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June 29, 1 979
Are RPsMoney?
Recent years have seen a speedup in the rate
of financial innovation. Banks and other financial intermediaries, it appears, have
created new types of liabilities to attract
funds from a public that has become sensitive
to the yields it receives on its I iqu id assets as
market rates of interest have soared.
Recently, for example, banks have developed
an important new source of funds in the form
of repurchase agreements, or RPs. Yet at the
same time, the traditional monetary aggregates have shown considerable weakness.
The question naturally arises whether the
two phenomena are related.
RPs are agreements on the part of banks to
sell Treasury or Federal agency securities to
their customers, coupled"with an agreement
to buy them back later (hence the term repurchase agreement) at a price which
includes accumulated interest. Accordi ng to
one school of thought, the class of assets the
public regards as money has grown to include RPs; in fact, the public has shifted
some of its money holdings from traditional
forms - primarily demand deposits - to
RPs, which have the advantage that they pay
explicit interest. According to another view,
RPs are a manifestation of a pervasive and
concentrated effort to economize on money
holdings in an era of high interest rates, but
are not unique in this respect and are not
themselves money.
The first view argues for redefining the
monetary aggregates to include RPs; the
second argues for trying to adjust the
demand fu nction for the trad itional aggregates to take accou nt of the move to
economize on cash balances. (The demand
function relates the amount of currency plus
deposits that households and businesses
want to hold at given interest rates, incomes
and prices.) Yet to date, the evidence is too
sketchy to tell which explanation will prove
the more usefu I in the sense of yielding a
stable demand function for money
especially for the narrow M1 measure.
Growth of RPs
RPs are one aspect of a much broader market for short-term funds, the Federal funds
market. Initially, it was simply a market
where member banks with surplus reserves
lent the excess to banks who had a shortage
of reserves. These loans took the form of
transfers of Federal Reserve deposits hence the name Federal funds market. In
1 964 the market expanded considerably
when the Federal Reserve allowed member
banks to count as Federal funds the deposits
which they borrowed from other banks
(both member and non-member), even if
such borrowing did not involve the transfer
of balances at the Federal Reserve. Further
expansion occurred after 1969, when
another ruling allowed banks to borrow
Federa I fu nds from other parties, provided
that such borrowings took the form of repurchase agreements against TreasLlry a-nd
Federal agency obligations. It should be
noted, however, that such borrowings have
been effectively limited to large firms and
state-and-local governments, because of the
size of transactions involved.
This 1 969 ruling allowed banks to borrow
from the public free of any reserve requirements, maturity restrictions or interest-rate
cei I ings. As a resu It, banks have been able to
offer large demand-deposit holders an
attractive alternative investment - a highly
I iqu id and relatively risk-free asset with a
very attractive rate of interest. According to a
1 977 Federal Reserve survey, up to 90
cent of RPs with nonbank customers have
maturities of less than 30 days, with 30 percent being overnight liabilities. Yields on
these RPs run somewhat below the Federal
funds rate, the difference'apparently reflecting the collaterization requirements
involved in such borrowing.
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Opinions
in this nevvsletter do not
necessarilv rellect lhe views of the man?lgernent
01 the Federa! Rc'servE' Bank of San rrJncisco,
nor of the Board of Governclrs of the Federal
Reserve Svstf."ill,
Board of Governors argues that there are
other assets which can be converted into Ml
readily without risk of capital loss and at
relatively I ittle transactions cost, so that they
too can be held for transactions purposes
and therefore should be included in Ml.
Thus this Board study argues for including
automatic-transfer savings accounts in the
defi n ition of M 1, for example, even though
technically such deposits are not a medium
of exchange.
Consequently, in some economists' eyes,
RPs are such close substitutes for demand
deposits that they should be added to the
conventional monetary measures to provide
a truer esti mate of the stock of money. Th is
contention has taken on added importance
recently because of a puzzling slowdown in
the monetary aggregates which, for Ml at
least, cannot be explained on the basis of
observed historical relationships. To those
who argue that RPs are money, there is no
puzzle in the recent shortfall: money growth
only appears to be slowing down because
money is being incorrectly measured. If RP
growth were included, they argue, the true
rate of monetary expansion would turn out
to be more robust than the conventional
aggregates indicate.
Another Board study has appl ied the same
argument to RPs.The study argues that firms
regard a large part of overnight RPsas available for transactions purposes, and therefore
as equ iva lent to conventional demanddeposit balances. If this hypothesis is correct, the demand for Ml plus transaction RPs
should be more stable than the demand for
each separately. In other words, adding
transactions-related RPs to Ml should
reduce the size of the prediction errors produced by the money-demand function. This
is exactly what the study found - the transactions component of RPscould explain 80
to 90 percent of the prediction error in the
money-demand function.
Close money substitute?
Two main points of view can be distinguished in answer to the question, "Are RPs
money?" One view considers RPs as a close
money substitute, and the second considers
RPs from a financial-innovation standpoint.
On the first point, contemporary theories of
the demand for money are dominated by the
concept of money as a medium of exchange,
which argues for a narrow, transactions related definition. Up to now, the empirical
counterpart of this definition has been Ml,
which is made up strictly of means of payment - currency and demand deposits.
