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 Title Page
 Table of Contents
 Introduction
 Section I: Principles of monetary...
 Section II: Instruments and indicators...
 Section III: Controlling the money...
 Section IV: The relationship between...






Title: Issues in monetary policy
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Title: Issues in monetary policy
Physical Description: vi, 124 p. : ill. ; 24 cm.
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Creator: Federal Reserve Bank of Kansas City -- Research Division
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Place of Publication: Kansas City Federal Reserve Bank of Kansas City
Publication Date: [1980]
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Table of Contents
    Front Cover
        Front Cover
    Title Page
        Page i
        Page ii
    Table of Contents
        Page iii
        Page iv
    Introduction
        Page v
        Page vi
    Section I: Principles of monetary analysis
        Page 1
        Money: A changing concept in a changing world, by Carl M. Gambs
            Page 2
            Page 3
            Page 4
            Page 5
            Page 6
            Page 7
            Page 8
            Page 9
            Page 10
            Page 11
        Velocity: Money's second dimension, by Bryon Higgins
            Page 12
            Page 13
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            Page 16
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            Page 26
            Page 27
            Page 28
    Section II: Instruments and indicators of monetary policy
        Page 29
        The choice of a monetary policy instrument, by J. A. Cacy
            Page 30
            Page 31
            Page 32
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            Page 47
        Monetary policy and economic performance: Evidence from single equation models, by Bryon Higgins and V. Vance Roley
            Page 48
            Page 49
            Page 50
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            Page 58
    Section III: Controlling the money stock
        Page 59
        The Federal Reserve and the government securities market, by Margaret E. Bedford
            Page 60
            Page 61
            Page 62
            Page 63
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            Page 74
        The Federal Reserve's impact on several reserve aggregates, by Jack L. Rutner
            Page 75
            Page 76
            Page 77
            Page 78
            Page 79
            Page 80
            Page 81
            Page 82
            Page 83
        Reserve requirements and monetary control, by J. A. Cacy
            Page 84
            Page 85
            Page 86
            Page 87
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    Section IV: The relationship between monetary growth and the economy
        Page 97
        Monetary growth and business cycles: Part I, by Bryon Higgins
            Page 98
            Page 99
            Page 100
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            Page 103
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            Page 105
            Page 106
        Monetary growth and business cycles: Part II, by Bryon Higgins
            Page 107
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        Money and Income: Is there a simple relationship?, by Robert D. Auerbach and Jack L. Rutner
            Page 118
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Full Text

issues
ISSHiS
in
monetary
policy


Federal Reserve Bank of Kansas City












Issues in Monetary Policy








Research Division
Federal Reserve Bank of Kansas City


Thomas E. Davis, Senior Vice President










Contents

INTRO DU CTION ..................................................................v

SECTION I: PRINCIPLES OF MONETARY ANALYSIS
Money A Changing Concept in a Changing World .....................................2
By Carl M. Gambs
Velocity Money's Second Dimension ........................ .......... .................. 12
By Bryon Higgins
SECTION II: INSTRUMENTS AND INDICATORS OF MONETARY POLICY
The Choice of a Monetary Policy Instrument ........................................30
By J. A. Cacy
Monetary Policy and Economic Performance:
Evidence from Single Equation M odels .............................. .....................48
By Bryon Higgins and V. Vance Roley

SECTION III: CONTROLLING THE MONEY STOCK
The Federal Reserve and the Government
Securities M market ..................... ...... ............ ... .. .... ........... 60
By Margaret E. Bedford
The Federal Reserve's Impact on Several
Reserve Aggregates ....................................................... 75
By Jack L. Rutner
Reserve Requirements and Monetary Control ...........................................84
By J. A. Cacy
SECTION IV: THE RELATIONSHIP BETWEEN MONETARY GROWTH
AND THE ECONOMY
M monetary Growth and Business Cycles: Part I ........................... .....................98
By Bryon Higgins
Monetary Growth and Business Cycles: Part II .......................................107
By Bryon Higgins
Money and Income:
Is There a Simple Relationship? ................. ....................... .............. ... 118
By Robert D. Auerbach and Jack L. Rutner











Introduction

One of the principal objectives of financial research at the Federal Reserve Bank of Kansas
City is to analyze issues relevant to the formulation and implementation of monetary policy.
Toward this end, numerous articles pertaining to some aspect of monetary policy have been
published in our Economic Review, which was previously called the Monthly Review. This
booklet contains reprints of 10 articles from the Review that we believe have continuing rele-
vance to monetary policy issues. While several of the articles have been reprinted elsewhere,
we have combined them into a booklet so that college and university students, banking school
students, and others interested in policy analysis may have a readily available source contain-
ing material devoted entirely to a discussion of monetary policy issues.
The initial section of the booklet contains articles that examine some basic concepts relevant
to monetary policy analysis. The first article considers the evolution of the concept of money
and addresses the issue of how to define money in a rapidly changing financial environment.
The next article discusses the determinants of the velocity of money and examines the secular
and cyclical behavior of velocity.
The articles in the second section analyze the extent to which monetary and reserve aggre-
gates are preferable to interest rates as policy guides. In the first article, the theoretical issues
involved in the choice between the money supply and an interest rate as the monetary policy
instrument are analyzed. The second article uses regression analysis to shed light on the rela-
tive ability of current and past movements in monetary aggregates and interest rates to predict
the impact of monetary policy actions on the economy.
The third section includes articles dealing with various aspects of monetary control. The
first article discusses the Federal Reserve's open market operations in government securities
and the role of open market operations in controlling the growth of money and credit. In the
next article, the empirical relationship between open market operations and reserve aggregates
is examined. The third article analyzes the impact of the level and structure of reserve require-
ments on the ability of the Federal Reserve to control monetary growth.
The final section contains articles dealing with the relationship between monetary growth
and economic performance. The first article investigates the historical relationship between
changes in the rate of monetary growth and cyclical fluctuations in economic activity. The
next article analyzes the association between monetary deceleration and recessions in the
period since 1952. The last article uses a variety of statistical techniques to determine the
extent to which the observed relationship between money and income results from the
independent influence of monetary growth on other economic variables.
It is hoped that the material in this booklet will be useful in clarifying some of the complex
issues in monetary analysis and will thereby contribute to further research and more fruitful
discussions of monetary policy issues.



Roger Guffey
President


February 1980









Section I

Principles of
Monetary Analysis











Money A Changing Concept in a Changing World



By Carl M. Gambs


It is a singular and, indeed, a significant
fact that, although money was the first eco-
nomic subject to attract men's thoughtful
attention, and has been the focal centre of
economic investigation ever since, there is at
the present day not even an approximate
agreement as to what ought to be designated
by the word. The business world makes use
of the term in several senses, while among
economists there are almost as many different
conceptions as there are writers upon
money.


The money stock has been given increasing
attention in recent years. Both the Federal Reserve
and the public currently closely observe the rate at
which the quantity of money is growing. Accom-
panying this increased attention to money is a
recognition that there is considerable disagreement
as to how money should be defined. As the above
1899 statement by A.P. Andrew demonstrates,
this disagreement is far from new.
While the nature of the disagreement over the
definition of money has changed since 1899, dis-
agreement seems always to have been present.2 In




'A.P. Andrew, "What Ought to be Called Money," Quarterly
Journal of Economics, Vol. 13 (January 1899), p. 219.


Carl M. Gambs is an assistant vice president and economist with
the Federal Reserve Bank of Kansas City. This article was
originally published in the January 1977 Monthly Review.


1974 the Board of Governors of the Federal Reserve
System, recognizing the importance of this prob-
lem, appointed the Advisory Committee on
Monetary Statistics (generally termed the Bach
Committee after Professor G.L. Bach, the chair-
man) to examine some of the issues involved. The
Bach Committee's report was released in June
1976,3 but given the extent of disagreement on the
subject, its conclusions are unlikely to greatly
reduce the controversy over the definition of
money.
An increasing source of difficulty in defining
money is the rapid change taking place in the
nation's payments system.4 Payments system
change was also a major factor at the time that
Andrew was writing, but has not been an important
source of controversy since the 1930s. The final
third of the 19th century saw radical changes in
the monetary system of the United States, partic-
ularly in the domestic payments system. On the eve
of the Civil War (January 1860), the American





'For an excellent discussion of both historical and current
controversies regarding the definition of money, see Milton
Friedman and Anna J. Schwartz, Monetary Statistics of the
United States (New York: National Bureau of Economic
Research, 1970), pp. 93-189.
3Board of Governors of the Federal Reserve System, Improving
the Monetary Aggregates, Report of the Advisory Committee
on Monetary Statistics, Washington, D.C., June 1976.
4 It is probably more accurate to refer to "payments systems,"
as there are currently a number of alternative ways of making
funds transfers. The term "payments system" is used here to
include all systems for making funds transfers, including those
which may only be implemented in the future.










money stock defined to include specie, bank
notes, and bank deposits consisted of $186
million in gold, $184 million in bank notes, and
$241 million in bank deposits.5 During and after
the war, the composition changed drastically. Bank
deposits increased from 38.6 per cent of money
holdings in 1860 to 54.7 per cent in 1867, and to
68.6 per cent in 1875. By 1899, deposits had risen
to 81 per cent of all money holdings.6 While we do
not have data on either the quantity of demand
deposits or the volume of payments by check during
this period, this movement from currency to bank
deposits was indicative of the shift that took place
in the payments system toward the making of pay-
ments by check.
In spite of this shift, there was a general reluc-
tance to include demand deposits in the money
supply. It is not clear to what extent late 19th
century economists realized that this change was
taking place. Since they did not have published
figures on the money stock, they were not aware
of the precise degree to which changes were
occurring. Perhaps the changes taking place were
recognized, but a kind of intellectual inertia caused
the economists of the day to prefer the traditional
definitions which excluded deposits. At any rate,
there seems to have been a general reluctance to
expand the definition of money to include bank
deposits,7 just as many economists are reluctant to
modify today's commonly accepted definitions.
There is at least some reason for believing that
changes in the payments system currently taking
place will be every bit as significant as the changes
of the 19th century. It is widely believed that the





5 Jack Lewis Rutner, "Money in the Antebellum Economy:
Its Composition, Relation to Income and Its Determinants,"
unpublished Ph.D. dissertation, University of Chicago (June
1974), pp. 182-83.
6 Post-Civil War monetary statistics, as compiled by Friedman
and Schwartz, are in U.S. Bureau of the Census, Historical
Statistics of the United States, Colonial Times to 1970, Bicen-
tennial Edition, Part 2 (Washington, D.C.: Government
Printing Office, 1975), pp. 992-93.


United States is in the early stages of movement
toward an electronic funds transfer system (EFTS),
a system where many perhaps most- payments
would be made in response to electronic instructions
rather than instructions written on a paper check.
While there are very wide differences of opinion
as to the likely speed and extent of EFTS develop-
ment, there seems to be little reason for doubting
that another change in the payments system is well
underway. Until recently, with the minor exception
of traveler's checks, payments could be made only
with currency and commercial bank checking
accounts. It is now increasingly possible to make
payments from other types of accounts commer-
cial bank savings accounts, accounts at sav-
ings and loan association (S&L's), mutual
savings banks (MSB's), credit unions
(CU's), and even certain mutual fund ac-
counts. In addition, an increasing proportion
of purchases is being made with credit cards.
In light of these developments, it seems useful
to attempt to consider whether these changes, like
the changes of the late 19th century, will require
modifications in our concept of money. This article
discusses the implications of payments system
changes for the various definitions of money pub-
lished by the Federal Reserve System. Also con-
sidered is the degree to which the usefulness of
current definitions is likely to be reduced and the
extent to which simple modifications of these
definitions can restore that usefulness.




7"On the other hand, the stretching of the word (money) to
make it cover such means of trade as bank deposits and bills
of exchange presents itself as even more objectionable, primarily
because it is in the highest degree discordant with the traditional
way of employing the term, and must inevitably tend therefore
to arouse suspicion, provoke antagonism, and entail misunder-
standing, and because at the same time there are plenty of other
expressions, such as 'currency,' 'circulating medium,' and
'means of payment,' which can be used quite as effectively to
represent the same all-inclusive concept," Andrew, p. 226.
H. Parker Willis, one of the leading monetary economists
of the day, was contending as late as 1925 that even bank
notes were not money. H. Parker Willis and George W.
Edwards, Banking and Business (New York: Harper and
Brothers, 1925), pp. 96-97.










CURRENT DEFINITIONS
OF MONEY
Three approaches to the definition of money have
been widely used. The traditional approach has
been to define money as those assets which can be
used to purchase goods and services or to pay debts
- that is, those assets which serve as media of
exchange. A second approach, suggested by Milton
Friedman, would define money as those assets
which serve as a "temporary abode of purchasing
power" that is, assets which are held during
relatively brief periods when an individual or firm
has receipts exceeding expenditures. The third
approach is not always explicitly stated, but has
been widely used in monetary research and seems
to have been extremely important to the Bach
Committee. This approach would define money as
the aggregate or aggregates which are highly cor-
related with gross national product or some other
measure of economic activity. Presumably this
approach rests on the belief that the money stock
thus defined would be of greater value in the formu-
lation of stabilization policy.
The Federal Reserve System regularly publishes
data for five alternative money stock definitions.
Multiple measures are published because there are
differences of opinion as to what is the appropriate
basis for defining money and because there is a
good deal of uncertainty as to what empirical
definition best fits the various theoretical
approaches. Since the Federal Reserve has only
limited access to data for many nonmember
institutions, the money stock definitions are inade-
quate in some instances.
Ml, which consists of currency and demand
deposits other than those held by commercial banks
and the U.S. Government, corresponds to the
traditional medium of exchange approach to the
money supply. It does not, however, include one
familiar medium of exchange, traveler's checks.8
M2 is M1 plus time and savings deposits of
commercial banks other than large negotiable
certificates of deposit (CD's) at weekly reporting
banks. M3 is M2 plus deposits at MSB's, S&L's,
and CU's. M4 is M2 plus large negotiable CD's,
and M5 if M3 plus large negotiable CD's. These


four definitions reflect to some extent the "tempo-
ary abode of purchasing power" approach, as well
as the belief of many economists that one or another
of these magnitudes is more closely related to GNP
than is M1.9
The "temporary abode of purchasing power"
approach seems to have been more discussed than
used in formulating M2 through M5. These defini-
tions all contain certain components which are
ordinarily held for long periods of time and exclude
other items which fulfill the "temporary abode"
function. It seems clear, for example, that long-
term bank CD's do not serve as a temporary abode
of purchasing power, yet, with the exception of
CD's larger than $100,000, they are included in all
of the broader definitions. Moreover, the similar
instruments of S&L's and MSB's are included in
M3 and M5. On the other hand, large negotiable
certificates of deposit clearly serve as a temporary
abode of purchasing power for large corporations,
but have been excluded from the most widely used
definitions.10 Since existing definitions do not con-



'The largest U.S. issuer of traveler's checks is not a commercial
bank and thus does not report to the Federal Reserve (or any
other bank regulator). At one time, bank-issued traveler's checks
were a part of the money supply. The two major banks in the
traveler's check business now use holding company sub-
sidiaries to issue them. Thus, they are not liabilities of the bank
and not part of the money supply.
'There has apparently never been an exhaustive study of the
numerous possibilities to determine empirically which definition
of money has been most closely related to economic activity
in the past. There have, however, been a number of limited
attempts in this direction. See Milton Friedman and David
Meiselman, "The Relative Stability of Monetary Velocity and
the Investment Multiplier in the United States, 1897-1958," in
Commission on Money and Credit, Stabilization Policies
(Englewood Cliffs, N.J.: Prentice-Hall, 1963), pp. 242-46;
Frederick C. Shadrack, "An Empirical Approach to the
Definition of Money," in Federal Reserve Bank of New York,
Monetary Aggregates and Monetary Policy (New York, 1974);
and Edward F. Renshaw, "A Note on Economic Activity and
Alternative Definitions of the Money Supply," Journal of
Money, Credit and Banking, Vol. 7 (November 1975), pp.
507-13.
t'This exclusion appears to be due to the influence of Milton
Friedman (Friedman and Schwartz, pp. 170-71), who argues
that negotiable CD's are more like commercial paper than like
other types of time deposits. Accepting this argument might,
however, imply including commercial paper in money, rather
than excluding large CD's.









sistently reflect the "temporary abode of pur-
chasing power" approach, this article concentrates
on the implication of changes in the payments
system for the medium of exchange and correlation
with economic activity approaches to the money
stock.
It should be noted that there are other changes
taking place which have implications for the
definition of the money supply which are beyond
the scope of this article. Perhaps the most important
of these is the change in the composition of the
time deposit portion of M2, which once consisted
entirely of household savings deposits but now
includes large quantities of business savings
deposits and long-term time deposits.1

MAJOR CHANGES IN THE
PAYMENTS SYSTEM

The Extension of Payment Accounts
To New Institutions
Historically, commercial banks have been the
only financial institutions to provide a deposit
account which could be used to pay third parties.
From 1933 to 1972 these payments could be made
only from noninterest-bearing demand deposit
accounts.12 Since 1972, there have been a number
of innovations which have allowed other institu-
tions to offer close substitutes for bank checking
accounts.
NOW Accounts. In 1972, following a favorable
court decision, MSB's in Massachusetts began
offering NOW accounts to their customers. These
accounts are legally savings deposits but allow the
customer to withdraw funds by writing a "nego-
tiable order of withdrawal (NOW)." Since a NOW
looks, and more importantly, functions like a
check, NOW accounts are from the point of view
of the customer an interest-bearing checking
account.



"For a detailed discussion of this point see Steven M. Roberts,
"Developing Money Substitutes: Current Trends and Their
Implications for Redefining the Monetary Aggregates," in Im-
proving the Monetary Aggregates, Staff paper, Board of
Governors of the Federal Reserve System, Washington, 1978.


Since their legal status was similar to that of
Massachusetts MSB's, savings banks in New
Hampshire followed the Massachusetts example
within a few months. A 1973 act of Congress
limited interest-bearing NOW accounts to these two
states and extended the power to offer them to
commercial banks and savings and loan associa-
tions. More recently, the power to issue NOW
accounts was extended to financial institutions in
the rest of New England (Maine, Vermont, Rhode
Island, and Connecticut), effective March 1, 1976,
and there is some Congressional sentiment for
extending them nationwide. The maximum interest
rate which can be paid on NOW accounts is uniform
for all offering institutions at 5 per cent, /4 per
cent less than thrift institutions are permitted on
regular savings accounts and the same as com-
mercial bank savings accounts.
The evidence from Massachusetts and New
Hampshire suggests that the introduction of NOW
accounts into a market does not lead to consumers
immediately moving their funds en masse from
checking to NOW accounts. However, it does
suggest that NOW accounts are likely to eventually
become the predominant type of household pay-
ment account. Since ownership of NOW accounts
is limited to individuals, sole proprietorships, and
nonprofit organizations, only the approximately $2
billion in demand deposits owned by these groups
(of $6 billion in total demand deposits) in the two
states was eligible for conversion to NOW
accounts.13 By June 30, 1976, total NOW account
deposits in Massachusetts and New Hampshire had
reached $1.2 billion, and were still growing at the
rate of more than 70 per cent per year. Unfortu-
nately, it is impossible to accurately estimate the
extent to which these funds came from demand
deposit accounts and the extent to which they came




"A limited number of MSB's were also authorized to offer
demand deposit accounts.
13 John D. Paulus, Effects of "NOW" Accounts on 1974-75
Commercial Bank Costs and Earnings, Staff Economic Study
No. 88, Board of Governors of the Federal Reserve System,
1976, p. 2.









from savings accounts at commercial banks or thrift
institutions. 4
The inability to estimate the sources of funds
which have gone into NOW accounts has serious
implications for any attempt to include them in
money stock estimates. Under current practice,
NOW accounts are not included in Ml. Thus, to the
extent that funds have moved out of demand
deposits into NOW accounts, current M1 data
underestimate the growth of medium-of-exchange
money. NOW accounts at commercial banks are in
M2, while M3 includes NOW accounts held at thrift
institutions. If all NOW balances had come from
demand deposits, adding total NOW account
balances into Ml would give a series which would
be historically consistent. To the extent that NOW
deposits have come from savings accounts, this
procedure would lead to an exaggerated picture of
the rate of growth of Ml, since some of the growth
would merely represent a transfer of funds from
savings to NOW accounts without any change in
the character or activity of the funds. Treating
NOW accounts as demand deposits would also
affect the rate of growth of M2, since some NOW
funds have moved from thrift savings accounts to
NOW accounts. Only M3 is unaffected by the
existence of NOW accounts.
It should be noted that NOW account totals are
not yet large enough to create a serious problem.
Total New England NOW accounts were only $1.5
billion as of July 30, 1976. Since NOW balances
have built up gradually over a 4-year period, their
effect on the rate of growth of the monetary
aggregates has been extremely small. However, if
NOW accounts are legalized for the entire nation, it



'4Paulus estimates that about 80 per cent of NOW balances have
come from demand deposits. This estimate is probably too high,
as it rests on the assumption that all funds in active NOW
accounts (those on which drafts are drawn) came from
demand deposits. However, some active NOW accounts almost
certainly represent the combination of what were previously
separate checking and savings accounts, and others are known
to be the funds of households that previously had accounts only
at thrift institutions and purchased money orders in lieu of using
a checking account. See Paulus, pp. 9-12.


would present serious complications for money
stock measurement. Consumers now hold approx-
imately $80 billion in demand deposits, much of
which based on the New England experience -
is likely to be converted to NOW accounts along
with some portion of consumer savings accounts.
Credit Union Share Drafts. Many credit unions
have recently begun offering their customers the
ability to make funds transfers with a check-like
instrument called a "share draft." In August of
1974, the Administrator of the National Credit
Union Administration granted three Federal CU's
temporary authority to begin offering share drafts.
These three CU's were joined by two state CU's
in a 6-month pilot program. While the authority to
offer share draft accounts is still officially tem-
porary, additional CU's were allowed to offer share
draft accounts following the end of the pilot
program. As of July 1976, 193 Federal credit
unions and a substantial number of state CU's were
offering share drafts.
Share draft accounts are usually interest bearing.
However, "dividends" (interest) are most com-
monly paid on the minimum account balance. Thus,
while credit unions paying dividends in the fourth
quarter of 1975 had an average stated rate of 5.67
per cent, the average rate paid was only 2.04 per
cent of total share draft balances.15 Legally, share
drafts are a payable through draft like the drafts
widely used by insurance companies and other
corporations. Unlike NOW account drafts, which
clear like checks and are eventually returned to the
account holder, share drafts normally do not move
beyond the bank through which they are payable.
That bank, in the majority of cases, is not the bank
at which the credit union keeps its regular working
balance. The funds are subsequently transferred
from the credit union's account at its own bank to
the paying bank. The information on the draft is
processed electronically and transmitted to the CU
or its servicing organization on magnetic tape.


15CUNA Research Division, Share-Drafts vs. NOW Accounts,
Credit Union Research Bulletin No. 182, Madison, Wis., April
1976, p. 7.









Thus, the customer receives only a statement rather
than a cancelled check, although he does make a
carbonless paper copy at the time of writing the
draft.
As of July 1976, the 193 Federal CU's offering
share draft accounts had $72 million in these
accounts. While this is a miniscule amount com-
pared to commercial bank demand deposit accounts
or even NOW accounts, the total in both state and
Federal credit unions probably exceed $100 mil-
lion. As roughly 99 per cent of credit unions are not
yet offering these accounts, there is clearly room
for considerable expansion.
The American Bankers Association and several
state bankers associations and individual com-
mercial banks have recently filed law suits asking
that share drafts be prohibited on the grounds that
there is no legal authority for them to be offered.
The NOW account experience would seem to
suggest that if these legal actions are successful,
credit unions may still be able to obtain the legisla-
tive authority necessary to continue offering share
drafts.
The money supply implications of share draft
accounts are precisely the same as for NOW ac-
counts. Since they provide a substitute for demand
deposits, their continued exclusion from Ml and
M2 underestimates the growth of medium of ex-
change money. Simply adding them to demand
deposits will not, however, be fully satisfactory,
since some portion of these funds would otherwise
have been in savings accounts at CU's or other
institutions. Unfortunately, there is currently not
enough data to include total share draft accounts in
any money stock definition narrower than M3,
since there are no available estimates of share draft
accounts at state credit unions.
Thrift Institution Checking Accounts. In several
states, MSB's have long had the power to issue
checking accounts. Recently, state chartered
MSB's and S&L's have been granted the authority
to offer checking accounts in Connecticut, Maine,
and New York, and state chartered S&L's have been
given the authority to offer noninterest-bearing
NOW accounts in Illinois. The long-run importance


of these accounts will obviously depend on the
future status of NOW accounts, although in Con-
necticut, thrift checking account balances on June
30 were nearly double NOW account balances.
There is ample reason to believe that thrift institu-
tions might eventually acquire a substantial share of
household checking-type accounts in the states
where they are allowed to issue them. The fact that
a very large portion of households choose to bank
on the basis of locational convenience suggests that,
in the long run, thrifts might obtain a market share
proportionate to their share of offices.
Thrift checking accounts clearly should be in-
cluded in M1, although it is difficult to do so as
long as the necessary data are not regularly reported.
These deposits are like thrift NOW accounts in
that they currently are in neither Ml nor M2. In
the past it has been impossible to determine the
size of checking account balances at mutual savings
banks because both checking accounts and escrow
accounts at many institutions have been identically
reported as demand deposits. Continued growth of
thrift checking accounts will imply a shifting of
funds from commercial banks to thrifts and will lead
to Ml and M2, as currently reported, growing at
slower rates than they would otherwise.
Money Market Mutual Funds. One of the more
interesting financial innovations of the 1970s has
been the development of the money market mutual
funds. These funds hold portfolios of short-term
corporate and government securities and bank
CD's. Individual buyers of these funds can thus
obtain returns which are not available without a
substantial investment (as in the case of CD's larger
than $100,000). Small businesses and institutions
which might be large enough to acquire the types of
instruments held by money market funds apparently
find that it is less costly to use a fund than to manage
their own holdings of such instruments.
Since 1974, an increasing number of these funds
have allowed fund owners to redeem their shares
by writing a check. These checks, which are drawn
on a bank account arranged by the fund, typically
can be written for any amount in excess of $500.
As of June 30, 1976, funds with this option had









$2.1 billion of the $3.4 billion in assets of all money
market funds. Most of the rest of the funds allowed
withdrawals by wire transfers, a method which may
be superior for many holders.
Money market funds benefited during their early
history from the unusually high rates then being
paid on short-term money market instruments.
These funds have not, contrary to the expectations
of some observers, experienced extremely sharp
declines with the subsequent fall in short-term
interest rates, although they are currently exper-
iencing little or no growth. Their inherent advan-
tages allowing small holders to obtain returns not
directly available to them and providing diversifica-
tion with low transactions costs make it seem
likely that they will continue to grow over the long
run. Furthermore, there is no technical reason why
these funds could not allow checks to be drawn
on them in much smaller amounts. Nor is there
any reason why the check-writing option need be
restricted to money market funds. Even with current
restrictions, these funds would seem to meet most
criteria for money. The liabilities of money market
funds are not, however, included in any of the
currently published definitions of money, although
their holdings of bank deposits are. If the minimum
size check which can be drawn should be reduced,
the case for treating them as money would be
strengthened.
While these accounts have received much less
attention than NOW accounts and share drafts, they
are currently more important quantitatively. In-
corporating them into money stock estimates would
be considerably more difficult, however, since
these institutions, unlike the issuers of NOW and
share draft accounts, do not report regularly to the
financial regulatory agencies.
The Increased "Moneyness" of Savings
Accounts
It has been the traditional practice to include
demand deposits, but not other deposits, as money
when using a medium-of-exchange criterion.
Changes occurring in the nature of savings ac-
counts, both at commercial banks and at thrift insti-
tutions, are making this practice increasingly unten-


able. A number of regulatory changes in recent
years have made it possible for households to use
savings accounts for third-party payments. These
changes mean that funds transfers are increasingly
being made with assets not included in M1, but
rather with regular savings accounts at banks and
S&L's. Thus, the medium-of-exchange criterion
for defining money is becoming increasingly
difficult to apply.
Bill Paying Services. In April 1975, S&L's were
given the power to offer bill paying services from
savings accounts. A similar power was granted to
commerical banks in September 1975. While these
services have generated relatively little activity to
date, they are serving as partial substitutes for
checking accounts where in use.
Telephone Transfers. In April of 1975, the Board
of Governors of the Federal Reserve System
reversed a long-held position and allowed banks to
transfer funds from an individual's savings account
to a checking account on the basis of a telephone
authorization. This action followed the develop-
ment of telephone transfer services by some thrift
institutions and nonmember banks. While tele-
phone transfers are not widely used, they are being
offered by a number of banks and they are clearly
reducing the barriers between savings and checking
accounts.
Automatic Transfers to Cover Overdrafts. A
proposal currently under consideration by the Board
of Governors might make the distinction between
savings and demand deposits much less important-
except for the lower reserve requirements on the
former. This proposal would allow an arrangement
whereby funds would automatically be transferred
in multiples of $100 from a savings account to a
checking account when the balance in the checking
account reached zero or some other predetermined
level. Were it not for the restriction that transfers
be in $100 multiples, depending on the pricing of
transfers, the transfer privilege might well lead to
the use of zero balance checking accounts, with
funds being transferred to cover every check. Such
a procedure would allow banks to reduce the
quantity of funds which must be held in required
reserves. Under the regulation proposed, 30 days'









interest would be lost on any funds transferred, so
these accounts would have a much lower yield than
do NOW accounts. The yield would probably be
more like the yield on CU share draft accounts.
The transfer privilege would also reduce the
usefulness of the traditional Ml definition, because
substantial quantities of demand deposits would
likely move into savings accounts. Simply in-
cluding savings accounts in M1 would not be totally
satisfactory, because the majority of funds in
savings accounts would not have come from
demand deposits. This is not a problem with M2
when the savings accounts are at commercial banks.
However, such accounts might be set up at thrift
institutions (especially since it might not be
necessary to forego 30 days' interest on transfers
from thrift accounts). To the extent that thrift
accounts are used in this way, only M3 would be
unaffected.
Savings and Loan EFTS Projects. Thrift institu-
tions outside of New England are generally pro-
hibited from offering checking or similar accounts.
The prohibition has led a number of S&L's to
attempt to develop electronic substitutes. The
Federal Home Loan Bank Board has authorized
S&L's to set up "remote service units" (RSU's)
on an experimental basis. RSU's are off-premise
terminals which may be used by either one or
several institutions. They may be located in a public
area such as an airport, but most commonly have
been placed in supermarkets. S&L's probably
gained an early lead over commercial banks in this
area because most S&L's already were handling
their savings accounts "on line" and because of
their strong desire to tap the checking account
market. More recently, commerical banks have
been prevented from setting up similar operations
in a number of states because of court decisions
that remote terminals were subject to state branch-




"rFifty-one state chartered institutions are also involved in
these projects. The institutions with the largest operations are,
however, generally federally chartered.


ing laws. (Federal S&L's, unlike national banks,
are not subject to state branching laws.)
The Federal Home Loan Bank Board reports
that as of May 1976, 85 Federal S&L's were
operating RSU's at 234 different locations.16 (Some
locations have several terminals, as at least one S&L
is placing them at individual supermarket check-
out counters.) These RSU's handled more than
56,000 transactions in May, with approximately
three-quarters of the transactions being withdrawals
and the remainder deposits. The dollar volumes of
deposits and withdrawals were approximately $2.7
million and $2.0 million, respectively. While
RSU's have not turned S&L savings accounts into
checking accounts, they have made these accounts
much more accessible.
The effect of S&L EFTS projects on the various
money stock concepts is similar to the other innova-
tions already discussed. To the extent that these
projects allow people to substitute an account with
an S&L for a checking account, it reduces the
usefulness of the current M1. And since S&L
accounts are not in M2, this aggregate is also
reduced in usefulness.

