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October 11, 1985

Deposit Deregulation and the Behavior of M1
M1, the narrow transactions measure of money,
grew at an approximate 12.5 percent annual rate
from the fourth quarter of 1984 to August1985. In
two of the last four months, it has grown at around
20 percent. These movements in M1 have
refocused attention on the impact of deposit
deregulation on the behavior of the monetary
aggregates. In particular, given the sharp decline in
interest rates since late in the third quarter of 1984,
some observers have suggested that deregulation
has permanently heightened the response of M1
to changes in interest rates.
In this Letter, we discuss how the demand for M1
has changed in response to deposit deregulation.
We present evidence suggesting that the response
of M1 to changes in market interest rates has been
altered, although perhaps only moderately, as a
result of the deregulation of interest payments on
transactions deposits.
However, we believe that any tendency for the
interest-sensitivity of M1 to increase in recent
years represents an intermediate rather than a lasting effect of deposit deregulation. In this regard,
we think that the behavior of M2, which has
undergone more complete deregulation, gives us a
view of what deposit deregulation may mean for
M1. The behavior of M2 suggests that, with complete deregulation, the long-run response of M1 to
changes in interest rates may actually be smaller. In
the short-run, by contrast, sluggish rate adjustment
by banks will result in an exaggerated response of
M1 to changes in market rates.

The impact of fixed ceilings
In examining its impact, it isuseful to trace the
chronology of deregulation. For M1, a major step in
the process of deregulation was the nationwide
authorization of fixed-interest rate ceiling NOW
accounts in 1981. Currently, these accounts have
ceiling rates of 5114 percent. In 1983, Super NOW
accounts were authorized; these are not subject to
interest rates ceilings but do require a minimum
balance. When first offered in January 1983, these
accounts carried a legal minimum requirement of
$2,500. This was reduced to $1,000 in January of
this year. It is important to note that both NOW
and Super NOW accounts are available only to
households and non-profit firms.

So far, the first of these two developments has
been more important for M1. As of August 1985,
total interest-bearing checking deposits stood at
$167 billion, or almost 28 percent of M1. Of these
interest-bearing deposits, about two-thirds were
NOWs and one-third Super NOWs. In other
words, Super NOWs constituted less than 10 percent of M1.
The dominance of fixed-ceiling (or regular) NOW
accounts has been important in determining the
impact that deposit deregulation has had on the
behavior of M1 up to this point. To a depositor, the
cost of holding funds in such an account is the
difference between the rate paid on NOW
accounts and that paid on an alternative market
instrum~nt such as Treasury Bills. This opportunity
cost, as it is called, is much lower for NOW
accounts than for traditional checking accounts
(demand deposits), which pay no explicit interest.
Consequently, a given change in market interest
rates represents a much greater percentage change
in the opportunity cost of NOW accounts than
demand deposits. For instance, if market interest
rates increase from 10 percent to 11 percent, the
percentage change in the opportunity cost of
NOW accounts is about 20 percent, whereas tbe
change in the opportunity cost for demand deposits is only 10 percent. If money holdings respond in proportion to relative changes in the
opportunity cost of holding money, as is usually
assumed, NOW accounts will be more affected by
a given interest rate change than demand deposits.
Thus, the overall interest-sensitivity of M1 should
increase with the introduction of fixed interest rate
transaction accounts.
To see whether there is support for this a priori
argument, we conducted statistical tests using data
from the first quarter of 1970 to the fourth quarter
of 1984. Our results show that the introduction of
regular NOW accounts in January 1981 did lead to
some increase in the sensitivity of M1 to changes
in market interest rates. However, the change
appears to have been relatively small - something
on the order of a 15-percent rise in the sensitivity
of M1 to market interest rates. (To be precise, we
find that the interest elasticity - which is a
measure of the interest-sensitivity - of M1

