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FRBSF

WEEKLY LETTER

September 20, 1985

Signals from M1 and M2
The robustness of M1 with respect to its target
range since the end of 1984 when M2 has been
more or less in line with its target raises some questions about the reliability of M1 as a guide to
monetary policy. A change in the behavior of M1
(from what past experience would lead us to
expect) would make it difficult to interpret what
fluctuations in M1 imply about the economy and,
consequently, impair its usefulness for monetary
policy. In this Letter we argue that such a judgment
against M1 is premature.

Behavior
The money supply, as measured by M1, surged late
last year and continued to grow rapidly in the first
half of 1985. From its average level in the fourth
quarter of 1984 through June 1985, M1 grew at
about an 11V2 percent annual rate. At that pace,
M1 - which includes currency, demand deposits,
NOW and Super NOW account balances, and
travelers' checks -easily outstripped the upper
bound of the 4 to 7 percent target range originally
adopted for it in February 1985 (see Chart 1). With
M1 so far above its original target and signs of sluggishness in the economy, the Federal Open Market
Committee changed the target for M1 to a 3 to 8
percent range (not shown in the chart) in its midyear review of the aggregates. The Committee also
set the base for the target equal to the average
value of M1 for the second quarter of 1985
(instead of the fourth quarter of 1984).
In contrast to M1, the broader measure of money,
M2, grew at about a 9% percent annual rate from
the fourth quarter of 1984 to June 1985. As a
result, M2 was only slightly above the upper
bound of its 6 to 9 percent target range depicted
by the cone in Chart 2. With M2 apparently behaving well, the Committee left the range for this
monetary aggregate unchanged.

Questioning Ml
The usefulness of M1 as a guide to policy is not
questioned merely because it has grown rapidly.
Strong growth in M1 at any time may simply reflect
sizeable changes in the economic variables, such as
income and interest rates, that are assumed to influence the behavior of M1. On this score, it can be

noted that the six-month commercial paper rate
was approximately 400 basis points lower at the
end of July 1985 than in mid-August 1984. Since
money holders will tend to keep higher balances
with lower open market interest rates, such a large
drop in rates would be expected to lead to an
expansion of money.
The usefulness of M1 derives from its having a
stable relationship with other economic variable~.
This stability has come into question in recent .
years because of financial innovation and deregulation in general and the introduction of NOW
accounts in particular.
One argument holds that these developments
have tended to magnify the response of the
demand for M1 to changes in market interest rates.
There are a number of channels through which this
could happen. For example, the paYlT)ent of
interest on NOW accounts reduces the opportunity cost of holding money. (The opportunity
cost is the difference between the return from
holding money and the return from holding an
alternative asset). With a lower opportunity cost
on NOWs, M1 will be more attractive as a vehicle
for holding savings balances. Becausethese bak
ances typically are considered more interest-sensitive than deposits traditionally held in M1, they
would be expected to raise the response of M1 to
changes in interest rates.
Notice also that the payment of a fixed rate of interest on NOWs means that the relative change in the
opportunity cost on these accounts is greater for a
given change in market interest rates than demand
deposits, which do not pay explicit interest. For instance, if market rates rose from 10 percent to 11
percent, the change relative to the original opportunity cost of holding NOW accounts would be
slightly more than 20 percent, while the same
change for demand deposits would be 10 percent.
Thus, to the extent that the demand for money depends upon the relative change in the opportunity
cost, NOW accounts, and thus M1, will show a
stronger responseto changes in market interest
rates than comparable household demand
deposits.

FRBSF
M1 reliability
While the potential for financial innovation and deposit deregulation to distort M1 clearly exists,
there remains the question of whether the actual
impact has been large enough to change the
usefulness of M1 as a guide to policy. To answer
this second question, we used the Federal Reserve
Bank of San Francisco's Monthly Money Market
Model. The model was estimated with data from
1976 to 1983. The purpose of this estimation was
to derive the relationship that prevailed between
M1 and its determinants (which, in this model,
consist of income, interest rates and changes in
bank loans) over that period. We then used this
estimated relationship to compute values for M1
over the period from November 1984 to June 1985
given the actual values of its determinants.

note that these predicted values of M1 based on
the relationships before deregulation lie above the
upper bound of the original 4 to 7 percent target
cone for M1 for 1985.
The under-prediction of M1 in the second simulation is consistent with the view that the response
of M1 to its determinants has changed somewhat
since 1980. However, the fact that the first simulation (where the model was estimated through
1983) tracks M1 closely through the first half of
1985 suggests that the change in structure is "small
enough" in the sense that the relationship estimated across the break can still incorporate
enough of the change to allow successful
prediction.

What about M2?
The estimated values of M1 obtained from this
exercise provide a straightforward way of ascertaining whether the relationship between M1 and
its determinants has changed since the beginning
of 1984. If this relationship has changed then the
estimated (or simulated) values should be systematically different from the actual values of M1 over
the same period.
Chart 1 depicts the simulated series as a dashed
line labeled Simulation A. The dashed line shows
that the Monthly Money Market Model predicted
virtually all the rapid rise in the M1 aggregate from
November 1984 to May 1985. The model did
under-predict M1 growth in June 1985. In that
month, M1 grew at an unusually rapid 20 percent
annual rate.