Credit Cards and Check Credit Plans
The fact that increased credit facilities reduce the
demand for money has long been recognized."
Traditionally, credit facilities have been treated as
a factor which could lead to shifts in the demand
for money, but which need not be explicitly taken
into account when estimating a demand for money
function. Keynes suggested incorporating credit
facilities directly into the analysis. Under his alter-
native treatment, unused lines of credit at com-
mercial banks would be included in the money
stock.18 This suggestion has, from time to time,
been reiterated by others. Until relatively recently,
overdraft accounts such as those long prevalent in



"lrving Fisher, The Purchasing Power of Money (New York:
MacMillan, 1922), p. 81.
"8J.M. Keynes, A Treatise on Money, Vol. 1 (London:
MacMillan, 1930), pp. 41-43.










Great Britain were virtually unknown in the United
States. Over the last decade, however, "check
credit" plans, as overdrafts are commonly called,
have been set up by a large number of banks.
Furthermore, the introduction of the bank credit
card has provided bank customers with an alter-
native payment mechanism and the functional
equivalent of overdrafts.
Unfortunately, at least for those who would like
to take Keynes' approach, no data are available on
total credit lines on either bank credit cards or check
credit accounts. A reasonable estimate for bank
credit cards is that credit lines total approximately
$30 billion.19 Commercial banks had $9.5 billion
outstanding on credit cards (as compared to $2.8
billion outstanding on check credit accounts) as of
June 30, 1976. This implies unused bank credit
card lines of about $20 billion. While this quantity
is certainly substantial, it would probably be unwise
to attempt to incorporate unused lines into the
money stock. These lines of credit are in many cases
granted and increased unilaterally by the credit card
bank and may have little relationship to the amount
of credit that the card holder is likely to use.
Furthermore, these lines frequently serve merely
as a signal to reexamine the card holder's credit
standing before increasing the line rather than as a
constraint on the amount of credit available.
That adding unused credit lines to the money
supply would be a dubious practice can be seen by
looking at the ratio of total debits to estimated
unused lines on bank credit cards. In the year ending
June 30, 1976, there was $22.9 billion extended on
bank credit cards and $4.5 billion of credit extended
on check credit plans. Dividing the $22.9 billion in
debits on bank credit card plans by the $20 billion
in estimated unused credit card lines gives a ratio



"The two major national bank credit cards reported a total of
42 million accounts as of March 31, 1976. If the average account
has a credit line estimated to be about $700, total lines are
approximately $30 billion.
20Richard L. Peterson, "Factors Affecting the Growth of Bank
Credit Card and Check Credit," Journal of Finance, Vol. 32,
May 1977, pp. 553-,64.


of about 1.1, as compared to the ratio of debits to
average balances in household checking accounts
which is believed to be in the range of 20-25. Never-
theless, the continued growth and use of credit card
and check credit accounts is likely to make the
relationship between any money stock measure and
the level of economic activity less stable. Since the
evidence suggests that both check credit and credit
cards are widely used during periods of tight
credit,20 it is quite likely that the degree to which
they substitute for money will vary cyclically.
Electronic Funds Transfer
Electronic funds transfer (EFT) developments
are probably the most widely discussed innovations
in the payments system today. While EFT is likely
to have a substantial effect on the demand for
money, its impact on the nature of money will likely
be confined to the areas already discussed, partic-
ularly by facilitating the growth of overdraft
accounts and by reducing whatever barriers remain
between noninterest bearing checking accounts
and interest bearing accounts.
If thrift institutions in most of the country con-
tinue to be barred from offering checking (or NOW)
accounts, they are likely to attempt to gain entry
into the payments system through an EFT system,
since the legal barriers to their participation in
electronic payments seem to be much less of a fac-
tor than they are in the area of paper payments.
It has also been widely suggested that an EFT
system will lead to a substantial increase in the use
of overdrafts (check credit). The fact that float will
be reduced or eliminated, it is argued, will increase
the demand for overdrafts. And to the extent that
EFT gives banks better control over overdraft
accounts, it is likely to lead them to market them
more aggressively.
To the extent that EFT developments lead to
thrift accounts being used as transaction accounts,
the volume of transactions conducted with Ml and
M2 as currently measured will be reduced. If the
development of an EFT system increases the use of
overdrafts, it will strengthen the case for including
them in the money stock. It will not, however,
eliminate the problems with this approach.









CONCLUSIONS

Just as the 19th century changes in the way that
payments were made required a broadened defini-
tion of the money stock, the changes currently
underway will require a broadening of any
definition based on which assets can serve as media
of exchange. Only the broadest definitions, those
which include the deposits of thrift institutions as


well as those at commerical banks, are likely to be
unaffected. Many policymakers and scholars prefer
to use a narrower definition. They are likely to be
increasingly faced with a dilemma as it is unlikely
that it will be possible to develop any narrow money
stock series which can be extended very far into the
past and still be conceptually consistent. The prob-
lem that Andrew noted in 1899 seems likely to be-
come more rather than less serious.









Velocity:

Money's Second Dimension


By Bryon Higgins


"Money has a second dimension, namely,
velocity. .. ." Arthur F. Burns in Congres-
sional Testimony.

Understanding the effects of monetary growth on
the economy is of crucial importance in formulating
monetary policy. Monetary growth that is insuf-
ficient to sustain a high level of economic activity
can impair economic growth, and monetary growth
in excess of the ability to expand real output can
intensify inflationary pressures. Although it is
generally agreed that the growth in the money
supply is an important determinant of economic
performance, there is seldom a consensus regarding
the rate of monetary expansion most conducive to
attainment of policy goals.
The relationship between the supply of money,
the price level, and real output has been the subject
of extensive debate among economists, policy
analysts, and other observers for well over 100
years. The predominant view prior to the 1930s was
that the sole determinant of the aggregate price level
was the quantity of money. The belief that the
growth rate of the money supply uniquely deter-
mines the rate of price inflation was the corner-
stone of the quantity theory of money. The simple
version of the quantity theory lost favor during the



Bryon Higgins is a senior economist with the Federal Reserve
Bank of Kansas City. This article was originally published in
the June 1978 Economic Review.


1930s as a result of worldwide economic turmoil.
It was generally believed at the time that policy
prescriptions deriving from existing economic
theories were inadequate to deal with the problems
resulting from the Great Depression.
In the crisis atmosphere surrounding policy
discussions at the depth of the Great Depression,
a new theory of employment and prices was
developed by John Maynard Keynes. Keynes
alleged that the simple quantity theory of money
was deficient in a number of important respects,
and he offered an alternative framework for
analyzing the relations between money, prices, and
economic activity. Policymakers and economic
analysts were receptive to Keynes's theory because
it offered an explanation for the apparent failure
of conventional policies to remedy the dismal
economic situation that existed and it proposed
alternative solutions. Keynesian economic theory
supplanted the quantity theory of money as the
predominant method for analyzing aggregate
economic relationships.
In the past two decades, however, there has been
a resurgence of interest in the quantity theory of
money. Beginning with Milton Friedman and his
students and colleagues from the University of
Chicago, monetarists challenged the validity of a
number of the basic tenets of Keynesian economic
theory. Recent experience has rekindled interest in
the relationship between the growth of the money
supply and the rate of inflation, with the monetarists
being the chief proponents of the view that exces-









sive monetary growth is the primary cause of
inflation.
Much of the debate about the most useful frame-
work for analyzing aggregate economic relation-
ships has centered on the relationship between
aggregate spending and the money supply. The
ratio of total spending to the money stock is com-
monly called the velocity of money. This article
analyzes the concept of the velocity of money and
discusses the importance of understanding the
determinants of velocity. The quantity theory of
money is presented, and Keynes' criticism of the
quantity theory of money is discussed. Empirical
and theoretical considerations relating to the deter-
minants of velocity are reviewed, the postwar rise
in velocity is discussed, and the recent behavior of
velocity is examined.

VELOCITY AND THE QUANTITY THEORY
OF MONEY

The Concept of Velocity
The income velocity of money is defined as the
ratio of nominal income (that is, the dollar value of
income at current prices) to the money stock.' If
Y represents the real quantity of goods and services
produced and P the average price paid for these
goods and services, then PY is the value of nominal
income, and V [=PY/M] is the income velocity
of money, where M represents the money stock.2
Income velocity measures the average num-
ber of times in a given period each dollar is spent
for currently produced goods and services.3 If the
value of current output, PY, is $100 and the money
supply is $20, then the income velocity of money
is 5 [=$100/$20]. In these circumstances, each
dollar of money is used to finance an average of $5
worth of currently produced goods and services.4



I For a summary of the literature on the quantity theory, see
Edwin Dean, ed., The Controversy Over the Quantity Theory
of Money (Boston: D.C. Heath and Company, 1965).
2 An alternative measure of velocity was often used by quantity
theorists. If T, the total number of purchases financed by
monetary exchange, rather than Y is used as the measure of


The Equation of Exchange
The concept of the velocity of money was used
by proponents of the quantity theory of money
to express the relation between the growth rate of
the money stock and the rate of inflation. The belief
of the quantity theorists that the rate of inflation is
determined by the rate of growth of the money
supply was based in part on the "equation of
exchange," which can be derived from the defini-
tion of velocity. Multiplying both sides of the
equation defining velocity (V=PY/M) by the
money stock yields the equation of exchange,
MV=PY.
The equation of exchange itself is merely a
convenient way of expressing the identity between
the dollar flow of expenditures and the market value
of output. Since the two sides of the equation of
exchange are merely alternative ways of viewing
the same transactions, they must be equal by
definition. One can derive inferences regarding the
causal relationship between inflation and the money
supply only by making additional assumptions
about the behavior of one or more of the variables
included in the equation of exchange. It is the
willingness to make certain assumptions about
variables in the equation of exchange that dis-
tinguishes adherents of the quantity theory of
money from those who find the equation of ex-




transactions, the transactions velocity of money can be defined
as V' = P'T/M, whereP' is the average price of all transactions.
The focus in this article is on the effect of the money supply
on income and economic activity. For this purpose, the income
velocity of money, V, is more useful than the more inclusive
transactions velocity of money, V'.
3 For simplicity, taxes, depreciation charges, and retained
earnings are ignored. Thus, it is implicitly assumed that the
value of total output is equal to the level of personal income.
4 It should not be inferred that the velocity of money actually
corresponds to the number of times individual dollars are used
to finance expenditures. Most money (defined in this article to
include currency and demand deposits held by the nonbank
public) is held in checking accounts, and it is impossible to
distinguish one dollar of checking account money from another.
Thus, it is impossible to trace each dollar and count the number
of times it is used to finance expenditures.








change merely a useful device for organizing infor-
mation about economic relationships.
Quantity theorists assumed that total physical
output and the income velocity of money are
unaffected by changes in the money stock and can
safely be assumed to remain constant in the short
run.5 For given values of Y and V, the equation
of exchange indicates that a change in the money
stock of a certain percentage must result in a change
in the price level of the same percentage. Thus, a
necessary inference from the quantity theory
assumptions regarding the insensitivity of the level
of output and the income velocity of money to
changes in the money stock is that the rate of price
inflation is determined by the rate of change of
the money stock and the "natural" growth rate of
real output.6
Quantity theorists believed that the level of out-
put in the economy is determined by the availability
and productivity of land, labor, and capital and is
not affected by the money stock. The view that
"money is a veil" that merely disguises the real
functioning of the economy was expressed
succinctly by a leading proponent of the quantity
theory, Irving Fisher:
except during transition periods,
the volume of trade, like the velocity
of circulation of money, is independent
of the quantity of money. An inflation
of the currency cannot increase the
product of farms and factories, nor the
speed of trains or ships. .. The whole
machinery of production, transporta-
tion, and sale is a matter of physical
capacities and technique, none of




5 It should be noted that some of the quantity theorists dis-
tinguish between the ultimate impact of a change in the money
stock and the temporary effects that characterize the transition
to the new equilibrium. The emphasis was always on the
long-run effects of changes in the money supply, however.
6 The "natural" growth rate of real output can be thought of
as the growth rate that results from increases in the labor
force and improvements in productivity, assuming that all
productive factors are fully employed at all times.


which depend on the quantity of
money 7
Thus, Fisher assumed that the potential output of
the economy is not affected in the short run by
changes in the supply of money. In general,
proponents of the quantity theory believed that the
actual level of output is normally equal to the
potential level of output. They denied that a situa-
tion in which there were unemployed resources
could persist except during "transition periods" to
full employment equilibrium. Thus, the quantity
theorists' assumption that real output is unaffected
by changes in the money supply resulted from their
belief that the ability to increase output is at all times
constrained by physical capacity limitations and the
existing technology of production.
The assumption that the velocity of money is
constant was deemed valid by the proponents of
the quantity theory because the rate of turnover of
money balances was believed to depend on
economic and social relations that are unaffected
by changes in the money stock. Again quoting
Fisher:
The average rate of turnover will
depend on the density of population,
commercial customs, rapidity of
transport, and other technical condi-
tions, but not on the quantity of
money .8
Given the various constraints imposed by the
economic and social organization, quantity
theorists assumed that there is a fixed relation
between total expenditures and the amount of
money held to finance those expenditures. Thus,
the demand for money was believed to depend only
on the level of income and on social customs and
institutional relationships.

The Cambridge Version
of the Quantity Theory
A number of economists from Cambridge


SIrving Fisher, The Purchasing Power of Money (New York:
The Macmillan Company, 1911), p. 155.
8 Fisher, p. 153.









University in England changed the focus of the
quantity theory of money without changing its
underlying assumptions. The Cambridge version of
the equation of exchange focuses on the fraction, k,
of income held as money balances. Thus, the
Cambridge version can be expressed as M = kPY.
The k in the Cambridge equation is merely the
inverse of V, the income velocity of money
balances, in the original formulation of the quantity
theory. The Cambridge version of the equation of
exchange is important, however, because it directs
attention to the determinants of the demand for
money rather than the effects of changes in the
supply of money. Assuming that total output and
the desired fraction of income held as money
balances are unaffected by changes in the money
stock, the Cambridge version of the equation of
exchange indicates that the price level is propor-
tional to the supply of money, with the factor of
proportionality being (1/kY). Increases in the
money stock in excess of the amount economic
units desire to hold at the prevailing price level
must lead to equiproportional changes in the price
level in order to equate the supply of and demand
for money. Thus, the result that the rate of inflation
equals the growth in the money supply less the
"natural" rate of increase in real output is the same
regardless of which formulation of the equation of
exchange is used. In both versions, the result
follows inexorably from the assumptions that the
velocity of money balances (or equivalently, the
desired fraction of income held as money balances)
and the rate of growth of real output are indepen-
dent of changes in the money supply.


KEYNES' CRITICISMS OF THE
QUANTITY THEORY

One of the most important criticisms of the
validity of the assumptions underlying the quantity
theory was made by John Maynard Keynes, an
economist whose name had once been associated
with the "Cambridge school" of economists that
reformulated the quantity theory. Keynes alleged
that the quantity theory framework was too rigid for


analyzing the effect of changes in the money supply
on expenditures and the price level. He proposed
a more complex theoretical framework for
analyzing aggregate economic relationships.
Keynes developed his theory during the early
1930s, a period when policymakers and economists
alike were becoming increasingly disenchanted
with a theory based on the assumption that
unemployment could persist only during temporary
transition periods to the "normal" conditions of
full employment equilibrium. With massive
unemployment and declining real output in most
industrial nations, the economics profession and
the public at large were receptive to a new economic
theory that seemed more consistent with observed
phenomena.

Liquidity Preference and Velocity
Keynes rejected the notion that households and
businesses want to hold a constant fraction of their
incomes in cash balances. Instead, Keynes said, the
income velocity of money depends on "many
complex and variable factors," and analysis based
on the presumption of constant velocity merely
disguises the "real character of the causation."'
Keynes identified three distinct motives for holding
money balances:

(1) to bridge the gap between
receipt of income and planned expen-
ditures the transactions motive;
(2) to provide a reservoir of pur-
chasing power that can be used to
finance unanticipated expenditures -
the precautionary motive; and
(3) to satisfy the desire to hold
wealth in the most liquid form if one
expects interest rates on alternative
assets to rise, thereby causing capital
losses the speculative motive.


SJohn Maynard Keynes, The General Theory ofEmployment,
Interest, and Money (New York: Harcourt, Brace and World,
1964), p. 299.









Keynes adopted the traditional Cambridge view
that money held to finance expenditures, including
both transactions and precautionary balances, is a
constant fraction of the level of income. However,
Keynes believed that money is held for purposes
other than as a medium of exchange. The specula-
tive motive for holding money is not directly related
to expenditures, according to Keynes, but depends
instead on the "liquidity preference" of asset
holders. The amount of money held in speculative
balances, Keynes hypothesized, depends on the
anticipated direction and magnitude of pros-
pective changes in market interest rates. If indi-
viduals believe that market interest rates are likely
to increase in the future, they have an incentive
to hold their wealth in the form of liquid assets in
order to avoid the capital losses on long-term assets
that would accompany the expected increase in
interest rates. Those who hold money because they
believe the yield on money balances will exceed the
yield on alternative assets are said to exhibit
liquidity preference.10 Keynes hypothesized that
more individuals expect a future increase in market
interest rates when the current level of interest rates
is low than when the current level of interest rates
is high. Thus, liquidity preference and the specula-
tive demand for money are hypothesized to be
inversely related to the current level of interest
rates.
Keynes' liquidity preference theory cast doubt
on the quantity theory assumption of a constant
income velocity of money. If money is held as a
store of value as well as a medium of exchange,
there need not be a fixed relation between the
money stock and the level of expenditures. The
determinants of the demand for money held to
satisfy liquidity preference the degree of risk
aversion and the expected yield on alternative
financial assets are not directly related to
expenditures or income. It is possible, therefore,
that the income velocity of money could change


10 In this context, the total expected yield on an asset is equal
to the interest payment minus the expected capital loss, each
expressed as a percentage of the market price of the asset.


from one period to the next because of changes in
expectations of future interest rate movements or
attitudes toward risk. Moreover, Keynes argued,
changes in the money supply can themselves lead
to changes in velocity. The initial effect of an
increase in the money supply, according to Keynes,
is a drop in interest rates. The fall in interest rates
leads to an increase in liquidity preference and a
consequent decline in the velocity of money.
Keynes' original formulation of the theory of
liquidity preference implies an "all-or-nothing"
choice between money and other financial assets.
An investor could maximize the expected return on
his portfolio of financial assets by holding only
long-term bonds if he expects market interest rates
to fall and by holding no long-term assets if he
expects market interest rates to increase, provided
the increase in rates is sufficiently large to make the
expected yield on long-term assets less than the
yield on money. It is generally believed, however,
that most investment portfolios include a wide
variety of financial assets, each with a different
yield and term to maturity.
James Tobin offered an alternative theory of
liquidity preference that is more nearly consistent
with observed portfolio behavior. Tobin assumed
that investors are concerned both with the expected
yield and the riskiness of alternative assets and that
most investors are willing to accept a somewhat
lower yield on their portfolio if, by doing so, they
can also reduce its risk. Even if the expected yield
on money balances is less than the expected yield
on alternative assets, investors may choose to hold
part of their financial wealth in cash balances as a
means of reducing the risk on their total portfolio
of assets. The higher are the expected yields on
alternative assets, however, the more costly it is to
obtain a reduction in the riskiness of a portfolio
by holding money balances. Thus, Tobin's theory
of liquidity preference predicts portfolio diversifi-
cation, with the fraction of financial wealth held


"1 James Tobin, "Liquidity Preference as Behavior Toward
Risk," Review of Economic Studies, Vol. 25, No. 67,
February 1958.









in money balances being inversely related to the
expected yield on alternative financial assets.


Keynes' Analysis of the Relation Between
Output and Expenditures
The second major difference between Keynesian
theory and the quantity theory is that Keynes did
not assume that departures from full employment
were temporary aberrations that could safely be
ignored in economic analysis. It is possible in these
circumstances that an increase in the level of
expenditure caused by an increase in the money
supply would lead to a rise in real output and
employment rather than being dissipated entirely in
higher prices. Keynes suggested analyzing the
conditions that determine how increased expen-
ditures will be divided between changes in real
output and changes in prices rather than assuming
at the outset, as the proponents of the quantity
theory did, that the level of output is determined
independently of the level of expenditure.


Implications of Keynesian Analysis
In summary, Keynes rejected the quantity theory
conclusion that an increase in the money supply
necessarily leads to an increase in the price level
of the same proportion. He argued that the extent
to which an increase in the money supply leads to
higher spending depends on the numerous factors
determining the income velocity of money -
factors such as the degree of liquidity preference
and the interest elasticity of various kinds of
expenditures. Moreover, Keynes asserted that
increased expenditures do not lead inexorably to
commensurate increases in the price level. Since
resources can be less than fully employed for sus-
tained periods, the level of real output can be
influenced by aggregate demand. Thus, according
to Keynes, the relation between changes in the
money supply and changes in the price level is not
as simple and direct as the quantity theory implied
but depends on a myriad of real and financial
conditions, each of which must be taken into
account when analyzing the prospective infla-


tionary impact of increases in the money supply.
There is now general agreement among
economists and other observers that Keynes was
correct in asserting that changes in aggregate de-
mand do not necessarily result in commensurate
changes in the overall price level. Theoretical and
empirical considerations have led most economists
to conclude that the rate of inflation accompany-
ing a given growth in aggregate expenditures
depends on the degree of utilization of productive
resources, anticipations concerning inflation, and
perhaps other factors.12
There is also general agreement among econo-
mists that the quantity theory assumption of a con-
stant income velocity of money is an oversimplifica-
tion. Variability in the income velocity of money
does not necessarily imply that changes in the money
supply do not have a predictable influence on
aggregate spending, however. If the factors affect-
ing velocity can be identified and the magnitude
of their effects determined, it would be possible to
estimate the size of prospective changes in velocity
and to adjust monetary policy accordingly.
Unexpected changes in velocity would thwart
attainment of the goals of monetary policy, how-
ever, if the monetary authorities use the growth in
the money supply as a measure of the impact of
monetary policy on the economy. If unpredictable
changes in velocity are both frequent and large,
it may be desirable to use something other than
growth in the money supply (interest rates, for
example) to gauge monetary policy.13 Thus,
reliance on the growth rate of the money supply as
an indicator of the effect of monetary policy on the
economy presupposes that the determinants of
velocity can be identified.



12 See, for example, Leonall C. Andersen and Keith M.
Carlson, "A Monetarist Model for Economic Stabilization,"
Federal Reserve Bank of St. Louis Review, Vol. 52, No. 4,
April 1970.
13 See J.A. Cacy, "The Choice of a Monetary Policy Instru-
ment," Federal Reserve Bank of Kansas City Economic Review,
May 1978, for a discussion of the factors affecting the choice
between interest rates and the money supply as a gauge of
monetary policy.









THE CURRENT VIEW OF THE
DETERMINANTS OF VELOCITY
A number of theoretical models have been
developed to explain the determinants of velocity.
Many of these models are based on the inventory
approach to the demand for money developed by
William Baumol and James Tobin.14 In general,
inventory models of cash management view money
balances as reservoirs or "inventories" of pur-
chasing power that can be drawn upon as needed
to finance expenditures. Earning assets are con-
sidered alternatives to money balances as temporary
repositories of funds held to bridge the gap be-
tween receipt of income and its subsequent
expenditure.

The Inventory Model of Cash Management
It is useful to analyze a simply inventory model
to understand the implications of such a model for
the determinants of the demand for money.15
Assume that an individual receives a lump sum
income payment of $Y at the beginning of every
month and spends this income at a constant rate
throughout the month, with all expenditures being




14 William J. Baumol, "The Transaction Demand for Cash:
An Inventory Theoretic Approach," Quarterly Journal of
Economics, Vol. 66, No. 4 (November 1952), and James
Tobin, "The Interest Elasticity of Transactions Demand for
Cash," Review of Economics and Statistics, Vol. 38, No. 3,
August 1956.
A number of alternative models of the demand for money
have been developed. The demand for money functions
advocated by most monetarists are more general than the
inventory models. Monetarist models view money as one of
many forms in which wealth can be held. The demand for
money is thus postulated to depend on total wealth and the
yields on money and other assets. At a very abstract level,
there is no conflict between monetarist models (or portfolio
balance models as they are sometimes called) and inventory
models of the demand for money. The distinguishing
characteristic of inventory models is the presumption that
the level of expenditures is an important determinant of the
fraction of wealth held in money balances. For an introduction
to monetarists' views on velocity and the demand for money,
see Milton Friedman, ed., Studies in the Quantity Theory of
Money (Chicago: University of Chicago Press, 1956).
15 The exposition of the inventory model that follows is
essentially the same as that presented in Baumol.


financed by checks drawn on the individual's
demand deposit. If the entire income payment is
deposited directly in the checking account at the
beginning of the month, the demand deposit
balances will exhibit the profile demonstrated in
Chart la, declining steadily from $Y at the begin-
ning of the month to $0 at the end of the month.16
The average daily balance in these circumstances is
$Y/2, and the income velocity of funds held in the
checking account is 2 per month [that is, (Income)/
(Average Balance) = ($Y per month)/($Y/2) = 2
per month].
The individual can reduce the average amount
held in his demand deposit by investing part of his
paycheck temporarily in interest-earning assets.
Assume, for example, that one-half of the monthly
income payment is deposited directly in a demand
deposit and the other one-half is invested in a short-
term interest-earning asset. The beginning balance
in this case is $Y/2, and the balance declines at
a steady rate until reaching $0 in the middle of the
month. At this point, the individual must redeem
the interest-earning asset purchased at the begin-
ning of the month and deposit the proceeds in his
demand deposit if he is to maintain the same expen-
diture pattern as in the previous example.'7 Deposit
of the funds from redemption of the interest-earning
asset results in an increase of the checking account
balance to $Y/2, which decreases at a steady rate
for the duration of the month and reaches $0 at the
end of the month. The pattern of the checking



16 The profiles in Chart 1 are simplified slightly to demon-
strate the essential characteristics of the inventory models.
Since demand deposit balances are computed only at the end of
each banking day, the measured balance in the demand deposit
would decrease by equal amounts each banking day, yield-
ing a "stairstep pattern" for the balance rather than the smooth
decline pictured in the charts. This simplification does not alter
the analysis, however.
17 For simplicity, it is assumed that interest earned on the
funds invested temporarily in short-term assets is reinvested
rather than being spent immediately. It is also assumed that
transfers of funds from interest-earning assets are always of the
same dollar amount as the original deposit in the demand deposit.
For a proof of this proposition, see James Tobin, "The
Interest Elasticity of Transactions Demand for Cash."










account balance corresponding to this sequence of
events is demonstrated in Chart lb. The average
daily balance in the checking account is reduced to
$Y/4 by the temporary investment of one-half of
each month's income in interest-earning assets, and
the income velocity of demand deposit balances is
increased to 4 per month [that is, ($Y per month)/
($Y/4) = 4 per month].
The reduction in the average demand deposit
balance and the consequent increase in interest
income is not costless, however. The individual
incurs a cost in transferring funds from interest-
earning assets into his demand deposit. Assuming
that there is a fixed brokerage fee, $b, associated
with such transfers, the decision to invest 50 per
cent of the monthly income receipt would increase
interest income net of transactions costs if the
incremental interest income exceeds $b. If an
individual finds it worthwhile to invest one-half of
his income in short-term assets at the beginning of
each month and makes one subsequent transfer of
funds in the middle of the month, he might consider
the possibility of investing two-thirds of his income
initially and making two intramonthly transfers
(after one-third of the month and two-thirds of the
month had elapsed) into his checking account. In
fact, an individual will find it profitable to increase
the proportion of funds invested in interest-earning
assets up to the point where the cost of making an
additional transfer of funds into his checking
account from other assets just offsets the incre-
mental income from reducing the amount held in
money balances.

