Monetary Aggregates: Their Use in the Conduct of Monetary Policy

Report for Congress
Monetary Aggregates:
Their Use in the Conduct of Monetary Policy
May 15, 2002
Marc Labonte
Analyst in Economics
Gail Makinen
Specialist in Economic Policy
Government ans Finance Division

Congressional Research Service ˜ The Library of Congress

Monetary Aggregates: Their Use in the Conduct of
Monetary Policy
Economic theory and history make a compelling case that monetary policy is
powerful in affecting the pace of economic activity and employment in the short run
and the rate of inflation in the longer run. Thus, unambiguous indicators should exist
for those formulating, executing, and overseeing monetary policy. To this end,
definitions of money are sought, as are collections of assets consistent with those
definitions. For these measures of money – known as monetary aggregates – to be
useful in a policy context, they must, at a minimum, be stable and predictably related
to spending, meaning that when they are changed, the subsequent change in spending
can be closely predicted. If they meet that test they can provide information about
the current posture of monetary policy. Should they be under the control of the
Federal Reserve (Fed), they may be useful as intermediate target variables in the
execution of monetary policy.
The monetary aggregates constructed by the Fed are no longer stable and
predictably related to spending, although they once may have been. A vast number
of studies have sought to explain the reason for this sudden instability. Their
findings highlighted efforts by financial institutions to get around federal regulations,
structural changes related to economic development, the use of U.S. currency abroad,
and a number of one-time events such as the thrift crisis of the mid-1980s.
Accounting for these developments led to refinements of the existing aggregates,
development of new aggregates, and new measures of opportunity costs. At most,
this research suggests that the refined old and new aggregates can provide useful
information about future income growth, employment, and inflation. Several of the
aggregates, however, do not seem to be under the control of the Fed.
Were monetary aggregates to exist that were stable and predictably related to
spending and under the control of the Fed, their use in the conduct of monetary policy
would likely be controversial. Some economists, who see monetary instability as the
major cause of business cycles, favor a rule-based policy of increasing the aggregates
at a fixed percentage per year. Others, with different notions of the causes of cyclical
instability, tend to favor a discretionary approach to policy and monetary fine tuning.
If ideal monetary aggregates do not exist or are not under the control of the Fed
if they do exist, monetary policy can be formulated and executed in terms of interest
rates. However, the relevant interest rates for household and business spending
decisions are the real or inflation-adjusted rates. These rates can be affected by
actions of others in the economy in addition to the Fed and by developments abroad.
Thus, their movements may provide little information about monetary policy.
The oversight of monetary policy is handicapped by a lack of reliable, objective,
and unambiguous monetary indicators. This leads to the unhealthy situation in which
those responsible for overseeing monetary policy must rely heavily on the Fed to
provide them with an assessment of policy, which falls short of an arms length
assessment. This report will not be updated.

The Link Between the Monetary Aggregates and the Economy..............1
The Velocity of Money.............................................4
The Definition of Money............................................4
The Functional Definition of Money (M1)..........................5
Velocity Instability and the “Missing Money”....................8
The Role of M1 in the Conduct of Monetary Policy...................9
The Empirical Definition of Money (M2)..........................10
Does Either M1 or M2 Still Have A Role in Forecasting Economic Activity?..12
The Search for A Stable Velocity of Money............................15
Efforts to Explain the Instability of M1's Velocity...................15
Maintaining the Definition of M1............................16
Changing the Definition of M1..............................17
Summary ...............................................19
Efforts to Explain the Instability of M2's Velocity...................19
Adding Assets to M2......................................20
Reduced Transactions Costs................................20
Additional Opportunity Costs...............................20
The Thrift and Banking Crisis...............................21
Structural Changes........................................22
Summary ...............................................22
Other Efforts to Redefine Money.................................23
Uses of the Alternative Measures of Money in the Conduct of Monetary
Policy ..............................................24
The Conduct of Monetary Policy and the Money Supply..................25
Can the Federal Reserve Control the Money Supply?.................25
Rule-Based Monetary Policy and the Money Supply.................26
An Alternative to the Ms as an Indicator of Monetary Policy...........27
Consequences of Ambiguous Indicators for the
Conduct of Monetary Policy....................................29
Conclusions .....................................................30
Glossary: Definitions of the Aggregates...............................31
Additional Selected Readings.......................................32
List of Figures
Figure 1: Velocity of M1............................................6
Figure 2: The Yield on 3-Month U.S. Treasury Bills......................8
Figure 3: The Velocity of M2.......................................11

Table 1: Growth Rates of Gross Domestic Product and M2.................2

Monetary Aggregates: Their Use in the
Conduct of Monetary Policy
The Federal Reserve conducts monetary policy by buying and selling U.S.
Treasury securities. This action alters the reserves of financial institutions, primarily
commercial banks, which in turn alters the availability of money and credit in the
U.S. The ultimate goal of Fed activity is to influence aggregate spending in such a
way that full employment and a low and stable inflation rate prevail over time.1
In conducting monetary policy, the Federal Reserve has a choice of a target.
Since money spending involves money, it could buy and sell U.S. Treasury securities
with the objective of targeting the growth of the money supply. Alternatively, since
changes in money and credit affect spending largely through changes in interest rates,
it could target one or more of those rates directly simply by supplying whatever
money is needed to meet its target. It cannot target money growth and interest rates
simultaneously, however.
The discussion in this report concentrates primarily on targeting the money
supply to achieve such changes in money spending that the goals of full employment
and stable prices are met. In recent years, the Fed has targeted interest rates instead
of the money supply. An important reason for this choice, as discussed below, is the
unstable link between the money supply and money spending. Nevertheless, some
economists for several reasons continue to prefer targeting money growth, and seek
a stable measure of money as a means of furthering that goal.
The Link Between the Monetary Aggregates and the
There are few topics in economics as contentious as the role of money in
business cycles. There is no doubt that money and economic activity are highly
correlated. Table 1 sets out the nature of this relationship. The average rate of
growth of nominal gross domestic product (GDP) over the past four decades is
shown relative to the average growth of a popular measure of money known as M2,
which is defined in the glossary.
One cannot help but be struck by the close relationship between the two
variables over most of the period. Moreover, when the growth rate of real GDP is
subtracted from that of nominal GDP, the growth rate of M2 provides a good deal of
information about the rate of inflation. For example, over the period 1960-2000, M2

1For an overview of monetary policy, see CRS Report RL30354, Monetary Policy: Current
Policy and Conditions, by Gail Makinen.

grew at an average compound annual rate of 7.1% while real GDP grew at an average
compound annual rate of 3.5%. The difference, 3.6%, closely approximates the
average compound annual rate of growth of the implicit price deflator for GDP,
4.0%.2 Thus, the excess of M2 growth over real GDP growth seems to be highly
correlated with the inflation rate over this 40-year period.
Table 1: Growth Rates of Gross Domestic Product and M2
Time PeriodAverage Growth Rate ofAverage Growth
Nominal GDPRate of M2

