 Ask
Dr. Econ
February 2005
How does the Fed determine interest rates to control the money supply?
Your question highlights a common misconception about how the Fed conducts
monetary policy. For a period of time, the Fed did in fact implement
monetary policy by controlling the monetary aggregates (the quantity of
money). However, developments in the financial services industry, changes
in the relationship between the money supply and the economy,
as well as changes in views on monetary policy, eventually led to the
Fed reverting back to implementing monetary policy through changes in
interest rates (the price of money).
What are the monetary aggregates, and why does the Fed still care about
them?
Though the Fed no longer implements changes in monetary policy by controlling
the growth rate of the money supply, the monetary aggregates are still
monitored by economists as an indicator of future economic activity.
One measure of the money supply, real or inflation-adjusted M2, is classified
as a leading economic
indicator. In order from most narrow to most broad, the three
nominal monetary aggregates published weekly by the Federal Reserve Board
in the H.6 Release, Money
Stock Measures are:
- M1: The most liquid forms of money including currency in
the hands of the public, travelers checks, demand deposits, and other
deposits
against which checks can be written.
- M2: M1, plus savings accounts, time deposits of under $100,000,
and balances in retail money market mutual funds.
- M3: M2, plus large-denomination ($100,000 or more) time
deposits, balances in institutional money market mutual funds, repurchase
liabilities issued
by depository institutions, and Eurodollars held by U.S. residents
at foreign branches of U.S. banks and at all banks in the United Kingdom
and Canada.
When the money supply grows, consumers and businesses have relatively
more money in their hands with which to purchase goods and services.
Therefore, in theory, faster money supply growth should be associated
with faster economic growth after a short lag of perhaps two or three
quarters. However, many important changes in how financial assets are
held by the public have changed over time and the relationship between
money supply growth rates and the economy has deteriorated.
Why doesn’t the Fed still conduct monetary policy by controlling
the size of the monetary aggregates?
The Fed’s Purposes
and Functions (2005) publication describes the change
that has occurred over time in the relationship between monetary aggregates
and Gross Domestic Product (GDP):
“[T]he relation between the growth in money and the growth
in nominal GDP, known as ‘velocity,’ can vary, often
unpredictably, and this uncertainty can add to difficulties in using
monetary aggregates
as a guide to policy. Indeed, in the United States and many other
countries with advanced financial systems over recent decades, considerable
slippage
and greater complexity in the relationship between money and GDP
have made it more difficult to use monetary aggregates as guides
to policy.
In addition, the narrow and broader aggregates often give very different
signals about the need to adjust policy. Accordingly, monetary aggregates
have taken on less importance in policy making over time.”
Historical growth of money and the economy
Below is a simple comparison of the growth rates of the real M2 and
real growth rates of the U.S. economy; the gray bars represent periods
of recession as defined by the National
Bureau of Economic Research (NBER).
This graph illustrates how the relationship between money growth and
the economy has changed over time.
The chart displays the “before” period, when monetary policy
focused on the monetary aggregates, which ended in the mid-1980s, as
well as the “after” period, when the importance of monetary
aggregates as indicators of future economic performance diminished. From
1960 until the mid-1980s, each recession is preceded by a sharp decline
in the growth rate of real M2. However, in the period after the mid-1980s,
the correlation between the growth rate of real M2 and the economy is
much weaker.
Changing financial services
One of the key factors behind the change in the relationship between
money and the economy has been the significant changes in the financial
services industry over the years. New banking laws and the development
of new types of financial assets and products have blurred the distinctions
between balances counted in the monetary aggregates and other types of
financial assets. In short, these developments brought about significant
changes in the way people hold money and other types of financial assets.
For example, monitoring the monetary aggregates for clues to future economic
performance became much more difficult once savers could frequently and
cheaply shift between balances counted in M2 (like money market mutual
fund shares) and other financial balances that are not counted in the
money aggregates (such as mutual fund shares). Moreover, even the relationship
between the aggregates changed since the early eighties.
"Depositors moved funds from savings accounts—which are
included in M2 but not in M1—into [Negotiable Order of Withdrawal]
accounts, which are part of M1. As a result, M1 growth exceeded the
Fed's target
range in 1982, even though the economy experienced its worst recession
in decades. The Fed de-emphasized M1 as a guide for monetary policy
in late 1982, and it stopped announcing growth ranges for M1 in 1987.
By the early 1990s, the relationship between M2 growth and the performance
of the economy also had weakened. Interest rates were at the lowest
levels in more than three decades, prompting some savers to move funds
out of
the savings and time deposits that are part of M2 into stock and
bond mutual funds, which are not included in any of the money supply
measures."
Broken relationship between money and the economy
In July 1993, Federal Reserve Chairman Alan Greenspan testified before
Congress that the Fed would no longer use the monetary aggregates to
guide FOMC policy—in large part because the long-run relationship
between M2 and the economy had broken down.
"[I]f the historical relationships between M2 and nominal income
had remained intact, the behavior of M2 in recent years would have
been consistent with an economy in severe contraction.’ Chairman
Greenspan added, ‘The historical relationships between money
and income, and between money and the price level have largely broken
down, depriving
the aggregates of much of their usefulness as guides to policy. At
least for the time being, M2 has been downgraded as a reliable indicator
of
financial conditions in the economy, and no single variable has yet
been identified to take its place.”
Since the Chairman’s announcement in 1993, the relationship between
the growth rate of M2 and real GDP has remained weak.
Today, the Fed targets
the price of reserves—the federal funds
interest rate—to implement monetary policy. For more information
on how the Fed sets monetary policy today, see the Federal Reserve Bank
of San Francisco’s publication, U.S.
Monetary Policy: An Introduction.
For a historical account of changes in the Fed’s approach to
monetary policy over recent decades, see Dr.
Econ’s January 2003
posting.
“The
Money Supply,” Fedpoint, Federal Reserve Bank of
New York, January 2003.
Velocity
of money is commonly defined as the ratio of nominal gross domestic
product to money stock, or the rate at which money balances turn over
(or change hands) in a period of time relative to expenditures on goods
and services.
A larger velocity means that a given quantity of money
is associated with a greater dollar volume of transactions.
“The
Money Supply,” Fedpoint, Federal Reserve Bank of
New York, January 2003.
Ibid.
To
see how the Federal Reserve watches monetary trends, see the Federal
Reserve of St. Louis’ Monetary Trends publication.
Dr. Econ receives a lot of questions about the money supply. For previous
discussions, please see:
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