Implications of the Inventory Model
Inventory models of cash management imply that
the amount of cash held in transactions balances is
inversely related to the yield on alternative assets.
Thus, the interest sensitivity of the transactions
demand for money provides a reason for expecting
the income velocity of money to vary directly with
the level of interest rates, a result that reinforces
the liquidity preference effect of higher interest
rates on velocity that was posited by Keynes. The
incentive to economize on cash balances by holding


Chart 1
MONTHLY PROFILE OF
MONEY BALANCES


Y





Y/2 -






June 1


June 30 Time


Dollars
Y

lb.


June 1 June 15 June 30 Time










funds in interest-earning assets must be weighed
against the cost incurred in transferring funds to
determine the optimal allocation between money
and other assets.
In addition to the implication of an interest-
sensitive demand for transactions balances, the
inventory approach to the demand for money
implies that the velocity of money tends to increase
as income rises. This tendency results from
economies of scale in managing transactions
balances, which is implied by theinventory models.
Economies of scale exist if economic units desire to
increase their cash balances less than porpor-
tionately to increases in the level of expenditures.
The formal solution to the simple inventory model
indicates that the optimal amount of money balances
held for transactions purposes increases proportion-
ately less than anticipated expenditure because it
becomes practical to hold a larger percentage of
working balances in interest-earning assets as the
scale of expenditure increases.18

Extensions of the Inventory Model
The assumption of the simple inventory models
that the timing of withdrawals from checking
accounts is known with certainty is somewhat
unrealistic. For many individuals and businesses,
the magnitude and timing of many expenditures are
somewhat unpredictable. Moreover, the time that
elapses between the day a check is written and the
day the corresponding funds are withdrawn from
the demand deposit is subject to a number of
random elements. It may be prudent, in these cir-
cumstances, to keep a cushion of liquidity in cash
balances to ensure against insufficiency of immed-
iately available funds. The desire to maintain a
cushion of liquidity in the form of cash balances
to meet unforeseen contingencies is what Keynes
called the precautionary motive for holding money.
Many of the same principles that govern manage-



18 For a more complete exposition of the formal derivation of
the income and interest rate elasticities implied by the inventory
model, see the Appendix on p. 26.


ment of transactions balances also apply to manage-
ment of precautionary balances.19 Alternative
sources of liquidity are available for precautionary
purposes. The cost of holding precautionary
cash balances is the interest income foregone on
alternative liquid assets, and the larger is the scale
of anticipated expenditures, the greater is the
reward for holding a portion of precautionary
balances in interest-earning assets rather than
money. In addition, the likelihood of having a
large percentage of cash disbursements occur
unexpectedly within a given time period is inversely
related to the number of expenditures since sto-
chastic elements tend to average out as the fre-
quency of expenditures increases.20 Thus, the
theoretical framework for analyzing the precau-
tionary motive for holding money implies that the
amount held in precautionary balances is inversely
related to the yield on alternative assets and
increases less than proportionately to the level of
expenditures.

THE POSTWAR RISE IN VELOCITY
The ratio of gross national product (GNP) to
the narrowly defined money stock (Ml), which is
the ratio most commonly used to measure the
income velocity of money, has risen steadily in the
postwar period (Chart 2). The analysis of the
transactions, precautionary, and speculative
motives for holding money outlined earlier is
generally consistent with the upward trend in
velocity for the past 30 years. The various theoret-
ical considerations previously discussed imply, for
instance, that the demand for money decreases as
the level of interest rates rises. The upward trend in
interest rates in the postwar period helps to explain




'9 See S.C. Tsiang, "The Precautionary Demand for Money:
An Inventory Theoretical Analysis," Journal of Political
Economy (January-February 1969), for an analysis of factors
affecting the amount held in precautionary money balances.
20 For a detailed analysis of the effect of uncertainty on the
demand for money, see Don Patinkin, Money, Interest, and
Prices (New York: Harper and Row, 1965), Chapters 5 and 6.










the secular increase in the income velocity of
money.
The implication of the simple inventory model
- that the amount of money held to finance
expenditures increases less than proportionately to
the level of expenditures provides an additional
explanation for the upward trend in income
velocity. Real income and expenditure have grown
steadily in the postwar period, and the relatively
slower growth of the money stock indicates
the plausibility of the hypothesis of economies of
scale in cash management.
The growing availability of money substitutes
has probably also contributed to the rise in velocity
in the postwar period. The inventory models imply
that the cost of converting interest-earning assets
into money is a significant determinant of the
fraction of income held as cash balances. It is
unlikely, however, that the multitude of factors
affecting the ease of transferring funds is adequately
captured by the assumption of a constant brokerage
fee. A variety of new types of financial assets has
been developed over the past 30 years, and the
effect of many of these financial innovations has
been to make it easier for firms and individuals to
maintain a larger fraction of their liquid balances
in earning assets. The growing importance of non-
bank financial intermediaries has been particularly
important in expanding the types of money
substitutes available to the household sector.
Many of these liquid assets are such close sub-
stitutes for demand deposits and currency that
a number of analysts have suggested the concept
of money be broadened to include time and savings
deposits.21 Virtually all analysts agree that the
various financial innovations in the past three
decades have lowered the effective cost of con-
verting earning assets into money and have
thereby contributed to the upward trend in the



21 See Milton Friedman and Anna Jacobson Schwartz, Mone-
tary Statistics of the United States (New York: National Bureau
of Economic Research, 1970), for a comprehensive discussion
of the issues involved in choosing the types of assets to be in-
cluded in 'the' money supply.


income velocity of the narrowly defined money
supply.
In summary, many factors have contributed to
the rise in the income velocity of money in the
postwar period. Inventory models of cash manage-
ment provide a useful framework for analyzing the
impact of higher interest rates, economies of scale,
and financial innovation on the income velocity of
money. The implications of the inventory models
are consistent with postwar experience in a
qualitative sense, but it is only by empirical estima-
tion of the quantitative impact of various influences
on the demand for money that definitive con-
clusions can be drawn regarding the importance of
each factor for the behavior of the income velocity
of money.
A number of empirical studies have attempted
to determine the important parameters of the
aggregate demand for money function.22 The
equation to be estimated typically specifies the
demand for real money balances as a function of
the yield on one or more alternative assets and some
measure of real income."2 It is often assumed that




22 For ease of exposition, the term "demand for money
function" will be used to refer to functions with either the
quantity of money balances or the income velocity of money
(or its inverse) as the variable to be explained. A velocity
function can easily be converted to an explicit demand for money
function by simple algebraic manipulation. Thus, a particular
specification of a velocity function implies a unique specifi-
cation of the demand for money function and vice versa.
For a summary of much of the empirical work on the
demand for money, see Edgar L. Feige and Douglas K.
Pearce, "The Substitutability of Money and Near-Monies: A
Survey of the Time-Series Evidence," Journal of Economic
Literature, Vol. 15, No. 2, June 1977.
23 Milton Friedman, "The Demand for Money: Some
Theoretical and Empirical Results," Journal of Political
Economy (August 1959), advocates use of a long-run concept of
income in specifying a demand for money function. Friedman
argues that individuals adjust their desired money balances in
line with the sustainable level of income over a prolonged period,
a concept which he calls "permanent income." Karl Brunner
and Allan H. Meltzer, "Predicting Velocity: Implications
for Theory and Policy," Journal of Finance, Vol. 18, No. 2,
May 1963, prefer to include wealth rather than either current
or permanent income in the demand for money function.
If something other than current income is included as the











Chart 2
THE POSTWAR TREND OF M1 VELOCITY


GNP/M1


6











M1 Velocity







3





2




1950 1954 1958 1962 1966 1970 1974 1978


individuals and businesses do not adjust their
actual cash balances to desired levels instantane-
ously. This assumption is incorporated by in-
cluding past values of income and interest rates in


scale variable in specifying a demand for money function, the
derivation of a velocity function requires that the relation
between current income and the included scale variable be
specified. The necessity to specify the relation between current
income and either permanent income or wealth, neither of which
can be measured directly, introduces the possibility of
compounding errors in specifying the demand for money


the equation explicitly or by inferring the speed of
adjustment to desired values from the coefficient
on the lagged value of the money stock.
The results from empirical estimation of the


function and errors in measuring the independent variables used
to explain the demand for money. In addition, it is difficult
to see the relevance of concepts such as permanent income and
wealth for the demand for money by the business sector. To
avoid these conceptual problems, the discussion in this article
focuses on the traditional specification of the demand for money
function, with measured income as the scale variable.










demand for money function differ substantially
according to the statistical techniques used, the
period for which the equation is estimated, and
the precise specification of the form of the function.
In general, though, the empirical results are
generally consistent with the predictions from the
inventory models outlined earlier.24 Most studies
find that the demand for money increases less than
proportionately to the level of income, that yields
on alternative assets have a significant negative
impact on the desired level of cash balances, and
that the introduction of new types of liquid assets
results in slower growth in the quantity of money
demanded.
In the judgment of many analysts, empirical
estimates indicate that the demand for money
function has exhibited substantial stability and
that unexpected changes in the income velocity of
money are therefore unlikely to invalidate the use
of the money supply or its growth rate as the
primary indicator of monetary policy. A number
of economists consider the evidence on the stability
of the demand for money function so persuasive
that they advocate reinstitution of a revised version
of the quantity theory of money as the primary
framework for analyzing macroeconomic relations.
The monetarists, as the new advocates of a revised
quantity theory are called, assign a primary role to
growth in the money stock as a determinant of the
growth in total spending. Indeed, most monetarists
deny that factors other than the growth in the money
supply, such as fiscal policy, exert any systematic
influence on income or inflation except, perhaps,
in the very short run.25
The consensus regarding the relative stability of
the demand for money and velocity functions that
emerged from the numerous empirical studies
mentioned has had a significant impact on the



24 Empirical estimates of the income and interest elasticities of
the demand for money from numerous studies are reported in
Feige and Pearce.
25 See Andersen and Carlson for an example of the model of
the economy considered relevant for macroeconomic analysis
by two well-known monetarists.


implementation of monetary policy. The Federal
Reserve has increasingly emphasized the impor-
tance of monetary growth for economic perfor-
mance in the past several years. The general climate
of opinion seemed, until recently, to have come full
circle from the constant velocity assumption of
the original quantity theory, through the de-
emphasis of velocity resulting from the economic
experience in the 1930s and Keynes's criticism of
the quantity theory, to the apparent empirical
verification of a stable demand for money function
and the belief that unpredictable changes in
velocity are unlikely to have a significant impact
on income and inflation. The assumption of a
constant income velocity as a basis for analyzing
aggregate economic relations was replaced by the
presumption that velocity was predictable, though
not necessarily constant.



THE BEHAVIOR OF VELOCITY IN THE
CURRENT RECOVERY
Recent experience has led some analysts to
question whether the behavior of the income
velocity of money is predictable. Velocity -
especially for Ml has increased quite rapidly
in the past three years, and the degree of the
rise in velocity, particularly in 1975 and 1976,
seems to many to be inconsistent with past
experience. Although the income velocity of money
typically increases substantially during economic
upturns, the rapidity and duration of the most
recent rise in velocity has been exceptional (Chart
3). The rapid growth in Ml velocity for the past
three years is particularly surprising when one
considers the accompanying pattern of increases in
market interest rates. One of the primary factors
contributing to the normal increase in velocity
during periods of economic expansion is the rise
in market interest rates that typically accompanies
rapid economic growth. Businesses and households
intensify their efforts to economize on cash
balances as the opportunity cost of holding money
rises. A substantial portion of the increase in










velocity during the current expansion occurred in
1975 and 1976, however, a period in which
market rates were generally declining. Thus, the
interest sensitivity of the demand for money does
not provide a complete explanation of the behavior
of velocity in the current recovery.
The quickened pace of financial innovation in
the 1970s accounts for a portion of the apparent
downward shift in the demand for money function
in recent years. A number of regulatory and legal
decisions have permitted financial institutions to
offer plans that have resulted in a decline in desired
M1 balances relative to income. Thrift institutions,
for example, have begun to offer interest-bearing
accounts that can be used to make payments in
much the same way as can checking accounts.
Commercial banks have responded by making it
easier for their customers to transfer funds out
of interest-earning deposits into checking
accounts. In addition, businesses and state and local
government units have been authorized to hold
some of their funds in savings deposits. All of these
and other innovations have undoubtedly contributed
to the reduction in the desire to hold funds in
checking accounts. The total impact of all of these
financial innovations can explain only a small
fraction of the recent shortfall in the demand for
money, however.26
Even after taking account of the probable impact
of financial innovation, most empirical studies have
found that the behavior of Ml velocity in recent
years cannot be explained by traditional demand
for money functions. A great deal of additional
empirical work will be needed to resolve what one
author has called "The Case of the Missing
Money."27



28 For an estimate of the impact of financial innovation on the
demand for money, see Jared Enzler, Lewis Johnson, and
John Paulus, "Some Problems of Money Demand," Brookings
Papers on Economic Activity, 1976:1.
27 Stephen M. Goldfeld, "The Case of the Missing Money,"
Brookings Papers on Economic Activity, 1976:3. Goldfeld tried
to explain the rapid increase in velocity in recent years using
a number of alternative specifications of the demand for money
function. While some specifications proved to be slightly better


Resolution of the puzzling behavior of velocity in
recent years has important implications for
monetary theory and policy. If the recent behavior
of velocity can be explained within the general
framework of traditional economic analysis,
predictions based on the presumption of a stable
velocity function will continue to be important
determinants of the course of monetary policy. It
is possible that the rapid increases in velocity in
the last few years can be satisfactorily explained by
economic determinants that have not previously
been incorporated into theoretical and empirical
studies of the relation between the money supply
and the level of income. Incorporation of these
determinants could yield a velocity function that is
sufficiently stable to be valuable for economic and
policy analysis. If, on the other hand, the factors
causing the atypical behavior of velocity in recent
years cannot be identified, economic analysis based
on the predictability of the income velocity of
money might result in future policy errors that
impair economic performance. Thus, questions
regarding determinants of the velocity of money
are certain to continue to play a dominant role in
discussions concerning the future course of
inflation, income, and employment.


than others, none were capable of satisfactorily explaining the
recent behavior of velocity. Goldfeld concluded that
"Specifications that seem most reasonable on the basis of
earlier data are not the ones that make a substantial dent in
explaining the recent data" and that his efforts to solve the puzzle
of the shortfall in the demand for money had been unsuccessful
(p. 725).
Michael Hamburger, "Behavior of the Money Stock: Is
There a Puzzle?" Journal of Monetary Economics, Vol. 3,
No. 3, July 1977, claims to have solved the puzzle of the
recent behavior of velocity. The primary differences between the
demand for money functions specified by Goldfeld and
Hamburger is that Hamburger includes the yields on a wider
variety of assets and constrains the income elasticity of the
demand for money to be 1. The constraint on the income
elasticity, although not uncommon, seems difficult to justify on
either theoretical or empirical grounds. It remains to be seen,
therefore, whether the solution to the money demand puzzle
posited by Hamburger provides a basis for confidence in
predictions of the future course of velocity.










Chart 3
CYCLICAL BEHAVIOR OF M1 VELOCITY

INDEX



Recession T ) Recovery
116



114
73:IV-77:IV

112


60:11-63:IV
110
no--------------------^--. -- / --

108 -----

/ / 69:IV-73:I11
106



104



102



100



98




-5 -3 -1 0 +1 +3 +5 +7 +9 +11
Quarters from Trough









CONCLUSIONS
A central assumption of economic analysis is
that there are certain key relations in the economy
that are stable enough over time to warrant con-
fidence in predictions based on economic models
that incorporate those relations. One of the central
relations on which economists and policymakers
have traditionally relied in analyzing aggregate
economic activity is the connection between the
money supply and the level of income. The concept
of the velocity of money has been both lauded and
scorned at various stages in the development of
economic theory. This article has discussed the
evolution of macroeconomic theories that have
affected the attitudes toward the concept of velocity
and the empirical evidence that supports these
attitudes. Although there is not now, nor has there
ever been, complete agreement regarding the
determinants of the income velocity of money, the
concept of velocity will almost certainly remain a
subject of extensive debate among policymakers,
economists, and other analysts. As economic
theory and data availability have become more
refined, understanding of the behavior of velocity
has advanced substantially. Continued effort will be
required, however, to ensure that knowledge about
the factors affecting velocity is keeping pace with
the changing economic and social environment in
which policy decisions are made.

APPENDIX
In the inventory models of the transactions
demand for money, the interest incentive to
economize on cash balances is counterbalanced
by the cost of transferring funds from interest-
earning assets into money as necessary to finance
expenditures. Although it is traditionally assumed
that the primary cost of converting earning assets
into cash is the fixed brokerage fee associated with
transferring funds, it seems likely that the major
cost for individuals of transferring funds is the
opportunity cost of the time necessary to effect such
a transfer. Particularly if funds are held temporarily
in time and savings deposits at financial inter-
mediaries rather than in money balances, a major


factor contributing to the perceived cost of trans-
ferring funds out of interest-earning assets into cash
is the reduction in leisure time resulting from
careful management of cash balances. For a more
complete exposition of this point, see Dean S.
Dutton and William P. Gramm, "Transactions
Costs, the Wage Rate, and the Demand for
Money," American Economic Review, Vol. 63,
No. 4 (September 1973). The same study provides
a possible explanation for the discrepancy between
the income elasticity of the demand for money
estimated empirically and the scale elasticity
implied by simple inventory models.
It is informative in this regard to reformulate the
inventory model to take account of both the
substitution effect and the scale effect of a change
in income resulting from a change in the real wage.
If in addition to a fixed brokerage fee (b) for
transferring funds from one type of asset to another,
there is an opportunity cost of time equal to a
proportion (g) of the individual's real wage, then
the total cost (X) of maintaining a cash balance
needed to finance transactions is:

X = r(C/2) + (Y/C) (b + gw)

where

Y = total expenditures per time period,
C = the size of transfers from interest-earning
assets into cash,
w = the real wage per period,

and

r = the opportunity cost per period of holding
funds in noninterest-bearing form.

Differentiating this expression with respect to C
and setting the result equal to zero, we find that the
cost function is minimized by holding an average
balance C/2 equal to the square root of [Y(b + gw)/
2r]. The elasticity of the average cash balance with
respect to the volume of expenditures is +1/2 as
in the Baumol formulation.
But since an increase in the real wage increases









the opportunity cost of time necessary to effect
transfers into or out of money, an increase in
income resulting from an increase in the real wage
has an effect on the demand for money which is
independent of the level of expenditure. The
magnitude of this effect can be found by differ-
entiating the expression for average cash balances
with respect to w and multiplying the result by
[w(C/2)]. This yields an expression for the (partial)
elasticity of the demand for money with respect
to the wage rate which, when simplified, is 1/2
[1/(1 + b/gw)]. This "pure income effect" due to


the substitution possibilities between leisure and
income in regard to managing active money
balances will be closer to +1/2 the larger is the
percentage of the total cost of transferring funds
attributable to the opportunity cost of the individ-
ual's time. If, therefore, income is used to measure
both the scale of expenditure effect and the sub-
stitution effect, one would expect the measured
income elasticity to be in the interval (+1/2, +1).
Thus, a measured income elasticity close to +1
does not, as is often alleged, refute the hypothesis
of economies of scale in cash management.








Section II


Instruments and Indicators
of Monetary Policy











The Choice of a

Monetary Policy Instrument


By J.A. Cacy


Alternative methods of conducting monetary
policy have been extensively debated in recent
years. Much of the debate has centered around the
question of whether the Federal Reserve should use
interest rates or the money supply as the instrument
variable in conducting monetary policy. This article
analyzes some aspects of this question. The first
section of the article defines an instrument variable
and outlines the relationship between instrument
and goal variables. A model of the economy is
presented in the second section. The third and
fourth sections use the model to analyze the choice
of an instrument variable. The last section
summarizes the article findings.

INSTRUMENT AND GOAL VARIABLES
An instrument variable is one the Federal
Reserve controls on a continuous basis. By
controlling instrument variables, the Federal
Reserve influences the behavior of goal variables,
which measure conditions or processes related to
the System's overall economic goals. The Federal
Reserve's goals include, in general terms, reason-
able price stability, high employment, satisfactory
economic growth, and international balance. For
example, a price index may be a goal variable


J.A. Cacy is a vice president and senior economist with the
Federal Reserve Bank of Kansas City. This article was
originally published in the May 1978 Economic Review.


because it measures the extent of inflation, a
process related to the general goal of price stability.
Thus, one objective of the Federal Reserve in
controlling instrument variables may be to
influence the behavior of a price index.
Instrument variables have two characteristics.
First, they are controllable that is, they are
closely related to Federal Reserve actions; and
they can be observed continuously so that any
imprecision in the relationship can be immediately
compensated for by Federal Reserve actions. The
other characteristic is that instrument variables
are closely related to goal variables or to other
variables related to goal variables; and information
is available about these relationships.
Because a number of variables are potential
instrument variables, the Federal Reserve must
choose one or more to control. As mentioned
earlier, this article deals with the choice between the
interest rate and the money supply. The article also
discusses the alternative of using both variables as
instruments.' When only the interest rate is used, a




SThe article assumes that there is only one interest rate and one
measure of the money supply. Also, the article assumes that
both the interest rate and the money supply can be continuously
controlled. While these assumptions are unrealistic, they allow
the analysis to focus on the important issue of the choice
between interest rates and the money supply.










"pure" interest rate policy is followed, defined as
a policy of maintaining the interest rate at a
specified level for a specified period. The period
is referred to as the decision period. When only the
money supply is used as an instrument variable, a
pure money supply policy is followed, defined as a
policy of maintaining the money supply at a
specified level during the decision period. When
both variables are used, a "combination" policy is
followed, defined as moving the interest rate and
the money supply during the decision period in
response to certain developments.
National income is treated as the Federal
Reserve System's goal variable in this article. It is
assumed that policymakers want to achieve a
specified level of income because income below
that level is accompanied by unutilized resources,
while income above that level is accompanied by
inflationary pressures.

THE IS-LM MODEL
In considering the instrument choice problem,
the relationship between instruments and goal
variables must be analyzed. To do so, a model of
the economy is needed. One frequently used is the
IS-LM model, a highly simplified theoretical
macroeconomic model. Due to the simplified and
theoretical nature of the model, conclusions about
monetary policy based on the model are not
definitive. Policy analysts, however, have found
the model very useful in identifying general
considerations relevant to the choice of instrument
variables.
The IS-LM model has three variables -
national income, the interest rate, and the money
supply. The major focus of the model is real
national income, which (in the absence of supply
constraints) is determined by the aggregate demand
for goods and services. Aggregate demand, in
turn, is generally determined by two broad sets of
factors- "real" factors and "monetary" factors.
Real factors refer to factors such as the return
on investment that directly affect the public's
aggregate spending (consuming, investing) and
saving behavior. Monetary factors affect the


public's money-holding behavior and have an
indirect effect on aggregate demand. In line with
the real/monetary dichotomy, the IS-LM model
divides the economy into real and monetary sectors.
Each sector is summarized by one equation or
function. In the real sector, the equation is the IS
function which summarizes the relationship be-
tween income and the interest rate in the real
sector. In the monetary sector, the LM function
summarizes the relationship between income and
the interest rate, given the supply of money.

The LM Function
The LM function is a relationship between the
levels of real national income and the interest rate
that are consistent with equilibrium in the financial
or monetary sector of the economy. Monetary
sector equilibrium means that, in the aggregate,
economic units are holding the quantity of money
balances they plan or demand to hold, and that the
quantity of money demanded is equal to the quantity
of money supplied, with the quantity of money
supplied being given. Also, monetary sector
equilibrium means that, if equilibrium exists, there
is no tendency for income to change due to the
underlying factors affecting equilibrium in the
monetary sector that is, due to adjustments by
economic units with regard to their holding of
money balances.
The LM relationship is based on one underlying
relationship, along with the condition that the
demand for money equals the supply of money.
The underlying relationship is the demand for
money function, or the relationship between the
quantity of money demanded and the rate of
interest and income.
To illustrate how a given combination of income
and rate of interest may be consistent with
equilibrium in the monetary sector, assume that
when the interest rate and income are at certain
levels, say i1 and y, economic units will demand
to hold a certain quantity of money balances. Now
assume the quantity of money supplied is equal
to this quantity demanded, so that if i, and y,
are realized, economic units will be holding the










quantity of money they plan to hold that is, the
demand for money will equal the supply. Thus,
given the supply of money, i1 and y, are consistent
with monetary sector equilibrium. When i, and y,
are realized, there is no tendency for income to
change due to factors affecting income in the
monetary sector.
The LM function is a positive one that is, a
high rate of interest is associated with a high level
of income and a low rate of interest is associated
with a low level of income. The function is positive
because the quantity of money demanded is
negatively related to the rate of interest and
positively related to the level of income. Money
demanded is negatively related to the rate of interest
because a relatively high interest rate encourages
economic units to economize on money balances,
while a low interest rate discourages units from
economizing on balances. The quantity of money
demanded is positively related to income because a
relatively high level of income creates a need for a
relatively high level of balances, and a low level of
income creates a need for a low level of balances.
To illustrate the positive slope of the LM
function, assume that certain levels of the interest
rate and income are consistent with monetary sector
equilibrium. Now assume a higher level of income.
At the higher level, economic units will demand
more money balances, so that the quantity of money
demanded will be greater than the quantity
supplied. Now assume, in addition to the higher
income, successively high levels of the interest rate.
At the higher levels, units will demand fewer
money balances. At some higher interest rate,
the lesser demand due to the higher interest rate will
offset the greater demand due to the higher income,
leaving the quantity of money demanded un-
changed and equal to the unchanged supply of
money. Thus, the higher income requires a higher
interest rate to maintain equilibrium.
As shown in Figure 1, the LM function slopes
upward and to the right. In the figure, monetary
equilibrium exists if the rate of interest is it and
income is y, or if the rate of interest is i, (higher
than i1) and income is y2 (higher than y,). All other


combinations of the interest rate and income that
lie on the LM curve are consistent with monetary
sector equilibrium, also.

The IS Function
The IS function is a relationship between the
levels of real national income and the interest
rate that are consistent with equilibrium in the real
sector of the economy. Real sector equilibrium
means that, given the interest rate and income,
consumers are consuming the amount they intend
or plan to consume, savers are saving the amount
they plan to save, investors in capital goods are
investing the amount they plan to invest, and that
planned saving equals planned investment.2 Also,
real sector equilibrium means that, if equilibrium
exists, there is no tendency for income to change
due to underlying factors affecting income in the
real sector that is, due to adjustments by
economic units with regard to the amounts they
consume, save, and invest relative to their incomes
and the interest rate.
The IS function is based on two underlying
functions or relationships, along with the condition
that planned saving equals planned investment. One
underlying relationship is the investment demand
function, a relationship between planned invest-
ment and the rate of interest. The other relationship
is the consumption function, or alternatively the
saving function, the latter being a relationship
between income and planned saving.
To illustrate how a combination of income and
the interest rate may be consistent with real sector
equilibrium, assume that when the interest rate is at
a given level, say it, investors plan a given amount
of investment. If realized, the investment generates
income in the sector of the economy that produces
capital goods. Economic units receiving the income
save part and consume part of the income. The part
consumed also generates income, with part being


SIn a more complete model, containing a government and a
foreign sector, the equilibrium condition would be that saving
equals domestic and net foreign investment plus the govern-
ment's budget deficit.










Figure 1
THE LM FUNCTION


Interest
Rate


i2 rh- - - -- -


Income


saved and part consumed, and so on. Thus, the
given level of investment generates or supports a
given level of income, say y, with the level of
income being that level at which the amount savers
plan to save equals the amount investors plan to
invest. Given the interest rate, i,, the real sector
equilibrium level of income is y,. When i, and y,
are realized, planned consumption, saving, and
investment are realized; planned saving equals
planned investment; and there is no tendency for
income to change due to factors affecting income in
the real sector.


The IS function is an inverse one that is, a
high rate of interest is associated with a low level
of income and a low rate of interest is associated
with a high level of income. The IS function is
inverse because the underlying investment demand
function is inverse. A high rate of interest tends to
discourage investment and therefore results in a low
level of income, while a low rate of interest tends
to encourage investment and results in a high
income. The inverse IS relationship is said to
slope downward and to the right, as illustrated
in Figure 2. In the figure, real sector equilibrium


I I


ilC---------









Figure 2
THE IS FUNCTION


Interest
Rate


'1 ----


2 F--


Income


exists if the rate of interest is i1 and income is y,,
or if the rate of interest is i2 (lower than i,) and
income is y, (higher than y,). All other combina-
tions of the interest rate and income that lie on the
IS curve are consistent with real sector equilibrium,
also.

Full Equilibrium in the IS-LM Model
Full equilibrium in the IS-LM model exists if
both the real and monetary sectors are in
equilibrium. The full equilibrium combination of
the rate of interest and income is a combination


that is consistent with the conditions that planned
saving equals planned investment, and the demand
for money equals the supply of money, with the
supply of money given outside the model. If full
equilibrium exists, there is no tendency for income
to change due to factors affecting income in either
the real or monetary sectors.
Full equilibrium may be illustrated graphically
by drawing both the IS and LM functions on the
same graph. The full equilibrium interest rate and
income levels are given by the intersection of the
two functions. In Figure 3, the full equilibrium









combination of interest rate and income is ii and
yi. If any other combination of the interest rate
and income exists, income tends to change. For
example, at point A in Figure 3, real sector equilib-
rium exists and economic units are saving,
consuming, and investing according to plan.
However, monetary equilibrium does not exist, and
the economic units are not holding the quantity of
money balances they demand to hold. In particular,
the supply of money exceeds the demand for
money. Under these circumstances, units attempt to
reduce their money balances by buying securities,
which increases the price of securities and lowers
the rate of interest. As the interest rate declines,
investors tend to increase their capital investment,
and the higher investment generates a higher
income. These adjustments by economic units tend
to propel the interest rate down and income up, so
that the interest rate and income are propelled
toward point B in Figure 3 and the equilibrium
combination, ii and yi.

