RICHARD D. PORTER
THOMAS D. SIMPSON
EILEEN MAUSKOPF
Staff, Board of Governors of the Federal Reserve System
FinancialInnovationand
theMonetaryAggregates
THE MOSTRECENTWEAKNESS
in the monetary aggregates has reopened
basic questionsaboutthe stanceof monetarypolicy. The patternof markedly slow rates of growthhas been especiallyevidentin M1. In the six
quarterspreceding1978:4, M1grew at an averageannualrate of nearly
8 percent, about 3 percentagepoints below the growthrate of nominal
GNP. But in that fourthquarter,M1slowed to a 4.3 percentannualrate,
while GNP expandedat a 15.6 percentrate;moreover,in 1979: 1, M1declined, while nominalGNP expandedat a 9.5 percentannualrate.
There are strikingsimilaritiesbetween the behaviorof M1 in recent
monthsand the prolongedweaknessin this aggregatefrom mid-1974 to
early 1977. In both periods,M1grewat a muchslowerratethanthatpredictedusing historicalrelationshipsamongM1,GNP, and interestrates.
This weaknesscan be seen in table 1, which shows predictedand actual
levels andgrowthratesof M1,basedon a conventionalM1demandequation. Fromthe periodbeginningin mid-1974to 1977: 1, the errorin predictingM1 cumulatedto $34 billion as the actual annualgrowthrate of
M1 averagedabout 3.5 percentagepoints less than that predicted.From
1978:3 to 1979: 1, the M1 errorgrew by $15 billion, as the actual M,
growthrateaveragedalmost7.5 percentagepointsless thanthatpredicted.
In each of these periods of unusuallyslow money growth,legislative
Note: The views expressed in this paper do not necessarily agree with those of
the Board of Governors. We want to thank Steven H. Axilrod, Jared J. Enzler, Edward C. Ettin, John H. Kalchbrenner,Kenneth J. Kopecky, David E. Lindsey, and
membersof the Brookingspanel for their comments.
0007-2303/79/0001-0213$00.25/0 C Brookings Institution
214
Brookings Papers on Economic Activity, 1:1979
Table 1. ActualandPredictedValuesandErrorsfrom a DynamicSimulationof an
M1DemandEquation,1974:3-1979 :1
Annualizedrate of growth
Yearand (percentorpercentagepoints)
quarter,and
summary
PreActutal dicted Error
statistic
Actual
Cumulative
Pre- Cumulativepercentage
error
dicted
errora
Yearandquarter
4.0
1974:3
4.6
4
1975:1
2.1
2
5.7
3
7.3
4
3.0
4.6
1976:1
2
6.4
3
4.2
4
7.4
7.4
1977:1
7.4
2
3
8.7
4
7.4
6.7
1978:1
9.2
2
8.2
3
4.3
4
1979:1
-2.4
279.0
282.1
283.6
287.7
292.9
295.1
298.5
303.3
306.5
312.1
317.9
323.8
330.8
336.9
342.5
350.4
357.5
361.4
359.2
284.0
290.1
296.3
302.9
309.9
317.0
324.6
331.6
338.1
344.8
352.2
360.1
367.5
374.3
380.8
389.7
398.0
406.5
414.9
7.9
8.6
8.5
8.9
9.2
9.2
9.6
8.6
7.8
8.0
8.6
9.0
8.2
7.4
7.0
9.4
8.5
8.6
8.2
Summarystatistic
Mean error
Mean absoluteerror
Root-mean-squareerror
-4.0
-4.0
-6.4
-3.2
-1.9
-6.2
-5.1
-2.2
-3.6
-0.5
-1.2
-1.6
0.5
-0.0
-0.3
-0.2
-0.3
-4.3
-10.6
-2.9
3.0
4.0
Level(billionsof dollarsor percent)
-5.0
-8.0
-12.6
-15.2
-16.9
-21.9
-26.1
-28.3
-31.6
-32.7
-34.3
-36.3
-36.7
-37.4
-38.3
-39.4
-40.5
-45.1
-55.7
-1.8
-2.8
-4.5
-5.3
-5.8
-7.4
-8.8
-9.3
-10.3
-10.5
-10.8
-11.2
-11.1
-11.1
-11.2
-11.2
-11.3
-12.5
-15.5
-29.6
29.6
32.3
Sources: Actual values are from the Board of Governors of the Federal Reserve System. Predicted
values are from a dynamic simulation of the Ml equation in the appendix, table A-1. This equation uses
the same specification and sample period (1960:4 to 1974:2) as the equation for Ml reported in "A Proposal for Redefining Monetary Aggregates," Federal Reser-veBulletin, vol. 65 (January 1979), p. 26. Figures
are rounded.
a. Cumulative error as a percent of actual level.
and regulatorychangeshave creatednew kinds of depositsor permitted
expandeduse of existingones, contributingto some substitutionof other
financialassetsfor M1.The recentweaknessin M1has coincidedwith the
introductionof automatictransferservices (ATS) in November 1978.
