The Demand for Money

The text describes the first link in the transmission mechanism from the perspective of the credit market, that is, in terms of an increase in bank loans and investments that causes interest rates to fall-at least initially. There is, however, an alternative way to tell this story, which is to look at what happens to the supply of money-the total amount of cash balances held by the public. The increase in bank loans and investments is funded, among other ways, by banks creating new deposits, that is, by an increase in the supply of money circulating in the economy. Thus the fall in interest rates as banks expand loans and investments is associated with an increase in the supply of money to the economy. By the same token, a smaller stock of money is associated with higher interest rates.

This behavior is consistent with what economists know about the way the public manages its cash holdings. Currency and checkable deposits either do not pay interest at all, or pay rates that for the most part are below market yields. keeping part of one's funds tied up in money therefore is expensive because it means foregoing a market yield on those funds. For that reason, businesses and households try to get by with lower cash balances when market rates of interest are high, and they are willing to keep larger amounts of money on hand when interest rates are low.

Economists call the amount of cash balances businesses and households want to hold the economy's demand for money. As we have just noted, this demand for money has been observed to be negatively related to market interest rates. That is, the higher are market rates, the lower is the amount of cash balances the public wants to hold, or, as economists would say, the lower is the quantity of money demanded by the public. By the same token, low interest rates mean a higher demand to hold money.

This negative relationship between money demand and interest rates means that an increase in the amount of money circulating in the economy-in the supply of money in other words-should lower interest rates, because if it did not, the public would find itself holding money in excess of what it wants to hold or "demand." The process by which rates are lowered has already been described: the new money is lent out by banks, adding to credit availability in the economy and causing interest rates to fall. Conversely, a lower supply of money means tighter credit and higher interest rates.

If this money demand relationship is consistent over time (economists would say, if it is a "stable" relationship) monetary policy can be formed in terms of money supply targets. If the Fed wants to be more restrictive, for example, it can set lower targets for the monetary aggregates because it can expect interest rates to rise and total spending in the economy to be dampened when these targets are hit. Conversely, it could expect higher targets for money to have an expansionary impact on the economy.

Events in recent years have raised the question of whether the economy's demand for money can in fact be known with any degree of precision. In the mid-1970s, for example, historically high interest rates combined with new and cheaper computer technology prodded banks and their customers into adopting new techniques for managing cash balances. Those "financial innovations," as they came to be called, allowed the public, especially businesses, to make everyday transactions with significantly lower holdings than before. With the benefit of hindsight, it is now possible to calculate fairly accurately the decline in the economy's demand for money during that episode. However, it was not nearly as obvious at the time. For that matter, when the episode began it was not certain that any adjustment to financial innovations was taking place; nor was it clear later on when the transition period would end. Because of these uncertainties, it was difficult for the Fed to calculate the target for money growth that would take account of both its goals for the economy and the changing cash needs of the public.

Roughly coinciding with the rapid changes in cash management practices was a proliferation of new types of liquid financial instruments and deposits, such as money market mutual funds, NOW (Negotiable Order of Withdrawal) and Super-NOW accounts, and money market deposits accounts. These developments raised two major concerns: first, that the existing definitions of money were outmoded and therefore no longer useful as guides to making policy; second, that these new types of deposits would alter the public's demand for money because their features differed from those of existing forms of money. For example, new types of checkable deposits, such as NOW accounts, paid interest while traditional checking accounts did not. NOW accounts provide households with a more attractive way of holding their money and, therefore, could be expected to raise their demand for money.

The Federal Reserve responded to the first concern by implementing a major redefinition of the monetary aggregates in February 1980. To address the second concern, the System attempted to assess the impact of the new accounts on money demand, and to "adjust" the figures for money to take into account the change in the public's preferences for cash balances. Thus, in 1981, the Federal Reserve estimated that the nationwide introduction of NOW accounts raised the public's demand for money because now they could hold the funds in interest-bearing accounts. The actual growth in money of 5.1% for 1981 was accordingly adjusted downwards to 2.2% in recognition that part of the growth in money during the year was simply to accommodate the public's increased preferences for money. In other words, the adjusted figure was a more accurate gauge of the impact of monetary policy on the economy.

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