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FRBSF

WEEKLY LETTER

Number 92-38, October 30, 1992

Would a New Monetary Aggregate
Improve I'Ollcy!
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M2 growth has been significantly slower than the
Federal Reserve expected when it set the 1992
annual target range of 2% to 6% percent. Since
the fourth quarter of 1991, the aggregate, which
includes currency, checking accounts, various
kinds of savings instruments, and small time deposits, has increased at an annual rate of only 1Y2
percent. This is the third successive year in which
M2 has been close to, or below, the lower bound
of its annual range.
For many years, M2 was a useful long-run policy
indicator because the public's willingness to hold
M2 assets had a stable and predictable relationship to the level of nominal GDP. As shown in
Chart 1, the velocity of M2, measured by the
ratio of nominal GDP to M2, fluctuated around
an almost constant level from 1959 to 1989. But
in recent years the link between M2 growth and
nominal GDP appears to have deteriorated.
Since 1989, the yields on short-term securities
have declined more rapidly than deposit rates
paid on M2 assets-thus reducing the opportunity cost of holding M2-but we have not seen
the drop in its velocity we would have expected
from past experience. V2 was at roughly the same'
level in the second quarter of this year as in the
second quarter of 1989, even though the opportunity cost of holding M2 declined more than
150 basis points.
The slowdown in M2 growth has been concentrated in a decline in the volume of small time
deposits. For the other components of M2-currency, checking accounts, and savings instruments
-we see either strong or moderate growth. Initially, the decline in small time accounts mostly
reflected the closing of weak thrift institutions
that had been paying above-market interest rates
to attract time deposit funds. More recently, funds
also have been shifting out of time accounts at
commercial banks.
Before these developments began, I suggested an
alternative definition of M2 that would exclude
small time deposits (Motley 1988). A variation

Chart 1

Velocity of M2 and
Opportunity Cost
Ratio

Percent

.60

10
Opportunity Cost

8

.55

80

82

84

86

88

90

on this theme has been taken up by Poole (1991),
who proposes an alternative monetary aggregate
that he calls MZM, to stand for Money with Zero
Maturity. This aggregate would include all of
the current M2 except small time deposits, plus
institution-only money market funds, which currently are included in M3 but not in M2.
The opportunity cost of MZM also has declined
since 1989. In the case of this aggregate, however, this decline in opportunitycost has had the
expected effect of causing its velocity to decrease
(see Chart 2). In other words, although growth
in MZM also has slowed, this slowing is in line
with historical experience. Poole argues that this
greater stability in the demand to hold MZM assets would make it a better target for policy.

"Money" in theory and practice
In monetary theory, "money" is regarded as a
unique and special asset for two reasons. First,
money is an asset that gives its holder immediate
purchasing power over goods and services. Second, holding money involves little or no interest
rate risk, because either it yields no interest, or
any interest return that it does yield rarely changes.

FRBSF
Chart 2

Velocity of MZM and
Opportunity Cost
Percent

Ratio

1.2
8

1 .0

6

.8

,......•........./ ..........•.........."
".....

.

4

Opportunity Cost

.6

2

80

82

84

86

88

90

These features mean that money is held as a
"temporary abode of purchasing power" rather
than for investment purposes, and the amount
of money the public chooses to hold is closely
related to total spending.
Until the late 1970s, M1, which includes only
currency and checking accounts, satisfied both
these criteria. Since assets in M1 could be spent
immediately but yielded no interest, people had
an incentive to hold only transactions funds in
this aggregate. As a result, the demand to hold
M1 was found to be especially closely linked to
nominal spending.
M2 also was a close empirical proxy for the theoretical concept of "money" in this period. Most
of the assets in M2 yielded a zero or regulated
return. Depository institutions often permitted
their customers to liquidate savings deposits on
demand or with only a short delay, making them
almost as liquid as M1. Small time deposits generally could be liquidated before maturity at the
cost of paying an early withdrawal charge. As a
result, for many people, all M2 assets (and not
only those in M1) were almost risk free and relatively liquid. Although M2 was found to be less
reliably rlilated tothe short-run performance of
the economy than M1, it did provide some useful
policy information.

Deregulation and the aggregates
The deregulation of deposit interest rates beginning in the late 1970s had two important effects on
these aggregates. First, since some M1 deposits

yield an interest return, people had less incentive
to separate thei r transactions and nontransactions
funds and to hold only transactions balances in
M1. As a result, shifts of funds between M1 and
non-M1 assets within M2 occurred more frequently. This weakened the link between M1 and
nominal income and appears to have made the
demand for M1 unstable. As a result, Ml became
less useful as a policy indicator, and the Federal
Reserve ceased to set gro\A/th targets for this aggregate after 1986.
Second, M2 has become a less homogeneous
aggregate. Although no longer regulated, yields on
savings and checking accounts still are adjusted
relatively infrequently. The resu It is that savi ngs and
checking accounts continue to be used largely as
temporary abodes of purchasing power by assetholders who respond only slowly to interest rate
changes. By contrast, depository institutions treat
small time deposits as managed liabilities and vary
their yields flexibly in response to changes in the
returns on other short-term instruments and in their
requirements for funds to finance the credit demands of their customers (Judd and Trehan 1992).
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other short- and intermediate-term investment
instruments and are held by people who are more
rate-sensitive. This means that the volume of small
time deposits is more apt to respond to shocks affecting the credit and securities markets than is
the remainder of M2. For example, one explanation of the recent decline in small time deposits
is that the unusually steep yield curve has induced investors to shift funds out of time deposits at depository institutions and into instruments
with longer maturities, for example, bond funds.
This change in the character of small time deposits has made them less like the rest of M2 than
they used to be. As a result, the demand for M2
as a whole'l'rTlay have become less stable. By contrast, MZMremains a relatively homogeneous
collection of liquid assets. This may explain why
the velocity of MZM has remained in line with
historical experience in the last three years, while
that of M2 has not.