Impact of a Change in the Supply of Money
The IS-LM model may be used to analyze the
impact on the rate of interest and income of a change
in the quantity of money supplied. Since the LM
function assumes a given quantity of money
supplied, a change in the supply of money causes
the LM curve to shift. An increase in the supply
of money shifts the function to the right, because
any given interest rate requires a higher income
level to be consistent with the monetary sector
equilibrium. The higher income level is required
to increase the quantity of money demanded to the
higher quantity supplied, so that the demand for and
supply of money are equal. Similarly, a decline in
the supply of money shifts the function to the left.
Thus, the position of the LM function is affected
by the supply of money.
An increase in the supply of money that shifts
the LM function to the right lowers the rate of
interest and increases income, as illustrated in
Figure 4. In the figure, the money supply is
assumed initially to be a certain amount, M,, which
results in a certain LM function, labeled LM,.


Given M, (and the IS function), the interest rate is
i, and income is y, Now assume an increase in
the supply of money to M,, which shifts the LM
function to LM2 and results in a decline in the
interest rate to i2 and an increase in income to
y2. The analysis of the forces that cause the interest
rate and income to move from i, and y, to i2 and
Y2 is identical to the analysis of the movement from
point A to point B in Figure 3.
CHOOSING THE INSTRUMENT
The IS-LM model may be used to analyze the
choice of the best instrument to use in conducting
monetary policy.3 This section treats the choice
between the interest rate and the money supply,
while the following section discusses the possibility
of using both variables. In general, the relative
efficacy of the two variables as instruments depends
on the relative closeness of their relationship to the
goal variable, national income. Relative closeness
depends on the characteristics of the IS and LM
functions, linking the interest rate, money supply,
and income. In particular, relative closeness
depends especially on whether and to what extent
the two functions are stable.
In view of the importance of stability, this
section's analysis of instrument choice is divided
into four parts, distinguished by the extent of
stability. In the first part, both the real and the
monetary sectors are assumed to be stable. In the
second part, the real sector is stable, but the
monetary sector is unstable. In the third part, the


SThe IS-LM model was first used to rigorously analyze the
problem of instrument choice in William Poole, "Optimal
Choice of Monetary Policy in a Simple Stochastic Macro
Model," Quarterly Journal of Economics, Vol. 84, May
1970, pp. 197-216. Also, see Stephen F. LeRoy and David
E. Lindsey, "Determining the Monetary Instrument: A
Diagrammatic Exposition," Special Studies Paper No. 103,
Board of Governors of the Federal Reserve System (1977);
LeRoy and Roger N. Waud, "Applications of the Kalman Filter
in Short-Run Monetary Control," International Economic
Review, Vol. 18, No. 1, February 1977, pp. 195-207; and
Benjamin M. Friedman, "The Inefficiency of Short-Run
Monetary Targets for Monetary Policy: Comments and
Discussion," Brookings Papers on Economic Activity (1977:2),
the Brookings Institution, Washington, D.C., pp. 293-346.









Figure 3
FULL EQUILIBRIUM


Interest
Rate


i2



1,


Y2 yl


real sector is unstable, but the monetary sector is
stable, and in the fourth part, both sectors are
assumed to be unstable. The analysis of the better
instrument is preceded by a brief discussion of the
meaning of stability and instability.


Meaning of Stability and Instability

Stability in both the real and monetary sectors
means that the IS and LM functions remain in the


positions they are expected to occupy and do not
fluctuate away from or around their expected
positions. For the IS function to be stable, policy-
makers must know the precise levels of investment
that investors plan at various interest rate levels, as
well as the precise amounts of consumption and
saving that consumers and savers plan to undertake
at various income levels. For the LM function to
be stable, policymakers must know the precise
quantities of money demanded at various interest


Income









Figure 4
IMPACT OF A CHANGE IN THE MONEY SUPPLY


Interest
Rate


LM2 (M = M2)


Income


Y2 Y1


rate and income levels.
Instability in the monetary sector means that the
LM function fluctuates around its expected
position. That is, for various rates of interest,
equilibrium income levels fluctuate above and
below expected levels of income. Instability in
the LM function arises when policymakers do not
know the precise quantities of money balances that
are demanded at various interest rate and income
levels. Thus, they do not know, for various rates


of interest, the precise levels of income that are
consistent with equilibrium in the monetary sector
of the economy. However, while policymakers are
uncertain about the precise position of the LM
function, they can estimate its expected position.
That is, for various interest rate levels, they can
estimate the levels of income that are expected to
be consistent with monetary sector equilibrium.
Instability in the real sector means that the IS
function fluctuates around its expected position.








Instability in the IS function arises when policy-
makers do not know the precise amounts of invest-
ment that are planned at various interest rate levels
or the precise amounts of consumption and saving
that are planned at various income levels. Thus,
policymakers do not know, for various interest rate
levels, the precise levels of income that are con-
sistent with equilibrium in the real sector of the
economy. However, while policymakers are
uncertain about the precise position of the IS
function, they can estimate its expected position.



Instrument Choice Under Stable Conditions
If both the monetary and real sectors are stable,
neither an interest rate policy nor a money supply
policy is preferred. Both policies are equally good
because the target level of income is achieved by
using either the interest rate or the money supply as
an instrument variable.
Under stable conditions, an interest rate policy
maintains the interest rate at that level associated
with the target level of income, as indicated by the
IS function. This is the interest rate that leads to a
level of investment sufficient to generate the target
level of income. The "maintained" interest rate
level may be designated as i*, and the target level
of income may be designated as y*. (See Figure
5.) By maintaining the interest rate at i*, the target
level of income, y*, is achieved. (Throughout this
article, i* designates the interest rate that is
maintained under an interest rate policy, and y*
designates the target level of income.)
A money supply policy maintains the money
supply at the level that causes the LM func-
tion to intersect the IS function at the target
level of income. This is the money supply that
equals the quantity of money demanded when
income is at the target level. The maintained level
of the money supply may be designated as M*.
As shown in Figure 5, by maintaining the money
supply at M*, the target level of income, y*, is
achieved. (Throughout this article, M* designates
the money supply that is maintained under a money
supply policy.)


To summarize, if both the monetary and the real
sectors are stable, there is no difference between
using the money supply and the interest rate as the
instrument variable. Use of either variable achieves
the target income level. Moreover, maintaining the
interest rate at i* under an interest rate policy
results in a money supply of M* the maintained
level under a money supply policy. Similarly,
maintaining M* results in i*. In other words, i*
implies M* and M* implies i*.

Instrument Choice Under Instability
in the Monetary Sector
If the real sector is stable but the monetary
sector of the economy is unstable, an interest rate
policy is better than a money supply policy. The
interest rate policy is better because the target
level of income is achieved when using the interest
rate, but the target income may not be achieved
when using the money supply.
Under these conditions of stability in the real
and instability in the monetary sectors, an interest
rate policy maintains the interest rate at the level
associated with the target level of income,
according to the IS function. As above, maintaining
the interest rate at i* achieves y*.
A money supply policy maintains the money
supply at that level that causes the expected LM
function to intersect the IS function at the target
level of income. However, in this case, maintaining
the money supply at M* does not ensure the
achievement of the target level of income because
the LM function fluctuates and is unstable, as
illustrated in Figure 6. In the figure, the expected
LM function is labeled LMe. The function may
fluctuate, though, possibly shifting leftward to
LMp. (Throughout the remainder of the article,
LMe indicates the expected LM function when the
money supply is maintained at M*, while LMp
indicates the function that may possibly result when
the money supply is maintained at M*.) The left-
ward shift may be due to economic units
temporarily demanding a greater than expected
quantity of money balances. If the LM function
shifts leftward to LMp, the level of income









Figure 5
STABILITY IN REAL AND MONETARY SECTORS


Interest
Rate


LM (M = M*)


Income


achieved by maintaining the money supply at M*
is yM, which is less than y*. Alternatively the LM
function may shift rightward due to units de-
manding a smaller than expected quantity of money
balances. In this case (not shown in Figure 6), the
achieved level of income is greater than the target
level.
In summary, if conditions are stable in the real
sector but unstable in the monetary sector, the


interest rate is better than the money supply as an
instrument variable. Moreover, unlike the previous
case, there is a difference between using the two
variables. In this case, i* does not necessarily
imply M*. Maintaining the interest rate at i* may
result in a money supply either above or below
M*, as the LM function fluctuates around its most
likely position. In the case illustrated in Figure 6
of a leftward shift in the LM function to LMp -


I










Figure 6
INSTABILITY IN THE MONETARY SECTOR


Interest
Rate


LMe and LMi


Income


YM y*


NOTE: LMe represents the LM function that is expected when M* is maintained; LMp represents the function that may
possibly result when M* is maintained; and LMi represents the function that results when i* is maintained.


due to a greater than expected demand for money
- the money supply that results from maintaining
i* is higher than M*. The higher level of money
balances (which, under an interest rate policy, holds
the LM function at the expected position) is needed
to provide for the greater than expected demand for
money. Similarly, maintaining the money supply at
M* may result in an interest rate above or below
i*. In the case of a leftward shift in the LM function,


the level of the interest rate that results from
maintaining M* is higher than i*. The higher
interest rate (designated by iM) is needed to reduce
the greater than expected demand for money
balances.

Instrument Choice Under Instability
in the Real Sector
If the monetary sector is stable but the real









Figure 7
INSTABILITY IN THE REAL SECTOR


Interest
Rate


iM -


Y* YM Yi


NOTE: LMe represents the LM function that is expected when M* is maintained, and LMi represents the function that results
when i*is maintained.


sector of the economy is unstable, a money supply
policy is better than an interest rate policy. The
money supply policy is better because, while the
precise target level of income is not achieved by
using either instrument, the divergence between the
income level achieved and the target level will be
less when using the money supply than when using
the interest rate as an instrument variable.
Under conditions of monetary stability and real


sector instability, an interest rate policy maintains
the interest rate at that level associated with the
target level of income as indicated by the IS
function, assuming the function occupies its
expected position. However, maintaining the
interest rate at i* does not ensure achievement of the
target level of income. This is because the IS
function fluctuates and is unstable, as illustrated in
Figure 7. In the figure, the expected IS function


Income









is labeled ISe. The function may fluctuate, though,
possibly shifting rightward to ISp. (Through the
remainder of the article, ISe indicates the expected
IS function, while ISp indicates a possible
function.) The rightward shift may be due to
economic units temporarily investing more than
expected. If the IS function shifts rightward to ISp,
the level of income achieved by setting the interest
rate at i* is y,, which is more than y*. Alternatively,
the IS function may shift leftward due to units
temporarily investing a smaller than expected
amount. In this case (not shown in Figure 7), the
achieved level of income is less than the target level.
A money supply policy maintains the money
supply at that level that causes the LM function
to intersect the expected IS function at the target
level of income, assuming the IS function occupies
its expected position. However, M* does not ensure
achievement of the target level of income because
the IS function is unstable. In the case illustrated
in Figure 7 of the rightward shift in the IS function
to ISp, the level of income achieved by maintaining
the money supply at M* is y,, which is greater
than y*. In the case of a leftward shift in the IS
function (not shown in Figure 7), the level of
income achieved by maintaining the money supply
at M* is less than the target level.
In summary, if conditions are stable in the
monetary sector but unstable in the real sector, the
money supply is better than the interest rate as an
instrument variable because the divergence be-
tween the achieved level of income and the target
level is less when using the money supply than
when using the interest rate. The smaller divergence
is illustrated in Figure 7, which shows that the
difference between y* and y, the level of
income achieved when using the money supply -
is less than the difference between y* and y, -
the level of income achieved using the interest rate.
Moreover, there is a difference between the two
policies, as i* does not imply M* and M* does
not imply i*. Maintaining the interest rate at i*
may result in a money supply either above or
below M*, as the IS curve fluctuates around its
most likely position. Similarly, maintaining the


money supply at M* may result in an interest rate
either above or below i*.
Instrument Choice Under Instability
in the Real and Monetary Sectors

If conditions are unstable in both the real and
monetary sectors, either the interest rate or the
money supply may be the best instrument variable,
depending on certain factors. One factor is the
relative instability of the IS and LM functions. As
illustrated in Figure 8, a money supply policy is
preferred if the IS function is less stable than the
LM function. The figure assumes a rightward IS
shift and a leftward LM shift, with the IS shift
being more pronounced. The greater IS shift may be
verified by noting that the distance between points
A and B exceeds that between points A and C.
Figure 8 shows that a money supply policy is
preferred because the divergence between y* and
YM is less than the divergence between y* and y,.
Since a money supply policy is preferred if the
IS function is less stable than the LM function,
the analyst might expect that an interest rate policy
is preferred if the LM function is less stable.
However, in the case of a less stable LM function,
an interest rate policy is not necessarily preferred.
The policy choice depends on the extent the LM
function is less stable as well as on the slopes of the
two functions. Ignoring the slopes, the money
supply tends to be the better instrument if the
instability of the LM function exceeds the IS
function's instability by a small amount. If the
excess instability of the LM function is large,
however, the interest rate tends to be the better
variable.
Figure 9 illustrates the impact on instrument
choice of the degree of excess LM instability. The
figure assumes a rightward IS shift and two alter-
native leftward LM shifts. Both LM shifts exceed
the IS shift, with the shift labeled LMp exceeding
the IS shift by a larger amount than does the shift
labeled LMp. (Note that both line segments AC
and AD exceed AB.) In the case of the relatively
small shift to LMp, a money supply policy is pre-
ferred even though the LM shift exceeds the IS










Figure 8
IS MORE UNSTABLE THAN LM


Interest
Rate


I II I Income
Y* YM Yi
NOTE: LMe represents the LM function that is experienced when M *is maintained, and LMI represents the function that results
when i* is maintained.


shift. In the case of the relatively large LM shift
to LMp, however, an interest rate policy is
preferred.
In addition to stability, the choice of an instru-
ment depends on the slope of the IS and LM
functions. The slope of a function refers to the
relative changes in the interest rate and income
that occur between equilibrium combinations of
the two variables. The slope is steep if, for any
given change in the interest rate, the change in


income is small. The slope is "flat" if, for any
given change in the interest rate, the change in
income is large.
Ignoring the degree of excess instability of the
LM function, if the LM function is relatively steep
(flat), the interest rate (money supply) tends to be
the better variable. The LM function is relatively
steep (flat) if the demand for money is relatively
insensitive (sensitive) to interest rate changes.
Thus, an interest rate (money supply) policy tends









to be preferred if the demand for money is relatively
insensitive (sensitive) to changes in the rate of
interest.
If the IS function is relatively steep (flat), the
money supply (interest rate) tends to be the better
instrument variable. The IS function is relatively
steep (flat) if the demand for investment is relatively
insensitive (sensitive) to interest rate changes.
Thus, a money supply (interest rate) policy tends
to be preferred if the demand for investment is
relatively insensitive (sensitive) to changes in the
rate of interest.4

COMBINATION POLICY
This section discusses the possibility that using
both the interest rate and the money supply as
instrument variables may be preferred to using
either one or the other. The use of both instruments
is referred to as a combination policy. Under a
combination policy, instead of maintaining either
the interest rate or the money supply at some
specified level, policymakers move both variables
in response to shifts in the IS and LM functions.





4 The impact on instrument choice of the slope of the LM
function can be illustrated by envisaging the impact on yM
of a progressive steepening of the LM function labeled LMp
in Figure 9. The steepening would be shown by a counter-
clockwise rotation of LMp around an axis located at point
C. As LMp rotates and becomes steeper, yM becomes progres-
sively further from y*. This increases the divergence between
yM and y* and increases the likelihood that a money supply
policy is inferior to an interest rate policy. (Note that the
rotation in LMp does not affect Yi.)
The impact on instrument choice of the slope of the IS
function can be illustrated by envisaging the impact on yM
of a progressive steepening of the IS function labeled ISp.
The steepening would be shown by a clockwise rotation of
ISp around an axis at point B. As ISp rotates and becomes
steeper, yM becomes progressively closer to y*, increasing
the likelihood that a money supply policy is preferred to an
interest rate policy. (Note again that the rotation in ISp does
not affect yi. Also note that at some point, the clockwise
rotation of ISp moves yM above y* and a further rotation
beyond this point increases the divergence between yM and
y*. However, the divergence cannot exceed the divergence
between y* and yi. Thus, it cannot result in conditions
whereby an interest rate policy is preferred.)


If precise information is available about shifts
that occur in the functions, a combination policy is
the preferred policy. For example, in the case
illustrated in Figure 9, a combination policy would
move the interest rate above i* and move the money
supply above M*. The policy would achieve the
target income level, y*, and would therefore be
preferred to an interest rate or a money supply
policy. While a combination policy is preferred,
its implementation may not be feasible because
information about shifts in the IS and LM functions
may not be available. An assumption that policy-
makers have precise information about the shifts is
unrealistic and is equivalent to assuming that the
functions are stable.
Some information, however, may be available
that may possibly allow implementation of a
combination policy. In general, three types of
information may be available. First, some informa-
tion is provided by observing the money supply and
the interest rate. Thus, observed deviations of the
interest rate away from i*, when the money
supply is maintained at M*, indicate that the IS
and LM functions have shifted. An observed
tendency for the interest rate to move above i*
indicates a probable leftward shift in the LM
function and a rightward shift in the IS function
because leftward LM shifts and rightward IS shifts
tend to place upward pressure on the interest rate.
Similarly, a tendency for the interest rate to move
below i* indicates a leftward IS shift and a right-
ward LM shift.5



5 The assumption that upward (downward pressure on the
interest rate is due to rightward (leftward) shifts in the IS
function and to leftward (rightward) shifts in the LM function
is based on the reasonable assumptions that some relationship
exists between the magnitude of shifts and that small shifts are
more likely to occur than large ones. In other words, any given
degree of pressure on the interest rate most likely reflects the
smallest possible shifts in each of the functions that would be
consistent with the relationship and would produce the given
degree of pressure. This implies, for example, that any given
deviation of the interest rate above i*, when M* is maintained,
is more likely to be caused by a small rightward IS shift and
a small leftward LM shift than by, say, a large leftward IS shift
and a large leftward LM shift.









Figure 9
LM MORE UNSTABLE THAN IS


Interest
Rate


YM' YM Y* Yi


Income


NOTE: LMp and LMp, represent functions that may possibly result when M* is maintained. The function labeled, LM
was not drawn; it would intersect ISp at point B.


Information provided by observing the interest
rate and the money supply, however, is not
sufficient to support implementation of a combina-
tion policy. This is because the information
indicates only the probable direction of IS and LM
shifts and does not indicate their probable extent.
For example, upward interest rate pressure may
reflect either large IS and small LM shifts or small
IS and large LM shifts. A large IS shift would
call for a combination policy that moves the interest
rate above i* by a large amount, while a small IS
shift would call for a policy that moves the interest
rate above i* by a small amount. Moreover, no


basis would exist for determining the desirable
course of action. Thus, information provided by
observing the interest rate and the money supply
is insufficient to allow the implementation of a
combination policy.
A second type of available information may
be about the relative stability of the IS and LM
functions. For example, past experience may show
that one of the functions tends to be more unstable
than the other. Under these circumstances, it may
be reasonable to assume that the more unstable
function shifts more than the other one. This
information about the relative stability of the IS









and LM functions, along with information provided
by observing the interest rate and money supply,
may be sufficient to allow the implementation of a
combination policy. The implementation may be
based on two reasonable assumptions: (1) pressure
on the interest rate to move away from i*, when
M* is maintained, reflects counterdirectional shifts
in the IS and LM functions; and (2) the extent of
the shifts in the functions reflect their relative
stability, as indicated by past experience.
Implementing a combination policy is illustrated in
Figure 10. In the figure, when M* is maintained,
the interest rate tends to move above i* to i,. It
is assumed that the pressure on the interest rate
reflects rightward IS and leftward LM shifts, and
the LM shift is twice the IS shift. The greater LM
shift may be verified by noting that the distance
between points A and C on the chart is twice the
distance between points A and B. If the functions
shift as assumed, the combination policy achieves
y* by moving the interest rate to ic and the money
supply to Mc.6 Thus, the policy would be preferred
to either an interest rate policy or a money supply
policy.
Of course, the combination policy would not
always achieve y*. The IS and LM functions would
not always shift in accordance with past experience;
that is, the two assumptions stated in the preceding
paragraph would not always be realized. Neverthe-
less, the combination policy would be preferred
because it would result, on average, in smaller
divergencies between the achieved and target
income levels than an interest rate or a money
supply policy.
A third type of information may be about the
behavior of income. While it is unrealistic to
assume that the precise level of income is observed


during the decision period, some information may
be available about the extent that income is
deviating from the target level. Suppose, for
example, that information is available to indicate
that income is falling below the target level. Also,
assume that the LM curve is known to be more
unstable than the IS curve, and that the interest
rate tends to move above i* when M* is maintained.
Under these circumstances, as above, it is reason-
able to assume that the IS curve has shifted right-
ward and the LM curve has shifted leftward, with
the LM shift being more pronounced than the IS
shift. In this case, though, the assumption of the
leftward LM and the rightward IS shifts is solidified
by the observation of a shortfall in income below
the target level because these shifts tend to reduce
income while opposite shifts tend to increase
income. Thus, a combination policy may be
implemented with increased confidence.

CONCLUSIONS
This analysis of the choice of a monetary
instrument leads to several conclusions. One is
that the choice depends importantly on the relative
stability of the relationships among economic
variables. The money supply tends to be better than
the interest rate as a monetary instrument to the
extent that the demand for money function is stable
and the demand for investment and the saving
functions are unstable. The interest rate is better to
the extent that the demand for money function is
unstable and the demand for investment and the
saving functions are stable.
Another conclusion is that instrument choice also
depends on the sensitivity of the demand for money
and investment to changes in the rate of interest.
The money supply is the better instrument variable


6 The combination policy assumes that the IS and LM functions
shift in accordance with the ratio of the variances of the shifts.
For a complete treatment of the combination policy, see LeRoy
and Lindsey, "Determining the Monetary Instrument," cited
earlier.









Figure 10
THE COMBINATION POLICY


Interest
Rate


ic h---


YM Y* Yi


NOTE: LMc represents the LM function that results when the money supply is moved to Mc. LMI is omitted.


to the extent that the demand for money is sensitive
and the demand for investment is insensitive to
changes in the rate of interest. The interest rate is
better to the extent that the demand for money is
insensitive and the demand for investment is
sensitive to changes in the rate of interest.
A third conclusion is that a combination policy


- using both variables as instruments may be
more effective than using either the money supply
or the interest rate. The combination policy is better
to the extent that information is available on the
extent of stability in the relationships among
economic variables and on the current behavior of
economic variables.









Monetary Policy and Economic Performance:

Evidence From Single Equation Models


By Bryon Higgins and V. Vance Roley


Economists and other analysts generally agree
that monetary policy actions taken by the Federal
Reserve have an important impact on the economy.
This agreement is not, however, accompanied by a
consensus on how best to analyze and measure the
effects of policy actions. An increasing number of
observers argue that policy actions should be
measured by movements in the money supply and
that the Federal Reserve should focus on the money
supply in the implementation of monetary policy.
These observers emphasize the money supply be-
cause they believe that monetary policy actions
affect the economy primarily through their impact
on the money supply. Monetarists have presented
theoretical and empirical evidence of a close
relationship between the money supply and nominal
gross national product (GNP) to support this view.
Empirical results derived from direct estimation of
the relationship between the money supply and
GNP using single equation econometric models
have been a particularly influential type of evidence
provided by monetarists to bolster their position.
Neither monetarists nor others, however, have
made extensive use of the single equation approach
to investigate the relationship between GNP and
financial variables other than the money supply,
such as interest rates. Theoretical considerations,
however, suggest that interest rates as well as the
money supply have important effects on the
economy. Thus, economic theory supports the

Bryon Higgins is a senior economist and V. Vance Roley is a
financial economist with the Federal Reserve Bank of Kansas
City. This article was originally published in the January 1979
Economic Review.


nonmonetarist view that the Federal Reserve should
consider the effect of policy actions on interest
rates as well as the money supply. In light of these
theoretical considerations, the single equation
approach is employed in this article to investigate
and compare the empirical relationships between
GNP and a number of financial variables, including
interest rates as well as the money supply. The
first section of the article presents a general over-
view of the way monetary policy actions affect the
economy, analyzes the advantages and dis-
advantages of the single equation approach, and
discusses alternative financial variables that may
usefully be included when employing the single
equation econometric technique. The second
section presents empirical evidence derived from
use of the single equation approach to compare the
relationships between GNP and alternative
financial variables.

MONETARY POLICY AND GNP
Researchers have investigated the impact of
monetary policy actions on nominal GNP which
measures aggregate spending on goods and services
by households, businesses, government, and
foreigners because it is generally believed that
policy actions affect the economy primarily by
influencing aggregate spending. Aggregate
spending, in turn, directly affects the production
of goods and services and the unemployment and
inflation rates. Thus, the primary goal of monetary
policy is to achieve GNP growth that is consistent
with the ultimate objectives of monetary policy -
high employment, economic growth, price









stability, and a sustainable pattern of international
transactions.

General Overview of the Effects
of Monetary Policy Actions
Federal Reserve policy actions affect GNP by
influencing a wide range of financial and non-
financial variables that affect spending decisions
of households and businesses. The Federal Reserve
most directly affects financial variables that are
closely related to the reserve positions of banks.
The Federal funds rate and the monetary base, for
example, are so directly affected by policy actions
that they could be controlled with a considerable
degree of precision by the Federal Reserve.
Financial variables that are less closely related to
banks' reserve positions, such as monetary and
credit aggregates and market interest rates, are less
directly affected by monetary policy actions and
are therefore subject to somewhat less precise
control by the Federal Reserve. The effects of
policy actions on nonfinancial variables are
even more remote.
The effects of policy actions are reflected first
in financial variables such as the Federal funds
rate and the monetary base and are subsequently
transmitted to other financial and nonfinancial
variables. After affecting the Federal funds rate and
the monetary base, policy actions affect banks'
willingness to expand loans, investments, and
deposits. The adjustment in banks' portfolios
results in a change in the yield on a whole spectrum
of real and financial assets. These changes in
relative yields induce portfolio realignments by
other financial and nonfinancial businesses and by
households. The resulting changes in the cost of
credit and the implicit yields on real assets affect
spending behavior of both businesses and house-
holds directly. The change in the level of interest
rates also affects the market value of the existing
stock of bonds, equities, and other assets. The
resulting effect on total wealth also influences the
spending decisions of consumers. Finally, because
of institutional arrangements that constrain lending
rates in certain sectors of the economy, a change


in the level of interest rates may affect the avail-
ability as well as the cost of credit. This credit
availability effect also influences spending deci-
sions, particularly in the housing sector.
The response of aggregate spending to monetary
policy actions leads to a change in aggregate
production and income, which results in further
changes in the demand for money and credit. This
feedback effect generates additional changes in
portfolio choices, the cost and availability of credit
and total wealth, which lead to further changes in
spending and additional feedback effects.
Because of lagged adjustment of businesses and
households and the complexity of the interrelations
among various sectors of the economy, the ultimate
impact of monetary policy actions on the aggregate
demand for goods and services may occur over a
period of several months or even years. Thus, it is
difficult to predict the timing as well as the magni-
tude of the effects of alternative policy actions.

Structural Versus Single Equation
Approaches to Measuring the Impact
of Monetary Policy
There are several possible methods of
investigating relationships between GNP and
those financial variables that are potentially
useful as measures of the effects of monetary
policy actions. One method is to employ a dis-
aggregated structural model of the economy to
analyze the response of each of the components
of aggregate spending to monetary policy actions.
This is done by estimating the parameters of several
major economic relations thought to be important
in the transmission mechanism for monetary policy.
The resulting equations are combined to form a
structural model of the economy. The model
provides a consistent set of empirical relationships
that reflects spending responses of economic
decisionmakers to policy actions. After the param-
eters are estimated, the model may be used to
predict the effects of policy actions on GNP and on
each of the components of aggregate spending.
Another method of analyzing relationships
between GNP and financial variables is the single









equation approach. In recent years, single equation
models of total spending have become increasingly
popular as tools for investigating the impact of
policy actions. This approach has been used
extensively by researchers at the Federal Reserve
Bank of St. Louis. As the term implies, a single
equation model uses one equation containing one or
more key variables to explain movements in GNP
without attempting to explain its separate com-
ponents. A single equation model may be viewed
as a summary of, or a "reduced form" solution to,
a structural model. Thus, the single equation
implicitly incorporates all of the complex interrela-
tionships that are explicitly allowed for in a
structural model. In this sense, the single equation
and structural approaches to policy analysis and
economic prediction are consistent in principle.'
A disadvantage of the single equation approach
is that it cannot be used to analyze the impact of
policy actions on the individual components of
aggregate spending." Furthermore, the mechanisms
by which policy actions are transmitted to spending
behavior of households and businesses cannot be
determined within the framework of a single
equation model. Thus, it is impossible to dis-
criminate precisely between alternative theories
of the exact channels through which monetary
policy actions affect the economy using the single
equation approach. For some purposes, how-
ever, detailed information about the transmission
mechanism of policy actions may not be as impor-



1 There can be serious statistical problems in estimating a
single equation model when the financial variable used as an
explanatory variable was not the variable policymakers tried
to control during the period for which the equation is estimated.
For a discussion of potential simultaneity bias, see Edward M.
Gramlich, "The Usefulness of Monetary and Fiscal Policy as
Discretionary Stabilization Tools," Journal of Money, Credit,
and Banking, Vol. 3, May 1971.
2 If policymakers have a policy horizon long enough to allow
for changes in the capital stock, for example, they may
sometimes prefer additional investment spending, which
increases the capital stock, rather than consumption spending.
In this situation, analysis of the effect of policy actions on
aggregate demand disguises the possible benefits that would
result from changing the current composition of aggregate
demand toward greater investment in capital goods.


tant as a reliable indication of their total effect
on aggregate spending.
One of the primary advantages of the single
equation approach is that it does not require
detailed knowledge of the structure of the economy.
Those who advocate the single equation approach to
policy analysis believe that the interrelationships
in the economy are too complex to be represented
in an econometric model of the economy." If so, it
may be preferable to base predictions on the direct
relationship between policy actions and total
spending rather than risk omission of an important
link in the transmission mechanism. Once the
relationships between aggregate spending and
financial variables have been estimated empirically
by a single equation model, the model may be used
to predict the level (or growth) of aggregate demand
that would result from particular values of the
variables used to measure the influence of monetary
policy actions.

