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Changing M oney D em and? How much money is enough? To the layman, the answer may be evident, but to the economist, it's a very complex subject, especially since long-run relationships linking the demand for money to the level of economic activity and interest rates appear to have broken down since mid-1974. Moreover, a wrong answer could be dangerous, for if policymakers miscalculate the amount of money that businesses or households need to carry out their transactions, recession or in flation could result—depending on the direction of the error. Several puzzling pieces of evidence have surfaced in recent months to suggest a possible shift in the nation's demand for money. First, some econometric models have been systematically overforecasting the money demand, generating predictions which are significantly greater than the actually realized magnitudes. Second, velocity (mon ey turnover) has risen rapidly dur ing the recovery period, suggesting a decline in the volume of money needed to support a given level of transactions. Third, short-term in terest rates have generally moved downward since last fall, quite in consistent with the recovery in ec onomic activity and the upsurge in velocity. These three observations would suggest that the demand for money has fallen sharply, making it possi ble for people to reduce their cash balances at each level of income and yet feel sufficiently liquid to permit a decline in interest rates. If 1 a decline in money demand has actually occurred, then the provi sion of a slower growth in money supply is appropriate to finance the recovery. However, if money demand has not declined, then a somewhat more rapid growth in money supply is needed to finance the recovery. Some analysts are not convinced that the demand for money has changed. They point to the relative stability in money demand in the past in the face of major changes in financial institutions, economic conditions, and shocks to the inter national economic system. They suggest that the simultaneous over forecasting of money demand in large models, rise in velocity and falling interest rates can be explained by factors other than a decline in money demand. Evidence from econometrics Consider the over-forecasting of money demand in various econo metric models. Whereas the actual money supply (M-i) totaled about $295 billion in the fourth quarter of 1975, the typical model would sug gest that households and businesses desired to hold at least 5 percent more than that, judging from past relationships of income, interest rates and money. This gap had gradually developed from mid-1974 to the end of 1975. The gap does not appear to have widened in recent months. This overforecasting of money de mand could come about either be cause of a decline in money de(continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. mand or because of the inappropri ateness of the interest rate chosen to measure the opportunity cost of holding money. Typically, the Treasury bill rate is used for this purpose, since it gives such a good fit for past periods. However, the bill rate may not have been the best measure in the 1974-75 period, be cause of the substantial rise in risk as perceived by households and businesses appropriate to the re cent era of unprecedented inflation and recession. Risk aversion has shown up in many ways: a sharp rise in the savings rate; a rising preference to hold currency rather than bank deposits; a conservative investment demand by corpora tions in the face of a strong recov ery in corporate sales and profits; and a decision by banks to widen the spread between their loan rates and the cost of their funds. It could be argued that the defaultfree Treasury bill rate is inappropri ate in this setting and it should be re placed by a rate which incorporates risk. It could be measured by the wide rate spread between lower rated and higher-rated corporate bonds, such as has appeared since mid 1974. However, there are no comparable published risk differ entials for lower and higher rated short-term instruments, which are the standard measures used in money-demand equations. One possible alternative would be the bank prime business-loan rate. This is not a completely satisfactory al ternative, but it does produce bet ter forecasts of the demand for 2 money from mid-1974 to end-1975 than the T-bill rate does. If the risk argument is correct, then the de mand for money is just as stable now as in the past. The incentive to economize on non-interest earning cash balances is measured best by the higher interest rates the private sector faces, rather than by the default-free interest rate on short term government securities. Evidence from velocity The large rise in velocity in the second half of 1975 tends to corrob orate the econometric-forecasting evidence regarding the reduction in the demand for money. This rise in velocity was unusually rapid, ex ceeding a 10-percent annual rate— compared with trend growth of less than 3 percent. If we are entering