However, a staff study of the Federal Reserve
A New York Federal Reserve study obtained
similar, though somewhat more ambiguous,
findings. That study added total RPs, both
bank and non-bank (security dealer), to the
new M 1 measu re proposed by the Board
staff, and obtained a more stable demand
function in doing so. However, it is
impossihle to disentangle the contribution
of RPsto this stabil ity, since other categories
were included such as money-market
mutual funds, state-and-Iocal government
savings deposits, and corporate savings
deposits. Moreover, as the study emphasized, the RP series is incomplete - the
bank RPs are for money-center banks only.
Also, it fails to distinguish very short-term
RPs, which have perhaps the strongest claim
to be considered close substitutes for
money, from other maturities.
Financial innovation?
An alternative approach interprets RPs as a
2
symptom of a shift in the demand for money,
rather than a cause. This argument assumes'
that technological innovation in money
management, spurred by recent high interest rates, has allowed firms to pare down the
cash balances they hold for transactions purposes. The funds released have been invested in a variety of liquid assets, including RPs
but also including Treasury bills, commercial paper, large CDs, and Eurodollars.
Moreover, the growth of RPs has not come
entirely from excess cash balances; partof it
has come at the expense of other Iiqu id nonmoney assets.
and the debate over how it affects the demand for money is as old as monetary
economics itself. Money was once - and
for a long time - considered synonymous
with currency. The increasing popularity of
checking accounts in the 19th century
sparked 'a long controversy over whether
they were money, or whether their influence
cou Id be adequately accou nted for by adjusting the velocity of currency - that is, its
demand function. Ultimately, economists
found it more useful, on empirical grounds,
to include demand deposits in the definition
of money.
For these reasons, some economists argue
that singling out RPs to add to money is
unlikely to produce a stable demand function for money. Adding other candidates for
money substitutes
money-market funds,
for example
is unlikely to work for the
same reasons. These economists claim that a
better explanation would be obtained from
showing how the process of financial innovation has affected the demand for the
conventional monetary aggregates. As support, they note that any redefi n ition of
money is itself likely to become quickly
obsolete if financial innovation continues its
rapid pace. And further innovation is almost
certain if reserve requirements are imposed
on the categories included in the new definitions of money, since banks will then have
an incentive to create still further new types
of liabilities.
The controversy over how to deal with the
current apparent instability in the demand
for money ultimately will be resolved in the
same way. But the choice of an interim strategy for deal ing with this greater uncertainty
about the demand for money is much less
obvious. The issue is less critical for M2 than
for M1 . The demand function for the broader
aggregate apparently has changed much
less than the M1 demand function,
according to studies made at the Federal
Reserve Bank of San Francisco. This suggests
that M? will be our most reliable mo.netary
indicator for a while. Therefore, as an
interim strategy, we may have to rely heavily
on it until we can sort out what has been
happeni.ng to M1 .
John Scadding
Different methodologies
The two different interpretations of the role
of RPs represent different methodologies for
coping with the impact of financial innovation on the demand for money. Both have
the same aim
to derive an empirical
demand function for money that is stable.
The first interpretation argues that this is
better accolT)pl ished by redefining money to
include RPs; the second believes that it
would be easier to account for the shift in the
existing definition(s) of money.
Both of these approaches have been used
before. Financial innovation is nothing new,
3
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B AN KI N G D ATA-TWE LfTH fEDERAL RESERVEDISTRI CT
(Dollar amounts in millions)
SelectedAssetsand Liabilities
large Commercial Banles
Loans (gross, adjusted) and investments*
Loans (gross, adjusted) - total#
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U.s. Treasury securities*
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savings deposits
total
Time deposits
total#
Individuals, part. & corp.
(Large negotiable CD's)
Weekly Averages
of Daily Figures
Amount
Outstanding
6/13/79
126,821
103,966
30,214
37,732
21,831
1,605
7,681
15,174
42,729
.31,202
29,901
49,817
41,046
16,862
Change from
year ago@
Dollar
Percent
6/6/79
-
-
-
-
-
716
799
82
208
86
140
30
113
318
175
31
544
604
424
+ 15,970
+ 14,802
+ 3,146
+ 8,112
+
+
+
+
NA
NA
-
+
+
+
+
+
-
Weekended
Weekended
. 6/13/79
6/6/79
Member Bank ReservePosition
Excess Reserves( + )/Deficiency ( - )
Borrowings
Net free reserves ( + )/Net borrowed( - )
Change
from
14.41
16.60
11.62
27.39
NA
NA
246
1,414
2,274
1,622
449
4,071
5,065
1,269
-
3.10
+ 10.28
+ 5.62
+ 5.48
1.48
+ 8.90
+ 14.08
7.00
Comparable
year-ago period
8
165
173
20
73
53
17
30
47
+ 739
+ 1,684
+ 159
+ 125
+
+ 226
-
Federal Funds- Sevenlarge Banks
Net interbank transactions
[Purchases (+ )/Sales (-)1
Net, U.5. Securities dealer transactions
[Loans (+ )/Borrowings (-)I
407
* Excludes trading account securities.
# Includes items not shown separately.
@ Historical data are not strictly comparable due to changesin the reporting panel; however, adjustments
have been applied to 1978data to remove as much as possiblethe effects of the changesin coverage.In
addition, for some items, historical data are not available due to definitional changes.
Editorial comments may be addressedto the editor (William Burke)or to the author .... Freecopiesof this
and other FederalReservepublications can beobtained by calling or writing the Public Information Section,
Federal ReserveBank of SanFrancisco,P.O.Box 7702, SanFrancisco94120.Phone(415)544-2184.
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