ATS has encouragedthe shiftingof fundsfrom demand-depositaccounts
to savingsaccounts.Duringthe earlierperiodof weak M1growth,negotiable-orders-of-withdrawal
(NOW) accountsat commercialbanks and
Richard D. Porter, Thomas D. Simpson, and Eileen Mauskopf
215
thrift institutionsin New England and share drafts from credit unions
emerged,providingindividualswith an explicitreturnon checkablebalances. In addition, commercialbanks were authorizedto offer savings
accountsto domesticgovernmentunits in November 1974 and to businesses in November 1975. Such new accountsencouragedsome deposit
holders to shift funds from demand-depositaccounts.However, Board
staffestimatesindicatethat such developmentscan explainno more than
one-fourthof the estimatedshortfallin M1growthshownin table 1 during
the earlierperiod,and thatATS can explainonly aboutone-fourthof the
weaknessduringthe most recentperiod.' Furthermore,technicalexplanationsthat are sometimessuggested,such as growthin FederalReserve
float,do not accountfor much,if any,of the weakness.2
Finally, table 2 confirmsthat, duringeach period of weaknessin M1,
sizableforecasterrorsalso emergedin M2. Table 2 shows that, by early
1977, the cumulativeoverpredictionfrom a standardM2equationslightly
exceededthe $34 billion overpredictionof M1.Since 1978:3, the level of
the M2errorincreasedby almosttwice as much as the M1error.Thus the
weakgrowthin M1cannotbe explainedby the substitutionof savingsand
timedepositsfor demanddeposits.3
It is importantto note that,in both periods,weaknessin the aggregates
emergedat a time when short-terminterestrateswere at historicallyhigh
levels. Meanwhile, other financial instruments-security repurchase
agreements(RPs) and money-marketmutualfunds-apparently became
more widely used as deposit substitutes.In the next section the analysis
focuses on the relationshipbetweenhigh interestrates, the weaknessin
monetaryaggregates,and the role of these new instruments.
Process
The Cash-Management
Much of the weaknessin demanddepositsrelativeto GNP in recent
yearshas been in the depositholdingsof nonfinancialcorporations,which
1. Board staff estimates suggest that the introduction of ATS accounts nationwide and NOW accounts in New York depressed M1 growth by about 1 percentage
point at an annual rate in 1978:4 and by nearly 3 percentagepoints in 1979:1.
2. From 1978:4 to early 1979, Federal Reserve float became large (but recently
it has returned to a more normal level), while Ml was virtually unchanged during
this period.
3. The weakness in M1 has been entirely attributableto the demand-depositcomponent; forecasts of currencyhave continuedto be accurate.
Brookings Papers on Economic Activity, 1:1979
216
Table2. ActualandPredictedValuesandErrorsfrom a DynamicSimulationof an
M2 DemandEquation,1974:3-1979 :1
Level(billionsof dollarsor percent)
Annualizedrate of growth
Yearand (percentor percentagepoints)
Cumulative
quarter,and
PrePre- Cumulativepercentage
summary
error
errora
Actual dicted
statistic Actual dicted Error
Yearandquarter
6.1
1974:3
4
6.6
6.4
1975:1
2
9.5
10.0
3
4
6.8
10.5
1976:1
10.0
2
3
8.8
12.6
4
10.9
1977:1
2
9.0
10.0
3
7.9
4
7.0
1978:1
2
8.4
3
9.9
7.7
4
1.6
1979:1
7.6
8.2
9.5
10.6
9.9
11.0
13.0
11.7
10.9
11.7
12.2
12.1
10.6
9.2
8.4
10.3
10.3
10.3
9.8
Summarystatistic
Mean error
Mean absoluteerror
Root-mean-squareerror
-1.5
-1.6
-3.0
-1.1
0.1
-4.2
-2.5
-1.7
-2.1
0.9
-1.2
-3.1
-0.6
-1.3
-1.4
-1.9
-0.5
-2.6
-8.2
599.9
609.8
619.6
634.3
650.2
661.2
678.6
695.5
710.9
733.3
753.3
770.3
789.6
805.3
819.3
836.6
857.3
873.9
877.4
604.1
616.5
631.1
647.9
664.0
682.2
704.3
724.9
744.7
766.4
789.7
813.6
835.1
854.3
872.3
894.7
917.9
941.6
964.8
-2.0
2.1
2.7
-4.2
-6.7
-11.5
-13.5
-13.8
-21.0
-25.7
-29.3
-33.8
-33.1
-36.4
-43.3
-45.5
-49.0
-53.0
-58.2
-60.6
-67.8
-87.3
-0.7
-1.1
-1.9
-2.1
-2.1
-3.2
-3.8
-4.2
-4.8
-4.5
-4.8
-5.6
-5.8
-6.1
-6.5
-7.0
-7.1
-7.8
-10.0
-36.5
36.5
42.6
Sources: Same as table 1, but using the M2 equation. Figures are rounded.