Some change in M1
The simulation results described above provide
evidence that the relationship between M1 and its
determinants has not changed significantly since
the end of 1983. However, it is possible that a
change did occur somewhat earlier, especially with
the nationwide introduction of NOW accounts. To
investigate this possibility, we estimated the
Money Market Model over the period 1976 to
1980. The relationship obtained from this estimation was then used to simulate M1 in a manner
similar to the first simulation.
This second simulation is shown in Chart 1 as a
dotted line labeled Simulation B. The model does
not predict all of the expansion in M1 between
November 1984 and June 1985. It is important to

Given that M1 has grown so fast relative to its
targets, it is only natural that considerable attention would be given to explaining its behavior.
Likewise, with M2 relatively well-behaved, it
would hardly seem necessary to explain why it is
so much closer to its target. Nevertheless, understanding why M2 is close to its target is essential to
evaluating whether that aggregate is indeed signalling anything different from what M1 is signalling
for monetary policy.
In comparing the behavior of M1 and M2 relative
to their respective targets, it is also necessary to
look at how the targets have changed. The M2
target for 1985 was the same as that for 1984 6-9 percent. In contrast, the top of the target range
for M1 was one percent lower in 1985 than it was
in 1984 - the M1 range was 4-8 percent in 1984
and 4-7 percent in 1985. Our point is that if the
top of the M2 target range also had been reduced
by one percentage point in 1985, M2 would have
been noticeably above itstarget range in June as
well.
The second point involving M2 is that, like M1, it
has undergone changes as a result of deposit
deregulation and financial innovation. These
changes likely have altered its relationship to the
economic variables that influence its behavior. For
example, over the past several years, a growing
proportion of the components within M2 have
come to carry yields that vary with market interest
rates. These flexible yields mean that, over the
long-run at least, a large fraction of M2 may not be
responsive to changes in market interest rates. The

Chart 1
M1: Actual and Simulated Values

Chart 2
M2: Actual and Simulated Values

$ Billions

$ Billions

600

2600
Simulated M2 .....

2550

590

...

..•...
2500

......

580

570

560

550

JUN JUt AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN

1984

JUN JUt AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN

1984

1985

presence of such a relationship between interest
rates and a significant portion of M2 could lead to
a sharp divergence in the growth of M1 and M2
during a period marked by a large change in
interest rates, with M1 showing a much stronger
response.

Simulating M2
To illustrate how the behavior of M2 has recently
changed, we simulated M2 using estimated prederegulation relationships. For this purpose, an M2
equation was estimated over the period 1970 up
to 1979 - the first full year of the six-month
money market certificate. (That account had a
$10,000 minimum denomination and a yield based
on the six-month Treasury bill rate.) In the equation, the explanatory variables were contemporaneous and lagged values of personal income and
the six-month commercial paper rate, and
lagged values of M2.
The dotted line in Chart 2 shows that the pre"
dicted values for M2 began to diverge from those
of actual M2 in the early part of 1985. From March
on, the difference between the predicted series
and actual M2 grows increasingly larger. By June
1985, the simulated series based on pre-deregulation relationships over-predicts M2 by a wide
margin. Moreover, the simulated M2 is substantially above its target cone.
These results are consistent with the view that the
responsiveness of M2 to changes in market rates
has decreased significantly since deregulation
began. Thus, even if there had been no change in

1985

the responsiveness of M1 to interest rates due to
deregulation, the relative behavior of M1 and M2
would have been noticeably different from what
past experience would lead us to believe.

Summing up
In this Letterwe have examined the behavior of
M1 and M2 with respect to their target ranges over
the first half of 1985. The intent was to examine
whether the apparent differences in this behavior
gave conflicting signals about policy. The empirical
evidence presented above indicates that M1 and
M2 are not sending contradictory messages.
The apparent disparity in their behavior comes
from two sources. First, deposit deregulation
appears to have affected the two aggregates in
opposite directions. The empirical evidence indicates that M2 has become less sensitive to interest
rate changes, which explains its relatively low
response to the decrease in interest rates since
mid-August 1984. For M1, the empirical evidence
indicates an increase in its sensitivity to interest
rates, although it appears that this was not a large
increase.
Second, the apparent difference between the
behavior of the two aggregates becomes exaggerated when the original target ranges established in
February 1985 are used as a frame of reference. As
mentioned above, the range for M2 was left
unchanged (compared to its range over 1984),
whereas the top of the target range for M1 was
lowered by one percentage point.

Fred Furlong and Bharat Trehan

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.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasu ry and Agency Secu rities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts~Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding
8/28/85

192,992
174,582
50,879
64,195
35,559
5,434
11,324
7,086
196,672
45,753
31,251
13,575
137,344

Change
from
8121/85

-

484
576
332
33
191
8
177
85
44
3
196
62
22

45,104

51

38,152
22,612

48
471

Period ended
8/26/85

Change from 8/29/84
Dollar
Percent7

-

11,370
11,899
1,561
3,308
6,055
396
588
59
9,150
3,176
3,026
1,549
4,424
7,374

-

3,200
2,195

Period ended
8/12/85

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

91
25
66

-

12
59
46

1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 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

6.2
7.3
3.1
5.4
20.5
7.8
4.9
0.8
4.8
7.4
10.7
12.8
3.3
19.5

-

7.7
10.7