1960-1969 7.2% 7.1%

1970-1979 10.6% 9.8%

1980-1989 7.8% 8.0%

1990-1999 5.3% 3.8%

Memorandum: 1995-20005.9%6.1%
Source: Board of Governors of the Federal Reserve; Bureau of Economic Analysis.
It is well known that correlation measures only the degree to which variations
in the two data series coincide. It does not necessarily imply anything about cause
and effect. Indeed, in terms of table 1, the contention among economists is whether
the changes in M2 cause the changes in nominal GDP or vice versa. The jury is still
out on this question and probably will never be able to render a verdict acceptable to
all parties. Nevertheless, the relationship of money to economic activity suggests two
possible roles that money might play in the formulation and execution of monetary
The first role is that of an intermediate target variable. In this role, the Federal
Reserve would manipulate the money supply or its growth rate to achieve such goals
as high employment, high real GDP growth, or low inflation. As far as inflation is
concerned, the information above suggests that a growth rate of M2 of about 3.5%
per year would yield a fairly stable price level (or low rate of inflation).
For M2 or any other measure of money to be used as an intermediate target, it
must be either directly or indirectly under the control of the Federal Reserve. For
much of the Federal Reserve era (after 1913), the money supply could not be
controlled. This was because the United States adhered to an international monetary
system that used fixed exchange rates. A central feature of fixed exchange rate
regimes is that monetary policy must be directed to maintaining the exchange rate.
As such, it cannot focus on manipulating the money supply in a way that is
inconsistent with that objective.

21960 is generally chosen as a base date for making comparisons because the money supply
data for earlier years are not quite compatible with the post-1959 data.

Since the early 1970s, however, the United States has participated in the
international monetary system on the basis of flexible exchange rates. Under this
system, central banks theoretically have great freedom in manipulating their
respective national money supplies. However, they do not have direct control over
that supply. Rather, they control the reserves that are available to depository
institutions, on the basis of which deposit money can be created.3 How much money
is created in any given period also depends on other factors. Important among these
are the preferences of the public for how it wishes to hold its money assets (in the
case of M2 this means currency, demand deposits, and various types of saving and
time deposits) and the actions of depository institutions that influence those
preferences. Also of some importance are the reserves that depository institutions
choose to hold relative to the various types of deposit liabilities outstanding (some
of these are legally imposed while others are voluntary). A more extensive
discussion on the ability of the Fed to control the money supply is given below.
Thus, the Federal Reserve does not have day–to–day control over the money
supply. Its control is only indirect and depends on the closeness of the relationship
of reserves to the various measures of money.
Even though a case can be made that the Federal Reserve has been able to use
the money supply as an intermediate target variable for the past 30 years or more, it
has apparently chosen not to do so.4 In recent years, this reluctance has been
associated with what has been called the "instability in the velocity or turnover rate
of money." While this topic is discussed below, what is involved can be gleaned
from table 1. The close relationship between money and nominal GDP, so evident
in the 1960–1989 period, is weaker in the 1990–1999 period. Clearly something
altered the relationship between M2 money growth and the growth in nominal GDP.
Nevertheless, for a considerable period of time the Federal Reserve reported to
Congress growth rate target ranges for various measures of money. This practice
may seem curious since manipulating these measures of money is not the objective
of monetary policy. One might even have questioned the usefulness of this exercise.
However, the data above do show that for much of the past 40 years money growth
has been closely related to both nominal GDP growth and the rate of inflation.
Even if causation runs from income growth to money growth, or if the Federal
Reserve cannot control the money supply, or it chooses not to control the money
supply, movements in the growth rate of the money supply might, nevertheless,
provide a good deal of useful information about some important performance
parameters of the economy. For example, the data above suggest that the growth rate

3Control over reserves is supplemented by control over the legal reserve obligations imposed
on these institutions (the obligations were differentiated by the type of deposits supplied by
these institutions) and by control over the discount rate which sets the cost to a depository
institution when it must borrow reserves from the central bank to make up any reserve
4During the period October 1979 to October 1982, the Federal Reserve appeared to use the
growth of M1 as an intermediate target. This episode is examined below.

of M2 has been a good predictor of (or source of information about) the future
growth of nominal GDP and the rate of inflation.
However, for money to be the preeminent informational variable, the close
relationship between it and various measures of economic performance must
continue. Although the conditions under which a measure of money serves as an
informational variable are less demanding than in its role as an intermediate target
variable (e.g., it does not have to be under the control of the Federal Reserve) its
usefulness in providing information diminishes in the absence of a close relationship
between it and, for example, aggregate spending. Thus, the emergence of “velocity
instability” which reduced the usefulness of money as an intermediate target variable
has also reduced its usefulness as a source of information about the current and
expected performance of the economy.
The Velocity of Money
While the amount of money in existence is an important determinant of the
amount of money spending that can or will take place, it is not the only factor. Also
of importance is the number of times each unit of money is spent during a given time
period. This spending or turnover rate of the existing amount of money is commonly
known as the velocity of money or the velocity of money's circulation.
These notions can be formalized in terms of a simple equation. Let the amount
of money in existence be symbolized by M, its velocity of circulation by V, and total
money spending by PY (where P is a price index and Y a measure of the quantity of
real goods and services). Then:
In order to calculate V (which is equal to PY/M), we need to be able to measure
both M and PY.
In theory, PY symbolizes total money spending on all goods, services, and
financial and real assets that takes place in an economy over a given time period.
Since measures of total spending do not exist, PY is often proxied by the nominal
value of GDP or some subdivision thereof such as net national product, national
income, personal income, etc. Given any measure of PY, the calculated value of V
will be different for different definitions of M (and, for each definition of M, V will
also differ for different measure of PY).
The Definition of Money
Providing a generally accepted definition of money has proven to be elusive.
Economists have taken several approaches to this task. The first has been what might
be called the traditional or functional approach. It starts by saying that “money is
what money does.” And money is any asset that simultaneously performs all four of

the basic functions of money: serving as a unit of account, medium of exchange,
store of value, and standard of deferred payment. A second definition holds that
money is a “temporary abode of purchasing power.” This definition seems to focus
on the store of value role stressed by the traditional definition. The role of each
definition in selecting a group of assets to call money is worth exploring for it
rationalizes the composition of assets included in M1 and M2.
The unit of account role is basic to money as it is the common denominator in
terms of which all goods, services, and assets can be expressed and their relative
values compared. In the case of the United States, the unit of account is the dollar.5
The medium of exchange role says that whatever is money must be the dominant
means used to make payments or effect exchange. The store of value role
emphasizes that money is a generalized means for holding wealth. The standard of
deferred payments means that money is used for writing contracts that require future
The Functional Definition of Money (M1)
The functional definition suggests that money consists primarily of those assets
that can be used to make transactions –– mainly paper currency (including coins) and
deposits against which checks can be drawn. This collection of assets corresponds
closely to what the Federal Reserve has defined, since 1980, as M1.
The M1 velocity of money is shown in Figure 1. It is calculated by letting the
nominal value of gross domestic product (GDP) serve as a proxy for total money
spending or PY. It is obvious from Figure 1 that the M1 velocity of money has not
been a constant. Throughout much of the post–1959 period it rose. Between 1959
and 1981, M1 velocity grew at a compound average rate of about 3.2%. It declined
from 1981 to 1994 and then began to rise. By 1997 it had surpassed its 1981 peak
and by 2001 it reached its highest value in the 1959-2001 period. Between 1997 and
2001, M1 velocity grew at an average compound rate of 3.6%, somewhat higher than
its average growth rate from 1959-1981.