The Single Equation Approach and
Alternative Financial Variables
Those who use the single equation approach to
policy analysis frequently rely on a single financial
variable to measure the total influence of monetary
policy on aggregate spending. It is very important
that the financial variable used in a single equation
model be the best single measure of the various
influences of monetary policy actions on spending
decisions. There is nothing inherent in the single
equation approach that dictates the choice of a
particular financial variable. Those who advocate
the single equation approach to policy analysis,
however, have generally favored the use of a
monetary aggregate. Thus, the single equation
approach has come to be identified with the
monetarist view of policy analysis.
Most of the studies that have estimated
single equation models of aggregate demand have
used the narrowly defined money stock (Ml) as the

3 See, for example, Michael W. Keran, "Monetary and Fiscal
Influences on Economic Activity The Historical Evidence,"
Federal Reserve Bank of St. Louis Review, Vol. 51, No. 11,
November 1969.









sole financial variable. Some have included a
measure of fiscal policy, though, and a few have
included a measure of strike activity.4 The analysts
using this approach have generally concluded that
the relationship between Ml and aggregate spend-
ing is sufficiently reliable to warrant use of a
monetary growth target as the method of imple-
menting monetary policy. Since the Federal
Reserve cannot control monetary growth directly,
however, some analysts have advocated use of the
monetary base as the monetary control variable.5
The monetary base is composed of currency and
reserves and is often considered to be a primary
determinant of the money supply. Evidence from
single equation models indicates that movements
in aggregate spending are related almost as closely
to the monetary base as to the money stock.
The evidence from single equation models of the
close relationship between the growth of aggregate
spending and the growth of the money supply has
been interpreted by many as strong support of the
monetarist belief that the Federal Reserve should
focus on monetary and reserve aggregates in the
implementation of monetary policy. Indeed, if GNP
growth is closely related to monetary growth, it
seems plausible for the Federal Reserve to set
targets for these aggregates that appear to be
consistent with the desired growth in aggregate
spending. Thus, the evidence from single equation
models has undoubtedly contributed to the Federal
Reserve's increased emphasis on monetary
aggregates in recent years.
Existing single equation studies, with few
exceptions, have not considered the possibility that
financial variables other than monetary aggregates





4 See, for example, Michael Hamburger, "Behavior of the
Money Stock: Is There a Puzzle?" Journal of Monetary
Economics, Vol. 3, 1977.
5 See, for example, Leonall C. Andersen and Denis S.
Karnosky, "Some Considerations in the Use of Monetary
Aggregates for the Implementation of Monetary Policy,"
Federal Reserve Bank of St. Louis Review, Vol. 59, No. 9,
September 1977.


may also be closely related to aggregate spending.
The relationship between interest rates and
aggregate spending, for example, has not been
extensively explored within the framework of
single equation models. Although there is no
theoretical reason for preferring the use of a
monetary or reserve aggregate to the use of an
interest rate in a single equation model of aggregate
demand, those who emphasize the importance of
interest rates have generally believed that a more
extensive model should be used to analyze their
effects on economic activity. One study did,
however, compare the explanatory power of a
long-term interest rate and the money supply in
single equation models of aggregate spending.6
The empirical evidence led the author to conclude
that "changes in interest rates do not give a
systematic or consistent indication of monetary
influences on economic activity and thus are not a
reliable indicator" of the effects of policy actions
on total demand.7 The author concluded that policy-
makers should rely on movements in the money
stock rather than movements in interest rates to
measure the effects of policy actions on the
economy.
The question of whether there is a close relation-
ship between a short-term interest rate and
aggregate spending has been neglected by previous
studies employing the single equation approach.
There is some reason to believe that movements in
money market rates might be a better measure of the
short-run effect of policy actions on spending than
are movements in long-term rates. While monetary
policy actions are reflected quickly in the money
market and dominate movements in short-term
rates, policy actions are only one of several impor-
tant factors affecting longer term rates. In particu-
lar, the Federal funds rate the rate on very




6 Michael W. Keran, "Selecting a Monetary Indicator -
Evidence from the United States and Other Developed
Countries," Federal Reserve Bank of St. Louis Review, Vol.
52, No. 9, September 1970.
7 Keran, p. 12.










short-term funds borrowed by commercial banks -
is very sensitive to policy actions. Moreover, move-
ments in the Federal funds rate have a major impact
on expectations of the future course of monetary
policy because the Federal Reserve establishes
ranges for the Federal funds rate that seem
consistent with attainment of policy objectives.
Finally, the extent to which depository institutions
ration credit has been determined during several
critical periods by the relation of ceiling rates on
time and savings deposits to short-term market rates
- which are directly affected by the Federal funds
rate.


A COMPARISON OF INTEREST RATES
AND MONETARY AGGREGATES IN
PREDICTING THE IMPACT OF
MONETARY POLICY ACTIONS
In this section, the single equation approach is
used to empirically investigate and compare the
relationships between GNP and four financial
variables that may potentially be used to measure
the impact of policy actions. The variables are the
narrowly defined money stock (Ml), the monetary
base, the corporate bond yield, and the Federal
funds rate. The comparison is based on the relative
ability of single equation models of the four
relationships to predict changes in GNP. To use the
equations to predict changes in GNP, the param-
eters of the equations were first estimated. The
estimation procedures and results are discussed in
the next subsection, followed by a discussion of
the results of the predictions.

Estimation Results
The four equations are simple relations that have
GNP as the dependent variable and the four
financial variables as independent variables. In
the equations, all variables are annualized quarterly
percentage changes, with all variables except the
interest rates being seasonally adjusted.8 Each
equation contains a constant term that is intended
to capture the average effects on GNP of variables
omitted from the equations.9 Because the changes in
a financial variable may have an impact on spending


decisions for a considerable time, each equation
contains a distributed lag. The lag allows GNP
growth to be explained by movements in the
financial variable over a number of past periods.
The equation for the narrowly defined money
stock (Ml) is:


N
%AGNPt = a0 0
i=0


where %AGNPt


bi(%M1t-i) + et


percentage change in GNP at time t


%AMlti = percentage change in M1 at time t-i

et = residual of estimated relationship at time t

a0 bi = estimated parameters or coefficients

N = number of past periods a variable is
assumed to affect GNP


sum of bi parameters over the current
period and N past periods.


Xt Xt-
8 Percentage changes of the form Xt-


were used in


computing growth rates for GNP and each of the financial
variables. The results for the simple specification of Federal
funds rate equation vary somewhat when alternative methods are
used to compute growth rates. When positive and negative
values of the first differences of logarithms of the Federal funds
rate are entered as separate variables in an equation explaining
GNP growth, however, the results are similar to those reported
for the Federal funds rate equation in this article. For a more
detailed discussion of this issue, see Bryon Higgins and V.
Vance Roley, "Reduced-Form Equations and Monetary
Policy," Working Paper No. 79-1, Federal Reserve Bank of
Kansas City, 1979. Growth rates are frequently used in
estimating simple relationships between economic time series
variables for statistical reasons. See, for example, Michael J.
Hamburger, "Indicators of Monetary Policy: The Arguments
and the Evidence," American Economic Review, Vol. 62, May
1970; Keith M. Carlson, "Does the St. Louis Equation Now
Believe in Fiscal Policy?" Federal Reserve Bank of St.
Louis Review, Vol. 60, February 1978.
9 The estimated equations do not include any other potential
explanatory variables such as fiscal policy or strike
variables so that the predictive power of the individual
financial variables can be isolated.











The other three equations are similar to the M1
equation.
Each of the equations was estimated for a number
of sample periods. The estimation results for the
period from the first quarter of 1962 through the
fourth quarter of 1977 are representative of the
results in all the estimation periods.1" The results
for this period show that the equations for Ml and
the base generally conform to those reported in
other research." In particular, the positive sums of
N
the coefficients (Z bi) in the M1 and base equations
i=0
indicate that increases in M1 or the base are
consistent with increases in GNP. (See Table 1.)
Also, the higher corrected multiple correlation
coefficient, R2 of 0.28 for Ml indicates that M1
is slightly better than the base in terms of ability
to explain the changes that occurred in GNP within
the 1962-77 sample period. The equation using the
corporate bond yield also performs about as
expected based on the results of other research.12
In particular, the equation's R2 is relatively low.
The sum of the bi coefficients has a negative sign
as expected, indicating that increases in the bond
yield are accompanied by decreases in the growth
of aggregate spending.





o1 The estimated equations reported are those that resulted from
a systematic search procedure over unconstrained and
polynomial lags. The properties of the Federal funds rate
equation are somewhat more sensitive to the length of the lag
than are the properties of the monetary base and Ml
equations, perhaps because a large fraction of the explanatory
power of the aggregates' equations results from the contem-
poraneous correlation between the growth of GNP and the
growth of the monetary base and Ml. For a more detailed
discussion of the procedure used to estimate the equations and
other issues concerning the estimation results, see Higgins and
Roley. The starting date of the period was chosen primarily due
to the starting date of the number of past values used to test for
the appropriate lag length in the Federal funds rate equation.
" See, for example, Leonall C. Andersen, "Selection of a
Monetary Aggregate for Use in the FOMC Directive," Board
of Governors of the Federal Reserve System, Open Market
Policies and Operating Procedures, 1971.
12 See, for example, Keran.


The equation using the Federal funds rate is
especially interesting because a short-term interest
rate previously has not been considered in single
equation models of aggregate spending. As shown
by the sum of the bi coefficients, the estimation
results indicate that increases in the Federal funds
rate result in decreases in GNP growth. (See Table
1.) Additional results not shown in Table 1 indicate
that increases in the Federal funds rate over the
preceding 24 quarters have a uniformly negative
-2
impact on GNP.13 Finally, the R 2is higher for
the Federal funds rate equation than for equations
using Ml, the base, and the corporate bond yield,
indicating that the Federal funds rate has a slightly
greater ability to explain changes in GNP within
the sample period.14

A Comparison of Predictive Performance
This section compares the four single equation
models of GNP in terms of their ability to predict
GNP growth a year in advance. The predictive





13 The finding that the total interest rate effects occur with
long lags is not unique to this study. See, for example, Dale
W. Jorgenson, "Capital Theory and Investment Behavior,"
American Economic Review, Vol. 53, May 1963. Andersen
and Karnosky also find that lags of 24 quarters may be
appropriate when considering the total impact of changes of
M1. See Leonall C. Andersen and Denis S. Karosky, "The
Appropriate Time Frame for Controlling Monetary Aggregates:
The St. Louis Evidence," Federal Reserve Bank of Boston,
Controlling Monetary Aggregates II: The Implementation,
1973.
14 As is common with highly aggregative single equation
models of aggregate spending, all of the estimated equa-
tions have some theoretical and statistical problems. For
example, the current values of both Ml and the base are
included in their respective equations (Table 1), which may
result in simultaneity bias. That is, the direction of causation
between neither Ml and GNP nor the monetary base and GNP
is readily apparent. This problem is particularly troublesome in
these equations because of the large values of the current
quarter coefficients (b0 = 0.59 for Ml, b0 = 0.58 for the
base). The corporate bond rate equation is plagued by extremely
poor explanatory power and an implausible lag structure. The
Federal funds rate equation has an implausibly large constant
term, implying untenable long-run properties of the relationship
between changes in the funds rate and GNP growth.













Table 1
SUMMARY OF ESTIMATION RESULTS FOR
THE ALTERNATIVE NOMINAL GNP EQUATIONS
(Sample Period: 1962: Q1-1977:Q4)


Alternative
Independent
Variables


Estimated Coefficients
Sum of Lag
Coefficients
N
Constant ( I bi)
(ao) i=0


Narrowly Defined Money
Stock (M1)
Adjusted Monetary Base

Moody's Aa Utility
Bond Yield
Federal Funds Rate


3.914
(3.3)
0.724
(0.4)
8.531
(20.0)
14.53
(11.5)


0.822
(3.6)
1.00
(4.0)
-0.097
(-2.6)
-0.555
(-5.4)


0.28 2.88 1.87

0.24 2.96 2.05

0.13 3.18 1.51

0.36 2.72 2.37


NOTES: R2equals multiple correlation coefficient corrected for degrees of freedom. SE equals standard
error of estimate. DW equals Durbin-Watson statistic.
The M1 equation includes the current and past four quarters of observations estimated with a fourth
degree polynomial lag with the left-hand tail constrained to equal zero. The base equation includes the
current and past 25 quarters of observations estimated with a third degree polynominal lag. The bond
yield equation includes the past four quarters of observations estimated unconstrained. The Federal funds
rate equation includes the past 24 quarters of observations estimated with a sixth degree polynomial
lag with both tails constrained to equal zero.
Numbers in parentheses below coefficient estimates are t-statistics.


performance for yearly periods is particularly
relevant because the Federal Reserve currently uses
a one-year planning horizon in establishing growth
ranges for the monetary aggregates. The procedure
used in the comparison of the predictions of
GNP growth may be illustrated by reference to
the predictions for 1970. To predict the growth of
GNP in 1970, the equations were estimated using
data only through 1969. These estimated equations,
along with actual values of the financial variables
in 1970, were then used to predict GNP growth in


1970.1s Finally, the predicted values for GNP
were compared with actual GNP for 1970. This
procedure was followed for each year during the
period from 1965 through 1977.


15 This procedure using historical values of the alternative
financial variables may bias the results because it assumes
implicitly that the values of each financial variable could
have been controlled with equal precision. The possible bias is
especially prevalent for Ml and the long-term bond yield
because of the Federal Reserve's inability to exercise precise
control over their values.


SE DW










For each yearly prediction period, two statistical
measures were used to compare the predictive
performance of the four equations. One measure is
the prediction error, which is the arithmetic average
of the quarterly differences between actual and
predicted GNP growth. The second measure is the
root-mean-square error, which reflects the
variability of the individual quarterly prediction
errors within each year.16 In 1977, for example, the
Ml equation had the smallest prediction error with
a value of -1.42; that is, the quarterly GNP growth
rates, predicted using the Ml equation, aver-
aged 1.42 percentage points lower than actual aver-
age GNP growth. (See Table 2.) The corporate bond
rate equation had the lowest quarterly root-mean-
square error with a value of 2.81, indicating that the
variability of the four individual quarterly predic-
tion errors within 1977 were the smallest for this
equation. In other years, however, the base or the
Federal funds rate equations had the lower predic-
tion or root-mean-square errors. Thus, no firm
conclusion can be made about the predictive
performance of the four equations on the basis of the
individual yearly prediction periods. Firm con-
clusions require examining the results for the 1965-
77 period as a whole.



16 Let % AGNPp and % AGNPa be the predicted and
actual values, respectively, of GNP growth during the i-th
quarter of a given year. The prediction error (PE) for the
year is computed as
4
PE = [(% AGNP) NPaM)]/4,
i=1
where the individual quarterly values are divided by 4 because
all data were annualized for estimation and prediction purposes.
In 1977, for example, the individual quarterly prediction
errors (% AGNPP) (% AGNP) using the M1 equation
were -2.82, -5.11, 1.16, and 1.09, implying an annual
prediction error of -1.42.
The quarterly root-mean-square error is computed as
4
RMSE (quarterly)= Z [(% aGNPP) (% AGNP )]2/4)2.
i=1
Again using the individual quarterly prediction errors in 1977
for the Ml equation, the root-mean-square error equals 3.02.


For the 1965-77 period as a whole, two summary
statistical measures were used to compare the
predictive performance of the equations. One is the
average absolute prediction error, which is the
average of the absolute values of the prediction
errors for all of the years. The other measure is the
root-mean-square error of the yearly predictions,
which reflects the variability of the prediction errors
for the 1965-77 period as a whole.17 These
summary measures uniformly favor the equation
using the Federal funds rate as the best predictor
of GNP. In particular, the average absolute pre-
diction error is lower for the Federal funds rate
equation than for the other equations. This measure
indicates that the predicted values of annual GNP
growth differed from actual GNP growth by an
average of 1.23 percentage points during the
1965-77 period. (See Table 2.) The annual
root-mean-square error of 1.35 indicates that the
variability of the annual predictions was also
the lowest for the Federal funds rate equation.
The aggregates equations do the next best, but
the evidence is mixed concerning whether M1
or the base performs better. The equation using
the corporate bond yield is the least desirable as
judged by either summary measure of predictive
performance.

CONCLUSION
There are a number of methods for determining
the impact of monetary policy actions on the
economy. One method that has become increas-
ingly popular in recent years is to include a single




17 Let PE. represent the prediction error for the j-th year.
The average absolute prediction error (AAPE) is then
computed as
10
AAPE= Z PEj/10.
j=1
The root-mean-square error for the annual predictions is
computed as
r10 2 1'/2
RMSE (annual predictions) == j (PE) /10l
I '1 J













Table 2
ERRORS IN PREDICTING GROWTH RATES OF NOMINAL GNP
USING AGGREGATES AND INTEREST RATES

Measures for Annual Prediction Periods
Prediction Error Root-Mean-Square Error
Corporate Federal Corporate Federal
Prediction Bond Funds Bond Funds
Period M1 Base Rate Rate M1 Base Rate Rate
1968 1.04 -1.94 -2.54 -1.14 1.82 2.82 4.04 1.99
1969 1.79 -0.97 1.66 -1.92 2.20 2.11 2.83 2.49
1970 2.20 1.54 2.62 1.44 3.32 2.82 3.02 3.27
1971 -0.77 -1.75 -2.48 1.39 3.60 4.03 4.86 4.81
1972 -2.50 -2.91 -3.57 -0.87 2.77 3.57 3.82 2.62
1973 -1.85 -0.54 -2.90 -1.97 3.41 2.65 3.85 3.41
1974 0.86 3.08 -0.05 1.50 2.59 3.52 2.06 2.16
1975 -3.28 0.01 -2.97 -0.09 5.93 5.34 7.07 4.92
1976 -0.63 0.30 -0.43 0.51 2.18 2.10 2.57 1.86
1977 -1.42 -2.32 -2.33 -1.45 3.02 3.81 2.81 3.46


Summary Measures
Average Absolute Prediction Error Root-Mean-Square Error (Annual Predictions)
1.63 1.54 2.16 1.23 1.82 1.84 2.40 1.35


financial variable that is thought to summarize the
total effect of policy actions in a single equation
model of aggregate spending. Those who employ
the single equation approach have generally
restricted their attention to the relative ability of
monetary aggregates to explain changes in
aggregate spending. Because of theoretical
considerations indicating that interest rates may
have an important impact on aggregate spending,
the single equation approach was adopted in this
study to explore the potential usefulness of interest


rates as well as monetary and reserve aggregates in
the implementation of monetary policy.
The empirical results of this study indicate that
predictions of aggregate spending based solely on
past movements in the Federal funds rate are more
accurate than predictions based solely on current
and lagged movements in Ml, the monetary base,
or a long-term interest rate. Although different
specifications of the single equation models might
alter the results, the empirical evidence in this study
indicates that the Federal funds rate is the best single









financial variable for the Federal Reserve to use as
a measure of the effects of monetary policy actions.
The empirical results also indicate, however,
that all of the financial variables tested leave a
large percentage of the variation in total spending
unexplained. Thus, the evidence does not support
the proposition that aggregate spending depends
exclusively on a single financial variable. Fortu-


nately, the Federal Reserve need not rely exclu-
sively on a single financial variable in determining
the appropriate course for monetary policy. Infor-
mation on a large number of economic variables is
available to the Federal Reserve, and judicious use
of the information from all of these variables may
be preferable to exclusive focus on any single
financial variable.








Section III


Controlling the
Money Stock










The Federal Reserve and the Government

Securities Market


By Margaret E. Bedford


The Federal Reserve System has held Federal
Government securities since 1917, when the U.S.
Treasury issued a large supply to help finance
World War I. Initially, System purchases were
made to provide a market for Federal securities
and to supplement Reserve Bank earnings.
Through its participation in the Government
securities market, the System discovered that it
could influence bank reserves and money and
credit conditions in the economy. System pro-
cedures for participation in the market were
formalized in the Banking Acts of 1933 and 1935,
which gave the Federal Open Market Committee
(FOMC) power to determine the extent of Sys-
tem operations.
Federal Government securities are now the
Federal Reserve's largest asset, and the System
buys or sells Government securities almost every
business day. This article discusses the Federal
Reserve's holdings of and transactions in U.S.
Government securities. The first section deals
with trends in the Federal Reserve's holdings
since 1950. The second section treats short-run
fluctuations in the System's portfolio. In the third
section, the article discusses the types of trans-
actions used by the Federal Reserve to purchase
and sell securities, and the fourth section analyzes
the impact of these transactions on the Govern-
ment securities market.


TRENDS IN FEDERAL RESERVE
HOLDINGS OF U.S. GOVERNMENT
SECURITIES

The Federal Reserve System's holdings of U.S.
Government securities increased from $21 bil-
lion at the end of 1950 to $111 billion at the end
of 1977. (See Chart 1.) Throughout the period,
System holdings consisted mainly of marketable
U.S. Treasury securities, which amounted to $103
billion at the end of 1977. Since 1971, the System
has been authorized to purchase and sell Federal
agency obligations outright, and holdings of these
securities were $8.5 billion at the end of 1977. As
a percentage of total U.S. Government and Fed-
eral agency securities outstanding, Federal Reserve
System holdings increased from 8.1 per cent in
1950 to 13.6 per cent in 1977.
As a percentage of total Federal Reserve
assets, security holdings increased steadily from
44 per cent in 1950 to 81 per cent in 1977. Sys-
tem holdings of Government securities have
grown much more rapidly in the 1960s and 1970s
than in the 1950s. The average annual growth
rate of System security holdings was 8.7 per cent
in 1970-77, 8.5 per cent in 1960-70, and only
2.8 per cent in 1950-60.
The growth in the Federal Reserve's holdings
of U.S. Government and Federal agency securities
is related to the System's major purpose, which is
to foster growth in the nation's supply of money
and credit that will encourage economic growth,
stable prices, high employment, and balance in
international transactions. The System influences
monetary growth by providing for growth in the
nation's monetary base, which consists of certain
liabilities of the Federal Reserve member bank


Margaret E. Bedford, now with the Office of the Secretary,
was formerly an assistant economist with the Federal Reserve
Bank of Kansas City. This article was originally published in
the April 1978 Economic Review.










reserves plus currency in circulation outside
member banks.
To bring about growth in the monetary base,
the Federal Reserve increases its assets. When the
System acquires assets, such as securities, the
seller of the assets receives a claim on the Fed-
eral Reserve, which can be deposited in a bank or
converted into currency. The base increases in
either case, due to an increase in member bank re-
serves or in currency outside member banks. (In
practice, member bank reserves automatically rise
when the System purchases securities because a
Reserve Bank credits the account of a member
bank designated by the security dealer for the
amount of the securities sold.) While increases in
System assets support growth of the base, de-
clines in System assets lead to reductions in the
base. Also, increases in System liabilities, other
than those included in the base, result in declines
in the base, while decreases in nonbase liabil-
ities lead to increases in the base.
The relationship between the monetary base and
Federal Reserve assets and liabilities may be stated
as a balance sheet equation such as:

(1) Monetary base = F.R. holdings of
securities
+ other F.R. assets
F.R. liabilities, other
than the base.

or

(2) F.R. security holdings = monetary base
other F.R.
accounts,

where other F.R. accounts equals other F.R.
assets minus F.R. liabilities, other than the base.'
Equation (2) may be used to determine the amount
by which Federal Reserve holdings of securities
need to grow. The change in these holdings de-
pends on the needed growth in the monetary
base2 minus any rise in other F.R. accounts, or
plus any decline in other accounts. Since move-
ments in other F.R. accounts are largely indepen-


dent of Federal Reserve control,3 the System must
offset changes in these accounts with changes in



I Technically, the other factors affecting the monetary base in-
clude some items that are not on the Federal Reserve's balance
sheet, but are U.S. Treasury account items. These include
Treasury currency outstanding and Treasury cash holdings.
The effects on the monetary base of changes in Treasury cur-
rency outstanding are similar to those of a change in a Federal
Reserve asset, while the effects of changes in Treasury cash
holdings are similar to the effects of changes in Federal Reserve
liabilities. The term other F.R. accounts will be used
throughout this article for simplicity.
2 The need for growth in the monetary base is determined by
the desired changes in the money supply, currency and bank
deposits, to support economic growth. Increases in the public's
demand for currency must be supported dollar for dollar by
increases in the base. Increases in bank deposits are supported
by smaller increases in the base, since member banks are re-
quired to keep only a fraction of their deposits as reserves.
Increases in reserves to support deposit growth reflect, in part,
reserve requirement ratios and other factors that affect the
volume of reserves per dollar of deposits. Average reserve
requirements for member banks have generally declined in the
postwar period, reducing the need for growth in bank reserves
to support deposits. Since reserve requirements differ be-
tween member and nonmember banks, by size of institution,
and among classes of liabilities demand, savings, or time
deposits, and other borrowed money shifts in deposits
among the various categories or between banks alter the growth
in deposits that can be supported by a given volume of reserves.
Also, changes in regulations such as allowing member
banks to begin counting vault cash as reserves in 1960, the
change to lagged reserve accounting in 1968, and the
changes in the timing of crediting reserve accounts for checks
cleared in 1972 have an impact on the volume of bank re-
serves needed. Growth in reserves is also affected by banks'
demand for excess reserves, which in turn may be influenced by
regulatory provisions such as carry-over provisions in
reserve accounting.
3 The Federal Reserve does have control over some of the fac-
tors affecting "other F.R. accounts." Other accounts include
Federal Reserve holdings of bankers' acceptance which may
be increased or reduced at the discretion of the Federal Reserve.
Other accounts also include borrowings by member banks
from the Federal Reserve, over which the Reserve Banks have
administrative control. Member banks' borrowing may fluctuate
in response to Federal Reserve monetary policy. Generally,
when the Federal Reserve tightens its monetary policy stance
and interest rates rise, member banks increase their borrowing
at the Federal Reserve discount window. On the other hand,
an easing in policy usually leads to a decline in member bank
borrowing. Acceptances and member bank borrowing are
of relatively minor importance in the long run. The Federal
Reserve has reduced acceptance holdings in recent years, and
repayment of member bank borrowings have absorbed reserves
slightly on average in the 1970-77 period.










Chart 1
FEDERAL RESERVE HOLDINGS OF U.S. GOVERNMENT
AND FEDERAL AGENCY SECURITIES
(End of year, 1950-77)


1950 1955 1960 1965 1970 1975


SOURCE: Federal Reserve Bulletin.










security holdings to ensure needed growth in
the base.
Using equation (2) to analyze changes in
security holdings in the 1950-77 period, the
monetary base rose $79 billion during the period
with an increase in currency accounting for more
than three-fourths of the rise. (See Table 1.) Dur-
ing the same period, other F.R. accounts fell $6
billion. Thus, the Federal Reserve increased its
Government security holdings $86 billion to sup-
port the rise in the base and to offset the decline
in other F.R. accounts.
The decline in other F.R. accounts in the
1950-77 period reflects gold outflows (i.e., a de-
cline in gold certificates held by the Federal
Reserve) and an increase in Treasury deposits at
the Federal Reserve, which were only partly offset
by increases in Federal Reserve float and "all"
other F.R. accounts. The all other F.R. accounts
category includes assets such as loans to mem-
ber banks and Treasury currency outstanding and
liabilities such as Treasury cash holdings and
foreign and other deposits at Reserve Banks.
Some of these items are on the balance sheet of the
Treasury rather than the Federal Reserve but affect
the monetary base.
In the more recent 1970-77 period, the rise in
Federal Reserve holdings of Government securities
was about the same as the increase in the mone-
tary base, since other F.R. accounts did not
change much. The small change in other F.R.
accounts reflects a large increase in Treasury
deposits at Reserve Banks which was mostly off-
set by increases in other factors. A rise in the
gold certificate and SDR account supported
increases in the monetary base in the most re-
cent period, while declines led to reductions in
the base in the earlier periods.

SHORT-RUN FLUCTUATIONS
IN FEDERAL RESERVE HOLDINGS
OF GOVERNMENT SECURITIES

While Federal Reserve holdings of Govern-
ment securities have generally increased over the
long run, they fluctuate sharply in the short run.