increased from slightly more than 0.11 to slightly
less than 0.13 when the sample is extended from
1980 to 1984.) Thus, our findings suggest that deposit deregulation, at least through the end of
1984, has had a modest impact on the behavior of
M1 with respect to market interest rates when
compared with the behavior of that aggregate in
the 1970s.
One reason that our statistical analysis does not
reveal a large increase in the interest-sensitivity of
M1, despite what seems to be a strong a priori case
for such an increase, may be the implicit interest
paid on traditional transaction deposits. That is,
instead of comparing the zero explicit interest paid
on demand deposits with the 5114 percent paid on
NOWs, individuals also considered the value of
services (such as free checking) they received with
demand deposits. The available empirical evidence
suggests that the return on demand deposits (taking implicit interest into account) probably is closer
to the rate paid on NOWs than it is to zero. Consequently, it is likely that the introduction of NOWs
did not reduce the opportunity cost of holding
money by as much as the full 5114 percent banks
were allowed to pay. This implies that the resulting
change in the interest-sensitivity of M1 should not
be large.
The behavior of M1 also may have been affected
by developments involving business demand deposits, which are an important component of M1.
At the end of 1984, demand deposit balances of
financial (nonbank) and nonfinancial businesses
totaled about $200 billion and represented twothirds of gross demand deposits. While business
transaction deposits cannot earn explicit interest, it
is common for banks to pay implicit interest on
these deposits. At many banks, this is accomplished via compensating balance arrangements.
Under such arrangements, banks compensate businesses for holding demand deposits by providing
credit services (loans and loan commitments) and
operational services (e.g., lock boxes and wire
transfers) .
Particularly relevant to our discussion of the
interest elasticity of M1 is the growing role of compensating balances involving operational services
since the latter part of the 1970s. Under such arrangements, the implicit rate of return on business
demand deposits is determined by short-run
market interest rates (with an adjustment to reflect
the cost of reserve requirements). Thus, because of

compensating balances involving operational services, the opportunity cost of holding deposits
would not change by much in response to changes
in market interest rates. Consequently, business
demand deposits are not likely to be sensitive to
changes in market rates either.
Permitting flexible rates
The introduction of the regular NOW account
represents an intermediate stage in transaction deposit deregulation. Howev~r, the second phase of
this deregulation -flexible yields on transaction
accounts as represented by the Super NOW gradually is becoming more important. In addition
to the continued growth in Super NOW accounts,
fixed-interest rate ceilings will be effectively
removed from all household transaction accounts
in early 1986. This latter stage of deposit deregulation will have very different implications for the
behavior of M1.

The sensitivity of money to changes in market
rates declines when the yield on holding money is
allowed to vary with market yields. That is, if
market rates and the return on money move
together, there is no change in the relative opportunity cost of holding money as market rates vary.
Thus, in a world of flexible interest rates on deposits, money demand is likely to be much less
sensitive to changes in interest rates.
To glean some insights into what the second stage
of deregulation will mean for M1 , we looked at the
impact deregulation has had on M2. We chose M2
because deregulation of M1 has largely been
restricted to higher explicit but fixed yields, with
Super NOWs the only accounts not subject to
interest rate ceilings. In contrast, the deregulation
of M2, which started earlier - in 1978, has
involved both higher explicit yields and yields that
have tended to move with market interest rates.
To isolate the effects of deregulation, we focused
upon the part of M2 that has been most deregulated: "nontransactions" M2. This consists of the
part of M2 that is not counted in M1. It includes
MMDAs, savings accounts, small time deposits,
overnight Repurchase Agreements (RPs) and
Eurodollar accounts. Our statistical tests indicate
that the sensitivity of nontransactions M2 to
changes in market interest rates is significantly
lower than it was before 1979. To be more precise,
we find that a numerical measure of this sensitivity
is now less than half what it was prior to the
deregulation of M2.
A significant aspect of this lowered sensitivity is
that the decrease becomes effective only a few
months after the change in other market rates.