5The dollar was originally defined as a given quantity of gold. Over time it has evolved into
an abstract measure. The unit of account role is common to all definitions of money since
we measure money using the dollar.

Figure 1: Velocity of M1
5 Ve
31959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999
Source: Federal Reserve
For M1 to be used as an intermediate target variable, as noted above, it must be
under the control of the Federal Reserve. Federal Reserve control in this case is
indirect because the composition of M1 is determined by the preferences of the
public. Fed control resides primarily in control over the reserves available to
depository institutions, and the evidence suggests that reserve growth is the major
determinant of the growth of M1.
Control, however, is not in itself sufficient for using M1 as an intermediate
target variable. Its velocity must be stable and predictable. This means that the
behavior of M1's velocity must depend on and be explained by, ideally, a few
variables. Knowledge about the value of these variables will allow monetary
authorities to predict the value of V. If the behavior of V depends on a large number
of variables, it would be regarded as less predictable even if it were stable. If
velocity is not stable and predictable, then control of M1 will not ensure control of
money spending. Moreover, its ability to function as an informational variable or its
usefulness as an indicator of the future performance of the economy will also be
compromised as the growth rate of M1 (or any M) may provide little information
about the subsequent growth of spending and the rate of inflation.
Does the behavior of M1 velocity shown on Figure 1 suggest that it is unstable?
After all, it rose continuously for more than 20 years and then, for the next 13 years,
it followed a pattern that moved downward in an erratic sort of way, to be followed
by 7 years of upward growth at an average rate not too different from the 1959-1981

This behavior need not indicate instability. To see why, the factor or factors
thought to determine how rapidly the public spends or turns over its money must be
explained. Economists have devoted considerable efforts to this task. A widely used
behavioral model was developed by Professors Baumol and Tobin.6 In their model,
money is held only to make transactions. How much is held comes to depend not
only on planned transactions, but on two other factors: the income lost by holding
money rather than some interest earning asset (the so–called opportunity cost of
money) and the brokerage fee or cost, both financial and physical (e.g., time and
inconvenience) incurred when the income earning assets are converted into money.7
In this model, as interest rates rise, individuals will hold less money relative to
transactions (velocity will rise). Similarly, any innovation that lowers the
transactions cost of converting income-yielding assets into money will also decrease
money holdings relative to transactions (velocity will rise).
As this model was originally estimated, economists believed that the income-
yielding asset most likely to be held in lieu of money was one that was short term and
highly liquid such as a (3-month) Treasury bill. If this is a correct choice, can the
yield on 3–month U.S. Treasury bills explain the behavior of M1's velocity? The
annual yield on these bills during the period 1958–2001 is recorded on figure 2. The
most noticeable feature of these data is that they trend upward reaching a peak in

1981 and, then record a general decline over the subsequent 13 years.

6William J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic
Approach,” Quarterly Journal of Economics, vol. 66, November 1952, pp. 545–556; and
James Tobin, “The Interest–Elasticity of Transactions Demand for Cash,” Review of
Economics and Statistics, vol. 38, August 1956, pp. 241–247. Note that the Baumol–Tobin
model explains money holding or money demand rather than velocity. This is a distinction
without a difference. If households and businesses are holding money balances equal to
1/5th of income or total spending, then the velocity of money must be 5 and any factor
which reduces desired money holdings must raise the velocity of money and vice versa.
7The seminal discussion of the determinants of velocity is Irving Fisher, The Purchasing
Power of Money (New York: MacMillan, 1911). In addition to foregone income, Fisher also
listed as determinants such factors as the frequency of payments, size of payments, certainty
of payments, the coordination of income and payments, the distribution of income among
classes, the state of confidence, the availability of credit, uncertainty about the future, etc.
These other factors are thought to have a longer run influence on the behavior of velocity.
For a recent discussion of the development of velocity in the history of economic thought,
see Thomas M. Humphrey, “The Origins of Velocity Functions,” Federal Reserve Bank of
Richmond Economic Quarterly, vol. 79, Fall 1993, pp. 1–17.

Figure 2: The Yield on 3-Month U.S. Treasury Bills
10h T-
6d on 3 Mont
21960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000
Source: Federal Reserve
At first glance it would appear that a compelling case could be made that the
behavior of M1's velocity is stable and is explained by the movement of the yield on

3–month Treasury bills. Unfortunately, looks can be deceiving.

The velocity pattern in Figure 1 demonstrates instability over the past 15 years.
To see why in a simple way, if the yield on 3–month T–bills explains M1's velocity,
the value of velocity in 1993 ought to be about the same as in 1963 because in each
year the T–bill yield was about the same. Velocity, however, was quite different in8
the 2 years: about 3.36 in 1960 versus about 5.42 in 1993. It is obvious that other
factors are at work influencing the turnover rate of M1.
Velocity Instability and the “Missing Money”. Much of the discussion
about the instability (or lack of predictability) of M1's velocity, to be reviewed below,
has been carried out in terms of the "missing money” rather than address instability
directly. This occurs because rather than talk about the velocity of M1 directly,
various authors have phrased their investigations in terms such as “given the level of
GDP and the opportunity cost of M1 in 1980 (for example), how much money should
the public have been holding in that year?” This predicted level was then compared
with the level the public was actually holding and the latter was found to be less than
predicted –– giving rise to the notion that money was missing. This is, however, just
another way of saying that M1's velocity was higher than predicted. A simple
example will explain why. If the public was making a given level of expenditures
in 1980 with less M1 than was predicted, the velocity of M1 must have been higher
than predicted. That is the only way this could happen. From our discussion above,

8This is not to suggest that the relationship was unstable over the entire period. Note, for
example, that the rise in interest rates between 1981–83 and 1985–88 was followed by a rise
in velocity, similarly for the fall over 1983–85.

M1's velocity in 1993 was about 5.4 whereas based on the level of the T–bill rate it
was predicted to be about 3.4. Thus, missing money implies a higher than predicted
The Role of M1 in the Conduct of Monetary Policy
The growing conviction by influential Members of Congress that the
acceleration in the inflation rate during the 1970s was caused by too much money (by
excessive money growth relative to the growth in real output) led in 1975 to a
resolution requiring the Federal Reserve to report its objectives for money growth.
Later, in 1978, this requirement was enacted into law in the Full Employment and
Balanced Growth Act (popularly known as the Humphrey–Hawkins Act).9
As inflation during the 1970s accelerated into double digits, the Federal
Reserve, under the leadership of Paul Volcker, announced in October 1979 new
operating procedures emphasizing the growth of nonborrowed reserves as a means
for controlling the growth of M1. Thus, M1 appeared to be elevated from an
informational variable to an intermediate target variable. Not only did M1 have the
desirable characteristic that its components were almost exclusively held to make
transactions, but its velocity also had a very small variation about its trend rate of
growth (remember that in 1979 only the rising portion of M1's velocity shown in
figure 1 was known).
Whether M1 was in fact elevated to this role is unclear. At about this same time
evidence began to accumulate that its velocity was unstable. In October 1982, as the
deepest economic downturn since the Great Depression of 1929–33 was nearing its
end, the Federal Reserve began to de-emphasize M1 in its deliberations. By July
1987, the instability in M1's velocity was so apparent that the Federal Reserve
announced at the Humphrey–Hawkins hearings that it would discontinue setting a
target range for M1 growth.
Thus, M1 may have been used briefly as an intermediate target by the Federal
Reserve. The instability in its velocity, however, diminished its usefulness as a target
variable and, ultimately, robbed it of much of a role as an informational variable.
Efforts to explain its instability will be reviewed below. In addition, during the
period October 1979–October 1982, when M1 may have been used as an
intermediate target variable, its growth rate on a quarterly basis was highly erratic,
and market interest rates were much more variable than during the period when they
were the focus of Federal Reserve policy (as might be expected). Why the erratic
behavior of M1 growth occurred is unclear. Nevertheless, because of these

