjust
ing its instruments. (They are thus known as
information variables.) At each point in
time, the Fed predicts paths for information
variables that seem historically consistent
with the current best paths for its goal vari
ables and, as new data arrive, compares
them to the predictions. Since information
variables are not targeted, not every devia
tion from their predicted paths will warrant
a response or an attempt to fully offset the
deviation. What matters to the Fed is not
what these deviations mean for the informa
tion variables, but what they mean for the
goal variables’ movements toward their
targets. The Fed determines when and how
to respond by studying the estimated histor
ical relationships and uncertainties among
all known variables and the Fed’s instru
ments. Given any new bit of information, a
deviation of a variable from its predicted
path, the Fed decides whether and how its

best possible outcome has changed and how
it should adjust its instruments so they now
lead to that outcome. In practice, this
complicated policymaking process may be
somewhat informal and unsystematic.
Nevertheless, the process is best character
ized as a policy feedback rule that describes
the best setting for the Fed’s instruments
given its goals, their rankings, and all the
available information. (This rule is generally
what is meant by the term Fed policy.)
This monetary policy strategy of using vari
ables like the money measures as providers
of information about targeted goal variables
is better than targeting the information vari
ables themselves. Unlike targeting, the infor
mation variable strategy uses all available
information and is not likely to lead the Fed
to act in ways inconsistent with its goals. If
an information variable were targeted, the
Fed’s efforts to keep it on target might make
the Fed ignore information that other varia
bles were offering about its real goals. Not
targeting anything but those goals means
every piece of available information is
noticed. Similarly, if an information variable
were targeted, the Fed’s actions to keep it on
target might make it mistakenly lead the
economy away from the real goals. Not
targeting information variables means
responding to their deviations only to the
extent necessary to keep the economy
moving as close as possible to those goals.
Note that this best way to conduct mone
tary policy is quite different from the view
many people seem to have of the Fed’s strat
egy, at least with regard to its money supply
measures. The Fed does not, in a strict
sense, target these measures, as many seem
to believe. Moreover, in the information
variable strategy, predicted ranges for these
measures have no particular purpose. Every
movement in the money measures away
from their predicted paths is noticed and
valued for whatever significance it has for
movements in goal variables.

Policy Indicators
This is not to say that money supply ranges
are useless to the Fed. They are valuable as
indicators to the public and Congress of the
Fed’s policy intentions and performance.
■ Why Indicators?
Certainly telling the public something about
monetary policy is appropriate. This policy
affects people, individual decisionmakers,
not just impersonal variables. They are the
society whose welfare the Fed is aiming to
maximize. And that welfare is affected by
how much they know about what the Fed
intends to do.
O f course, not every individual is made
better off by any particular government
policy. People in different circumstances can
be affected quite differently. Borrowers and
lenders, for example, are affected differently
by a policy that results in lower interest
rates, after adjusting for inflation (lower
real interest rates, that is). Lower real rates
would help borrowers because they would
have to give up less real income to pay off
their loans. But lenders would obviously be
hurt by this policy since their investments
(the loans) would earn them less real
income. The choice of the policy that results
in lower real interest rates, like any other, is
a choice with individual gainers and losers.
Making such a choice in a democracy—
weighting the interests of different groups
of people— is generally considered a politi
cal task, one appropriately done by the
public’s elected representatives. Monetary
policy choices are not exceptions. However,
Congress established the Federal Reserve as
a fairly independent unit within the govern
ment, because some independence was
considered important for implementing
policy. The Fed contains no elected officials.