a. Cumulative error as a percent of actual level.
also becamemajorlenldersof RP funds.4Whileit is temptingto conclude
that weaknessin M1 simplyreflectsthe substitutionof such liquid assets
4. For econometric evidence see, for example, Helen T. Farr, RichardD. Porter,
and Eleanor M. Pruitt, "Demand Deposit Ownership Survey," in Improving the
Monetary Aggregates: Staff Papers (Board of Governors of the Federal Reserve
System, 1978), pp. 91-116. Also note that from 1970:2 to 1978:4 the ratio of personal income to gross demand deposits of consumersincreasedby 16.5 percent, while
the ratio of total business sales to gross demand deposits of nonfinancial businesses
increasedby 49.4 percent.
RichardD. Porter, ThomasD. Simpson,and Eileen Mauskopf
217
for demanddeposits,it is our view that these developmentsare part of a
generalprocessof intensifiedcashmanagement.
Severaldevelopmentslie behindthis moreintensivecash management.
Duringthe 1970s it has becomeless costlyfor corporatecash managersto
investexcess demandbalancesin the moneymarket.The cost of moving
fundsfrom accountswithlocal or regionalbanksto a money-marketasset
has fallen in real terms. Improvedinformationsystemsand forecasting
procedureshave been introduced,which reduce uncertaintiesregarding
near-termcashflowsandtherebypermitprofitablereductionsin demanddeposit balances. Moreover,high marketrates of interest in 1973-74,
1978, and early 1979 haveincreasedthe incentivefor managersto implement new cash-management
techniques.Reportsindicatethat large corporationsbegan to modify their cash-managementproceduresstarting
about 1973 and thatmanysmallercorporationshave begunto utilizethe
newertechniquesduringthe pasttwoyears.
These developmentscan be readilyinterpretedwithinthe established
inventorytheoryof thedemandfor moneyby firms.5Giventhe uncertainty
aboutday-to-daycashflows,depositholdings,m, will be positivelyrelated
to the transactionscosts, t, of exchangingdepositsfor interest-bearingassets and to the standarddeviation of net cash flows, a, and negatively
relatedto the opportunitycosts of holdingcash, r.6By purchasingcashmanagementseivices to reduceuncertaintyaboutcash flows, a firmmay
lowerits overallinventorycosts-the sum of expectedtransactionscosts,
the opportunitycosts of expected cash balances, and cash-management
costs.7 When this activityis profitable,averagedeposit holdings are reduced.Moreover,as short-terminterestratesrise,thereis a greaterincenactivitiesso thatthe demand
tive to increasethe use of cash-management
for moneybecomesmoreinterest-elasticat higherinterestrates.8Indeed,
5. See, for example, Merton H. Miller and Daniel Orr, "A Model of the Demand
for Money by Firms," QuarterlyJoutrnalof Economics, vol. 80 (August 1966), pp.
413-35.
6. More specifically, in the Miller-Orrmodel, expected cash holdings are given
by
4 {3to-I IM.
3 4rJ
7. See Richard D. Porter and Eileen Mauskopf, "Cash Management and the
Recent Shift in the Demand for Demand Deposits" (Board of Governors of the
Federal Reserve System, Division of Research and Statistics, n.d.).
8. Ibid, pp.34-36.
218
Brookings Papers on Economic Activity, 1:1979
it appearsthat industrycost-benefitratios for evaluatingsuch activities
dependexplicitlyon the level of short-termrates.
A varietyof cash-managementtechniques(for example, lock boxes,
controldisbursement,payable-throughdrafts,forecastingmodels,andinformationretrievalsystems) has improvedinformationabout near-term
cashflows.Frominterviewswith corporatecash managersandbankers,it
appearsthatone of the mostpopulartechniquescurrentlyin use is control
disbursement.This techniqueincreasesthe informationthat a firmhas at
the time investmentdecisionsare made about expectedclearingsagainst
its account.As a result,the firmcan reducethe amountof balancesthat
it holdsto meetanyunexpectedoutflowsfromits account.9On the receipts
side, lock boxes serve a similar function by increasingcertaintyabout
near-termcollectedbalances.'0
Anothercash-management
techniquethathas contributedto the weakness in demanddepositsis the cash-concentration
account,whichpermits
the customerto exploit economiesof scale that arisefrom operatingone
account ratherthan many scatteredaccounts.Using wire transfersand
depositorytransferchecks,the firmcan consolidatereceiptsinto a single
concentrationaccount from which it funds disbursements.Abstracting
fromthe costs of consolidatingaccounts,it can be shownthatthe optimal
9. In control disbursement,the firm typically maintains a zero or fixed balance
account at a "remote"bank which, because of its location, receives only one cash
letter from the Federal Reserve early each day. When the information in the cash
letter is sorted, the corporation is notified of the exact amount of funds needed to
cover all clearings against its account that day. The information comes early enough
in the day, usually by noon, so that a more accurate determinationcan be made of
funds available for investment. Checking accounts at other "nonremote" banks
usually are such that the firm will not know until late that day, or sometimes even
until the next day, the amount of funds needed for clearing. This is because other
banks may receive checks for clearing throughoutthe day by picking up cash letters
at Federal Reserveofficesor throughdirect sends.