9This conviction that inflation was caused by an excessive growth of money was influenced
by a similar conviction among an increasingly vocal number of economists. Known as
monetarists, they came to occupy an important place in the economics profession in the
1960s and 1970s and their central thesis that excessive money growth causes inflation
became a generally accepted view.

developments, money market participants were among those voicing disapproval of
Fed policy.10
The Humphrey-Hawkins Act also mandated the Fed to present semi-annual
reports to Congress. A central feature of these reports were growth rate ranges for
various measures of money and credit. Between the late 1980s and July 2000, the
Federal Reserve decided against setting monitoring ranges for the monetary
aggregates. Beginning in the early 1980s, the Fed decided to discontinue setting a
monitoring range for M1. In July 2000, a similar decision was made for the
remaining aggregates.
The instability in M1's velocity need not imply that monetary aggregates have
no role to play in the conduct of monetary policy. There are two other measures of
money, M2 and M3. The theoretical basis made for using either as an intermediate
target or informational variable comes from an alternative approach to defining
The Empirical Definition of Money (M2)
As noted above, the economics profession is not of one mind when it comes to
the role of money in business cycles. Beginning in the 1950s, two economists, later
to achieve great prominence in the profession, Milton Friedman and Anna Schwartz
(among others), began to publish research findings designed to convince a then
skeptical economics profession that money mattered and that variations in the growth
rate of the money supply played a major role in causing business cycles. Crucial to
this research was a definition of money or some empirical counterpart to the notion
of money.
Friedman and Schwartz, in justifying their definition, state “. . . we see no
compelling reason to regard the literal medium–of–exchange function as the
‘essential’ function of the items we wish to call ‘money’.” After all, except for the
moment in which money actually changes hands in a transaction (or is used as a
medium of exchange), it remains inactive, or, in their words, is “a temporary abode
of purchasing power.” What such a collection of assets would be was not to be
determined by logic. Rather, they sought a collection of assets, changes in the supply
of or the demand for, which would allow them to readily and accurately predict the
consequences for important economic variables such as nominal GDP.

10There is substantial doubt that M1 was ever elevated to the status of an intermediate target
variable. One reason for this doubt is that the Federal Reserve allowed base drift to occur.
Base drift occurs when the ending value of M1 during a given period is used as the base for
setting the growth rate target range for a subsequent period regardless of whether that ending
value for M1 is other than the midpoint of the prevailing growth rate range. Over time, if
base drift is not corrected, M1 growth (or the growth of any monetary aggregate) can be
higher or lower than would have occurred if each new growth rate range was positioned at
the mid–point of existing growth rate range.

After much consideration, Friedman and Schwartz settled on what was then
called M2.11 M2, it should be noted, contains assets that cannot themselves be used
directly as a medium of exchange. Nevertheless, in their studies, M2 was stable and
predictably related to nominal GDP.12 In addition, as shown in Figure 3, over most
of the 1959–1991 period, the velocity of M2 displays no trend, varying between 1.4
and 1.6 (it has the advantage of being a virtual constant with very small deviations
from its average value).13
Figure 3: The Velocity of M2
1. 9
1. 8
1. 7
1.62 Velocity
1. 5
1. 41959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999
Source: Federal Reserve
The near constancy of M2's velocity attracted the attention of the Board of
Governors, and it came to replace M1 as the preeminent informational variable in the
conduct of monetary policy. During the 1980s and early 1990s, the deliberations of

11As M2 was defined prior to 1980, it contained currency, non–interest paying demand
deposits, and saving and time deposits (time certificates of deposit or CDs were not in
existence during the period covered by the work of Friedman and Schwartz).
12The Friedman–Schwartz approach to money demand or velocity yields a model which is
somewhat different from Baumol–Tobin. Since money holding is viewed as an alternative
to both real and financial assets, its opportunity cost can be measured by such diverse factors
as interest rates, the yields on stocks, and the expected rate of inflation (which measures the
yield on goods). Velocity, however, rises as the opportunity cost of money rises as in the
Baumol–Tobin model. The Friedman–Schwartz model suggests that money holding is
linked to wealth (or its proxy, expected income) rather than to GDP.
13The velocity of the M2 used by Friedman and Schwartz has been computed by them for
the period 1869 to 1960. It slowly declined from about 4.6 in 1869 to a range of about 1.5
to 1.7 during the decade of the 1950s. See Milton Friedman and Anna J. Schwartz, A
Monetary History of the United States 1867–1960 (Princeton, NJ: Princeton University
Press, 1963), Table A–5, pp. 774–775. A factor in Friedman and Schwartz's selection of
M2 as their preferred measure of money is that they wanted a longtime series on money so
that they could examine its behavior over many business cycles. Prior to 1915, it is
impossible to separate demand from other deposits on the books of U.S. banks. Thus, to
examine the behavior of money over many cycles, M2 must be used.

the Federal Reserve and the semiannual Humphrey–Hawkins monetary policy reports
consistently used M2 as the basic money supply variable. Moreover, M2 is the basic
measure of money used in the large–scale econometric model of the United States
maintained by the Board of Governors of the Federal Reserve. M2, however, has not
been used as an intermediate target variable.
Unfortunately, beginning late in the 1980s and early 1990s, the behavior of M2's
velocity, like that of M1 a decade or so before, began to go off track. The
relationship of M2 to its opportunity cost, established in the post–World War II
period, could not explain the behavior of M2's velocity. While M2's velocity was
expected to fall as interest rates declined in the 1990s, it actually began a sharp rise
and reached its highest levels in the 40-year period. The M2 velocity values expected
or predicted to occur based on historical experience were less that the actual M2
velocity that occurred. In terms of the alternative way of expressing this
development used above, this was another case of “missing money.” That is, based
on GDP and the opportunity cost of M2, the public was holding less money than
predicted. The same problem that had bedeviled M1 came to bedevil M2.14
Quite clearly this development caused consternation among the Board of
Governors. In its semiannual monetary policy report to the Congress dated July 20,
1993, the Board for the first time expressed considerable uncertainty about the
usefulness of M2 and M3 as informational variables. While the Board continued to
set growth rate ranges for each aggregate, it concluded in that report:
With considerable uncertainty persisting about the relationship of the monetary
aggregates to spending, the behavior of the aggregates relative to their annual
ranges will be of limited use in guiding policy...and the Federal Reserve will
continue to utilize a broad range of financial and economic indicators in
assessing its policy stance.
The continued uncertainty in the behavior of the velocity of M2 (and M3) led
the Board of Governors to discontinue setting a monitoring growth rate range for
both the M2 and M3 measures of money. This was announced at the Humphrey-
Hawkins hearings held on July 20, 2000. Thus, M2 and M3 are now just two of the
many informational variables the Board uses in the formulation and execution of
monetary policy.
Does Either M1 or M2 Still Have A Role in
Forecasting Economic Activity?
The data on table 1 established the fact that money (M2) and nominal GDP have
a substantial degree of covariability (at least over the period 1959–1989). What has
been controversial about this finding is the implied cause and effect relationship.