(Its governors are appointed by the Presi
dent.) The Fed thus has a responsibility to
announce its policy plans to the public, to
provide an opportunity for Congress, their
elected representatives, to evaluate and
influence those plans.
But the choices of individual members of
the public will be influenced by the Fed’s
plans whether or not they are announced.
People making economic decisions pay
attention to all relevant information, and
most recognize that Fed policy is relevant; it
will no doubt have some effect on the value
of their dollars, for example. If the Fed does
not tell the public its policy, therefore,
people will try to guess it, and that could
make many people worse off. It means
resources which might have been used
productively will instead be used to reduce
the uncertainty about policy. That means
consumption and output will be less than
they would have been otherwise. And since
uncertainty about policy will not be elimi
nated, just reduced to varying degrees,
people will not be able to make decisions
which will make themselves as well off as
they might be. Announcing monetary policy
plans, in other words, helps individuals
maximize their own welfare.
How the Fed announces its plans matters,
too. It must be in some way the public can
use to watch how the Fed actually performs
so that the Fed knows it must explain if it
seems to act differently. For if the Fed does
not face such discipline, it may find a
change from the best plans tempting. And if
the public cannot easily monitor the Fed’s
performance, they may act to make such a
change inevitable.
The Fed’s announced plans, remember,
should be those based on its (and Congress’)
judgment of the best possible outcome for
its goal variables. The achievement of that
outcome usually depends on how commit
ted the public believes the Fed is to its best

policy. If the Fed is viewed as committed,
the best outcome will likely be achieved. But
if there are no formal ways to guarantee Fed
commitment, the public will have good
reason to be skeptical about it. For like
many other government policies, the best
monetary policy is not time consistent; as
time goes by, that is, the Fed may no longer
want to follow it. Instead, the Fed may want
to change policy in order to take advantage
of decisions the public commit themselves
to, to achieve outcomes it could not have
achieved otherwise. Eventually, though, the
public will come to expect the Fed to change
its policy, and they will act to protect them
selves when it does. Those actions will,
then, ensure a policy change and an actual
outcome worse than the best.
To make this more concrete, consider a
simple hypothetical example involving infla
tion and wage contracts. Suppose first that
the Fed must commit to implement what it
sees as the best policy plan. As it makes that
plan, it notices that the economy includes
some wage contracts that were negotiated in
previous periods; that is, the dollar amount
of the wages of some workers is fixed for
the current period. Then, in that period, the
Fed’s best policy may be to inflate, or raise
the price level, more than people who nego
tiated the contracts expected in order to
reduce the real value of wages and so stimu
late the economy. (If workers’ dollars buy
less, the workers cost less; so higher infla
tion encourages firms to hire more.) In
future periods, though, the Fed’s best policy
may be to not inflate at all, because other
wise people would build the inflation into
their wage contracts and the result would
just be higher inflation with no higher
employment. So, in sum, the Fed’s best
policy is to inflate only in the current
period. Since here the Fed must implement
its plan, it does. People expect it to and act
accordingly. And the result is no inflation
after the first period.

Now suppose the Fed is not forced to
commit to its best policy. The Fed will still
observe fixed wage contracts, based on
particular expectations for inflation. And
the Fed will still initially decide to inflate in
the current period and not to inflate in
future periods. If people believe the Fed is
committed to that policy, they will negotiate
new contracts expecting no inflation in
future periods. But as each new period
arrives, the Fed will want to reconsider its
policy. In each period, just as in the first, the
Fed will observe wage contracts based on
expectations of no inflation, so that it will
decide to inflate in that period and never
again. The policy (rule) it will actually be
following, though, will be to inflate every
period— a clear change. This policy cannot
work for long, of course. People will quickly
begin to expect the Fed to inflate more than
before and will begin to build that expecta
tion into their contracts. This will make the
Fed want to at least match that expectation
in order to prevent a drop in employment
(due to a rise in the real cost of workers).
The inflationary spiral will continue until
the inflation/unemployment tradeoff is no
longer attractive to the Fed. No formal
commitment in this example, then, will lead
to some inflation rather than no inflation,
without any increase in employment.
In summary, the policy that is best when the
Fed is committed— here, no inflation— is
not time consistent when the Fed is not
committed. And the policy that is time
consistent when the Fed is not committed—
here, some inflation— is worse than the
best when the Fed is committed.
Announcing Fed policy in a way that the
public can easily monitor can increase the
Fed’s commitment to the best policy and the
likelihood that the best outcome will be
achieved. If the Fed knows the public can
see its behavior and demand an explanation
or enforce discipline if the Fed seems to be
acting in a way inconsistent with its plan,