These fluctuations accommodate short-run
changes in the monetary base, which result from
temporary and seasonal movements in reserves
and changes in the public's demand for currency.
Also, short-run changes in securities offset changes
in other F.R. accounts, which are subject to wide
swings that, unless offset, would result in unde-
sirable changes in the base. In 1977, the weekly
absolute average change in other Federal Reserve
accounts was $2.1 billion, compared with $0.7
billion for the monetary base. (See Table 2.) Thus,
most of the $2.0 billion absolute average change
in security holdings was due to fluctuations in other
F.R. accounts.4 Chart 2 shows the close short-
run relationship between holdings of Govern-
ment securities and other F.R. accounts.
Short-run changes in Federal Reserve hold-
ings of Government securities were much larger
in 1977 than in 1970, as shown in Table 2. While
part of the increase may be attributable to higher
levels, absolute average weekly changes as a
percentage of the average level increased from
0.6 per cent in 1970 to 1.9 per cent in 1977. Taking
into account the changes in levels, the greater
fluctuations in security holdings were due to larger
movements in other F.R. accounts, as fluctuations
in the monetary base were equal in 1977 and 1970.
The greater changes in other F.R. accounts were
due mainly to a rise in the average change in
Treasury deposits at Federal Reserve Banks from
$124 million, or 11 per cent of the level in 1970,
to $2.1 billion, or 28 per cent of the level in 1977.
In 1970, the Treasury kept deposits at Federal
Reserve Banks at a fairly stable level and allowed



4 The Federal Reserve has some control over changes in other
F.R. accounts since these include the Federal Reserve's holdings
of acceptance and member bank borrowing. However, the
absolute average change in both acceptance held by the Federal
Reserve and member bank borrowing was less than $0.2 billion
in 1977.
5 For an explanation of the changes in the Treasury's pro-

cedures and their effect on the volatility of Treasury deposits at
Reserve Banks, see Peggy Brockschmidt, "Treasury Cash
Balances," Federal Reserve Bank of Kansas City Monthly
Review, July-August 1975.








































its deposits at commercial banks to fluctuate.
In the 1970's, the Treasury changed its cash man-
agement policies and began calling deposits from
commercial banks more quickly, thus increasing
balances at the Reserve Banks and increasing the
volatility of these deposits.5 Starting in May 1978,
the Treasury will be allowed to invest its balances
in interest-bearing notes at financial institutions.
This will reduce the week-to-week changes in
Treasury deposits at Reserve Banks, but the amount
of the reduction remains uncertain.

FEDERAL RESERVE TRANSACTIONS
IN GOVERNMENT SECURITIES
The large fluctuations in the Federal Reserve's
holdings of Government securities require the
System to conduct a large volume of transactions
in these securities. The System Open Market Ac-


count (SOMA) conducts transactions in U.S.
Government and Federal agency securities with
either foreign accounts or domestic security
dealers.6 Several types of transactions are used,
including outright purchases and sales of securi-
ties, redemptions of maturing securities, repur-
chase agreements (RP's), and matched sale-
purchase agreements (MSP's).
Outright transactions are conducted with
foreign accounts or domestic dealers with no agree-
ment to reverse the transaction. Reserves and
base money are provided when the System buys

6 Open market transactions are also conducted in bankers'
acceptance but these have been of relatively minor im-
portance in recent years when compared with transactions
in U.S. Government and Federal agency issues. In March
1977, the Federal Reserve announced that it would no longer
purchase or sell bankers' acceptance outright except under
unusual circumstances, since the market for bankers' ac-


Table 1
CHANGES IN FEDERAL RESERVE HOLDINGS OF SECURITIES,
THE MONETARY BASE, AND OTHER ACCOUNTS
(Based on annual averages of daily figures, billions of dollars)
1950-60 1960-70 1970-77 1950-77
F.R. holdings of U.S. Treasury
and Federal agency securities +8.0 +31.8 +45.8 +85.6

Monetary base +6.3 +27.6 +45.4 +79.3

Member bank reserves +2.1 + 9.8 + 6.7 +18.7
Currency* +4.2 +17.8 +38.7 +60.7

Other F.R. accounts -1.6 4.2 0.4 6.2

Gold and SDR's -4.9 7.4 + 1.2 -11.1
Treasury deposits at Federal
Reserve Banks +0.1 0.6 6.3 6.8
Federal Reserve float +0.6 + 1.8 + 0.7 + 3.1
All other F.R. accounts +2.6 + 1.9 + 4.0 + 8.5
*Vault cash of member banks was allowable as reserves as follows: None, June 21, 1917-Nov. 30, 1959; part, Dec. 1, 1959-
Nov. 23, 1960; all, beginning Nov. 24, 1960. Therefore, currency includes member bank vault cash in full in 1950 and in part
in 1960; while member bank reserves include vault cash in part in 1960 and in full in 1970 and 1977.
tAn increase (decrease) in Federal Reserve assets is entered as a positive (negative) figure, while an increase (decrease)
in Federal Reserve liabilities is entered as a negative (positive) figure.
Details may not add to totals due to rounding.












Table 2
ABSOLUTE AVERAGE WEEKLY CHANGES IN FEDERAL RESERVE HOLDINGS
OF SECURITIES, THE MONETARY BASE, AND OTHER ACCOUNTS
Absolute Average Weekly Changes


(As a percentage of the
annual average level)


(Levels, Millions of dollars)


1977


1970


1977

1,984

724

562
592

2,104

2,110
585
275


F.R. holdings of U.S. Government
and Federal agency securities

Monetary base

Member bank reserves
Currency (outside member banks)

Other F.R. accounts

Treasury deposits at FRB's
Federal Reserve float
All other F.R. accounts


securities and are absorbed when it sells or
redeems securities. A repurchase agreement in-
volves the purchase of securities by the Federal
Reserve from a dealer with the condition that the
dealer will buy back the same securities at a pre-
determined price or yield after a stated period of
time, not exceeding 15 days. An RP may be
terminated by either party prior to maturity unless
a nonterminable contract is made. RP's initially
provide reserves but absorb them again when
terminated. Matched sale-purchase agreements,
often referred to as reverse RP's, involve the sale


ceptances is well developed and efficient and no longer in
need of support through Federal Reserve participation. The
System remains a participant in the market through its re-
purchase agreements with dealers that are secured by bankers'
acceptance and by serving as agent in buying and selling ac-
ceptances for the accounts of foreign central banks. At the end
of 1977, SOMA holdings of bankers' acceptance were
less than $1 billion. The activities of SOMA in the bankers'
acceptance market will not be discussed further in this article.


of Treasury bills at stated prices by the Federal
Reserve to a domestic dealer or foreign account
with the condition that the System will buy the
securities back after a stated period, normally
less than 7 days. MSP's initially absorb reserves
but provide them again when terminated.7
The particular transaction chosen and whether
it is with the domestic market or foreign custom-
ers depends on the objective to be achieved -


7 Outright transactions with the market are normally made
through an auction in which dealers submit price bids for
securities of the type and maturity the SOMA Manager plans
to buy or sell. Foreign orders are executed at the "best" market
prices being quoted by dealers at the time of the transaction.
The distribution of RP's among dealers is determined through
an auction in which dealers submit bids at various rates. The
SOMA Manager accepts the bids in descending order up to
the amount needed. In executing MSP agreements, the Manager
requests dealers to make offerings in an auction indicating
the amounts and prices at which they would resell the same
securities to the System at maturity of the MSP's. The Account
Manager accepts the highest prices bid.


1970


11.3
11.0
1.0


28.4
14.6
1.2











Chart 2
FEDERAL RESERVE SECURITY HOLDINGS, MONETARY BASE,
AND OTHER ACCOUNTS



Billions of Dollars Billions of Dollars

115 Federal Reserve Holdings of U.S. Government and 30
Federal Agency Securities (left scale)

110 25

105 20

100 15

95 Other Federal Reserve Accounts (right scale) 10

135

130
Monetary Base
125

120

115

95
Currency (outside member banks)
90

85

80

40
Member Bank Reserves
35
40 -------------------------


I I I I I I I I I I I I I
J F M A M J J A S O N D

1977









provision or absorption of reserves or investment
needs of foreign customers. The technique used
also depends on the magnitude and duration of the
reserve need. RP's and MSP's are generally used
on a temporary basis to offset short-run fluctuations
in reserves, and outright transactions are used
when it is necessary to supply or absorb reserves
for longer periods.
The volume of transactions the SOMA con-
ducts in Government securities depends mainly
on the objectives of monetary policy as estab-
lished by the Federal Open Market Committee
(FOMC). At any point in time, objectives
typically involve maintaining the interest rate on
Federal funds within a specified range. The
Federal funds rate is the rate at which banks are
willing to lend or borrow immediately available
reserves, usually on an overnight basis; it is used
as an indicator of the degree of pressure on bank
reserves. The specified range for the funds rate is
chosen to be consistent with longer run objectives
of monetary policy, which involve providing the
volume of reserves and base money needed to
support adequate growth in money and credit
for the economy.8
Given the Federal funds rate objective, the
SOMA's daily and weekly transactions are de-
termined by the need to provide for those changes
in the base that are consistent with the funds rate
objective and to offset any changes in other F.R.
accounts that would cause a change in the base
that is not consistent with the objective. Changes in
the base may be needed to encourage a change in
the funds rate called for by policy objectives.
However, even if policy calls for a stable funds
rate, the base may fluctuate daily and weekly, due



8 The FOMC directive to the Account Manager states that the
Committee seeks to maintain the weekly average Federal
funds rate at a certain level, so long as Ml and M2 appear to
be growing over a 2-month period at annual rates within speci-
fied ranges. If it appears that growth rates over the 2-month
period are deviating from their ranges, the SOMA Manager
is instructed to modify the operational objectives for the weekly
average Federal funds rate within a range specified by the
Committee.


to seasonal and random shifts in the demand for
reserves and currency.
To illustrate SOMA's daily and weekly activ-
ity, gross transactions in Government securities
were $23.6 billion in the statement week ending
December 21, 1977. (See Table 3.) The net weekly
increase in security holdings was $7.7 billion, pro-
viding for a $3.4 billion rise in the base and off-
setting a $4.2 billion decline in other F.R. accounts.
These transactions were consistent with maintain-
ing the daily effective Federal funds rate within
a range of 6.51 and 6.57 per cent.
Transactions were conducted on each busi-
ness day of the week. On Thursday, gross trans-
actions were $7.2 billion and Federal Reserve
security holdings increased $4.7 billion, providing
for a $2.5 billion increase in the monetary base and
offsetting a $2.3 billion decline in other F.R. ac-
counts. (See Table 3.) The increase in securities
was accomplished through outright purchases
of securities, mainly from the market but also
from foreign accounts, and through maturing
MSP's with the market. Although MSP's with
foreign accounts matured, they were offset by an
increase in new MSP agreements with foreigners.
Federal Reserve holdings of securities in-
creased again on Friday and Monday. Although
the monetary base declined on Friday, the rise in
securities was needed to offset a larger decline in
other F.R. accounts. On Monday, the increase
in other F.R. accounts supplemented open market
operations in providing for an increase in the
base. On both Friday and Monday, outright
purchases from foreign accounts contributed part
of the increase in System security holdings, but
the remainder was gained through temporary trans-
actions. On both days, MSP's with foreigners
matured and new MSP agreements were entered.
On Friday, 1-day RP's were made and on Monday
new RP's were also entered, in part to offset
maturing 1-day RP's.
On Tuesday, System security holdings were
reduced slightly, as a decline in the monetary base
was largely accommodated through a drop in
other F.R. accounts. Changes in System security









holdings were achieved mainly through early
termination of RP transactions. Also, MSP
sales to foreigners were slightly greater than
maturing MSP's. On Wednesday, System security
holdings rose to support an increase in the mone-
tary base, which was partly facilitated by an
increase in other F.R. accounts. Accommodation of
foreign accounts through MSP's reduced System
securities in contrast to the System's desire to in-
crease holdings. Also, some RP's were terminated
prior to maturity on Wednesday. Thus, RP agree-
ments were entered with the market.
For the year 1977 as a whole, gross Federal
Reserve open market transactions in Government
securities amounted to $1,270 billion. (See Table
4.) Operations in marketable Treasury securities
accounted for 98 per cent of the total. The volume
of gross transactions was nearly evenly divided
between transactions with foreign accounts and
those with the domestic market.
Gross outright transactions were $34 billion,
or less than 3 per cent of total transactions in
1977. Transactions with foreign accounts
amounted to 40 per cent of all outright operations.
Individual outright transactions with foreigners
tended to be much smaller in size than those with
the market but occurred more frequently. In 1977,
outright transactions with the market were execu-
ted on only 22 days, while outright transactions
with foreign accounts occurred on 85 days. In
1977, net outright purchases provided a $10.2 bil-
lion increase in System securities.
The System has carried out most of its outright
open market transactions in short-term Treasury
bills in recent years. In 1977, transactions in bills
accounted for two-thirds of total outright trans-
actions. However, on a net basis, outright pur-
chases of coupon securities added somewhat more
to System security holdings than did net Treasury
bill purchases. Increases in Federal Reserve
security holdings have coincided with changes in
the types of securities issued by the Treasury, and
the maturity structure of the Federal Reserve's
holdings of marketable securities is similar to
the maturity distribution of all outstanding market-
ables. (See Table 5.) In recent years, the Treasury
has issued a larger net amount of coupon securities


than of Treasury bills as it attempted to lengthen
the maturity structure of the debt. Thus, the
Federal Reserve has acquired larger amounts of
coupon securities. In the 1970-77 period, net
coupon security acquisitions were $24.5 billion
compared with $20.7 billion for bills.
Outright transactions by SOMA in Federal
agency securities have been quite small compared
to transactions in U.S. Treasury securities. In
1977, transactions in agency securities were
$1.7 billion, about 5 per cent of total outright
transactions.
The bulk of the System's gross transactions
in Government securities in 1977 was conducted
through temporary RP and MSP agreements.
(See Table 4.) Gross repurchase agreements ac-
counted for nearly one-third of total gross trans-
actions. These transactions are largely conducted
in Treasury securities, with only a small amount
in agency securities. More than one-half of the RP's
initiated in 1977 matured or were terminated
within 1 day, and 82 per cent matured within 3
days. The remaining RP's had maturities of 4
to 7 days, and of these about one-third were made
under nonterminable contracts. RP's were initiated
on 88 business days in 1977.
Matched sale-purchase transactions amounted
to two-thirds of total gross open market trans-
actions in 1977. Gross MSP's with foreign accounts
accounted for nearly three-fourths of all MSP
transactions. MSP's with foreigners are normally
1-day transactions and were entered into on al-
most a daily basis in 1977. MSP's with the market
occurred much less frequently but were often for
periods longer than 1 day.
Gross open market transactions in Govern-
ment securities were substantially larger in 1977
than in 1970, with most of the growth in temporary
RP and MSP transactions rather than in outright
transactions (Table 4). The greater use of MSP and
RP transactions in 1977 is due in part to greater
short-term fluctuations in the monetary base and
especially in other F.R. accounts. The change in
the Treasury's cash management policies between
1970 and 1977 was largely responsible for the
greater fluctuations in other F.R. accounts. Also,
prior to the change in Treasury policy, if the










Table 3
FEDERAL RESERVE OPEN MARKET TRANSACTIONS IN U.S. GOVERNMENT
SECURITIES, AND CHANGES IN THE MONETARY BASE AND OTHER ACCOUNTS
(Statement week ended December 21, 1977, billions of dollars)


Total gross transactions
Outright transactions
With domestic market:
Purchases
Sales
Redemptions
With foreign customers:
Purchases
Sales
Matched sale-purchase
agreements
With domestic market:
Purchases
Sales
With foreign customers:
Purchases
Sales
Repurchase agreements
(domestic market)
Purchases
Sales
Net change in F.R. holdings of U.S.
Government and Federal agency
securities

Changes in:
Monetary base
Member bank reserves
Currency (outside member
banks)

Other F.R. accounts*
Treasury deposits at F.R.
Banks
Federal Reserve float
All other F.R. accounts


Thurs.
12/15
7.2


Fri.
12/16
4.0


Mon.
12/19
4.9


Tues.
12/20
2.6


Wed.
12/21
4.9


Total
23.6


1.0


0.1 0.2 0.1


0.4


- 3.6


-1.2 1.1
- 1.2


4.7 1.3 0.2 -0.4


-0.5
-0.3


1.7 7.7


-2.7
-3.2


0.7 -0.2 0.3 0.5


-2.3 -1.8


-0.3
-1.1
-0.9


-1.2
-0.9
0.2


0.5 -2.3


-1.4
1.6
0.4


0.2 1.5

1.7 -4.2


-1.8
-0.6
0.1


-5.5
0.8
0.5


Federal funds effective rate
(per cent)


6.52 6.55 6.56 6.51 6.57 6.54


NOTE: The data shown here on the monetary base and on other F.R. accounts are not necessarily the figures that were
available to the SOMA Manager on the day open market transactions occurred nor do they represent final figures for
those days. Data are collected with a long time lag and may be subject to substantial revision. Details may not add to
totals due to rounding.
*An increase (decrease) in Federal Reserve assets is entered as a positive (negative) figure, while an increase (decrease)
in Federal Reserve liabilities is entered as a negative (positive) figure.


















Total gr
Outrig
Tre
G
G
R


Oth
G


Table 4
FEDERAL RESERVE OPEN MARKET TRANSACTIONS
IN U.S. GOVERNMENT SECURITIES
(Billions of dollars)
1970
ross transactions 122.6
iht transactions, total 19.7
asury bills, total 18.4
ross purchases 11.1
ross sales 5.2
exemptions 2.2
Net change 3.7

er U.S. Treasury securities, total* 1.3
ross purchases 1.3


Gross sales
Redemptions
Net change

Federal agency securities, total
Gross purchases
Gross sales
Redemptions
Net change

Net increase in SOMA Government secur-
ity holdings due to outright transactions

Repurchase agreements, total
U.S. Treasury securities
Gross purchases
Gross sales
Federal agency securities
Gross purchases
Gross sales

Matched sale-purchase agreements (bills), total
Gross purchases
Gross sales

Total net changes in SOMA Government
security holdings

Memo: Total gross transactions with foreign
accounts included above

Outright transactions, total
Gross purchases
Gross sales

Matched sale-purchase agreements, total
Gross purchases
Gross sales


1977
1,270.2
34.4
23.1
13.7
7.2
2.1
4.4

9.7
7.2


2.5
4.7


1.3


0.2
1.2


10.2

386.7

178.7
180.5

13.8
13.6

849.1
423.8
425.2


637.1

13.6
7.3
6.3

623.5
310.9
312.6


SOURCE: Federal Reserve Bulletin.
NOTE: Sales, redemptions, and negative figures reduce holdings of the SOMA; all other figures increase such holdings.
Details may not add to totals due to rounding.
*Both gross purchases and redemptions include special certificates created when the Treasury borrows directly from the
Federal Reserve, as follows: 1977, $2.5 billion.










Table 5
PERCENTAGE DISTRIBUTION
OF MARKETABLE SECURITIES
November 30, 1977

Federal
Total Reserve
Out- Hold-
standing ings
Total marketables 100.0 100.0

Final maturity:
Within 1 year 49.1 53.5
Treasury Bills 34.4 38.6
Other Securities 14.6 14.9
1-5 years 33.8 28.6
5-10 years 10.0 10.7
Over 10 years 7.2 7.2

System needed to absorb a large volume of re-
serves, it could ask the Treasury to call balances
at commercial banks and deposit them in Reserve
Banks, thus reducing the need for open market
operations. With the change in Treasury policy,
this option was lost.9
Another reason for the rapid growth in MSP
and RP transactions is the Federal Reserve's
desire to accommodate foreign customers. Prior
to 1974, the System engaged only in outright
transactions with foreign accounts; but since
August 1974, it has entered into MSP's with
foreign customers (RP's from the foreign cus-
tomer's view). MSP's provide foreign customers
with a convenient means for investing short-term
balances of excess dollars in interest-earning
assets and aid the Federal Reserve in absorbing
reserves with minimum market impact. The
volume of foreign transactions has increased in

9 Although under current procedures the Federal Reserve has
been discouraged from requesting the Treasury to alter its
deposit distribution between Federal Reserve Banks and com-
mercial banks, the System may be able to do so under new
procedures. For a description of the new Treasury cash
management procedures, see Elijah Brewer, "Treasury to
Invest Surplus Tax and Loan Balances," Federal Reserve Bank
of Chicago Economic Perspective, November/December 1977.


recent years because foreigners have accumulated
large dollar balances, due to continuing deficits
in the U.S. balance of payments.
Prior to May 1977, the System carried out MSP's
with foreign accounts when they coincided with
System objectives. In May 1977, the Internal
Revenue Service (IRS) raised the possibility that
foreign central banks' earnings from RP's with the
market may be taxable. The Federal Reserve then
began acting as a principal for all foreign account
RP transactions with the domestic market. In 1977,
System MSP's with foreign accounts contribu-
ted to the need for market RP's on 47 of the 88
days that RP's were initiated.
Recent IRS rulings have clarified that foreign
banks' earnings on RP's will not be subject to
taxes when the Federal Reserve System acts as a
principal in the transaction. As a result, accounting
procedures have changed again. Foreign MSP's
appear as a SOMA transaction only when they
coincide with the System's policy objectives.
In other cases, the Federal Reserve Bank of New
York enters into MSP's with foreigners and makes
offsetting RP's with Government security dealers.
These transactions do not appear on SOMA's
records.
The volume of temporary open market trans-
actions has also been influenced in recent years
by the Federal Reserve's desire to keep day-to-day
fluctuations in the Federal funds rate within a
narrow range. In addition, the growth in the
Federal funds market in the 1970's may have re-
quired that SOMA engage in larger transactions
to affect the funds rate.
IMPACT OF FEDERAL RESERVE OPEN
MARKET OPERATIONS ON THE
GOVERNMENT SECURITIES MARKET
Federal Reserve open market operations in-
fluence the Government securities market mainly

o1 At times, an important objective of the Federal Reserve in
conducting open market operations has been to influence the
term structure of interest rates. This policy was used mainly
in the early 1960's when it was desirable to moderate down-
ward pressures on short-term interest rates to reduce interna-
tional capital flows.









by affecting bank reserves.10 Changes in reserves
affect the availability and cost of money and credit
in various credit markets, including the Govern-
ment securities market. In the short run, changes
in the Federal funds rate in line with Federal
Reserve policy influence the Treasury bill rate
and other rates on short-term Government securi-
ties. Over longer periods, both short- and long-term
rates are affected by the course of monetary policy.
In addition to the impact through reserves,
System transactions in Government securities
may directly influence the market. However, the
SOMA follows a number of policies designed to
minimize the impact of its transactions on the
market." First, the Account Manager utilizes
temporary RP and MSP transactions to reduce
the impact of System activity on interest rates on
Government securities. An outright purchase
followed in a few days by an outright sale would
have the same effect on reserves as an RP, and an
outright sale followed by an outright purchase
would have the same effect as an MSP. How-
ever the market does not view RP's and MSP's
the same as outright transactions since it does
not know whether outright transactions will be
reversed. When the Federal Reserve purchases
securities outright, it reduces dealer inventories.
If the dealers think the System may not sell
securities soon, they may bid for new inventory at
higher prices because they expect a smaller supply
to be available. Thus, there may be greater down-
ward temporary pressure on interest rates when an
outright purchase is used instead of an RP.
Likewise, the use of outright transactions instead
of MSP's may result in greater increases in in-
terest rates.
The System can also use transactions with
foreign accounts to minimize its impact on the
Government securities market. Foreign pur-


" The FOMC authorization for domestic open market opera-
tions limits the total change in SOMA holdings of U.S. Govern-
ment and Federal agency securities to $3 billion between
meetings of the FOMC. This limit was raised from $2 billion
on March 18, 1974, because of the larger short-term fluctua-
tions in reserves and factors affecting reserves.


chases of securities from the Federal Reserve
reduce the banking system's reserves, and foreign
sales to the System increase bank reserves. Direct
transactions with foreign accounts are usually
undertaken when foreign orders to buy or sell
coincide with System needs to alter reserves. If
the System did not carry out direct operations with
foreign central banks, contrasting types of trans-
actions would need to be conducted in the domestic
market. For example, if a foreign central bank
wanted to sell securities at the same time the Sys-
tem needed to supply reserves, the Account Man-
ager would have to ask for bids in the market for
the securities of foreigners to be sold and at the
same time purchase securities for the System's ac-
count. Although the market would see both types
of transactions, it might place greater emphasis on
the System's transactions, resulting in larger
interest rate movements because of expected
changes in the supply of securities.
The Federal Reserve System follows a number
of other practices designed to minimize the impact
of its transactions on Government security prices
and yields. First, SOMA sales of Government
securities have generally been limited to Treasury
bills in recent years. The Treasury bill market is
broad and active, whereas secondary market trad-
ing in many Federal agency and long-term
Treasury issues is relatively thin. Thus, System
sales of such securities tend to be unsettling to the
markets and could result in large prices changes.
Also, if the System were to sell long-term bonds,
it could pose problems for the Treasury if the
amount of bonds issued to the public at rates over
414 per cent approached the legal limit. Currently
the Treasury can issue up to $27 billion without
regard to the interest rate ceiling, and Federal Re-
serve and Government account holdings are not
included in this limit. The System holds one-fourth
of all marketable bonds issued with coupon rates
above 4/4 per cent.
Secondly, when the System purchases securities
for its account, it considers the maturity as well
as the prices offered. The System generally does
not purchase securities that are very close to









issue of securities in which its holdings are rela-
tively small. In purchasing notes and bonds and
Federal agency securities, the System must be
careful that its purchases do not overwhelm the
market resulting in large price changes.
Federal Reserve security holdings are widely
distributed among outstanding issues. As of
November 30, 1977, the System held some portion
of each of the 102 marketable notes and bonds
issued by the Treasury,'2 with the percentage of
individual issues held varying from less than 1
per cent to more than 70 per cent. The System also
held 126 different Federal agency issues, but these
holdings are limited by regulations to less than 30
per cent of any one agency security issue and
less than 15 per cent of the total amount outstand-
ing for any one agency. Federal Reserve bill hold-
ings are also distributed among the outstanding
issues.
Third, System participation in the new issues
market is minimized. To avoid influencing the
price or yield on new securities, SOMA does not
purchase new issues for cash for its own account
nor does it purchase "when-issued" securities.
The System may, however, purchase new issues
for cash on behalf of its foreign customers. Matur-
ing securities in the System account are exchanged
or allowed to mature without replacement. Since
April 1974, the System has entered Treasury bill
auctions on a noncompetitive basis, exchanging
its maturing bills for new issues at the average price
of accepted competitive tenders. This eliminates
the risk of having to undertake outright bill pur-
chases to maintain the same volume of security
holdings and reduces the Federal Reserve's in-
fluence in determining new issue Treasury bill
rates. The relative size of noncompetitive System
bids and competitive bids from the public tends to
remain fairly stable due to the System's distribu-
tion of bill holdings among outstanding issues.
This also minimizes System influence on Trea-
sury bill rates. Maturing notes and bonds are re-


12 This does not include 11/2 per cent EO notes which are held
only by private investors.


deemed or exchanged at the average price of
securities issued to private investors. Redemptions
can be a useful option when there is a need to
absorb reserves, since a redemption would have
relatively little direct impact on market rates.
However, redemptions of marketable Treasury
securities are made infrequently and normally
amount to only a few hundred million dollars at
any one time. System holdings of agency issues are
allowed to run off at maturity, and no new issues
are purchased in the secondary market until at
least 2 weeks after the issue date.
The Federal Reserve also tries to reduce its
impact on market attitudes during Treasury
financing operations. In much of the postwar pe-
riod, the Federal Reserve adhered to a policy
known as "even keel," normally meaning that
from a few days before the announcement of a
major Treasury security sale, the System would
not alter monetary policy i.e., change the
discount rate or reserve requirements, visibly alter
the Federal funds target rate, or make large out-
right purchases or sales of Government securities.
In recent years, the Federal Reserve has adhered
less closely to even-keel policy, since debt manage-
ment innovations have made Treasury financings
less vulnerable to sudden variations in market
interest rates. Formerly, the Treasury sold most of
its notes and bonds on a subscription basis with the
price and coupon rate set prior to the sale. Any
sharp rise in rates before the sale would make the
coupon rate appear relatively unattractive and
dampen investor interest, with the risk that the
Treasury would not be able to sell the desired
volume of securities. In the 1970s, the Treasury
has issued most notes and bonds on an auction
basis, with yields and prices determined through
bidding on the date of the offering. Thus, the rate
and price adjust to the current market level and the
risk of a financing failure is reduced.13



13 Two auction techniques the price auction and the yield
auction have frequently been utilized by the Treasury in
the 1970's. While the need for an even-keel policy has been
reduced under both methods, it is a less important policy









The need for the Federal Reserve to follow an
even-keel policy during Treasury financings has
also been reduced by the restructuring of the debt
into a more regular cycle of offerings. Most
financings are now moderate in size and occur on
a schedule that allows investors to accumulate
funds for purchasing Treasury issues. The fre-
quency of Treasury financings in recent years
makes it impractical for the System to maintain
an even-keel policy during all Treasury operations.
Further, even when the Federal Reserve main-
tained an even-keel policy, interest rate movements
were sometimes large during Treasury financing
periods, since rates are influenced by a number of
factors other than Federal Reserve policy.
Although the System does not adhere to a strict
even-keel policy, market transactions are mini-
mized during Treasury financings. In 1977, the
Federal Reserve executed outright transactions
directly with the market on only 5 out of 69 days
that Treasury bills were auctioned and on only two
occasions when notes or bonds were auctioned.
The System did enter into outright transactions
in the middle of a major refunding in November
1977. MSP and RP transactions and outright
transactions with foreigners were carried out


when the yield auction is utilized. In a price auction, the coupon
rate is set prior to the sale and the yield to maturity is adjusted
to current market rates through changes in the price. A sharp
rise in interest rates between the announcement of the coupon
rate and the sale date results in price bids on a discount basis.
If discounts become so large as to subject investors to original-
issue discount tax laws, the sale may be cancelled. Alternatively,
declines in interest rates result in premium prices, which when
very large reduce investor participation. Since 1974, the
majority of note and bond auctions have been on a yield basis,
with the coupon rate determined in the auction and a par price
set near the average yield. Thus, changes in interest rates do not
result in large price premiums nor discounts on the issue. Under
either method, rate changes between the sale date and the time
that dealers distribute the securities among their customers can
result in dealer profits or losses. Declines in interest rates result
in higher bond prices, providing windfall profits to dealers;
whereas increases in rates depress bond prices, resulting in
dealer losses and a reluctance on their part to participate in future
sales. Nevertheless, gradual changes in policy begun prior to
the auction will not result in large profits nor losses since
dealers can anticipate interest rate movements and adjust
their bids accordingly.


on many days of Treasury security sales.
SUMMARY
Federal Reserve operations in the Govern-
ment securities market developed as a result of the
System's need to control changes in bank reserves
and the monetary base and to influence monetary
growth. The System's holdings of U.S. Treasury
and Federal agency securities increased sharply
in the post-World War II period and were $111
billion at the end of 1977. In the short run,
Federal Reserve holdings of Government securities
fluctuate to accommodate temporary or sea-
sonal changes in the monetary base and to off-
set changes in other Federal Reserve accounts.
These short-run fluctuations require a large
volume of open market transactions. System Open
Market Account transactions are conducted
with foreign accounts and with domestic security
dealers. Outright purchases and sales of securities
provide for long-term changes in System security
holdings to support bank reserves and monetary
growth; while repurchase agreements and matched
sale-purchase agreements are used to accomplish
day-to-day changes in System security holdings
and to accommodate overnight investment needs
of foreign customers.
Federal Reserve open market operations mainly
influence the Government securities market
indirectly through their impact on reserves,
but they also may influence the market directly.
However, SOMA follows a number of policies
designed to minimize the impact of its transactions
on prices and yields in the market. First, the
Account Manager utilizes temporary MSP and
RP transactions and transactions with foreign
accounts when possible, since these transactions
have less impact on market rates than outright
transactions with the market. Also, System sales
are generally conducted in Treasury bills, where
the market is broad and active. Purchases are
distributed among a wide variety of issues, and
System participation in the new issues market is
minimized. In addition, the Federal Reserve tries to
reduce its impact on market attitudes during
Treasury financing operations.