14Since M1 is a component of M2, one might be tempted to ask why the instability in M1's
velocity did not immediately lead to instability in M2's velocity. A popular answer was the
“missing M1" was shifted into CDs. Since CDs are in M2, but not M1, this shift would have
no effect on M2's velocity.

A number of economists who believe that causality runs from changes in the
money supply to changes in nominal GDP have argued that the stability of this
relationship could be exploited for forecasting purposes. Knowledge of money
growth could be used, for example, to forecast the growth of nominal and real GDP
and the rate of inflation.
A good deal of analytical effort has been expended on this subject. Increasingly,
these efforts have been focused on what is called “time series analysis.” A central
feature of this analytical tool is the so–called “Granger test,” named after Prof. Clive
Granger, a pioneer in time series analysis. The essence of the Granger test is to see
whether additional variables can add any extra information or predictive power to
forecasting a focus variable that is not already contained in the history of the focus
variable itself. If it can (as determined by a statistical test of significance), the added
variable is said to “Granger cause” the focus variable or the variable whose value is
being forecasted.
A seminal use of this methodology in the study of money's influence on
economic activity was made by Prof. Christopher Sims in 1972. In this study, using
quarterly data from 1947 through 1969, M1 was found to Granger cause nominal
gross national product.15 That is, although the history of GNP provided a good deal
of information about the current and future values of GNP, this information was
enhanced (or an improved prediction was possible) by also using the history of the
growth of M1. Later, in 1980, Sims published the results of a more elaborate study
using monthly data involving a possible Granger causality role for both M1 and the
commercial paper rate.16 When both were used simultaneously with the focus
variable being the industrial production index, M1 no longer played a Granger causal
role in explaining this measure of economic activity (i.e., its contribution to
explaining the behavior of industrial production was no longer statistically
significant). A major role was, however, played by the commercial paper rate. The
sample period covered by this study ran from 1947 to 1978. What Sims may have
picked up in this study was the breakdown in the stability of M1's velocity –– the
extent of which was not too well documented in 1980.
Several subsequent studies using data from the 1980s and 1990s have come to
inconclusive results on the Granger causal role of money. For example, a study by
Friedman and Kuttner, incorporating quarterly data for the entire decade of the 1980s
(their sample runs from 1970:3 to 1990:4), appeared to sound the death knell for all
measures of money and credit now used by the Federal Reserve as information
variables.17 They could find no Granger causal role for the monetary base, M1, M2,
or credit in explaining the movements of nominal and real GDP and the rate of

15See Christopher Sims, “Money, Income, and Causality,” American Economic Review,
September 1972, pp. 540–552. Sims did not use the M2 measure of money in his study. He
did, however, use, in addition to M1, the monetary base, which consists of bank reserves and
currency in circulation. A Granger causality role for the monetary base was rejected.
16Christopher Sims, “Comparison of Interwar and Post–war Business Cycles: Monetarism
Reconsidered” American Economic Review, May 1980, pp. 250–257.
17Benjamin M. Friedman and Kenneth N. Kuttner, “Money, Income, Prices and Interest
Rates,” American Economic Review, June 1992, pp. 472–492.

inflation over their sample period. Various short term interest rates and the spread
between the 4–6 month commercial paper rate and the 90–day Treasury bill rate (this
difference being a measure of risk) did, however, play an important role in Granger
causing or explaining the behavior of the three focus variables. Estrella and Mishkin
reconfirm this conclusion in a more recent study. Using monthly data for the period

1960-1995, they reject even an informational role for the monetary base and M2.18

The conclusions of these studies have been disputed by several others. Using
the same time period and data, but with a slightly different equation than Friedman
and Kuttner, Feldstein and Stock conclude that the relationship between M2 and
nominal GDP is sufficiently strong and stable to warrant further investigations into
using M2 to influence spending.19
A 1992 study by Becketti and Morris, using quarterly data from 1970:1 through
1992:2, found a Granger causal role for M2 in explaining movements in real GDP
when the observations from 1979:4 through 1982:4 were excised from the sample.20
This is the period when the Federal Reserve supposedly abandoned interest rates as
intermediate target variables and replaced them with monetary aggregates.21
Becketti and Morris conclude:
The forecasts that ignore M2 failed to foresee the most recent recession
(1989–1990) and predicted a much stronger recovery than has occurred.... The
forecasts that included information on M2 also missed the recession, but they
accurately predicted the weakness of the recovery since the second quarter of


Finally, Duca reports some promising results in which M2, expanded to include
the dollars in bond mutual funds and bond and stock mutual funds, yields better
forecasts of nominal GDP growth over the 1990–94 period than does M2 by itself.22

18It should be noted that monthly income data do not exist. Estrella and Mishkin construct
a proxy series from the coincident economic indicators and the consumer price index. What
role this alternative measure of economic activity plays in their conclusion is unclear.
Arturo Estrella and Frederic Mishkin, “Is There a Role for Monetary Aggregates in the
Conduct of Monetary Policy?” Journal of Monetary Economics, vol. 40, 1997, pp. 297-304.
19Martin Feldstein and James Stock, “The Use of Monetary Aggregates to Target Nominal
GDP in Monetary Policy,” in Monetary Policy, Gregory Mankiw, ed., (Cambridge, MA:
NBER Studies in Business Cycles, vol. 29, 1994).
20Sean Becketti and Charles Morris, Federal Reserve Bank of Kansas City Economic
Review, Fourth Quarter, 1992), pp. 65–77. They could find no Granger causal role for either
M1 or the Monetary Base. Moreover, they report no results for any monetary aggregate and
nominal GDP or the aggregates and the rate of inflation, both having been used as focus
variables by Friedman and Kuttner.
21This finding is of some interest for supposedly during the period 1979:4–1982:4, M1, not
M2, was the intermediate target variable.
22John V. Duca, “Would the Addition of Bond or Equity Funds Make M2 a Better Indicator
of Nominal GDP?” Federal Reserve Bank of Dallas Economic Review, Fourth Quarter,

