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September 3, 1982
Volatility in Money and Interest
Starting in the early 1970's, the Federal Reserve began to shift the focus of its monetary
policy from the level of interest rates to control of the supply of money. This change was
spurred primarily by the accumulation of
much evidence linking inflation with excessive money growth. The' Fed has achieved
considerable success reducing the growth of
the monetary aggregates on an annual basis
since 1979, with the resultant benefit of a
downward turn in the rate of inflation, but it
has been less successful at controlling the
su pply of money over shorter periods of ti me.
Some of the Fed's critics, including leading
monetarists like Milton Friedman and Allan
Meltzer, have charged that variability in
monetary growth contributes to uncertainty
about inflation, high interest rates and
the poor performance of the economy. But
the Federal Reserve has countered that tight
short-run monetary control could further increase the variability in interest rate.sand,
besides, would not contribute measurably to
economic stability.
of its wealth in the form of money (at given
levels of income and prices).lfthe Fed did not
supply the extra money, interest rates would
rise because the demand for money would
have risen relative to the supply. The higher
interest rates would exert a depressing effect
on the economy, perhaps going as far'as to
cause a recession. To avoid this result, the Fed
bel ieves it must provide the additional money.
M1 growth between October 1981 and April
1 982 provides a good example of accommodating perceived increases in money demand. In this period, M1 (the chief definition
of money used by the Fed) grew relatively
rapidly to a level above the upper boundary
of its annual target range. This growth was
thought mainly to reflect the desire of the
public to hold more money as a precaution
against the uncertainties of a recession. The
Fed reasoned that if monetary pol icy were not
to be tighter than intended, then th is apparent
change in the demand for money would have
to be accommodated.
Supply-sideinfluences
The critical assumption in the Fed's argument
is that short-run changes in the quantity of
money represent differences in the underlying desire of the publiC to hold money, that is,
changes in the demand for money. This view
is often used by the Fed to justify accommodating rather than resisting deviations of
the quantity of money from its target.
The alternative view posits that the observed
changes in the quantity of money result from
changes in the supply of money which do not
necessarily correspond to changes in the
demand for money. According to this view,
the Fed shou Id not accommodate money
control deviations as often.
Accommodating demand
To illustrate why accommodating changes in
money demand can be appropriate, assume
that the pu bl ic sudden Iy wanted to hold more
An alternative view often attributes rapid M1
growth to factors affecting the supply of
money rather than its demand. This view
emphasizes two important features of money
in the
economy.
u.s.
Buffer stock. The first is the widely accepted
idea of money as a "shock absorber" or buffer stock between the public's receipts and
spending. In this view, short-run variations in
the observed stock of money may represent
independent changes in the quantity of
money supplied by banks to which the public
has not had time to adjust completely.
The view of money demand as largely passive in the short run, accommodating itself
to changes in the supply of money, reflects
the transactions costs of managi ng money
balances closely. Unanticipated inflows or
outflows of funds cause inventories of money
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balances to wander away from their desired
levels in the short-run because it is too costly
for some money holders to make the necessary purchases and sales of securities (or
goods and services) to bring money balances
back to their desired levels quickly.
to bring his balances into line, he may throw
the portfol io of other holders out of balance.
For this reason, the system as a whole takes
longer to ad just than does anyone household
or corporation.
Recent empirical evidence at this bank suggests that buffer stock effects are significant
-that the monetary aggregates can depart
Significantly from levels desired by the public
for up to six months at a time. This departure
has, however, only modest effects on interest
rates. In other words, over a period as long as
half a year, it is possible for money supply
factors to influence movements in the money
stock as the public's demand for money accommodates independent changes in supply.
This view does not dispute the effectiveness
of sophisticated cash management techniques and new instruments, like repurchase
agreements, that emerged in the 1970s. These
developments significantly lowered transactions costs for large corporations and, perhaps, wealthy households. But for most
households and small corporations, with
relatively low money balances on average,
the costs of managing money more closely
using the new techniques may still be too
high. Therefore, it remains optimal for these
groups to leave their inventories out of balance in the short-run.
Bankloans.The second feature in the supply
view is the relationship between changes in
the public's demand for credit, and changes
in the stock of money. Essentially, disturbances in the market for credit-for equities,
bonds, and money market instruments like
commercial paper-may filter through the
banking system and affect the stock of transactions deposits which are an important
component of money.