The Federal Reserve's Impact

On Several Reserve Aggregates


By Jack L. Rutner


A number of economists posit that "reserve
aggregates,"' such as the monetary base, are
crucial to the determination of the money sup-
ply.2 A previous article in this Review, which
examined the relationship between one reserve
aggregate the monetary base and two money
supply measures, did indeed find that the base
played an important role in the determination of
the money supply.3 Findings such as these have led
some economists to argue that the Federal Reserve
can control the money supply by controlling re-
serve aggregates. These arguments typically



The items which constitute the reserve aggregates are in the
modem world liabilities of the central bank and/or the Trea-
sury. Historically, gold and silver were used as reserves in
addition to central bank and Treasury liabilities.
2 See, for instance, Fred J. Levin, "Examination of the Money
Stock Control Approach of Burger, Kalish, and Babb," and
Michael J. Hamburger, "Indications of Monetary Policy: The
Arguments and the Evidence," both in Monetary Aggregates
and Monetary Policy (Federal Reserve Bank of New York,
1974).
3 Jack L. Rutner, "A Time Series Analysis of the Control of
Money," Federal Reserve Bank of Kansas City Monthly Re-
view, January 1975.


Jack L. Rutner, presently with Joel Popkin Co., was formerly
an economist with the Federal Reserve Bank of Kansas City.
This article was originally published in the May 1977 Monthly
Review.


assume that the Federal Reserve can easily control
reserve aggregates, and, while they recognize
that the Federal Reserve does not have direct
control over reserve aggregates, they nonetheless
assume that open market operations can be used
to effectively control the behavior of these vari-
ables. Empirical verification of this assumption,
however, has received only scant attention in the
professional literature, although the technical
or analytical relationship has received thorough
treatment.4
This article examines the relationship between
Federal Reserve open market operations and
reserve aggregates such as the monetary base. The
first section briefly treats the analytical relation-
ships, while the next section contains the results
of an empirical analysis of these relationships. The
article concludes with a discussion of the study's
implication for the Federal Reserve's ability to
control reserve aggregates.


4 The effect of open market operations on reserves was examined
by John H. Wood, "A Model of Federal Reserve Behavior,"
Staff Economic Studies, No. 17, Board of Governors of the
Federal Reserve System, mimeographed, and by Vittorio
Bonomo and Charles Schotta, "Federal Open Market Opera-
tions and Variations in the Reserve Base," Journal of Finance,
Vol. 25, No. 3, June 1970.
The omission of free reserves from the items examined in
this article was based on free reserves having been extensively
explored in the Wood and in the Bonomo and Schotta studies.









DETERMINANTS OF
RESERVE AGGREGATES

The Monetary Base
The monetary base consists mainly of those
liabilities of the Federal Reserve that are either a
part of the nation's money supply or that may be
used as bank reserves to support deposits that are
a part of the money supply. Specifically, the base
consists of two components: member bank de-
posits at the Federal Reserve and currency and
coin mainly Federal Reserve notes held by
commercial banks and the nonbank public."
Many factors affect the monetary base, with an
important one being the Federal Reserve's open
market operations in U.S. Government securities.
Suppose, for example, that the Federal Reserve
buys some securities from bond dealers and pays
for them with checks drawn on the Federal Reserve.
Suppose further that the bond dealers deposit the
checks in their bank accounts and the banks for-
ward the checks to the Federal Reserve to be added
to their reserve accounts. The open market opera-
tion would then result in an increase in member bank
reserves and therefore an increase in the monetary
base. The example, however, ignores the im-
pact of other factors which may also affect the
base and either offset or augment the impact of open
market operations. Movements in the base there-
fore may not necessarily correspond on a one-to-
one basis with movements in open market opera-
tions.
Factors other than open market operations
that affect the base may themselves be affected
- perhaps indirectly by open market opera-
tions, so that some of the impact of operations on
the base may be automatically offset. An example
of this type of factor is member bank borrowing
from Federal Reserve Banks. The purchase of
Government securities by the Federal Reserve and


5 The monetary base includes currency and coin issued by the
U.S. Treasury, which is not a liability of the Federal Reserve.
6 In actual practice, no checks would be written. Both the
dealers' and the banks' accounts would be credited directly.


the corresponding rise in reserves may produce a
decline in interest rates. The decline in interest
rates and the increase in bank reserves may cause
banks to reduce their borrowing from the Federal
Reserve, which in turn would tend to reduce bank
reserves and the monetary base. This reduction in
the base, then, would offset some or all of the initial
increase in the base produced by the open market
operation.
Other factors, however, may interact coinci-
dentally with open market operations. Thus, for
example, an increase in Federal Reserve float
due to inclement weather or other reasons may re-
sult in the increase in the base in the absence of
open market operations. The Federal Reserve,
however, may employ open market operations to
offset the impact of other factors that are ex-
pected to affect bank reserves and the base. Sup-
pose, for example, that the Federal Reserve wishes
to maintain bank reserves at a constant level but
anticipates that changes in float or in some other
factor could potentially reduce reserves. The
Federal Reserve, in this case, would purchase
securities in order to offset the impact of the other
factors, but the open market operations would not
result in a rise in bank reserves or the base.
Factors that affect the monetary base other than
open market operations may be conveniently
grouped together and referred to as "other factors."
Using this terminology, it may be said that changes
in the base are determined by two variables -
open market operations and other factors. The
relationship between the monetary base, open
market operations, and other factors may be
further clarified by reference to the balance sheet
of the Federal Reserve System (Table 1). This
balance sheet shows that the base consists mainly
of certain of the liabilities of the Federal Reserve
System, that is, deposits of member banks and
Federal Reserve notes held by commercial banks
and the nonbank public. Since the Federal Re-
serve's assets must equal its liabilities the
balance sheet must balance a change in any of
the Federal Reserve's asset items or in any of the
liability items other than items included in the base










Table 1
THE FEDERAL RESERVE BALANCE SHEET
(In billions of dollars)
August 11, 1976


ASSETS


_____________________________________________________________ 4


U.S. Treasury securities
All other assets:
Member bank borrowing
Float
Gold and SDR's
Other assets


Total


93.1
20.5


113.6


LIABILITIES


Liabilities included in
monetary base:
Member bank deposits
F.R. notes outstanding

All other liabilities:
U.S. Treasury deposits
Other deposits
Other liabilities
and capital

Total


NOTE: In addition to the Federal Reserve liabilities included in the monetary base, the base includes U.S. Treasury currency
outstanding, that is, currency and coin issued by the U.S. Treasury. As of August 11, 1976, Treasury currency was $10.7
billion, so that the monetary base was $115.3 billion ($104.6 billion of Federal Reserve liabilities included in the base plus
the $10.7 billion in Treasury currency). Note that the sum of the factors affecting the base add up to the base. Thus,
the base equals U.S. Treasury securities held by the Federal Reserve, $93.1 billion, plus other factors affecting the base,
$22.2 billion. The other factors are all other assets from the balance sheet, $20.5 billion, less all other liabilities, $9.0 bil-
lion, plus Treasury currency, $10.7 billion.
The specific components of other factors are: gold and SDR's plus member bank borrowings plus float plus other assets,
including bank premises, plus U.S. Treasury currency outstanding, less U.S. Treasury deposits less other deposits, including
foreign deposits, less other liabilities and capital.


maturity, and it may be more willing to accept an
could potentially result in a change in the base.
Thus, these asset and liability items are the
determinants of the base. Following the previous
discussion, these factors may be placed into two
groups. One group consists of changes in the
Federal Reserve's portfolio of U.S. Government
securities open market operations while the
second group consists of the other factors referred
to earlier. In summary, the following relationship
may be stated between the monetary base, open
market operations, and other factors:7
Changes in the monetary base
= open market operations
+ other factors affecting the base.


7 The actual definitions of the reserve aggregates and the Trea-
sury portfolio employed here differ somewhat from the general
description of the text. The Treasury portfolio as found in of-
ficial publications is valued at par. (See the Federal Reserve
Bank of New York publication, Glossary: Weekly Federal
Reserve Statements, New York (September 1972), p. 8, item 7
and 7a*). The desired variable, however, is the cash purchase
(and sale) value of the portfolio because it reflects more ac-
curately actual changes in reserves due to open market opera-
tons. The premiums and discounts are embedded in other assets
and liabilities and capital accounts, which, according to the
terms used here, are part of other factors. Allowing these pre-
miums and discounts to remain in other factors could overstate
the effect other factors have on the reserve aggregate. Un-
fortunately, these premiums and discounts are not readily avail-
able so an adjustment was made to approximate them by adding
to the portfolio the items other assets less premises less foreign


104.6


24.7
79.9


113.6










Other Reserve Aggregates
Reserve aggregates treated in this article, in
addition to the monetary base, are the unbor-
rowed monetary base, member bank reserves, and
unborrowed member bank reserves. The unbor-
rowed monetary base is the monetary base less
member bank borrowings from the Federal Re-
serve. This aggregate was developed because
some economists argue that changes in member
bank borrowings prevent the Federal Reserve from
controlling the total monetary base. Changes in
borrowing, according to this argument, tend to
offset the impact on the total base of open market
operations. Since changes in borrowings do not
affect the unborrowed base, it is argued that
the Federal Reserve can control the unborrowed
base better than the total base.
The relationship between the unborrowed
monetary base, open market operations, and other
factors is equivalent to that for the total monetary
base, except that member bank borrowings are not
included in the other factors that affect the unbor-
rowed base.


currency less other liabilities and capital plus capital and sur-
plus less Franklin National borrowings (beginning in October
1974 when it was moved from borrowings to other assets note
that the other factors employed here include Franklin National
borrowings). The reason the item "other capital accounts," the
difference between capital and capital paid in plus surplus,
was not used directly stems from its not being available on a
weekly average basis. Capital paid plus surplus, however, even
though also not available on a weekly average basis, changes
only infrequently. Thus, subtracting these items from other
liabilities and capital on a weekly average basis leaves other
liabilities and other capital accounts approximately on a weekly
average basis. The source for other assets and liabilities and
capital was from Federal Reserve Bulletins from the table on
Member Bank Reserves, while the remaining were from the
table on Consolidated Statement of Condition of all Federal
Reserve Banks.
Aside from these changes, the monetary base was changed
in two ways. The first involved adding "other deposits" at
the Federal Reserve to it because some of these deposits are
held by nonmember banks and certainly must contribute to their
reserves. Secondly, but for reasons not directly applicable to
this paper, the monetary base (as well as member bank re-
serves) was adjusted for reserve requirement changes. To main-
tain comparability, the same adjustment was performed on the
Treasury portfolio. Inasmuch as examination here is on a log
linear basis, the effects of this adjustment on the relationships
being examined should be small.


Member bank reserves is an important re-
serve aggregate because reserves provide the
support for deposits which are an important com-
ponent of the nation's money supply. The rela-
tionship between member bank reserves, open
market operations, and other factors is similar to
that for the monetary base, except that other fac-
tors affecting member bank reserves include
currency and coin held by nonmember banks and
the nonbank public. Such currency and coin is
included because changes in it affect member
bank reserves but do not affect the monetary base.
Unborrowed member bank reserves was developed
as a reserve aggregate for the same reason that
the unborrowed monetary base was developed.
Member bank borrowings are not included in the
other factors that affect unborrowed reserves, but,
as is the case with the total member bank reserves,
currency held by the public and by nonmember
banks is included.

EMPIRICAL EXAMINATION
As discussed in the previous section, open
market operations and "other factors" jointly
determine the behavior of each reserve aggregate.
This section examines the relative importance
of the two determinants by first estimating the cor-
relation between each reserve aggregate and
its determinants as well as the correlation between
the determinants. Then, these correlations which
are examined for weekly, monthly, and quarterly
observations for the period from January 1959
through December 1974 are used to draw
conclusions about the extent to which open market
operations or other factors determine reserve
aggregates.8



8 The intent of examining the three correlations associated
with each reserve aggregate for time periods of differing dura-
tions is to attempt to infer which, if either, of the reserve aggre-
gate's two components are determining it. Other factors on a
weekly basis, for example, may be highly associated with
reserve aggregates, but on a quarterly basis may not be related
at all. This could suggest that over the longer run open market
operations are offsetting the effect of other factors on reserves,
although other evidence needs to be present for this interpreta-
tion to be valid. The data employed for assessing the weekly









Two types of correlations are examined -
simple and partial. In both types, the correlation
coefficient, which may vary in value from -1.0 to
+1.0, measures the degree of association between
two variables. A high positive value indicates that
movements are highly and positively associated,
while a high negative value means that move-
ments are highly and negatively associated. Simple
correlations show the degree of association between
any two variables without taking account of the
possible association of either of the two variables
with any other variables. Partial correlations, which
are derived from regression analysis, show the
degree of association of two variables after taking
account of association with other variables. Two
sets of partial correlations were derived.
One set called Type I takes account of the
impact of past movements in both the dependent
and the independent variables in each regression.
The other set Type II takes account only of
past movements in the dependent variable.9




interaction of each of the four reserve aggregates with their
components are not seasonally adjusted figures beginning the
first week of January 1959 and ending in the last week of
December 1974.
The weekly data were then grouped into 208 4-week aver-
ages, termed monthly here, and 64 13-week or quarterly aver-
ages. This article's monthly figures differ from officially pub-
lished figures because the official figures are actually for a period
longer than 4 weeks. The quarterly figures differ as well because
the official quarterly figures are averages of official monthly
data. The choice of computing quarterly averages from the
weekly figures rather than employing official figures was de-
termined by the necessity of making certain adjustments to open
market operations, which could more accurately be accom-
plished with the original weekly data. This adjustment was
also the determining factor in employing 4-week averages. (For
adjustments, see footnote 7.)
9 The regressions are of the form:
Y = f (past Y, current X, past X, error term) (Type I)
Y = f (past Y, current X, error term) (Type II)
The dependent variable in one set of regressions was the change
in the natural logarithm of the reserve aggregate, while the
independent variable was either the change in the natural
logarithm of open market operations or the change in the natural
logarithm of other factors, as measured by the ratio of the re-
serve aggregate to open market operations. The choice of using
the change in these logarithms rather than changes in levels was
determined by the ability of logarithms to remove some
heteroscedasticity of the regression residuals. A second set of


The Monetary Base and
Unborrowed Monetary Base
The correlation results summarized in Table 2
show that during the 1959-74 period the mone-
tary base was more highly correlated with open
market operations than with other factors, especial-
ly for monthly and quarterly movements. The simple
correlation, for example, between the base and open
market operations for weekly movements in the var-
iables was .51, while the correlation between the
base and other factors was only .25. The simple
correlation between quarterly movements in the
base and open market operations increased to .66,
while the correlation between the base and other fac-
tors declined to .11, with the latter too small to
be statistically significant. The two types of
partial correlations derived from regression analy-
sis have a pattern similar to the simple correla-
tions.10

regressions for the interaction between open market operations
and other factors estimated the partial correlation between the
two, first using one and then the other as dependent variables.
The reason for reversing dependent and independent variables
in the second set of regressions was a consequence of other in-
conclusive evidence concerning the direction of causality be-
tween these two variables. Estimating the partial correlations
both ways, which as it turned out makes virtually no difference
to the conclusions, does not presuppose any apriori assumptions
about causality. The independent variables are not reversed
when the reserve aggregate is the dependent variable because
the reserve aggregate is the determined and not the determin-
ing factor.
The lags for the regressions were the following: 57 weekly, 13
monthly, and 5 quarterly.
The Box-Pierce chi-square test on the residuals when lagged
dependent variables are present was used. See G.E.P. Box
and David A. Pierce, "Distribution of Residual Auto-correlation
in Auto-regressive Integrated Moving Average Time Series
Models," Journal of the American Statistical Association, Vol.
65, December 1970, p. 1509.
In all but one of the regressions, significant autocorrelation
was present in the residuals. Thus, it was necessary to filter
the original variables in the several regressions so as to make
the residuals as nearly white noise as practicably possible. Two
techniques were used in determining the filter. One was from a
regression of the residuals on themselves, while the second was
to treat the residuals as moving averages and follow the tech-
nique described in T. W. Anderson, The Statistical Analysis of
Time Series (New York: John Wiley and Sons, Inc., 1971),
pp. 223-35.

o1 The partial correlations, however, differ from the simple
correlation in that the partial correlations indicate that on a week-









The correlation results also indicate that move-
ments in open market operations and other fac-
tors were fairly highly and negatively corre-
lated during the 1959-74 period, suggesting
that simultaneous but opposite movements in
the base's two determinants offset some of the
potential impact of each determinant. The extent of
these offsetting movements generally tended to
increase as the length of the time period increased.
Several conclusions may be drawn from these
correlation results. One is that open market
operations during the 1959-74 period offset the
impact of other factors on the monetary base,
although by itself the high negative correlation
between open market operations and other fac-
tors shows only that one offset the other." It is
the finding that the correlation between the base and
open market operations increased while the corre-
lation between the base and other factors de-
clined as the length of the time period increased
that suggests that it was open market operations
which offset other factors, rather than the other
way around.




ly basis open market operations and other factors, while still
having a very high negative correlation, are about equally cor-
related with the base. This suggests that, although both com-
ponents of the base are offsetting one another, they both play
about an equal role in weekly determination of the base. It also
suggests that the simple correlations are affected by some third
set of variables to which the base and open market operations are
responding. When this response is held constant, especially in
the Type I regression, open market operations are less highly
associated with the base while other factors are more highly
related.
The finding that the association between the monetary base
and its other factors is declining must mean that something is
offsetting other factors so that they have no effect on the base.
Since the base is composed of only two determinants and since
its association with open market operations was not declin-
ing, indicating that these operations are not being offset, it must
be open market operations which are offsetting other factors.
The high negative correlation between open market operations
and other factors which is either stable, as in the simple corre-
lations, or increasingly negative, as in the partial correlations,
indicates that other factors and open market operations are
indeed offsetting one another rather than, say, other factors
having self-canceling movements over time so that it has no
effect on the base.


A second conclusion suggested by the corre-
lation results is that open market operations during
the 1959-74 period were the dominant factor de-
termining movements in the base and not merely
offsetting movements in other factors. This
conclusion is supported by the finding that the
correlation between the base and open market
operations was fairly high considerably higher
than that between the base and other factors and
that this correlation did not decline as the length
of the time span increased. If open market opera-
tions had merely offset movements in other fac-
tors, either open market operations would have
been highly and negatively correlated with other
factors but not with the base, or the correlation
between open market operations and the base
would have declined as the time span of the ob-
servations lengthened. It should be added that,
since only a part of the movements in open mar-
ket operations could directly affect movements
in the base (because the rest of the movement in
open market operations was offsetting the other
factors), the base was not perfectly correlated with
open market operations even for the longer time
spans.
The correlation results for the unborrowed mone-
tary base are generally similar to results for the total
monetary base. The unborrowed base was more
highly correlated with open market operations than
with other factors that affect the unborrowed base.
Also, the unborrowed base became more highly
correlated with open market operations and less
highly correlated with its other factors as the length
of the time span increased. Another result was
that open market operations and other factors af-
fecting the unborrowed base were highly and nega-
tively correlated.
The only important difference between the un-
borrowed base and the total base is that for the
weekly time span the unborrowed base was more
highly correlated with its other factors than with
open market operations. This suggests that for
weekly periods the impact of other factors was
offset by open market operations to a greater extent
for the total base than for the unborrowed base.








Table 2
CORRELATION OF OPEN MARKET OPERATIONS, RESERVE AGGREGATES, AND OTHER FACTORS
Partial Correlations*
Type I Type II
Correlation of Simple Correlations Account Taken of Past Account Taken of Past
Movements in Both Dependent Movements in Dependent
and Independent Variables Variable

Weekly Monthly Quarterly Weekly Monthly Quarterly Weekly Monthly Quarterly

Monetary Base
Monetary base with:
OMOt .51 .62 .66 .40 .42 .49 .34 .40 .52
Other factors .25 .19 .11 .40 -.08 -.04 .23 .10 .15
OMO with other factors -.71 -.65 -.68 A.-.78 -.89 -.92 -.50 -.86 -.83
B.-.78 -.90 -.90 -.73 -.88 -.94
Unborrowed Monetary Base
Unborrowed base with:
OMO .33 .61 .67 .22 .46 .68 .17 .41 .59
Other factors .46 .26 .11 .58 .17 -.11 .60 .23 -.06
OMO with other factors -.68 -.61 -.67 A.-.66 -.84 -.90 -.57 -.79 -.81
B.-.67 -.84 -.88 -.61 -.74 -.85
Member Bank Reserves
Member bank reserves with:
OMO .38 .54 .47 .42 .50 .59 .29 .50 .36
Other factors .74 .73 .49 .72 .49 .63 .72 .62 .68
OMO with other factors -.34 -.18 -.54 A.-.32 -.57 -.53 -.25 -.53 -.50
B.-.32 -.55 -.49 -.04 -.53 -.48
Unborrowed Member Bank Reserves
Unborrowed reserves with:
OMO .13 .50 .40 .16 .48 .54 .12 .43 .44
Other factors .89 .81 .67 .92 .78 .77 .92 .79 .77
OMO with other factors -.34 -.11 -.42 A.-.24 -.28 -.37 -.20 -.18 -.29
B.-.24 -.28 -.33 -.20 -.13 -.35


*See footnote 9 for discussion of regressions from which the partial correlations were derived. Also, see footnote 7 for description of data used in
regressions.
tOMO refers to open market operations.
tin the case of the partial correlations between open market operations and other factors, the value of the correlation coefficient was estimated in two ways.
The first correlation given in the table, and denoted by A, was derived under the assumption that other factors determine open market operations. The
second, denoted by B, assumes that open market operations determine other factors. As the table shows, the results were quite similar. See footnote 9 for
a more complete discussion of this matter.
lndicates correlation is not significantly different than zero in a statistical sense (5 per cent level).










Member Bank Reserves
and Unborrowed Reserves
The correlation results for member bank
reserves and for unborrowed member bank reserves
differ considerably from the results for the base and
the unborrowed base. Both total and unborrowed
member bank reserves were less highly correlated
with open market operations than with other fac-
tors. This is true for the simple correlations as well
as for both sets of partial correlations. Also, unlike
the results for the base concepts, there was no sys-
tematic tendency for member bank reserves to be-
come more highly correlated with open market
operations and less highly correlated with other
factors as the length of the time span increased.12
This was especially true for the partial correlation
results. Thus, for example, the Type II partial cor-
relation between member bank reserves and open
market operations was higher for the monthly than
for the quarterly time span (.50 compared to .36,
see Table 2), while the correlation between reserves
and other factors was lower for the monthly than
for the quarterly time span (.68 compared to .62).
These correlation results for member bank re-
serves and unborrowed member bank reserves
suggest that during the 1959-74 period factors
other than open market operations were consider-
ably more important in determining these aggre-
gates than was the case for the monetary base and
the unborrowed base. The results also suggest that
open market operations did not tend to offset the
impact of other factors on reserves and unbor-
rowed reserves as much as was the case for the base
and the unborrowed base.13


12 The partial correlations also indicate that open market
operations were more highly correlated with member bank re-
serves and unborrowed reserves than with the monetary base
and the unborrowed base. It may be that, for the base concepts,
a relatively large portion of the variation in open market
operations offsets variations in other factors, leaving a relatively
small portion of the variation in open market operations to af-
fect the base concepts.
13 One interesting question that emerges from this study con-
cerns unborrowed reserves. This reserve aggregate is closest to
one variable on which the Federal Reserve actually focuses,
which is free reserves. Unborrowed reserves differ from free
reserves by the item required reserves. Yet, unborrowed reserves


Summary of Empirical Examination
In summary, two broad conclusions may be
drawn from the empirical examination. One is that
open market operations during the 1959-74 period
appear to have been considerably more important
than other factors in determining the monetary
base and the unborrowed base, but for member bank
reserves and unborrowed reserves, the correlation
results do not provide any evidence that open
market operations were a more important determi-
nant than other factors. It appears that for the base
concepts, open market operations offset much of
the impact of other factors on these reserve ag-
gregates as well as having had a direct impact on
these aggregates.
A second conclusion is that, in general, open
market operations were as important in determining
the unborrowed base as in determining the total
base, and the same conclusion holds when compar-
ing the impact of open market operations on unbor-
rowed and total member bank reserves. An excep-
tion is that, over weekly time spans, other factors
appear to have been more important than open mar-
ket operations in determining the unborrowed base
than in determining the base.

IMPLICATIONS FOR CONTROLLING
RESERVE AGGREGATES
The results of this analysis may be interpreted
to suggest that the Federal Reserve can use open
market operations to control the monetary base
and the unborrowed base. The evidence presented
in this article does not indicate whether or not the
Federal Reserve can control the two base concepts



is more highly associated with other factors than any other re-
serve aggregate irrespective of the time period, and similarly it
has the lowest negative association existing between other fac-
tors and open market operations. These results would seem to
contradict the Wood study and the Bonomo and Schotta study
cited earlier because they suggest that the impact of the other
factors on unborrowed reserves is offset. A possible explana-
tion is that the manager in the period covered by the data has
changed his modus operandi and so focuses on other targets
which have the net effect of resulting in the other factors of the
broader reserve aggregates being offset. Clearly, however,
this conundrum needs further examination.










better than member bank reserves and unborrowed
reserves. During the period studied 1959-74 -
the Federal Reserve did not necessarily attempt to
control reserve aggregates. Thus, even though
the findings indicate that factors other than open
market operations affected the reserve concepts
more than the base concepts, it may, nevertheless,
be true that the Federal Reserve could if it so
desired offset the effect of these other factors with
open market operations. Thus, while the article
could be used to infer which reserve aggregates the
Federal Reserve can control and these appear to
be the monetary base and, for monthly and quar-
terly time periods, the unborrowed base no con-


clusion can be drawn as to which aggregates the
Federal Reserve cannot control.14


14 The criterion used here for controllability is the ability of the
Federal Reserve to offset most or all of the impact of factors
other than open market operations on reserve aggregates. Under
certain circumstances, other measures of controllability may be
important as, for example, the standard error of estimate from a
linear regression with a reserve aggregate as a dependent vari-
able and open market operations as an independent variable. Be-
cause the Federal Reserve uses open market operations as a
control variable to both offset the effect of other factors and to
affect reserves directly, the standard error criterion is not appli-
cable, except possibly in a regression from a larger model which
takes into account the offsetting effects of open market oper-
ations on other factors.











Reserve Requirements and

Monetary Control


By J.A. Cacy


The Federal Reserve System requires that its
member banks hold a minimum volume of re-
serves, either as vault cash or on deposit at Fed-
eral Reserve Banks. The required minimum is
equal to certain percentages of various types of
deposits that the public maintains at member
banks. These percentages established by the
Board of Governors of the Federal Reserve
System are referred to as reserve requirements.
Reserve requirements are one of the instru-
ments the Federal Reserve uses in controlling
the money supply. In recent years, however, the
precise role that requirements play in monetary
control has been a subject of some controversy.
Some observers have claimed that requirements
are necessary if the monetary authorities are to
effectively carry out their responsibility of con-
trolling the nation's money supply. Other ob-
servers argue that requirements are not needed.
Disagreement also exists concerning the coverage
and structure of reserve requirements. Many ob-
servers hold that effective monetary control
requires that nonmember banks as well as nonbank
financial institutions be subject to reserve require-
ments. This contention is disputed by those who



J.A. Cacy is a vice president and senior economist with the
Federal Reserve Bank of Kansas City. This article was originally
published in the May 1976 Monthly Review.


claim that an extension of reserve require-
ments beyond member banks is not needed for ef-
fective monetary control. With regard to the struc-
ture of reserve requirements, some observers
argue that requirements should be applied uni-
formly on all types of deposits, while others
favor the current system of nonuniform require-
ments.
In this article the role that reserve requirements
play in monetary control is analyzed. The article
also discusses the impact on monetary control
that would result from an extension of reserve
requirements to nonmember banks and nonbank
financial institutions. The first section of the
article provides a background by discussing the
sources of monetary control as well as the factors
that tend to weaken monetary control.