However, the advantage of these two new monetary aggregates over conventional M2
is not large when the federal funds rate and the 10–year Treasury note yields are
added to the forecasting equation.
Nevertheless, while these studies may help us to understand the role of money
in business cycles, they also reveal that the results may be highly sensitive to the
focus variable used, the measure of money used, and the time period from which the
data are drawn. At most, these results should be regarded as suggestive in nature.
As such, they suggest that at least M2 may have continued value in providing some
information about the future course taken by real GDP.
The Search for A Stable Velocity of Money
Efforts to Explain the Instability of M1's Velocity
The instabilities in the velocities of M1 and M2 have not gone unnoticed.
Chronologically, the instability of M1's velocity occurred first. Ironically, by 1973,
the economics profession had accepted as fact that a stable velocity for M1 existed.
A highly regarded study by Princeton economist Stephen Goldfeld established this
fact.23 Goldfeld estimated an equation in which M1's velocity depended on interest
rates and income. This equation passed all the statistical tests of stability. Beginning
in 1974, however, the Goldfeld equation began to seriously underpredict M1's
velocity and thus overpredict the public's money holdings. This degree of error
continued to grow over the decade. In 1976, Goldfeld published a study on the
“missing money.”24 For the next several years the journals were filled with articles
purporting to explain what had happened. Some sense of the magnitude of this effort
can be gleaned from the fact that in 1982 two economists, Judd and Scadding,
surveyed this outpouring for the Journal of Economic Literature. Their survey article
contains 86 citations.25
The search for the cause of the instability had to confront a considerable number
of innovations that had and were occurring in financial markets during the 1960s and


1994, pp. 1–14.

23Stephen Goldfeld, “The Demand for Money Revisited,” Brookings Papers on Economic
Activity, no. 3, 1973, pp. 577–638. Rather than estimate directly a velocity equation,
Goldfeld estimated a money demand or money holding equation. As noted above velocity
and money demand equations are, however, equivalents.
24Stephen Goldfeld, “The Case of Missing Money,” Brookings Papers on Economic Activity,
no. 3, 1976. pp. 683–730.
25John P. Judd and John L. Scadding, “The Search for a Stable Money Demand Function:
A Survey of the Post–1973 Literature,” Journal of Economic Literature, September 1982,
pp. 993–1023. In a follow–up survey on the instability of M1's velocity, published in 1991,
Leventakis and Brissimis cite 109 articles. See John A. Leventakis and Sophocles N.
Brissimis, “Instability of the U.S. Money Demand Function,” Journal of Economic Surveys,
no. 2, June 1991. pp. 131–158.

1970s that could reasonably have been expected to affect the velocity of M1.26 These
innovations were due in large part to banks, and resulted from a clash between rising
market interest rates (documented in figure 2) and banking regulations that forbade
the payment of explicit interest on demand deposits and regulated those paid on
saving and time deposits. If banks wished to remain major players as financial
intermediaries, they had to come up with ways to pay interest to depositors or else
risk the loss of funds and their role in the intermediation process.
The research efforts by economists tended to take one of two approaches, both
of which were suggested by the Baumol–Tobin model (as modified by Miller and
Orr).27 The first approach continued to accept and use the then prevailing definition
of M1. However, it was thought that the variables used to measure expenditures,
broker fees, and opportunity costs were no longer adequate in light of the financial
innovations and other changes in the economy. Thus efforts were made to
reformulate or adopt new measures for some of these crucial explanatory variables.
Maintaining the Definition of M1. Since a major role for the breakdown
of M1's velocity was believed to have its origin in the demand deposit holdings of
businesses, business practices with regard to these holdings came under close
scrutiny. Important in this effort was a belief that banks were assisting businesses to
better manage their money holdings, including standing ready to convert money
holdings into interest earning securities on an overnight basis.
While finding a suitable empirical measure for these improved services proved
difficult, those selected did seem promising at the time to capture this structural
change in velocity. These improved cash management techniques were also thought
to reduce the variability in the income and expenditure flows of businesses, thereby
reducing their need for precautionary money holdings (as suggested by the
Miller–Orr model).
In a similar vein, it was questioned whether gross national product (GNP) or
some subdivision thereof was really an adequate proxy for those expenditures
requiring money. GNP (and GDP) after all, includes capital consumption allowances
and a number of imputations, neither of which require the use of money. In addition,
GNP and its subdivisions exclude spending on financial and existing real assets.
Nevertheless, so long as GNP (or GDP) moves in concert with total spending it will
not produce an unstable velocity. When this is not the case, it can affect the
perceived stability of velocity. For example, if turnover in financial markets
increases, money demand may increase, all else equal. Since this increase in money
holding does not affect income, measured velocity (PY/M) would fall for no apparent

26It should be noted that as M1 was then defined, it consisted only of currency and
non–interest bearing demand deposits. M2 consisted of M1 and savings and time deposits
(the now popular time certificates of deposits or CDs were unimportant at this time).
27An important modification of the Baumol-Tobin model made by Miller and Orr is to make
income and expenditures probabilistic rather than certain. As a result, any innovations that
reduce the possible dispersion of either can be expected to reduce the demand for money or
raise velocity. See Merton Miller and Daniel Orr, “A Model of the Demand for Money by
Firms,” Quarterly Journal of Economics, vol. 80, August 1966, pp. 413–435.

reason, and would appear unstable. There was a feeling that perhaps this was
happening in the 1970s. After a long period in which income and transactions
velocity were moving in concert, the growth in financial and asset transactions during
the 1970s relative to income growth might have caused M1's velocity to appear to be
unstable when in fact it was not. Efforts to find better measures of total spending,
while promising, did not provide the answer to the instability.28
Changing the Definition of M1. The second line of inquiry suggested that
since some of the innovations in financial markets consisted of new assets which
were highly substitutable for the assets then included in M1, the definition of M1
should be changed. During the late 1970s and into the 1980s, the regulations placed
on the interest rates depository institutions could offer on various types of deposits
were relaxed. This deregulation undoubtedly altered the range of assets that could
be regarded as substitutes for the assets in both M1 and M2.
Obvious choices were the interest-paying accounts then offered by State
chartered mutual savings banks to households on which checks could be drawn ––
these were the NOW accounts and Super NOW accounts (and later share drafts
offered by credit unions). By the mid–1970s, NOWs were authorized for most types
of depository institutions in the northeastern part of the United States. However,
since only households were able to hold NOWs at that time, they could explain only
a small part of the shift in M1's velocity since a large part of the problem was thought
to be due to the sudden decline in the demand deposit holdings of businesses.
Perhaps one of the most innovative explanations for the instability involved a
new arrangement banks had developed for paying interest to business customers, the
so–called repurchase agreement (or REPO). This involves a bank selling an asset
for a fixed period with the promise to repurchase it at a fixed price. The REPOs
could be for a very short time indeed –– overnight in fact. Garcia and Pak made an
interesting argument that banks allowed their business customers to use their demand
deposits during the day and, just before closing, would sell them REPOs on an
overnight basis.29 Thus, business demand deposits would be understated at the end
of the day by the amount of REPOs. When the REPOs were added to M1, they
accounted for much of the so–called “missing money.” Subsequent research,
however, cast doubt on the role REPOs were thought to have played in the decline
in M1s velocity.30

28See, for example, Charles Lieberman, “The Transactions Demand for Money and
Technical Change,” Review of Economics and Statistics, vol. 59, August 1977, pp. 307–317;
Jerred Enzler, Louis Johnson, and John Paulus, “Some Problems of Money Demand,”
Brookings Papers on Economic Activity, no. 1, 1976, pp. 261–280; and William Bomberger
and Gail Makinen, “Money Demand in Open Economies: Alternative Specifications”
Southern Economic Journal, July 1980, pp. 30–39.
29See Gillian Garcia and Simon Pak, “Some Clues in the Case of the Missing Money,”
American Economic Review, May 1979, pp. 330–334.
30This practice would not affect the velocity of M2, however, because the money market
accounts are included in M2.

