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IDJ®]p@rdtrtilil®lllifr IF lB3@rrnIk §@ITli IF July 15, 1977 Money'sSecondDimension When the Federal Open Market Committee meets next week to set target rates of growth for the money supply over the next year, its members will be trying to gauge the amount of monetary growth that will permit continued economic expansion yet not add to inflationary pressures. This question is not a simple one, since the impact of money on the economy depends not only on the amount of money people have available, but also on their willingness to hold it. As Fed Chairman Arthur Burns said at a recent Congressional hearing, "l Vtoney has a second dimension, namely, velocity, or. . . the intensity with which it is being used." The behavior of velocity is therefore certain to be a major topic in the upcoming discussions of the FO Me. IEvoh.atioff1l of a concept The technical definition of velocity is the ratio of nominal GNP to the stock of money. In the first quarter of 1977, nominal GNP was $1,799 billion, while the average level of M1 (currency plus demand deposits) was $314 billion. Thus, the velocity of the narrow money supply was 5.73. Similarly, the velocity of the more broadly defined M 2 money supply was 2.40 ( M2 equals M 1 plus bank time and savings deposits except large certificates of deposit). In a simple economy in which all money is in the form of currency, the concept of velocity can be understood intuitively. For example, if the amount of circulating cash were $1 million and nominal GNP were $5 million, the average dollar of currency would be used to purchase $5 of final goods and services. That is, each dollar would "turn over" five times during the year. In a modern economy, the bulk of the money supply is in the form of bank deposits of various kinds. Thus, it's not clear what we mean when we say that the average dollar of M 2being an agglomeration of currency, demand deposits, and time and savings accounts-Uturned over" 2.4·times. But the usefulness of the notion of velocity for the pu'rposes of monetary policy does not depend on its intuitive appeal. Rather, it depends on the predictability of velocity. After all, nominal GNP is just equal to velocity times the money supply, by its very definition. If a policymaker could predict the future course of velocity, he could control. nominal GNP by controlling the money supply. (Of course, he would need more information' to determine how much of any increase in nominal GNP would take the form of real GNP growth and how much would merely represent inflation.) Trend or random wand Clearly, the best of all possible worlds from a policy-maker's point (continued on page 2) Il)ce;)P)@lf1Imru®lITl1I IF®cdl®u@ll 'fRl 0 Opinions expressecl in this n Ewsletter 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. of view wou Id be a world of constant velocity. Unfortunately, the gods are not that kind, as a brief look at the numbers demonstrates. As recently as1960,M 1-velocity was only 3.52, compared to its current value of 5.73. While M 2-velocity has not changed significantly since 1960, a policy-maker could not safely regard it as a constant, either, since it has shown substantial variation on a year-ta-year basis. However, despite this variability, the movements of velocity might still be predictable if they exhibited a clear long-term trend. In A Monetary History of the United States, Milton Friedman and Anna Schwartz focussed much of their analysison the trends they discerned in the behavior of velocity. They noted a slow, secular decline in velocity from 1880 to the end of VVorid VVar II, interrupted by a number of episodes of partial rebound. Since World War II, velocity has generally been characterized by irregular increases. The whole Friedman-Schwartz approach hasbeen challenged by John Gould and Charles Nelson, in an article in the June 1974 issue of the 2 American Economic Review. They argue that the purported trends are in fact illusory, and that the movements in velocity can be adequately described asa "random walk." (Wall Street analysts are now familiar with the same type of theory, with reference to stock prices.) When a series behaves like a random walk, a knowledge of its past values is of no help in predicting future ones. The best prediction of the next period's value is that it will be the same asthe current period's. Other side of the coin Yet to say that velocity is a random walk only means that its own past history is of little use in predicting its future. That does not preclude the possibility of predicting it on the basis of a knowledge of other variables. In other words, a stable relationship might exist between velocity and, say, interest rates. In fact, there are ample theoretical reasons to suspect that just such a relationship exists, for the other side of velocity is the demand for money. To saythat the narrow money supply (M 1) turns over almost six times a year is the same as saying that people wish to hold in the form of money an amount equal to onesixth of nominal GNP. By holding this much of their wealth as money, they gain the convenience of having cash (or checks) available as needed, but they forego the interest return they could have enjoyed on a bond, for example. Presumably, the higher the interest payments they must forego, the greater the incentive they have to economize on holding money. Do the data suggest the existence of a stable demand for M 1? According to a study by Stephen Goldfeld in a recent issue (No.3, 1976) of the BrookingsPapers)a stable demand existed until about 1974.But moneydemand equations estimated from pre-1974 data have substantially overpredicted the public's M 1holdings since then. Put slightly differently, the equations have underpredicted the growth in M 1velocity. On the other hand, there has been no such marked deterioration in the stability of the demand for M2. Both of these findings can be partially explained by a number of technological and institutional changes occurring in financial mar- 3 kets in recent years. Innovations such as business savings accounts, interest-bearing NOVV accounts (negotiable orders of withdrawal), and money-market mutual funds have allowed individuals and firms to hold lessof their assetsin the form of M1. The use of computerized cash-management techniques and telephone transfers between time deposits and demand deposits have had a similar effect. As a result, a given level of M 1 is consistent with a higher level of GNP than before. But to the extent that some of the funds which used to be in M 1 have been shifted into the time-and-savings component of M 2, the demand for that broader aggregate has not been as affected by these innovations. As always, the future is uncertain. The demand for M1 mightreturn to its old relationship. But since Nt1demand-and, hence, M 1velocity-have been displaying unusual behavior for some time, in contrast to the more stable behavior of M 2-velocity, we can understand why some policymakers are now paying relatively more attention to M 2 than they did in the ,past. Kenneth Froewiss !! BMBH 'me::> 'o:lspue.l:l II.H!S (;SL. 'ON (U Vd 'S'1ll lInyw 55Vl::> e • 4Bln • t?!UJ0}!lE:::> • EpEAaN .04E PI -eUOZPV • qSEIV 0 :{} BANKING IlJATA- TWELfTH fEDERAL RESERVE DDSTIIUCT Selected Assetsand liabilities large Commercial Banks Amount Outstanding 6129/77 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:j: Large negotiable CD's 98,620 75,506 1,916 23,764 24,047 12,982 9,656 13,458 96,110 27,073 223 67,220 5,469 31,803 27,735 10,799 Weekly Averages of Daily Figures Week ended Member Banl<Reserve Position ExcessReserves(+)/Deficiency (-) Borrowings Net free(+)/Net borrowed (-) federal Funds-Seven large Banks Interbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions with U.S. security dealers Net loans (+)/Net borrowings (-) 6122177 + + + + + - + + + + + - 6129/77 Change from year ago Dollar Percent Change from 220 494 2 28 139 90 250 24 318 132 55 278 71 205 106 40 + + + + + + + + + + + .- Week ended 6122/77 75 4 79 + - 1,302 + 83 402 + 295 + + + + + + 8,617 7)22 633 1,342 3,680 1,774 29 1,324 5,238 1,865 319 3,880 731 5,521 588 2,289 + + + - + + - 9.57 10.74 49.34 5.99 18.07 15.83 0.30 10.91 5.76 7.40 58.86 6.13 11.79 21.01 2.08 17.49 Comparable year-ago period 1 4 3 + + 85 10 75 548 + 61 *Includes items not shown separately. :j:lndividuals, partnerships and corporations. Editorial comments may be addressedto 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. Pho.ne(415) 544-2184.