10. The bank operating the lock box can notify the corporation daily (or more
often) when items received at the lock box become collected balances. There are
two distinct effects associated with the use of lock boxes and control disbursement:
information is received about cash flows and the timing of receipts and clearings is
altered. Lock boxes and control disbursementwere initially marketed and utilized
for the latter ("float") purpose. The gains from these activities may be quite large,
and for some firms they are probablymuch larger than the gains from any reduction
in uncertaintyabout cash flow. However, it appearsthat most firmshave increasingly
realized the value of the accompanyinginformation gains. Moreover, it has become
clear that such information gains can easily exceed the "float"gains for firms with
large variationsin daily clearingsor collections.
RichardD. Porter, ThomasD. Simpson,and Eileen Mauskopf
219
amountof cash in the concentrationaccountis alwaysless than the optimal cashbalanceheld whenseparateaccountsaremaintained,even when
net receiptsin the differentaccountsare perfectlycorrelated.However,
when costs are associated with consolidatingfunds, the decision of
whetherto concentrateaccountsdependson the costs of concentrating
relativeto the gains. Tendingto lower the consolidationcosts are the reducedpersonnelandmanagementcosts of operatingonly one accountand
the advantageof spreadinganyfixedbrokeragefee over more investment
dollars. Because the gains from consolidationincreasewith the rate of
interest,there is more incentiveto concentratewhen interest rates are
high.
Coincidingwith the increaseduse of cash-management
techniqueshas
been the growingvolumeof veryshort-termliquidassetssuch as RPs and
money-marketmutual funds. In fact, many have argued that recent
periods of weakness in demand deposits can be traced mainly to the
growthin RPs andto money-marketmutualfunds.-The argumentsattributingthe weaknessin M, to the growthin these
short-termliquid assets must be interpretedcarefully. The traditional
theory of money demandis built aroundthe notion that changesin the
yield on an interest-bearingasset or changes in the cost of converting
interest-bearingassets into money will affectmoney holdings.Since RPs
have lower transactionscosts than many other assets of comparable
yields,theirintroductionand incorporationinto cash-management
strategies might be expected to reduce the volume of demand deposits held
at anygiveninterestrate.Butwhatis sometimesarguedis thatthe demand
for money has not really changed,but insteadis being incorrectlymea11. See P. A. Tinsley, B. Garrett, and M. E. Friar, "The Measurementof Money
Demand" (Board of Governors of the Federal Reserve System, Special Studies Section, November 1978); Gillian Garcia and Simon Pak, "Some Clues in the Case of
the Missing Money," American Economic Review, vol. 69 (May 1979, Papers and
Proceedings, 1978), pp. 330-34; and John Wenningerand Charles Sivesind, "Changing the MI Definition: An Empirical Investigation"(Federal Reserve Bank of New
York, April 1979).
The recent growth of money-marketmutual funds is impressive.Such funds have
grown from about $8.1 billion at the end of September 1978 to about $18.2 billion in
early April. Since these accounts have low brokeragefees, high overnight yields, and
are checkable, it is conceivable that two-thirdsof the increase in the M1 error in the
recent period can be assigned to this source. That is, suppose the $10 billion increase
in these funds comes only at the expense of household and corporatedemand-deposit
balances. Because of the economies of scale involved in pooling receipts and disbursements, the mutual funds surely hold less than $1 billion in demand deposits.
220
BrookingsPaperson Economic Activity, 1:1979
sured.By includingRPs in the narrowestmonetaryaggregate,no weakness in this aggregatewould emerge because the sum of M, plus RPs
would behave as M, alone did previously.12This argumentimplies that
RPs dominatedemanddepositsby someagents.'3
In the case of money-marketfunds, the questionof transactionscosts
is moot. Accountscontainingsuch funds are typicallycheckable;and for
most funds no chargesare made for drafts,providedthat checks exceed
a minimumamount.'4The checkabilityfeatureand the near-marketyield
on money-marketfundsmakethemattractiverelativeto demanddeposits.