the Fed is less likely to act that way. And
with such a monitoring system working, the
public is less likely to expect such a change
and act in ways that encourage it.
■ Why Money Ranges?
To completely communicate monetary
policy to the public, the Fed might give them
its feedback rule— how any particular new
piece of information will result in an instru
ment change given the Fed’s goals, the econ
omy’s interrelationships, and the inherent
uncertainties. This rule, however, is mainly
implicit in the Fed’s behavior; it is too infor
mal, complex, and possibly unsystematic to
describe explicitly. What the Fed tells the
public thus must be simpler than this rule
but clearly related to it.
Congress must have considered ranges of
growth in the Fed’s various money supply
measures adequate ways to indicate policy,
because it enacted laws specifying their use.
In regular monetary policy reports to
Congress, the Fed is required to reveal
planned annual growth ranges for these
measures, along with planned annual values
for its goal variables.
Congress’ choice of the money growth
ranges is not unreasonable. The money
measures are in the right position to stand
in for the Fed’s feedback rule; they are influ
enced by the Fed’s instruments and have had
quite stable relationships to its goal varia
bles. Planned growth in these few measures
is not hard to understand. And growth
ranges are better than paths as policy indi
cators because they are more representative
of the feedback rule. Ranges take into
account the fact that the Fed doesn’t, in a
strict sense, target money. Again, it responds
to deviations from money’s predicted path
only to the extent that the feedback rule
says is appropriate to get the targeted goal
variables back on track (moving as close as
possible to their targets). Given what is

happening to the other variables and inher
ent unpredictability in economic relation
ships, the Fed’s response to money
deviations will not generally keep money on
track (on its predicted path) too. Thus, a
range of money growth rates, not just a
path, is consistent with any particular
policy.
Besides to some degree representing the
Fed’s feedback rule, announced money
supply ranges give the public a fairly easy
way to monitor the Fed’s performance and
strengthen the Fed’s commitment to its
announced (best) plan. By just comparing
the actual growth in the money measures to
the Fed’s announced ranges, the public can
detect possible policy changes and call on
the Fed to explain them.

measure (M l) did not. (See Charts 1—3.)
M l grew nearly 12 percent during the year,
much more than the 4—7 percent growth
which as the year began the Fed said would
be consistent with its planned best policy.
Such unexpected growth surely is good
reason to suspect that the Fed might
actually have been doing something other
than it planned.
That suspicion could easily be wrong,
however. Money growth outside a range,
remember, could be caused by the public
rather than the Fed acting in some unex
pected way, so that the announced range no
longer fits the best policy. A closer look at
economic activity in the year is necessary to
determine which suspect is responsible.
■ W hat Changedf

The public should keep in mind, however,
that this monitoring method is imperfect.
The money growth ranges are, after all, not
perfect representatives of the feedback rule.
Discrepancies between predicted and actual
growth may thus be due to changes in the
public’s behavior rather than the Fed’s. If
longstanding behavior patterns change, the
relationships between the money measures
and goal variables change, and the Fed’s
announced ranges will no longer be appro
priate for its (unchanged) best policy.

