MONEY SUPPLY

MONEY: (FED Board of Atlanta) Every six weeks the FED meets to determine the near term course in monetary policy. The Federal Open Market Committee can adjust interest rates or bank reserves as it regards price stability, inflationary trends, etc. Although identified previously, here are the basic measures of money. Remember these, there will be a quiz.

M1= Currency

+ Demand deposits

Other checkable deposits, Including NOW, Super NOW, and ATS accounts, credit union share drafts

+ Travelers Checks of non bank users

M2= M1

+ Savings and small denomination time deposits at all depository institutions (including retail repurchase agreements)

+ Money market deposit accounts

+ General purpose and broker/dealer money market mutual funds shares (including tax exempt)

M3= M2

+ Large denomination time deposits at all depository institutions

+ Term repurchase agreements at commercial banks and thrifts

+ Institution only money market mutual fund shares (including tax exempt)

+ Term Eurodollar balances at depository institutions and MMMfs

+ Overnight repurchase agreements art commercial banks

+Overnight Eurodollar balances

Since the late 1970's the FED has been given the responsibility for maintaining an environment of low inflation and high employment- two difficult tasks. As stated, it normally uses the discount rate or bank reserves to make adjustments.

The money supply is impacted by the FED. If it wants to loosen money, it can buy securities from the public- hence putting more cash in their pocket. If it wants to reduce money, it can offer securities to the public and take money OUT of the system. It also can restrict or loosen the movement of money by increasing or decreasing interest rates and the reserve requirements at banks.

Most economists feel that the use of M-1 as a precursor of economic movement is now nil. Even the use of M-2 now is in doubt since the secular decline of depository financial institutions (DFI's) role in the credit market. Just for the record, below are the growth rates of M-1 & M-2 for the last decade. The last column shows how the DFI assets have dropped as a percentage of all intermediaries in the credit market.
Year M-1 M-2 DFI assets relative to all intermediaries
1982 8.85 9.1 56.1
1983 10.4 12.2 56.1
1984 5.4 8.0 56.6
1985 12.0 8.7 54.6
1986 15.5 9.2 52.6
1987 6.3 4.3 52.5
1988 4.4 5.2 51.6
1989 0.6 4.8 49.0
1990 4.2 4.0 47.6
1991 8.0 2.8 42.5





This simply makes the ability to gauge the potential of the economy all the more difficult.

How good is the M-2 barometer anyway? Maybe not that good since the FED Board of San Francisco 3/93 stated that deregulation and innovation in financial markets have loosened the long term relationship between money and income. Studies in the late 80's have shown an instability in previous M-2 relationships. They are suggesting that the spread between 6 month commercial paper and the 6 month Treasury bills rates are better indicators of economic activity. An increase in the paper bill spread was followed by a recession. The default rate of commercial paper goes up when a downturn in the economy is imminent, driving up its rate. Government backed bills however have no default and consequently the rates tend to widen just before a recession.

Generally, a 1% decrease in money growth yields a 1% decrease in inflation and nominal interest rates in the long run (though not immediately). The decrease in money supply reduces the amount of money available, raising interest rates and slowing the economy.

(The simplicity of the monetary prescription for lowering rates is lost when using an interest rate instrument, however. In order to slow inflation, the FED must first raise nominal interest rates, then lower them. An economist note that, "we cannot say with any confidence how much of an increase in rates is required to lower the inflation rate 1%." )

Since 1990, M-2 has grow more slowly than anticipated, relative to nominal GDP. However its velocity has increased markedly from its 1955- 89 average (about 1.65, FED Board of St. Louis). One widely held view is that the continuing upward stock and bond markets precluded the use of banks and money market funds as more and more families invested in these equity investments. But with the drop in both markets in 1994, economists thought a surge in M-2 would undoubtedly occur as families withdrew equity funds and deposited them in more traditional depositories. But this has NOT happened. It suggests- and this is the important part of all this commentary- that families may have permanently shifted assets into equities. In early 1995, this statement may be premature but does require recognition nonetheless as an indication of future projections. In late 1996, the funds are still actively being invested in equities, but that is probably more indicative of the continuing bull market than anything else.