If RPs and money-marketmutualfundstend to dominatemoney,then
the stabilityof the M, demandequationsmightindeedbe restoredby adding RPs or RPs andmoney-marketmutualfundsto M,. Table 3 provides
the simulationresultsfor a demandequationusingan M, specificationbut
estimatedfor the sum of M, plus RPs at commercialbanks, and for the
sum of M, RPs, and money-marketmutual funds. The table indicates
thatthe additionof RPs can cut the demanderrorappreciably.At the end
of 1975 the cumulativeerrorsin both the equationfor M, (table 1) and
the equationfor the sumof Ml andRPs (table 3) were about$20 billion.
From 1975:4 to 1978:3, the M, level errordoubledin size,whilethe error
in the equationcontainingRPs increasedby about half. Most recently,
from 1978:3 to 1979:1, the M, errorincreasedby an additional$15 billion, at a time whenthe errorfor the sumof M, andRPs grewby $10 billion. A betterperformancewas shownby the broaderaggregate,MI, RPs,
and money-marketmutualfunds.The table showsthat since 1976:1, the
equationfor thismoneymeasurehas predictedquiteaccurately.
Should we concludefrom this evidence that RPs and money-market
12. This argumentis set forth in Garcia and Pak, "Some Clues in the Case of the
Missing Money."
13. To be a dominant asset, the RP market must be active late in the day when
firms know the amount of demand balances needed to cover net disbursements.Alternatively, if the market closes earlier in the day, the returns on an RP must be
large enough to cover potential overdraft charges or the penalty for breaking an RP
commitment.
14. The checkability of money-market funds is limited to some extent by the
typical requirement that checks must exceed $500. However, the average size of
checks written at commercial banks is roughly $500. See "Check Processing at
Federal Reserve Offices,"Federal Reserve Bulletin, vol. 65 (February 1979), p. 99.
Other Board staff estimates suggest that about 10 percent of all checks written have
face amounts of $500 or larger.
Richard D. Porter, Thomas D. Simpson, and Eileen Mauskopf
221
Table3. Errorsfrom a DynamicSimulationof a Money-DemandEquationfor
AlternativeMeasuresof Money, 1974:3-1979: 1
Cumulativeerror
Yearand
auarter,and
summary
statistic
Yearandquarter
1974:3
4
Ml andRPs
Billionsof
dollars
Percent"
M1,RPs, and money-market
mutualfunds
Billionsof
dollars
Percent"
-6.2
-8.8
-2.1
-3.0
-5.7
-7.4
-1.9
-2.5
1975:1
2
3
4
-14.1
-15.7
-15.7
-20.0
-4.7
-5.2
-5.1
-6.5
-11.4
-12.3
-12.5
-16.9
-3.8
-4.0
-4.0
-5.4
1976:1
2
3
4
-23.3
-23.1
-24.4
-24.5
-7.4
-7.1
-7.4
-7.3
-20.0
-19.9
-21.5
-21.4
-6.3
-6.1
-6.4
-6.3
1977:1
2
3
4
-26.6
-27.7
-26.6
-25.2
-7.7
-7.9
-7.4
-6.8
-23.3
-24.7
-23.8
-22.1
-6.7
-6.9
-6.5
-5.9
1978:1
2
3
4
-25.7
-28.4
-28.6
-29.5
-6.8
-7.4
-7.3
-7.3
-21.7
-22.9
-21.7
-21.0
-5.7
-5.9
-5.4
-5.1
1979:1
-38.8
-9.7
-25.2
-6.1
Summarystatistic
Mean error
Mean absolute error
Root-mean-square
error
-22.8
22.8
-18.7
18.7
24.0
19.6
Sources: Same as table 1, but using the equation for the sum of Ml and security repurchase agreements
at banks (RPs) and the equation for the sum of M1, RPs, and money-market mutual funds. Those equations use the same specification as the M1 equation in the appendix, table A-1. The RP data used here
are preliminaryand are under review by the Board staff. The RP series is believed to contain considerably
more estimation error than the money stock figures. Moreover, RP estimates for 1978:4 to 1979:1 are
based on September 1978 call report relationships and are likely to be revised, perhaps substantially,
as some recent call reports information becomes available.
a. Cumulative error as a percent of actual level.