If money finds its way into these "loosely"
managed portfol ios, it may stay there for a
while. Moreover, as one money holder tries
The critical variable connecting money and
credit is the stock of commercial bank loans.
From the public's point of view, bank loans
are an alternative form of financing to borrowing in open financial markets such as the
commercial paper market. The rate that
banks charge on their loans (prime rate) relative to open market rates therefore helps
determine the amount of bank loans the pubI ic wants to take out. A lower spread between
prime and commercial paper rates encourages the public to borrow more from banks.
The resulting rise in bank loans causes the
supply of money to increase as the loan proceeds are paid out to the borrowers in the
2
The impl ications for policy ofthe supply-side
analysis are quite different from that of the
demand view. The latter, as we have seen,
would argue that accommodating increases
in money demand would prevent interest
rates from rising orfalling and, thus, monetary policy from being inadvertently too tight
or too loose.
form of newly created transactions deposits.
As we have seen, the transactions costs of
cash management mean that part of these
new deposits may stay in the economy for
up to six months with but slight effect on
interest rates.
An important implication of this view of the
money supply process is that "disturbances"
in the credit markets can influence the money
stocle For example, an unexpected decrease
in the public's demand for bank loans would
cause a decrease in the money stocle The
credit control program of March 1980 is a
dramatic example of a credit market "shock"
that influenced the money supply, having
contributed to its sharp decline in the spring
and its rebound in the summer and fall. Another example is the collapse ofthe bond
market in early 1 980, which suddenly shifted
borrowing into banks and caused M1 to accelerate. Finally, developments in the real
sector, such as inventory cycles, can' influence bank loans and Ml.
In contrast, the supply view would argue that
the increase in money, thoughtto be a change
in demand, actually represents an incipient
excess supplyof money. If not removed, this
excess supply would cause spending to rise.
In other words, policy would turn out to
be more expansionary than intended if the
increase in money were accommodated.
Hence, policy should resist the increase
in money. The supply view argues for keeping relatively tight control over the stock
of money in order to prevent money "surprises" from exerting a destabilizing effect
on the economy.
PolicyImplications
JohnP.JuddandJohnL. Scadding
The supply side view provides an alternative
to the traditional explanation of the observed
positive association between money and interest rates in the short run. In the supply
view, the positive relationship between
money and interest rates is explained by shifts
in the demand for credit. An increase in the
demand for short-term credit (including bank
loans), perhaps because of high cost and
uncertainty in the long-term bond market,
would lead to both an increase in deposits as
banks provided more loans and an increase
in interest rates as banks competed for additional reserves to support the new deposits.
This appears to have been one of the influences in the October 1 981 -Apri 11982 period
of high Ml growth when fast growth in bank
loans contributed to an increase in money
growth and interest rates.
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BANKIN G DATA-TWELFTH FEDERALRESERVE
DISTRICf
(Dollar amounts in millions)
SelectedAssetsandLiabilities
LargeCommercialBanks
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)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess Reserves ( - )/Deficiency (-)
Borrowings
Net free reserves ( - )/Net borrowed (- )
• t?pt?AaN• o4t?PI
t?uoz!l'v'.
t?>j
5 t?1'v'
Amount
Outstanding
Change
from
8/18/82
8/11/82
161,049
140,979
44,337
57,297
23,408
2,722
6,454
13,616
38,663
26,901
30,801
99,934
90,212
37,924
337
334
- 248
20
18
206
2
1
628
- 672
60
1,116
754
870
Weekended
8/18/82
28
4
24
Change from
year ago
Dollar
Percent
9,478
10,336
4,915
3,264
475
1,365
478
1,336
970
104
939
13,945
12,351
2,497
Weekended
8/11/82.
-
-
212
79
291
6.3
7.9
'12.5
6.0
2.1
100.6
8.0
8.9
2.4
0.4
3.1
16.2
15.9
7.0
Comparable
year-ago period
16
32
16
* Excludes trading account securities.
# Includes items not shown separately.
Editorialcommentsmaybeaddressed
to theeditoror to theauthor.... Freecopiesof thisandotherFederal
Reservepublicationscanbeobtainedbycallingor writingthe PublicInformationSection,FederalReserve
Bankof SanFrancisco,
P.O.Box7702,SanFrancisco
94120.Phone(415)544-2184.
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