One aspect of the search for the missing money was to reopen the debate about
the appropriate definition of money. The fact that the velocity of M2 had all the
statistical properties of stability did not go unnoticed. Moreover, the equation used
to predict M2's velocity for forecasting purposes, neither over- nor underpredicted it.
It thus appeared that the velocity of M2 was immune to the changes in financial
structure, financial innovations, and the deregulation of banking that had taken place
during the 1960–1980 period. M2 then became the primary informational variable
for monetary policy.
Nevertheless, research continued into the causes of the instability of M1's
velocity –– including the velocity of the augmented M1 for all NOW accounts, share
drafts and the like were included in the new definition of this aggregate announced
by the Federal Reserve in 1980.31 Perhaps the final act in this research drama was
played in 1992 when Duca presented evidence that the major reason for the weakness
in business demand deposit holdings had to do with interest rates and compensating
balances. 32
When businesses borrow from banks, they are generally required to hold certain
deposit balances at those banks –– so–called compensating balances. These balances
can be an important fraction of total business demand deposits. A Federal Reserve
survey of 60 large banks in 1987, for example, suggested that roughly half of all
business demand deposits were, in fact, compensating balances. As interest rates
rose during the 1960s and 1970s, compensating balances became more costly for
businesses, even though banks tried to pay interest on them implicitly. Duca argues
that, as a result, an increasing number of businesses incurred the set–up costs for
borrowing directly in the commercial paper market rather than borrowing indirectly
using banks as intermediaries. This shift to direct borrowing brought about a marked
decline in compensating balances and, thus, in business holdings of demand deposits.
This decline, Duca’s evidence suggests, explains much of the “missing money.”
An equally serious problem arose from the increasing popularity of the U.S.
dollar as an international currency. Dollars are held by foreigners as a hedge against
an uncertain political and economic future, to finance illegal activities (the narcotics
trade), and as a currency for conducting legitimate business (as in Ecuador).
Estimates (using only $100 denomination bills) suggest that this sum has risen from
about 10% of the total in the early 1970s to about 50% in 2001.33 This overstatement
is not small. In 2001, currency was more than 50% of recorded M1. Thus, the
recorded data on M1 progressively overstates the amount of M1 that is used for
spending in the United States.

31It should not be forgotten that these changes to the definition of M1 also required a
redefinition of the opportunity cost of money. Redefinition of opportunity cost was also an
important part of the research effort highlighted above in which the old measure of M1 was
32John V. Duca, “U.S. Business Credit Sources, Demand Deposits, and the ‘Missing
Money’,” Journal of Banking and Finance, vol. 16, 1992, pp. 567–583.
33For more information, see U.S. Library of Congress, Congressional Research Service,
Why is the Amount of Currency in Circulation Rising? by Gail Makinen, CRS Report 30904.

Summary. The stability displayed by the velocity of M1 through the early
1970s gave rise to a view among some economists that M1 could be used as an
intermediate variable for the conduct of monetary policy as well as providing a good
deal of information about the likely course to be taken by the economy. This
optimism was shaken by the apparent instability of M1's velocity that appeared in the
early 1970s and continued for some years thereafter. Research has identified several
factors as responsible for this instability. First, structural changes have occurred in
the financial environment that determines velocity. These changes are due in part to
the growing sophistication of the economy and the financial intermediaries that it
creates and to changes in the legal environment that governs intermediaries.34
Second, changes in the nature and availability of substitute assets for money can both
alter the opportunity cost and create measurement problems for M1. Third, the use
of American currency abroad creates problems for measuring the effective amount
of M1 that circulates in the U.S. Finally, there can be a series of one time and largely
transient events that can alter the velocity of money. A prominent one, analyzed
below, was the thrift and banking crisis of the mid-1980s.
Efforts to Explain the Instability of M2's Velocity
The velocity of M2 proved to be quite stable during the 1980s and, without
doubt, it became the preeminent informational variable for the Board of Governors.
The semiannual monetary policy reports make ample reference to the behavior of M2
and its velocity compared with other measures of money and credit.
This happy state of affairs did not last. The velocity of M2 began to rise in 1990
when the standard estimating equation predicted it would fall. As in the case of M1,
the problem with M2's velocity has also been phrased in terms of the missing money.
Moreover, the economic expansion that got underway in March 1991 seems to have
been set in motion and sustained with no help from M2. In fact, given the behavior
of M2, it is doubtful that any expansion should have occurred, much less been
It is now widely acknowledged that the weakness in M2 growth (or the missing
money) is tied to three of its components: currency, much of which circulates abroad,
money market mutual fund balances, and time certificates of deposit (CDs),
especially the latter.
As with M1, an extensive and on–going research effort has been undertaken to
find the missing money or explain the perverse movement in M2's velocity. While
some of it has been found, the results of this effort are inconclusive, i.e., only some
of the instability in M2's velocity has been reduced. It is still too unstable, or the
research too tentative, for M2 to be considered as an intermediate target variable and,
of course, the instability, though reduced, does little to enhance the informational

34For an account of the interaction of economic growth and financial intermediation, see
John Gurley and Edward Shaw, Money in a Theory of Finance (Washington, DC: Brookings
Institute, 1960).

value of M2. In general five explanations have been put forth to account for the
missing M2.
Adding Assets to M2. Some economists tried to account for the effect of
financial innovation on M2. It was noticed that the “missing money” coincided with
the rapid growth of bond and equity mutual funds. An argument was made that these
funds were very good substitutes for the savings accounts and CDs supplied by banks
and, therefore, should be included in an augmented M2. Some studies have used
such an augmented M2 and found that its velocity is more stable than for
conventional M2. Among the studies opting for the expanded monetary aggregate,35
Duca reports that he is able to account for over 40% of the missing M2. However,
a problem with augmented M2 is that, unlike the assets in conventional M2, bond
and equity funds are subject to capital gains and losses. These gains and losses will
change the value of M2 independent of changes in its opportunity cost, making
velocity appear to be unstable.
Reduced Transactions Costs. Transactions costs, or the cost to buy and
sell assets, play a role in the Baumol-Tobin model of money demand. If those costs
decline, the model predicts that individuals will hold less money or that velocity will
rise. The introduction of bond and equity mutual funds was thought to have made
this possible. In some cases, bond mutual funds became part of a family of mutual
funds offered by banks which allowed depositors, at low transactions costs, to
transfer funds from bond funds to money market mutual funds on which checks can
be written. Failure to account for this fall in transactions costs was one element
thought to account for missing money.36
Additional Opportunity Costs. The third explanation is to some degree
complementary with the first. It has to do with interest rates, the spread in interest
rates, and deregulation. As the interest rates banks could pay on their various
deposits were deregulated, it is argued, these deposits became better substitutes for
a variety of other earning assets such as stocks and bonds. Failure to account for this
change was believed to be responsible for some of the missing money. The
economists taking this line advocated altering the opportunity cost variable in the
standard velocity estimating equation. In particular, they urged that the yields on
both short and long term assets be included in the equation (less the interest that was
paid on the assets in M2). The spread between long and short term interest rates
supposedly captured the ability of the bond and stock funds to attract dollars from,
or divert those that were intended to go to, depository institutions (this is due to the
fact that bond funds can hold longer term assets and, as the spread widens, offer
higher rates than can depository institutions on their CDs).