222
Brookings Papers on Economic Activity, 1:1979
mutualfunds, takentogether,explainthe M1puzzle?In the earlyperiod
from mid-1974 to early 1976, they clearly do not help much, although
morerecentlytheyhelp considerably.However,resultsin table 3 aremisleading insofar as part of the growth in RPs and money-marketfunds
shouldbe relatedto the increasein their own yields over this period. If
these equationswere respecifiedto includethe appropriateown rates,we
expect the predictedvalues would be higher and the errors would be
larger.'5Put differently,in the mostrecentperiod,how can we be surethat
growthin money-marketmutualfundsor RPs has not come at the expense
of timeandsavingsdepositsas well as demanddeposits?16
The econometricevidenceindicatingthat RPs can only accountfor a
portionof the M1shortfallis reinforcedby some featuresof the RP market. It is difficultto substantiatethe allegation that firms can convert
demanddepositsinto RPs at the end of the day when they have perfect
certaintyabouttheir cash flow. Reportsbased on interviewssuggestthat
the volume of RPs negotiatedlate in the day is small. Similarly,alleged
arrangements
in whichexcessdemandbalancesare automaticallyinvested
at the end of the day in RPs appearto accountfor only a smallfractionof
RPs. In fact, most RP transactionsare arrangedearlyin the day and they
are rarelyallowed (by eitherthe bank or the nonbankdealer) to be reversedat a laterpoint in the day. Also, cash managerscan choose from a
varietyof alternativesto commercialbankRPs havingsimilarnet returns,
such as RPs with nonbank dealers, offshore dollar deposits, specially
tailoredcommercialpaper,andmoney-marketfunds.'7
15. Some crude empiricalwork supportsthese assertions.When the federal funds
rate (as a proxy for the own rate on RPs) was added as an independentvariable to
the equation for the sum of Mi and RPs, the simulation errorswere somewhat higher
than those given in table 3.
16. Recall that most recently the M2 error (in billions of dollars) has increased
much more than has the Mi error.
17. An RP arrangedwith a commercial bank results in an immediate reduction
in the public'sdemand-depositbalances,while an RP arrangedwith a nonbankdealer
or a similar transaction with another nonbank institution does not lead to such an
immediate decline in demand deposits. However, when the Federal Reserve uses the
federal funds rate as the operating target, the level of deposit holdings is essentially
determined by demand; in this case, the effects of these other transactions on the
money supply are likely to be the same. For example, the dealer could disbursethese
funds by repaying a maturingRP or by acquiringsecuritiesfrom the nonbankpublic;
as a result, such funds would likely return to private demand accounts. But, because
the public does not want to hold these deposits, additional transactions will occur
that will place downward pressure on market rates of interest. Through efforts by
RichardD. Porter, ThomasD. Simpson,and Eileen Mauskopf
223
Althoughit might appearthat money-marketmutualfunds have displaced demand deposits, the evidence indicates that the funds are not
being used as demanddeposits. To date, industrysources indicatethat
only about one draftper month is writtenon these accounts,compared
withtwenty-twoper monthon regulardemand-depositaccounts.In addition, the annualturnoverrateof the money-marketfundobligations-that
is, the dollarvolumeof redemptionsdividedby averagedollarvolumeappearsto averageonly two and a half to three.This rate is substantially
below the annualdemand-depositturnoverrateof aboutone hundredfor
accountsat banksoutsideNew York City andonly slightlylargerthanthe
turnoverrates for all passbook savings accounts at commercialbanks.
Finally, the typical money-marketfund accountis largerthan the usual
transactionsaccount,averagingabout $20,000 for stockbrokerand general purposefunds and about $60,000 at funds restrictedto particular
institutions.
Giventhe institutionalevidenceon RPs and moneyfunds,such investments can best be viewedas affectingM1throughtheirrole as buffersto
demand deposits instead of as replacementsfor demand deposits. For
many individuals,the money-marketfunds apparentlyserve as a more
efficientdemand-depositbufferthan do passbooksavingsaccounts;corporationshave apparentlyfound money-marketfunds and, to a greater
degree, RPs to be attractivebuffers.An increasein the yields on these
assets would thus tend to constrainM1 growthin the same way that an
increasein the rate on passbookaccountswould. Moreover,these instruments presumablyhave attractedfunds from those assets that have traditionallyacted as buffersin additionto drawingfunds from demanddepositbalances.A properlyspecifieddemandequationfor these assets
thereforewouldprobablyhaveto includeportfolioconsiderationsin addition to transactionelements.
The above considerationsare consistentwith the implicationsof the
cash-management
process.Cash-management
techniquespermitfirmsto
conducta given scale of operationswith smalleramountsof demanddethe central bank to stabilize short-term rates of interest, these unwanted demand
balances will tend to be removed from the system. The key issue is the length of
time it takes for such demand balances to be removed. If the time is sufficientlybrief,
then a desire by the public to reduce its demand balances and to acquire dealer RPs
will result in a reduction in demand deposits in much the same way as if the RPs are
arranged with a commercial bank, even though the latter process will be more
roundaboutthan the former.
224
Brookings Papers on Economic Activity, 1:1979
posits. In otherwords,the cash-management
processresultsin a shift in
the demandfor moneyrelativeto GNP. Nevertheless,the role of RPs and
money-marketfunds in this process is importantin severalways. First,
even in the absenceof increasingfamiliaritywith cash-management
practices, the positive overnightyields to be earnedon these assets enhance
theiruse as a bufferto demanddepositsandconsequentlyreducedemanddepositbalances.Second,the yields increasethe incentiveto utilizethose
cash-managementtechniquesthat reduce uncertaintyabout near-term
cashflows,thusfurtherreducingthe level of demanddeposits.