a period of unpredictable move ments in money turnover, it means increasingly unstable relationships between money and income due possibly to an increased instability in the demand for money. A close look at the data suggests that velocity has not moved signifi cantly away from the levels that might be expected at this stage of the business cycle. Recent move ments have paralleled the typical cyclical pattern, with velocity growth above trend in the upswing of the cycle and below trend in the downswing. Velocity fell signifi cantly below trend in the three quarters preceding the cyclical trough in the second quarter of 1975. The rise in the first three quarters of recovery has just re turned velocity to its trend level. Moreover, the magnitude of the recent deviation from trend was actually less than in certain earlier periods, such as 1966-67. Indeed, in that particular period, similar ques tions were raised about changes in the demand for money but later evidence indicated the absence of a significant shift. Evidence from interest rates The unexpected decline in interest rates in late 1975 and early 1976, like the evidence provided by forecast ing models and velocity data, tends to support the argument for a de clining demand for money. Typical ly, rising rates go along with the type of recovery in output and velocity that we have recently expe rienced, so that the sudden decline was quite unexpected. It should be recalled that the mar ket interest rate is made up of two components, the real rate and an inflation premium. The real rate is determined by the real demand for credit and other “ real” factors. The inflation premium in short-term interest rates is determined by re cent inflation experience. The dif ferential impact of these two ele ments goes a long way in explaining a number of surprising twists in short-term markets during the last several years. For example, the upsurge in rates in the first half of 1974 occurred when real GNP and real credit demand was declining. What explains this and other unu sual movements in interest rates? To a large extent, short-term inflation 3 expectations. Inflation, of course, has always had a major impact on short-term interest rates, but in the past, inflation has usually risen only during boom periods. But then, in the past several years, inflation has moved independently of cyclical movements in real output. Thus, in 1974, when interest rates rose to unprecedented levels in the face of a decline in real GNP, they appar ently reflected that period’s un precedented high level of short-run inflation expectations, offsetting the impact of the concurrent de cline in real GNP. By the same token, the current fall in short-term interest rates is associated with a recent slowing in inflation and thus in short-run inflation expectations. Taken together, the three develop ments cited—overforecasting of the money demand, rising velocity and falling interest rates—could suggest a decline in the nation’s demand for money. But as indicated, there may be alternative explanations for these phenomena. The moneydemand equation yields different results with the choice of an inter est rate that incorporates a high-risk premium; velocity may not be too far out of line given the present stage of the business cycle; and interest rates may not be too far out of line given the fall in short-run inflation expectations. The issue is uncertain, and the jury of economic theorists may remain split for years to come. Unfortunately, policy makers have to deal with these uncertainties while the jury is still out. 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E>)SB| v • J j | 0 '0 3 S J3 U B JJ UBS ZSZ O N llW liH d aivd a o v is o d s n n v w s s v i d is m j upjn8®8a>^fl BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 4/14/76 + + + + + + - Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Government deposits Time deposits—total* States and political subdivisions Savings deposits Other time deposits^ Large negotiable CD's 88,360 65,769 2,193 23,010 19,534 10,688 9,998 12,593 88,394 25,033 430 61,314 6,611 25,612 26,721 11,635 Weekly Averages of Daily Figures Week ended 4/14/76 Member Bank Reserve Position Excess Reserves Borrowings Net free(+)/Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions of U.S. security dealers Net loans (+)/Net borrowings (-) Change from 4/07/76 397 403 455 2 38 29 12 18 654 293 42 285 448 87 426 662 Change from year ago Dollar Percent + + + + + + + + - + + + + + + + + - 2,077 120 675 1,193 172 822 2,268 71 3,278 1,172 125 1,936 553 6,104 2,455 4,205 Week ended 4/07/76 2.41 0.18 44.47 4.93 0.87 8.33 29.34 0.56 3.85 4.91 22.52 3.26 7.72 31.29 8.41 26.55 Comparable year-ago period 42 16 58 61 0 61 + 1,338 + 1,139 + 2,584 + 1,419 + + 1,303 - 779 + 6 1 5 •Includes items not shown separately, individuals, partnerships and corporations. Editorial comments may be addressed to the editor (William Burke) or to the author. . . .Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184.
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