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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)
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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
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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.
@FedFRASER