Incentivesfor CashManagement
Technologicaldevelopmentsand competitiveforces in the marketfor
liquidfundshave contributedto reductionsin the public'sholdingsof demanddepositsrelativeto GNP. Computerizationhas facilitatedthe regular monitoringof cash balances and has improved the accuracy of
cash-flowforecasts.Also, the growing availabilityand convenienceof
wire transferspermitfunds to be transferredreadilyfrom one demanddepositaccountof a firmto anotheror betweenliquid assetsand demand
accounts.Moreover,nonbankinstitutions,such as money-marketmutual
funds,and securitydealershave intensifiedtheireffortsto attracta growing shareof the public'sliquidassets,as haveforeignbankingoffices.
These developments-the increasinguse of cash managementand the
emergenceof new or more attractiveliquid assets-might be viewed as a
consequenceof the legal prohibitionof intereston demanddepositsand
the absenceof the paymentof intereston bankreserves.As a consequence,
bankshave devisedmethodsof payingimplicitintereston theirdemanddepositbalances.At largebanks,compensationusuallytakes the form of
creditservices (typicallylines of credit) and cash-managementservices.
The imnplicitcompensationrate paid on demand balances is generally
tied to a money-marketrate, adjustedfor the proportionheld as idle
requiredreserves, and applied to collected balances in the account.'8
18. Specifically, the rates on treasury bills (usually with ninety-day maturity)
are used to set an "earningscredit rate." Compensating balances are then equal to
the value of services divided by the earnings credit rate, where this rate is the bill
rate multipliedby one minus the reserverequirement.
RichardD. Porter, ThomasD. Simpson,and Eileen Mauskopf
225
Theseimplicitratesstillfall shortof the competitiveratebecauserequired
reservesheld by memberbanksagainsttheirdepositsdo not earninterest.
If a competitiverate of interestwere paid on requiredreserves,banks
wouldbe able to offertheir customersmore attractiveterms.But even if
interestwereallowedon demanddepositsandcompensationwerepaid on
requiredreserves,demanddepositsandothernear-moneyfinancialinstrumentswould have differentyields.Becausedemand-depositfunds can be
depositedor withdrawnat any time duringthe businessday, they have
higherreservemanagementcosts for the bank than do very short-term
investments.Becauseof these higherreservemanagementcosts, the rates
that would be offered on demandbalances would fall short of market
yields on investmentswith very shortmaturities,such as RPs.19And customerswould continueto have incentivesto use cash-managementtechniques,both to earnthe higherrateon nearmoney and to slow disbursementsandspeedup receipts.
Interpretingthe MonetaryAggregates
The financialinnovationsdiscussedabove presenta numberof difficultiesfor the interpretationof the monetaryaggregatesand for the conduct of monetarypolicy. Some of these difficultiescan be reduced by
changingthe definitionsof the monetaryaggregates.Indeed, the recent
proposalsby the Board stafffor redefiningthe monetaryaggregatestake
accountof importantdevelopmentsthathave alteredthe depositliabilities
of depositoryinstitutions.20
The proposedM1containsnewly introduced
transactionsdeposits,such as NOW andATS balances.The proposedM2
19. This argument is consistent with the observation that RPs arrangedearly in
the day generally have a higher yield than RPs placed later. If a bank or dealer held
collateral until late in the day (when the customers are more certain of what their
cash position will be), then on average the RP issuer would be left holding excess
collateral. To offset the possibility of such a loss, the issuer would be forced to offer
a lower rate on RPs placed late in the day. Reports indicate that, under the circumstances, customers prefer to receive a more favorable morning yield, thus incurring
the costs of uncertaintythemselves.
20. "A Proposal for Redefiningthe Monetary Aggregates,"Federal Reserve Bulletin, vol. 65 (January 1979), pp. 13-42.
226
BrookingsPaperson Economic Activity, 1:1979
addsto this savingsdepositsat all depositoryinstitutionson groundsthat
recent regulatorychangesand competitivepressureshave generallyenhanced the liquidityof all savings balances. Meanwhile, the growing
illiquidityof time deposits at all depositoryinstitutionshas been recognized, and all such deposits have been excludedfrom the proposedM2
andincludedinsteadin the proposedM3.However,even these aggregates
generallydo not havestabledemandfunctions.