An Exemplary Year

The experience of 1985 illustrates the need
for caution when using the Fed’s money
growth ranges to monitor monetary policy.
At a glance, at least one of these monitors
seems to have detected a policy change in
1985. Although the Fed’s broad measures of
money (M2 and M3) grew fairly comforta
bly in their announced ranges, its narrow

The most readily available evidence for
1985 seems to point at the public. That
evidence is an apparent change in the
simplest expression of the relationship
between general economic activity and
money: the annual ratio of the gross
national product (GNP) to M l. Historically,
this ratio has risen, over the last 20 years an
average of around 3 percent. A rise in the
ratio means that any increase in the denomi
nator— M l — is more than matched by an
increase in the numerator— GNP. If a
change in Fed policy had caused the great
M l jump of 1985, therefore, GNP should
give the Fed away by jumping even more.
This is not what the data show, however
(Chart 4). While M l grew nearly 12 percent
in 1985, GNP grew only about 5Vi percent.
Rather than rising in 1985, that is, the ratio
of these two indicators fell.
The change in behavior that this ratio
change suggests is a critical slowdown in the
rate that the public is spending its dollars.
(The ratio is popularly known as the veloc
ity of money.) The change may be critical
because stability in the velocity of money is
often considered necessary for monetary

Charts 1-3 Money Growth vs. the Fed's Ranges in 1985

M l is currency held by the
public plus travelers’ checks
plus demand deposits plus
other checkable deposits,
including negotiable order of
withdrawal (N O W and
SuperNOW) accounts,
automatic transfer service
(ATS) accounts, and credit
union share draft accounts.

4th Qtr.
1984

1985

"This is the range the Fed announced in February 1985. In July 1985, the Fed announced a new
range of 3 - 8 % growth for the second half of the year. M l outgrew that range too.

Chart 2 M2
$ Bil.
2,600

M 2 is M l plus savings and
small denomination time
deposits plus money market
deposit accounts plus shares in
money market mutual funds
(other than those restricted to
institutional investors) plus
overnight repurchase agree
ments and certain overnight
Eurodollar deposits.

2,500

2,400

4th Qtr.
1984

1985

Chart 3 M3
$ Bil.

3,200

3,100

3,000

Source: Federal Reserve Board of Governors

M 3 is M 2 plus large time
deposits plus large
denomination term repurchase
agreements plus shares in
money market mutual funds
restricted to institutional
investors and certain term
Eurodollar deposits.

Chart 4 The GNP/M1 Ratio (Velocity) in 1960-85

I960

1970

1980

1985

Sources: U.S. Department of Commerce, Federal Reserve Board of Governors

policy to be effective. In this simple version
of how policy works, the total amount of
economic activity, or spending, in the nation
is thought of as equal to the total amount of
money in the economy multiplied by the
number of times each dollar is spent (veloc
ity). The Fed is seen as influencing economic
activity as it desires by varying the money
supply appropriately. But to do that effec
tively, velocity must be predictable; other
wise, the Fed cannot know what effect any
particular money change will have on
spending.
But the apparent change in this simple ratio
is not adequate evidence of an unusual
change in how the public handles money.
Though the ratio has increased on average
in the past, it has decreased in individual
years before— as recently as in 1982, in
fact. Besides that, the relationship between
money and economic activity is much more
complicated than the simple ratio suggests.
Many more economic variables than just
the money supply influence the level of
spending, and their changes often have
effects over time which the ratio ignores. If
all this were taken into account, the public’s
behavior as reflected in the 1985 ratio may
have been predictable. And then the rapid

money growth in the year may have been
due to a Fed policy change after all.
A better way to determine what happened
in 1985 is to take the Fed’s more sophisti
cated view as expressed in its announced
ranges of growth for M l, one of its infor
mation variables, and GNP, a goal variable.
These ranges were based on the complicated
interrelationships and uncertainties among
all available economic variables. They thus
take into account the way the ratio of GNP
to M l is usually influenced by other varia
bles over time. If the relationship between
spending and money did not change
unusually in 1985, but the Fed surrepti
tiously changed its policy, the greater-thanexpected increase in M l implies that the
growth in GNP should have been greater
than expected too. But again, that is not
what the data show (Chart 5). While M l
grew more than initially expected in the
year, GNP grew less than expected: only
about 5Vi percent rather than between 7
and 8Vz percent. Thus, although the Fed did
miss its announced range for GNP, it
doesn’t seem to have meant to.
Yet even this is not unquestionable evidence
that a change in the public’s behavior is

Chart 5 GNP Growth vs. the Fed's Range in 1985
$ Bil.
4,200

4,000

3,800
4th Q tr.