A better indicator?
Although MZM appears to be a better empirical
proxy than M2 for the theoretical concept of
"money;' it is not necessarily true that it would
be a reliable indicator in the future. First, it is
always possible to find an aggregate that in the
past was more closely related to nominal GDP
than potential alternatives; but its past performance is not independent evidence that this relationship will persist in the future. It should not be
surprising that when one moves beyond the sample period used to define an aggregate, the rela-

tionship may deteriorate. For example, the present
definition of M2 itself was chosen in part because the demand for it was found to be a stable
function of a small number of variables over a
sample period that ended in 1979. Just as innovation and deregulation affected the behavior of M2
after it was defined, new liquid assets could be
developed in the future that would be close substitutes for the present components of MZM. For
example, some bond funds already allow investors to write checks up to a certain maximum
against their holdings.
A second problem arises because causation runs
not only from money to the economy but also
from the economy to money. Even though an
aggregate's velocity has been stable, it may not
provide useful information if the Federal Reserve
is unable or does not choose to control it closely.
To test whether a change in an aggregate provides useful information about future GOP growth,
one must take account of the causation in both
directions.
One way to examine the indicator properties of
an aggregate is to estimate a statistical model
that ~;;pt~res both kinds of causation and to examine the responses of GOP and inflation to
unexpected changes in the aggregate. I have estimated two four-variable vector error correction
models that include a monetary aggregate (M2
or MZM), a corresponding opportunity cost variable, real GOP and the price level. When estimated over a sample period that ends in 1989,
both models yield theoretically plausible coefficient values and predict that an unanticipated
increase in the aggregate will be associated with
a permanent rise in the average price level and a
temporary increase in real GOP. These results
conform to theoretical expectations.
However, the indicator properties of both aggregates have deteriorated since 1989. Chart 3 compares real GOP since 1989 with forecasts from
the two statistical models. Both models would
have missed the downturn in GOP in 1990 and
overestimated the strength of the subsequent
recovery.

Conclusions
In recent years the velocity of M2 has been higher
than expected given the levels of nominal GOP
and interest rates. No such shift in the behavior

Chart 3

RealGDP
Billions
5,310
M2

5,220
5,130
5,040
4,950
4,860

89

90

91

92

4,770

of MZM's velocity has occurred. In addition,
MZM more closely approximates economists'
traditional notion of what they mean by "money:'
These findings provide support for proposals that
the Federal Reserve use MZM as a policy indicator in place of M2.

However, one cannot be optimistic that such a
change would improve the implementation of
monetary policy. The fact that a particular monetary aggregate has been stably related to the
economy's performance in the past does not provide independent evidence that it would continue
to be a good indicator in the future, especially in
a period of ongoing financial change. And despite the stability in the demand function for MZM,
its ind icator properties appear to have deteriorated
almost as much as M2.

Brian Motley
Senior Economist

References
Judd, John, and Bharat Trehan. 1992. "Money, Credit,
and M2:' FRBSF Weekly Letter (September 4).
Motley, Brian. 1988. "Should M2 be Redefined?"
Federal Reserve Bank of San Francisco Economic
Review (Winter) pp. 33-51.
Poole, William. 1991. "Choosing a Monetary Aggregate: Another Look." Shadow Open Market Committee (SOMC) Policy Statement and Position
Papers (September 29-30).

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 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, Fax (415) 974-3341.
Printed on recyCled paper Q
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with soybean inks.
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Index to Recent Issues of FRBSF Weekly Letter

DATE NUMBER TITLE

AUTHOR

4/10
4/17
4/24
5/1
5/8
5/15
5/22
5/29
6/5
6/19
7/3
7/17
7/24
8/7
8/21
9/4
9/11
9/18
9/25
10/2
10/9
10/16
10/23

Hutchison/judd
Throop
Zimmerman
Neuberger
Trehan
SchmidtlDean
Cromwell/Schmidt
Sherwood-Call
Walsh
Sherwood-Call
Cromwell
Parry
Trenholme/Neuberger
Furlong
Sherwood-Call
judd/Trehan
Moreno
Glick/Hutchison
Throop
Schmidt/Gruben
Throop
Glick/Hutchison
Zimmerman

92-15
92-16
92-17
92-18
92-19
92-20
92~21

92-22
92-23
92-24
92-25
92-26
92-27
92-28
92-29
92-30
92-31
92-32
92-33
92-34
92-35
92-36
92-37

Monetary Announcements: The Bank of japan and the Fed
Causes and Effects of Consumer Sentiment
California Banks' Problems Continue
Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy
EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank Independence
First Quarter Results: Good News, Bad News
Are Big U.s. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currency Crisis
Southern California Banking Blues

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.