The instabilityof the estimateddemandfunctions for the proposed
aggregates(and for the currentaggregates)ariseslargelyfromthe fundamental changes that are occurringin the nature of deposits and near
money. But we believe that the shifts of the demandfunctions arise at
processdiscussedearlier.Creleast as much from the cash-management
atingan empiricalframeworkfor evaluatingand predictingthe impactof
the cash-managementprocess is difficult,however,for several reasons.
processis limited.MoreHistoricalexperiencewiththe cash-management
over,the incentivesfor continuedcashmanagementare closely tied to the
existenceof regulations,high interestrates, and technologicaland competitive developments.Thus it is quite difficultto isolate the impact of
eachof thesefactorson the demandfor money.
The increasingavailabilityof new money substitutesposes an additionalproblem.Someof thesemoneysubstitutes,such as RPs, are offered
by domesticbanks;others, such as money-marketfunds and short-term
commercialpaper,are availableat nonbankinstitutions.Eurodollarsare
offeredby bankingofficesabroad-foreign banksandforeignbranchesof
U.S. banks.One coulddeal with suchmoneysubstitutesby includingvery
short-termliquid investmentsin measuresof the monetaryaggregates.
Thus M1-or perhapssome broaderaggregate-could include the RP
liabilitiesof commercialbanks and dealers,money-marketfunds, Eurodollar holdings of U.S. residents,short-termcommercialpaper, and so
forth.
Whilea broadermoneymeasurehas some desirableattributes,it is unlikelythatit wouldbear as close a relationshipto transactionsor GNP as
process
demanddepositsduringthoseperiodswhenthe cash-management
is relativelydormant,such as the periodpriorto mid-1974. To the extent
that the cash-managementprocess is unpredictable,a broadermeasure
may have some "built-instability"because much of the funds released
from demanddeposits will likely be placed in such short-termbuffers.
However,the interest-bearing
componentof such a measuremay oftenbe
RichardD. Porter, ThomasD. Simpson,and Eileen Mauskopf
227
dominatedby motives besides transactionsdemandrelatedto income.2'
For example,assetholdersmay at timeswant to keep a largeproportion
of theirfinancialassetsin very short-termfundsfor portfolioreasons.Accuratelypredictingsuchmovementsis difficult.Furthermore,the spectrum
of availableliquidassetsmay expandso thatfundscould shiftfromthose
buffersincludedin a particularmonetaryaggregateto those excludedfrom
the aggregate.22
In principle,one could separatethe total volume of these buffersinto
a portionthat is relatedto portfoliomotives and one relatedto transactions motives. The latter could then be combinedwith ordinarytransactions balances to form a new transactions-relatedmeasureof money
along the lines of Tinsley, Garrett,and Friar.23It is not clear, however,
that econometricprocedureshave been refinedto the point where the
transactions-related
portionof suchinstrumentscan be reliablyseparated
from the remainder.Moreover,as noted above, to the extent that many
financialinnovationstendto be partof an ongoingprocessrelatedto cashmanagementand competitivepressures,new instrumentsare likely to
appear as transactionsbalances, requiring continued redefinition of
money. Alternatively,data on the short-termbuffersand cash-management developmentscould be used to adjustjudgmentallythe growthof
the aggregates.The targetedgrowthin the monetaryaggregatescouldthen
be modifiedto reflectthe impactof suchdevelopments.
For the mid-1974 to early 1977 period, such ex post judgmental
changeswould undoubtedlyplace adjustedgrowthin M1and M2 at rates
closer to the predictedvaluesthan to the actualvalues in tables 1 and 2.
A similarchangein the currentperiodof apparentweaknesswouldshow
adjustedgrowthratessomewhatstrongerthanthe measuredgrowthrates.
It is reasonableto assume,therefore,thattargetedgrowthratesof nominal
GNP are consistentwith somewhatslowergrowthin currentmeasuresof
the monetaryaggregatesthan the historicalrelationshipssuggest.However, giventhe unpredictabletimingand size of the shiftsin M1demand,
21. This point is elaboratedin Tinsley, Garrett, and Friar, "The Measurementof
Money Demand." Restrictingthe techniques to overnight instrumentswould reduce
this problem but not eliminate it. Moreover, if such instrumentsare included, why
not include those maturingin two days? A definitionalboundaryhas to be arbitrarily
drawnsomewhere,but where?
22. Any excluded instrumenthaving yields and transactionscosts similar to those
included is likely to have a high elasticity of substitutionwith included instruments.
23. Tinsley, Garrett,and Friar, "The Measurementof Money Demand."
228
Brookings Papers on Economic Activity, 1:1979
it is likelythat even the best adjustmentswill be off the mark.In such an
environment,it is more importantthan ever that policymakerssupplement informationon monetaryaggregateswith data on near money and
otherfinancialassets, interestrates, and directindicatorsof currentand
futuredevelopmentsin the economy.
APPENDIX
Appendix table A-1 shows estimatedequationsfor money demand,
basedon some alternativedefinitionsof the monetaryaggregatesdiscussed
in the text.
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