1985

*This is the range the Fed announced in February 1985. In July 1985, the Fed announced a new range of
6.25—7.75% growth for the year. G N P did not reach that range either.
Sources: U.S. Department of Commerce, Federal Reserve Board of Governors

responsible for the rapid money growth in
1985. Just comparing the actual M l and
GNP growth to the Fed’s ranges is not good
enough because the Fed doesn’t tell us
enough about those ranges. Presumably
they correspond to some probability about
where these variables will fall if historical
relationships and uncertainties don’t
change. How high the probability is deter
mines whether or not the apparent change
in the GNP/M1 relationship is statistically
significant. If the ranges represent regions
where GNP and M l can be expected to fall,
say, 95 percent of the time, then, since GNP
was below its range while M l was above its
range in 1985, we can say with a high
degree of confidence that the relationship
changed in that year. But if the ranges repre
sent only, say, 50 percent probability
regions, then we cannot be very confident
about what happened; the variables’ move
ments in 1985 could have been as likely due
to chance as to anything else. The probabili
ties matter because the more confident we
can be that the behavioral relationship
changed, the more confident we can be that
Fed policy did not change.

Researchers at the Minneapolis Federal
Reserve Bank have built a statistical model
of the U.S. economy that can objectively
determine whether or not the unexpected
movements in 1985 M l and GNP were
significant. The model can, in effect, repli
cate the Fed’s policymaking process. Using
only the statistical interrelationships among
economic variables evident in any chosen
historical period, the model can predict for
any variable a path and various intervals
around that path within which the data
say— with any selected degree of confi
dence— that the variable will fall if the rela
tionships don’t change. For the 1985
experience, a historical period of 1982-84
seems appropriate because the Fed’s operat
ing procedures and the regulatory environ
ment of financial firms were fairly
consistent across those years. To find a
significant change, a 70 percent confidence
interval seems adequate. It means, again,
that history says the variable can be
expected to fall in the range 70 percent of
the time if historical relationships remain
the same; a variable will fall by chance
above (or below) the range only 15 percent
of the time. (Those are l-in-7 odds.)

The model does find the 1985 unexpected
movements in M l and GNP to be statisti
cally significant (Charts 6 and 7). The
actual paths of M l and GNP growth are
outside their 70 percent confidence intervals
and in the same unusual pattern that the
Fed’s evidence shows. Clearly, the move
ments of these measures are most likely due
to a change in relationships among

economic variables, just as the simple
GNP/M1 ratio suggests. All this evidence
implies, then, a 1985 change in the public’s
behavior, not Fed policy.
■ Why the Change?
The change in behavior that confounded the
Fed’s M l monitoring range seems to be a
decision by the public to hold more of its

Charts 6 and 7 Money and GNP Growth vs. a Statistical Model's Ranges* in 1985
Chart 6 M1
$ Bil.
620

600

580

560

4 th Q tr.

1985

Chart 7 GNP
$ Bil.

4,200

4,000

3,800

*These ranges are the regions in which M l and GNP and likely to fall 70% of the time, according to a
vector autoregression model of the U.S. economy based on 1982-84 data.
Sources: Federal Reserve Board of Governors, U.S. Department of Commerce, Federal Reserve Bank of
Minneapolis