SOURCES OF MONETARY CONTROL
The money supply is importantly influenced by
Federal Reserve actions such as open market
operations and changes in reserve requirements.
The money supply also is affected by factors
that are not under the control of the monetary
authorities. For this reason, monetary control is
imprecise in that the Federal Reserve can seldom
establish the money supply at precisely the level
the System considers desirable. Monetary control
would be precise if changes in the noncontrollable









factors and their impact on money were predictable.
In this case, the Federal Reserve could take off-
setting action. However, the impact of the non-
controllable factors is not entirely predictable.
Thus, while the Federal Reserve exercises a de-
gree of control over the nation's money supply,
monetary control is made imprecise by the exis-
tence and unpredictability of noncontrollable
factors.

Controllable Factors
The Federal Reserve exercises a degree of
control over the nation's money supply for several
reasons. One reason is that the System can main-
tain fairly precise control over the nation's mone-
tary base, and the base affects the money supply.
The Federal Reserve can control the monetary
base because the base consists primarily of the
deposit and currency liabilities of Federal Re-
serve Banks. The System controls these liabilities
by controlling its assets. For example, when the
Federal Reserve brings about a net increase in
its assets by buying U.S. Government
securities or making loans to banks the in-
crease in assets is typically accompanied by an in-
crease in the System's deposit or currency liabilities
that constitute the monetary base.
The monetary base affects the money supply
because base money, if held by the public as
currency, is a part of the money supply. Moreover,
base money not held by the public as currency
flows into commercial banks and other depository
institutions and provides these institutions with
reserves. Therefore, increases or decreases in the
monetary base tend to add to or subtract from the
reserves of the financial system. With higher or
lower reserves, financial institutions tend to ac-
quire larger or smaller portfolios of loans and
investments, thereby creating a larger or smaller


1 Various concepts of the monetary base have been used. The
concept used in this article is sometimes referred to as the
"source base." It is defined as deposits of private financial
institutions (mainly member banks) at Federal Reserve Banks
plus Federal Reserve and Treasury currency held by financial
institutions and the public.


money supply. The money supply then is positively
related to and partly determined by the monetary
base. For example, when the Federal Reserve
buys U.S. Government securities to increase the
monetary base, the rise in the base tends to in-
crease bank reserves. The increase in reserves
tends to result in an increase in the money supply.
Another factor providing the Federal Reserve
some control over money is the System's authori-
ty to establish and alter reserve requirements on
deposits at member banks. Reserve requirements
contribute to monetary control in two ways. First,
changes in reserve requirements tend to produce
changes in the money supply. For example, a
reduction in requirements will increase the excess
reserves of the banking system and thereby tend to
result in a rise in the money supply. Second, the
level and structure of requirements affect the
magnitude of the impact on money of noncon-
trollable factors. This second aspect of the role
of reserve requirements is discussed in detail
later.

Noncontrollable Factors
There are a number of noncontrollable factors
that affect the money supply and tend to weaken
monetary control. One is shifts in the composition
of deposits. Compositional shifts affect the money
supply because such shifts affect the required
reserves ratio, which in turn affects the money
supply. The required reserves ratio, or simply the
r-ratio, is defined as the amount of reserves that
financial institutions are required to hold as a
per cent of the deposit component of the money
supply.2 An example of a compositional shift that


2 The deposit component of the money supply depends on the
definition of money. For the narrowly defined money supply,
Ml, the deposit component consists of demand deposits at com-
mercial banks other than interbank and U.S. Government
deposits. For the M2 definition of money, the deposit com-

ponent consists of the deposit component of M1 plus time and
savings deposits at commercial banks other than large nego-
tiable CD's. For M3, the deposit component consists of the
deposit component of M2 plus deposits at savings and loan
associations, mutual savings banks, and credit unions. Theo-
retically, deposits of these nonbank institutions at commercial
banks should be excluded from the deposit component of M3.










affects the r-ratio is a shift out of demand deposits
at member banks and into demand deposits
at nonmember banks. Since nonmember bank
deposits are not subject to reserve requirements
set by the Federal Reserve, this shift will reduce
required reserves and, therefore, reduce the r-ratio.
The required reserves ratio affects the money
supply by influencing the volume of resources that
banks allocate to idle balances. In this way,
the r-ratio affects the volume of loans and
investments that banks hold, which in turn in-
fluences the money supply. For example, if the
r-ratio is high, banks will be required to main-
tain relatively large idle balances. Therefore,
the volume of loans and investments that banks
can acquire will be small. In turn, the small volume
of loans and investments will tend to produce a low
money supply. The money supply then is inversely
related to the r-ratio. Thus, shifts in the composition
of deposits that cause the r-ratio to decline such
as shifts out of demand deposits at member
banks and into demand deposits at nonmember
banks will cause the money supply to increase.
By the same token, shifts that cause the r-ratio to
increase will lead to a decline in the money supply.
An additional noncontrollable factor that affects
the money supply is the excess reserves ratio, or
the e-ratio. The e-ratio is the volume of excess
reserves held by financial institutions as a per
cent of the deposit component of the money supply.
Excess reserves are reserves held in excess of
required reserves.3 The e-ratio affects the money
supply in the same manner as the r-ratio. That is,
a high e-ratio means that financial institutions
maintain large idle balances and low portfolios of
loans and investments. Thus, the money supply is
inversely related to and partly determined by
the e-ratio.
A third noncontrollable factor affecting the


3 For the Ml and M2 definitions of money, excess reserves
include excess reserves of member banks plus base money
(currency and deposits at Federal Reserve Banks) held by
nonmember banks. For M3, excess reserves consist of excess
reserves for M2 plus any base money held by nonbank finan-
cial institutions.


money supply is the currency ratio, or c-ratio.
This ratio is defined as the amount of currency
held by the public as a per cent of the money
supply.4 The c-ratio influences the money supply
because it affects the total reserves financial
institutions have available. That is, if the c-ratio
is high, publicly held currency will be high and the
amount of base money that is available for re-
serves will be low. Thus, the money supply is
inversely related to and partly determined by the
c-ratio. For example, suppose the c-ratio is 25 per
cent and the money supply is $250 billion, so that
the volume of currency held by the public is $62.5
billion. Now suppose the public wishes to increase
its c-ratio to 30 per cent. Since the public now
wishes to hold $75 billion rather than $62.5
billion in currency, the public will increase its
currency and decrease its deposits by $12.5
billion. The decline in deposits will result in
a decline in bank reserves. Banks will respond
to the decline in their reserves by reducing their
holdings of loans and investments, which in turn
will result in a further decline in deposits and in a
drop in the money supply. Thus, an increase in
the c-ratio will tend to result in a decline in the
money supply.

Determinants of the Money Supply
In summary, the money supply is affected by
the monetary base and the r-, e-, and c-ratios.
The precise relationship between the money supply
and its determinants may be stated as a formula:5

M= B
r+e+c(l-e-r)
The letters in the formula are defined as follows:
M =money supply.
B =monetary base.



4Currency held by the public consists of currency outside
commercial banks (other than any currency held by U.S.
governmental agencies). For M3, currency held by the public
should theoretically exclude currency held by nonbank
financial institutions.
5 The formula is general and holds for any definition of money.
A particular formula may be derived for each definition.










r = r-ratio = required reserves as a per cent of the
deposit component of the money supply.
e = e-ratio = excess reserves as a per cent of the
deposit component of the money supply.
c =c-ratio = currency held by the public as a per
cent of the money supply.


That part of the formula containing the three
ratios is known as the money multiplier, which
may be represented by the letter m. Then,
m=l/[r+e+c(1-e-r)] and M=Bm. For ex-
ample, suppose the r-ratio is .15, the e-ratio
is .05, and the c-ratio is .25. In this case, the
value of the multiplier is 2.5 and the money
supply is equal to 2.5 times the base. That is:
1
M=Bm=B)
r+e+c(l-e-r)
1
=B- =B (2.5).
B .15+.05+.25(1-.05-.15) B

The formula for the money supply may be
used to illustrate the extent that the Federal
Reserve can control money as well as the way
that noncontrollable factors weaken mone-
tary control. Suppose the multiplier is 2.5
during some month and the Federal Reserve
wants the money supply to equal 250 in the
following month. If the three ratios do not
change, the Federal Reserve can completely
control money by taking action to establish
the base at 100, so that M=Bm= 100(2.5)=250.
Even if the ratios change, the Federal Re-
serve can completely control money if the
changes in the ratios can be predicted. For
example, suppose the c-ratio increased to .30.
The rise in the c-ratio will reduce the multiplier
to 2.27 and tend to reduce the money supply
below 250. If the increase in the c-ratio can be
predicted, though, the monetary base can be in-
creased above 100 precisely enough to offset the
impact of the rise in the c-ratio. The base would
need to equal 110, so that M=Bm=110(2.27)=
250. However, to the extent that the change in the
c-ratio cannot be predicted, the Federal Reserve
cannot determine the precise level of the monetary


base that will result in the money supply being
equal to 250.
The degree of precision, then, in the Federal
Reserve's control over money depends on the
magnitude of unpredictable changes in the non-
controllable factors and the extent that such
changes affect the money supply. The extent
that money is affected by changes in noncon-
trollable factors depends partly on the level
and structure of reserve requirements.


THE LEVEL OF
RESERVE REQUIREMENTS AND
MONETARY CONTROL
The level and structure of reserve require-
ments, then, affects the Federal Reserve's ability
to control the money supply. The level of require-
ments refers to the general level of require-
ments on all types of deposits, while structure
refers to the relative levels of requirements
on different types of deposits.
Monetary control is affected by the level of
requirements because, in the first instance, re-
quirements help determine the size of the r-ratio.
That is, high or low requirements produce a high
or low r-ratio. Secondly, the r-ratio's size affects
the impact on money of changes in the noncon-
trollable currency ratio and excess reserves ratio.
Alterations in these ratios lead to small changes in
money when the r-ratio is high and to large changes
in money when the r-ratio is low. In other words,
the impact of changes in the e- and c-ratios varies
inversely with the size of the r-ratio.
The impact on money of changes in the
currency ratio varies inversely with the level of
requirements because when the r-ratio is high,
alterations in the c-ratio produce small alterations
in the excess reserves of financial institutions.
For example, suppose the public decides to in-
crease its c-ratio by augmenting its currency hold-
ings and reducing its deposits, that is, by with-
drawing currency from banks. The currency out-
flow will reduce the reserves of the banking
system, with a portion of the decline occurring in













Table 1
THE LEVEL OF THE r-RATIO AND
CHANGES IN THE c-RATIO
AN ILLUSTRATION


r-ratio
e-ratio
c-ratio
Multiplier (m)
Monetary base (B)
Money supply (M=Bm)

Currency (C=cM)
Deposits (D=M-C)
Required reserves (R= rD)
Excess reserves (E=eD)

Currency outflow
Decline in required reserves
Decline in excess reserves
Decline in money supply


Case 1
r-ratio=.15
Initial Subsequent
Position Position
(c=.25) (c=.30)
.15 .15
.05 .05
.25 .30
2.50 2.27
100.0 100.0
250.0 227.3


62.5
187.5
28.1
9.4


68.2
159.1
23.9
8.0


Case 2
r-ratio=.20
Initial Subsequent
Position Position
(c=.25) (c=.30)
.20 .20
.05 .05
.25 .30
2.29 2.11
109.4 109.4
250.0 230.2


62.5
187.5
37.5
9.4


69.1
161.2
32.2
8.1


excess reserves and the remainder in required
reserves reflecting the drop in deposits asso-
ciated with the outflow. The decline in required
reserves will be large if the r-ratio is high. Thus,
if the r-ratio is high, a given outflow of currency
from banks (that is, a given increase in the c-ratio)
will produce a small drop in the excess reserves of
banks. The small decline in excess reserves, in
turn, will lead to a small decline in loans and
investments, in deposits, and in the money supply.
The role of the level of reserve requirements
in affecting the impact of changes in the c-ratio
may be illustrated further by using the formula
for the money supply. In Table 1, two cases dif-
ferent only with regard to the r-ratio are ana-
lyzed and compared. In case 1, the r-ratio is assumed
to equal .15, that is, reserves must equal at least
15 per cent of deposits. In case 2, the r-ratio is
assumed to equal .20. In all other aspects the


cases are similar. It is assumed that the Federal
Reserve wants the money supply to equal 250, and
initially money is 250. In addition, the e-ratio
is assumed to be .05, and the c-ratio is assumed
initially to equal .25 and then unexpectedly to
increase to .30.
In case 1, the multiplier initially is 2.5. Given
this value of the multiplier, the Federal Reserve
establishes the money supply at 250 by taking
action to establish the monetary base at
100[M=Bm=100(2.5)=250]. A subsequent in-
crease in the c-ratio from .25 to .30 reduces the
multiplier from 2.5 to 2.27. The currency outflow
from banks is 5.7, required reserves decline 4.3,
so that the drop in excess reserves is 1.4. Since
the rise in the c-ratio was not predicted, the
Federal Reserve maintains the base at 100 and the
money supply declines to 227.3 or by 22.7.
In case 2, which assumes a higher r-ratio, the










initial value of the multiplier is 2.29. Thus, the
Federal Reserve can establish the money supply at
250 by setting the base at 109.4. The subsequent
rise in the c-ratio to .30 reduces the multiplier to
2.11. Excess reserves decline 1.3 and the money
supply falls by 19.8. The decline in excess reserves
and in the money supply is less in case 2 than in
case 1 because the r-ratio is high. Put another way,
the deviation of the money supply from the desired
level is less when the r-ratio is high. Therefore,
high reserve requirements tend to enhance


6 The lagged reserve accounting system that is now in opera-
tion is a technical factor that should be considered in an analysis
of the impact on monetary control of reserve requirements.
Under this system, required reserves during any statement week
are based on the level of deposits 2 weeks earlier. For this
reason, noncontrollable factors, such as changes in the currency
ratio, do not affect required reserves during the week they occur.
Instead, the immediate impact of these changes is felt entirely
in excess reserves. For example, a change in the currency ratio
that results in a $1 currency outflow would produce a $1 de-
cline in excess reserves in the week the outflow occurs. Two
weeks later, however, the outflow would produce a decline in
required reserves. The lagged decrease in required reserves
would be accompanied by a rise in excess reserves that would
offset part of the original $1 decline. The eventual net drop in
excess reserves would be the same under the lagged as under a
nonlagged system. In both cases, furthermore, the eventual
impact would depend on reserve requirements.
Theoretically, lagged reserve accounting could prevent
reserve requirements from affecting monetary control. That is
because, under the lagged system, a change in noncontrollable
factors would have the same immediate impact on excess re-
serves whether reserve requirements are high or low. For this
reason, requirements might not affect the immediate portfolio
response of banks to changes in noncontrollable factors. Further-
more, while requirements would affect the eventual impact of
noncontrollable factors on excess reserves and bank portfolio
adjustments, the lagged system could allow the eventual impact
to be predicted and offset by Federal Reserve action. Thus,
lagged reserve accounting could prevent the level and structure
of reserve requirements from having any effect on the Federal
Reserve's ability to control money.
In practice, however, reserve requirements undoubtedly do
affect the immediate portfolio response of banks to changes in
noncontrollable factors. The reason is that banks, in making
portfolio adjustments, are likely to consider the impact of im-
mediate changes in noncontrollable factors on their eventual ex-
cess reserves. Since reserve requirements, under the lagged
system, would affect the eventual impact on excess reserves,
requirements would likely affect immediate portfolio adjust-
ments. If so, the Federal Reserve's ability to control money
would be affected by the level and structure of reserve require-
ments.


monetary control when the source of imprecision
of control is changes in the c-ratio.6
The role of reserve requirements in affecting
the impact on money of changes in the excess
reserves ratio is similar to requirements' role in af-
fecting the impact of changes in the c-ratio. That is,
the magnitude of the impact on money of changes
in the e-ratio varies inversely with the level of
requirements. This statement could be illustrated
by using the formula for the money supply, and the
illustration would be similar to that in the preceding
paragraph. It would show that unpredicted
changes in the e-ratio cause small changes in the
money supply when the r-ratio is high and large
changes in money when the r-ratio is low.
In summary, then, high reserve requirements
tend to enhance monetary control when the
imprecision of control results from unpredicted
changes in the e- and c-ratios.

THE STRUCTURE OF
RESERVE REQUIREMENTS AND
MONETARY CONTROL
The Federal Reserve's ability to control
money is affected by the structure as well as the
level of reserve requirements. The structure of
requirements may refer to the relative levels of
requirements on different types of deposits in-
cluded in the definition of money. Alternatively,
structure may refer to the level of requirements on
included deposits relative to the level on excluded
deposits. Both types of structure affect monetary
control by affecting the impact on money of various
shifts in the composition of deposits.

Structure with Regard to Included and
Excluded Deposits
The structure of requirements with regard to
included and excluded deposits affects the
impact on money of shifts between included and
excluded deposits. These compositional shifts have
their impact on money through the r-ratio, as may
be seen by the following formula:
r=rn + rxg,
where









rn = reserve requirements on included deposits,
rx = reserve requirements on excluded deposits, and
g-ratio = the ratio of excluded to included deposits.

In the context of the formula, a shift in the
composition of deposits between included and
excluded deposits is reflected as a change in the
g-ratio. Changes in the g-ratio cause changes in the
r-ratio which lead to alterations in the money supply.
A given change in the g-ratio will have a
relatively small impact on money when the level of
requirements on excluded deposits is low rela-
tive to requirements on included deposits. In
other words, the g-ratio's impact on money
varies directly with the size of rx relative to that
of rn. That is because a given change in the
g-ratio will result in a relatively large change in
excess reserves if requirements on excluded
deposits are low relative to requirements on
included deposits.
For example, suppose the public decides to
alter the composition of its deposits by in-
creasing its time deposits, which are excluded
from Ml, and reducing its demand deposits,
which are included in Ml. Initially, this change
in the g-ratio will reduce Ml. However, part of the
initial drop in Ml will tend to be offset because
the rise in time and decline in demand de-
posits will reduce required reserves and increase
excess reserves. Excess reserves will increase
by a large amount if requirements on time deposits
are low relative to requirements on demand
deposits. The large rise in excess reserves will
encourage a large increase in loans and invest-
ments, leading in turn to a large increase in the
money supply. The large increase in the money
supply will offset a large part of the initial drop
in money due to the rise in the g-ratio. The
Federal Reserve's control over Ml, therefore, is
enhanced by low reserve requirements on
time deposits relative to requirements on de-
mand deposits.
In general, control over any definition of
money is enhanced by low requirements on
deposits excluded from the definition of money


relative to requirements on deposits included in
the definition of money.
Structure with Regard to Different Types
of Included Deposits
Monetary control also is affected by the
structure of reserve requirements with regard to
different types of deposits included in the
money supply. The impact on money of shifts
among included deposits varies inversely with
the degree of uniformity of requirements on
various types of included deposits. That is be-
cause shifts among included deposits have a small
impact on excess reserves when the degree of
uniformity is high.
For example, suppose the public shifts out of
demand deposits at member banks and into
demand deposits at nonmember banks. Since
both types of deposits are included in Ml,
initially the shift will not affect Ml. Subsequently,
however, Ml will tend to rise because the shift
will reduce required reserves and increase excess
reserves. That is because requirements on deposits
at member banks exceed the requirements on
deposits at nonmember banks. Excess reserves
would not be affected if member and nonmember
banks were subject to uniform requirements.
Thus, control over any definition of money is
enhanced by uniform reserve requirements on
deposits included in the definition of money.

MONETARY CONTROL AND EXTENDING
RESERVE REQUIREMENTS
The impact of monetary control of extending
reserve requirements beyond member banks
depends on many factors. One important factor
is the nature of the extension. For example,
extending requirements on demand deposits of
nonmember banks would have different con-
sequences than extending requirements on
deposits of nonbank financial institutions. Also,
the level of the new requirements would have
implications for monetary control. In addi-
tion, control would be affected if requirements on
member banks were simultaneously altered.
Another important factor is the relative impor-









tance of the different noncontrollable factors that
weaken the Federal Reserve's control over money.
A particular extension of requirements may en-
hance or weaken the System's ability to control
money, depending on whether alterations in the
currency and excess reserves ratios or shifts in
the composition of deposits are more important in
contributing to imprecision of monetary control.
The definition of the money supply that is to be
controlled is another factor that must be con-
sidered in analyzing the impact on monetary
control of extending reserve requirements. A
particular extension may enhance control over one
definition of money and weaken control over
another definition.

An Illustration: Extending Reserve
Requirements to Demand Deposits of
Nonmember Banks
The impact of these various factors may be
illustrated by tracing out the effect on monetary
control of extending reserve requirements in
various ways. Suppose, for example, that re-
quirements were extended to the demand de-
posits of nonmember commercial banks and
that such requirements did not exceed current
requirements on demand deposits of member
banks. The Federal Reserve's control over Ml,
which consists of publicly held currency plus
demand deposits at commercial banks, would
likely be enhanced by an extension of this nature.
Such an extension would increase the r-ratio
for M1 and would, thereby, reduce the impact on
Ml of changes in the currency ratio and in the
excess reserves ratio.
Some observers have argued, in effect, that
an extension of reserve requirements to non-
member banks would not increase Mi's r-ratio.
According to this argument, nonmember banks
would use their correspondent balances they now
hold at member banks to satisfy their reserve
requirements. In other words, nonmember
banks would transfer deposits they hold at member
banks to Federal Reserve Banks. The reduction in
deposits at member banks would reduce the re-


quired reserves of member banks. It is argued, in
effect, that this reduction in the required reserves
of member banks would offset the increase in
the required reserves of nonmember banks, so
that total required reserves and, therefore, Mi's
r-ratio would remain unchanged. The argument
is not valid, however, because the decline in the
required reserves of member banks would be
only a fraction of the amount that nonmember
banks transferred to the Federal Reserve in
satisfaction of their new reserve requirements.
Thus, an extension of reserve requirements to
nonmember banks would increase the r-ratio
for Ml.
An extension of reserve requirements to the
demand deposits of nonmember banks, in addi-
tion to reducing the impact of changes in the
currency ratio, also would reduce the impact on
Ml of shifts in the composition of deposits. (See
Table 2.) For example, the extension would in-
crease the degree of uniformity of requirements
on demand deposits of member and nonmember
banks. Since both types of deposits are included in
Ml, an increase in the degree of uniformity of
requirements would reduce the impact on Ml of
shifts between the two types of deposits. Also,
an extension of requirements to nonmember bank
demand deposits would increase the requirement
on such deposits relative to the requirement on
various types of time deposits. Since nonmember
bank demand deposits are included in M1 and time




SWhile Mi's r-ratio would increase, an extension of reserve
requirements to nonmember banks could possibly fail to re-
duce the impact on Ml of changes in the currency ratio. This
would occur if nonmember banks would use their vault cash to
satisfy their reserve requirements. In this case, the excess re-
serves ratio would decline and offset the increase in the r-ratio,
so that the sum of the r-ratio and e-ratio would remain un-
changed. Therefore, the size of the c-ratio relative to the size
of the r- and e-ratios combined would remain unchanged. If
this occurred, the impact of changes in the c-ratio on Ml would
remain unchanged. Therefore, an extension of reserve re-
quirements to the demand deposits of nonmember banks would
reduce the impact of changes in the c-ratio only if such require-
ments were high enough so they could not be satisfied with
vault cash.












































deposits are excluded, an increase in the relative
level of requirements on nonmember demand
deposits would reduce the impact on Ml of
shifts between the two categories of deposits.
The Federal Reserve's control over M2 and M3
would be enhanced in some ways and weakened in
others by an extension of reserve requirements to
the demand deposits of nonmember banks." Con-
trol would be enhanced because the extension
would increase the r-ratios for these money supply
measures and, thereby, reduce the impact on them
of changes in the currency and excess reserves
ratios. Also, the extension would reduce the
impact on M2 and M3 of shifts between mem-
ber and nonmember bank demand deposits.
In addition, the effect on M2 of shifts between
demand deposits at nonmember banks and time


deposits at nonbank financial institutions would
be reduced.
Monetary control over M2 would be weakened
when the source of imprecision is shifts be-
tween demand and time deposits at nonmember
banks. The impact on M2 of shifts between these
two types of deposits would be increased because
both types are included in M2 and the extension
would decrease the degree of uniformity of re-




8 M2 is defined as M1 plus time and savings deposits at com-
mercial banks other than large negotiable certificates of deposit.
M3 is defined as M2 plus deposits at savings and loan associa-
tions, mutual savings banks, and credit unions. Theoretically,
M3 should exclude deposits of nonbank institutions at com-
mercial banks.


Table 2
IMPACT ON MONETARY CONTROL OF
EXTENDING RESERVE REQUIREMENTS
AN ILLUSTRATION

Requirements extended to:

Demand Deposits of Demand and Time Deposits of Non-
Sources of Imprecision in Nonmember Banks members & Time Deposits of Nonbanks
Monetary Control M1 M2 M3 M1 M2 M3
Changes in e- and c-ratios improve improve improve improve improve improve
Compositional shifts:
Among commercial bank deposits:
Demand deposits, member and
demand deposits, nonmember improve improve improve improve improve improve
Demand deposits, member and
time deposits, nonmember no impact no impact no impact weaken improve improve
Demand deposits, nonmember
and time deposits, nonmember improve weaken weaken no impact no impact no impact
Demand deposits, nonmember
and time deposits, member improve uncertain uncertain improve improve improve
Time deposits, member and
time deposits, nonmember no impact no impact no impact improve improve improve
Between time deposits of nonbanks
and:
Demand deposits, member no impact no impact no impact weaken weaken improve
Demand deposits, nonmember improve improve weaken no impact no impact no impact
Time deposits, member no impact no impact no impact improve weaken improve
Time deposits, nonmember no impact no impact no impact no impact no impact no impact










quirements on them. For the same reason, the ex-
tension would increase the impact on M3 of
shifts between demand deposits at nonmember
banks and both time deposits at nonmember
banks and time deposits at nonbank financial
institutions. Thus, the net impact on M2 and M3 of
extending reserve requirements to the demand
deposits of nonmember banks would depend on
the relative importance of various shifts in the
composition of deposits as well as of changes in
the currency and excess reserves ratios in con-
tributing to imprecision in monetary control.

Another Illustration: Extending Reserve
Requirements to Nonmember Banks and
Nonbanks
For an additional illustration, suppose
reserve requirements were extended to demand
deposits at nonmember banks and to time
deposits at these banks and at nonbank financial
institutions. Suppose further that the
new requirements were uniform with regard to
all types of deposits. An extension of require-
ments in this way would likely enhance the
Federal Reserve's ability to control the M3 defini-
tion of money. M3's r-ratio would be increased so
that the impact on M3 of alterations in the e- and
c-ratios would be reduced. Also, the extension
would reduce the impact on M3 of certain shifts
in the composition of deposits. For example,
the extension would increase the degree of uni-
formity of requirements on deposits at member
banks and deposits at nonbank financial insti-
tutions. This would reduce the impact on M3
of shifts between these two types of deposits
because both types are included in the definition
of M3. (See Table 2.)
The impact on the M1 and M2 definitions of
money of a uniform extension of reserve re-
quirements is less certain than in the case of
M3. In some ways, the Federal Reserve's ability
to control Ml and M2 would be enhanced. Bet-
ter control would occur in that the r-ratios of
M1 and M2 would be increased so that the impact
on these measures of alterations in their e- and


c-ratios would be reduced. In addition, the
impact of certain compositional shifts would be
lowered. For example, the extension would in-
crease the degree of uniformity of requirements
against demand deposits at both member banks
and nonmember banks. This would reduce the
impact on Ml and M2 of shifts between these
types of deposits because both types are included
in the definition of both measures.9
In other ways, the uniform extension of re-
serve requirements would reduce the Federal
Reserve's ability to control M1 and M2. Con-
trol would be weakened in that the impact on
these measures of certain compositional shifts
would be increased. For example, a uniform
extension of reserve requirements would increase
requirements on deposits at nonbank institu-
tions relative to requirements on demand de-
posits at member banks. Since deposits at non-
banks are excluded from Ml and M2 and demand
deposits at member banks are included in both
measures, the extension would increase the im-
pact on Ml and M2 of shifts between these two
categories of deposits.
Thus, the net impact on the Federal Reserve's
ability to control Ml and M2 of a uniform exten-
sion of reserve requirements to nonmember
banks and to nonbanks would depend on the rela-
tive importance of various sources of impre-
cision of monetary control. If changes in the e-
and c-ratios and certain compositional shifts -
such as shifts between demand deposits at mem-
ber and nonmember banks are important,
control over Ml and M2 would be improved.
However, if other compositional shifts such
as shifts between demand deposits at member




9 It may be maintained that certain deposits at nonbanks, such
as NOW accounts at some mutual savings banks, probably
should be included in both M1 and M2. An extension of require-
ments to these kinds of deposits likely would strengthen
the Federal Reserve's ability to control Ml and M2 defined
to include these kinds of deposits.




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