That is, the contemporaneous response of nontransactions M2 to a change in interest rates is not
significantly different from its prederegulation
response, but the change in the growth rate of M2
two to three months after an interest rate change is
now significantly smaller. Thus, once the full
effects of an interest rate change have worked
themselves out, the change in M2 is smaller than
what it used to be prior to deregulation.
This finding is consistent with the rate-setting
behavior of financial institutions that some observers have commented upon recently. Rates on
Money Market Deposit Accounts, for example, do
not decrease immediately after a fall in market
rates but do so with a lag.For our purposes, the
point is that once the rate adjustment is complete,
the opportunity cost of these accounts is close to
what it was before the change in market rates. This
explains why nontransactions M2 shows a lower
sensitivity to interest rate changes in the long-run.
It is natural to expect that M1 will show a response
similar to that of M2 once deregulation is complete. However, there are several reasons that the
change in the behavior of M1 may not be as great
as it has been for non transactions M2. One
obvious reason is that currency, a major component of M1, does not earn interest. Second, households can be expected to continue to hold (non interest-bearing) demand deposits, especially
because the implicit interest earned on such
accounts is not taxable. (Household demand deposit accounts totalled $80 billion at the end of
1984, or 14 percent of M1 at that time.) Finally,
there are as yet no proposals to permit businesses
to hold interest-bearing transaction accounts.
For the more immediate future, it is even less clear
what the impact of deregulation will be. Even
though regulatory restrictions on household M1
accounts will be removed in early 1986, one cannot predict how quickly banks will move to implement either higher explicit rates or flexible rates.
Recent experience suggests that banks will change
their policies slowly. For example, the legal
minimum deposit requirement on Super NOWs
was reduced from $2,500 to $1,000 early this year
but most banks have not yet implemented the
change. While competitive pressures probably will
move the market toward making flexible rate transactions accounts more widely available, banks also
may be slow to abolish fixed-rate NOWs.

To the extent that banks are slow to adopt flexible
rate accounts, the transition of M1 to a lower
interest-sensitivity may be delayed. The
experience in 1985, particularly since May, appears
to support this proposition. Short-run market rates
have been approaching the fixed ceilings on NOW
accounts without any systematic action by banks
to adjust these rates. In addition, the rates offered
on Super NOWs also have not been adjusted as
rapidly as rates offered on managed liabilities such
as large CDs. The result has been an explosion in
M1 growth.
Whether banks will continue their present
behavior in the future is as yet uncertain. The prevailing level of interest rates is likely to be an
important factor. If market rates fall sufficiently,
banks are likely to reduce the rates they offer on
fixed-ceiling NOW accounts, effectively turning
them into variable rate accounts. Even with variable rates, however, it is likely that further rate
adjustments on these accounts will lag behind'
changes in other market rates. During any such
intervening period, the growth rate of M1 is likely
to change significantly in response to changes in
market rates.

Summing up
In this Letter, we have discussed the case for an
increase in the interest-sensitivity of M1. Despite
the existence of a strong a priori case for a large
increase in M1 sensitivity, our empirical results
show only a modest rise through the end of 1984.
More important is the fact that we expect this
increase in sensitivity to be reversed as more and
more of M1 comes to offer variable yields.
However, M1 is likely to continue to show large
responses in the period immediately following
changes in market interest rates. As discussed
above, this occurs because banks are slow to vary
the yields on transaction accounts when market
rates change. Thus, M1 growth in the short-run will
now be subject to an additional influence - the
rate-setting behavior of banks. This could lead to
some instability in the response of M1 to changes
in market interest rates in the short-run, making it
more difficult to interpret the behavior of M1
following changes in these rates.

Fred Furlong and Bharat Trehan, Economists

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.


040 PI


!!omoH O!UJoJ!l0)









aAJaSa~ IOJapa~

~uaw~Jodaa 4)Joasa~
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures


Change from 9/19/84
















- 1,445





Period ended

Period ended




Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (-)
Net free reserves (+ l/Net borrowed( -)




1 Includes loss reserves, unearned income, excludes interbank loans

Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change