funds than usual in what the Fed has classi
fied as M l types of accounts. This change
seems to have been caused by a combination
of institutional and interest rate changes.
M l is meant to be a measure of the funds
readily available for spending. As such, it
includes not only coins and currency in
circulation, but also various types of check
ing accounts. Traditionally, financial firms
were not allowed to pay interest on these
accounts, so the public held in the accounts
only what they thought they would need for
transactions. This kept a clear separation
between the nation’s spending and savings
money.
Since 1981, however, that separation has
been breaking down. The financial industry
has been progressively deregulated since
then, and the public has been offered the
opportunity to earn interest on accounts
with checkwriting privileges (NOWs and
Super-NOWs, for example). Though
initially restricted (with low interest rate
ceilings and high minimum balances), these
types of accounts have been very popular
and increasingly so as their restrictions have
been loosened. The Fed has counted many
of these accounts as M l money because of
their heavy use for transaction purposes.
But because they bear interest, the accounts
have undoubtedly held some funds which in
previous years would have been held in
savings accounts.
Until 1985 this element of savings in M l
accounts may not have been large, because
interest rates on the competing savings
instruments were much higher. But in 1985
the continued deregulation of such accounts
was joined by a drop in market interest
rates to make M l accounts even more
attractive for saving. With market rates
close to rates on checking accounts, the
public had less incentive than before to
move funds from checking accounts to
savings accounts. Thus, fewer did, and the

Fed’s M l money measure grew more than
expected as a result.
■ W hat Now?
The experience of 1985 increases the uncer
tainty about the future relationships
between money and other economic varia
bles, especially interest rates and GNP. A
significant rise in interest rates, for example,
might now result in a flow of funds from
checking accounts to savings instruments, a
change which history would not have
predicted. How much of a rise in rates
would cause such an outflow? How large
would the outflow be? And what effect
would this have on the total level of spend
ing? With very little evidence on the new
relationships and interest rates still low,
such questions are hard to answer.
The increased uncertainty, though, does not
mean the Fed must abandon its money
supply measures. Its feedback rule, after all,
takes into account the uncertainties about
the historical relationships among the Fed’s
instruments, information variables, and
goal variables. With one year of unusual
data to go on, that rule will simply tell the
Fed to respond less to any deviation of M l
from its predicted path because a wider
range of growth rates may now be consist
ent with its goals. To be a good representa
tive of this rule (and a good communicator
of Fed policy), then, future M l ranges must
be wider than their predecessors to encom
pass that wider range of growth.
Just how wide the Fed’s announced M l
range should be in any year, however, is
hard to determine. The range for 1986, for
example, shouldn’t necessarily match those
any statistical model might produce, for
they would be based on a particular histori
cal data period and a particular level of
confidence, both of which are to some
extent arbitrary. But the announced range
shouldn’t necessarily be the result of any
such objective procedure. For in selecting a

range to announce, the Fed (and Congress)
must moderate the need for the range to
reflect increased uncertainty by a perhaps
less quantifiable need for it to effectively
monitor policy. The wider the range is, to
take account of uncertainty, the less often it
will detect policy changes, which may make
such changes more likely. The narrower the
range is, though, to make policy changes
more obvious, the more often it will mistak
enly detect such changes and the more often
the Fed will have to waste resources explain
ing such mistakes. The choice of an appro
priate width for the M l range, therefore, is
at least partly a judgment call.

Conclusion

Despite the unusual experience of 1985, the
Fed’s money supply measures will remain
useful to the Fed— not as targets, but as
providers of information about its goals,
just like many other variables. The
announced growth ranges for these
measures will remain useful too, as commu
nicators to the public of Fed policy inten
tions and deeds, even though M l ’s range
will likely be somewhat wider than recently.
Still, questions remain: Are the money
measures the best variables to use to indi
cate policy? And are policy indicators best
expressed as ranges? These are important
questions, worth serious attention by
researchers. The best answer to both today
may be “We think so.” Congress directed
the use of money ranges, and so far no
clearly better options have been proposed.

Full text of Annual Report of the Federal Reserve Bank of Minneapolis : 1985 Annual Report : The Fed's Money Supply Ranges: Still Useful After All These Years

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