35 John V. Duca, “The Case of the Missing M2,” Federal Reserve Bank of Dallas Economic
Review, Second Quarter 1992, , pp. 1–24; and “Should Bond Funds Be Added To M2?”
Journal of Banking and Finance, vol. 19, 1995, pp. 131–152.
36Duca presents evidence that movements in the costs of taxable bond funds made possible
by new technologies can explain much of the movement in M2's velocity during the early

1990s. See John Duca, “Financial Technology Shocks and the Case of the Missing M2,”

Journal of Money, Credit, and Banking, vol. 32, November 2000, pp. 820-839.

Among those studies using either multiple opportunity costs or the addition of
a spread variable is that of Feinman and Porter.37 Estimating equations that add
either multiple interest rates or a spread variable (they use the spread between the
30–year Treasury bond yield and the 3–month Treasury bill rate), they report they
have found more than two-thirds of the missing M2.
The Thrift and Banking Crisis. A fourth explanation for the missing money
is related to the thrift and banking crisis of the mid-1980s and weakness in the sector
in the early 1990s. Adjusting M2 velocity for this one-time event has taken several
routes. The first builds upon the activities of the Resolution Trust Corporation
(RTC). Its activities, it is argued, made the yields on CDs more uncertain. It did this
because in dealing with failed thrifts, the RTC would either pay off the CD holder or
transfer the CD to the merging or purchasing institution which had the option of
repricing the CD. Since many CDs in failed institutions were higher yielding than
at acquiring institutions, this increased the uncertainty of CD yields. An attempt was
made to incorporate this increased uncertainty into the standard equation explaining
velocity. It should be noted that the activities of the RTC were not expected to have
a lasting effect on M2's velocity. This is, in essence, a one-time effect. Once the
RTC had completed its activities, M2's velocity was expected to be governed by only
its systematic determinants (e.g., opportunity cost, brokerage fees, and income).
Using conventional M2, Duca, after incorporating a measure of this uncertainty
in a standard estimating equation for velocity, was able to explain what happened to
83% of the missing money. When M2 is augmented by adding bond and equity
mutual funds, the addition of the RTC uncertainty variable enables him to account
for 95% of the missing money.38 Carlson and Parrott, also using conventional M2,
report that they are able to account for much of the missing money when their
variable accounting for RTC activities is added to a standard M2 velocity equation.39
Their study, unfortunately, does not include data from most of the 1990s.
Orphanides and Porter’s approach is somewhat different. First, they purge the
conventional measure of M2 of currency that circulates abroad and an estimate of
money tied up as collateral in mortgage-backed securities pools. The velocity
computed from their modified M2 is related to the capitalization of banks, revisions
of stock market earnings, the liquidity of Treasury securities, the term spread on

37Joshua Feinman and Richard D. Porter, “The Continuing Weakness in M2,” Finance and
Economic Discussion Series Working Paper No. 209, (Federal Reserve Board: September


39John B. Carlson and Sharon E. Parrott, “The Demand for M2, Opportunity Cost, and
Financial Change,” Federal Reserve Bank of Cleveland Economic Review, Second Quarter
1991, pp. 2–11. In this study, the change in thrift deposits is added to the velocity
estimating equation as a proxy for the change in opportunity cost brought about by the RTC
restructuring activities.

Treasury yields, and stock market volatility. They report that this velocity is stable
enough that their reconstituted M2 is a good informational variable.40
Lown, Peristiani, and Robinson account for the problem related to the banking
and thrift crisis by constructing a new M2 series. This consists of the M2 that would
have occurred if it had been supplied only by well capitalized banks and thrifts. They
find the velocity derived from this new series to be stable and argue that their
modified M2 may contain useful information about economic growth.41
Structural Changes. A fifth approach has been to argue that there was an
acceleration in the long term structural changes affecting the intermediation process
in the United States during 1990-94 that further diminished the role of commercial
banks as intermediaries. As a result, the same or a greater amount of spending took
place in the economy with less money. This would appear as a rise in M2's velocity
unrelated to a change in income or its opportunity cost. A major reason for the
diminished role of banks as intermediaries, it was argued, was the removal of the
subsidy given them by the federal government.
The nature of the subsidy was in the provision of deposit insurance at rates that
bore little relation to the riskiness of the assets that banks acquired. Moreover,
deposit insurance made it possible for these institutions to get by with capital
accounts that in many cases were also unrelated to the riskiness of the assets.
Changes in deposit insurance premiums and the imposition of risk based capital
standards have made it more costly for banks to lend. As a result, borrowers have
sought funds by borrowing directly from lenders or from other intermediaries (e.g.,
insurance companies, pension funds, etc) rather that indirectly through banks. The
decline in the banking sector’s share of lending is matched, it is argued, by the run
off of CDs – the principal managed liability of banks.
Summary. The research agenda to find the missing M1 was simply extended
to find the missing M2 when its velocity became unstable in the early 1990s. It has
involved redefining M2, redefining the opportunity cost of M2, accounting for
changes in the institutional setting determining M2 velocity, and factoring in any
number of changes essentially of a one time nature to account for the resolution of
the thrift and banking crisis of the mid-1980s.
While much of this research has been fruitful in fostering our understanding of
the role of the financial system in the economic health of the nation, it failed to make
much of an impression on the published reports of the Board of Governors and did
not prevent the Board from discontinuing the setting of growth rate ranges for the
monetary aggregates. In large measure this is due to the variety of results that have
been obtained. (Contrast, for example, the findings of Duca with those of Feinman
and Porter. Each purports to find much of the missing money with quite different

40Athanasios Orphanides and Richard Porter, “Making Sense of the Monetary Aggregates,”
preliminary draft, Federal Reserve, December 2001.
41Cara Lown, Stavros Peristiani, and Kenneth Robinson, “What Was Behind the M2
Breakdown?” Federal Reserve Bank of New York, working paper, July 1999.

approaches.) In addition, the weakness in M2 is of such recent origins that sufficient
time may not have elapsed to see whether these new equations have a good record
for prediction.42
Other Efforts to Redefine Money
Before concluding this discussion it is worth reporting on two other efforts to
construct new monetary aggregates that are theoretically consistent. The first is the
effort by Professor William Poole, now president of the Federal Reserve Bank of St.
Louis.43 Poole draws his inspiration from Friedman and Schwartz's definition of
money as a “temporary abode of purchasing power.” For Poole, these should be
assets “that can be accessed without notice and at par.” He calls assets that have
these characteristics assets of zero maturity. All assets currently in M2 are zero
maturity assets except CDs, which have a fixed and positive term to maturity.
Should they be cashed before maturity, their holders incur a penalty. Thus, their face
and conversion values differ. However, Institution Only Money Market Funds, now
included in M3, have the zero maturity characteristic. Poole proposes to gather all
these zero maturity assets into a common aggregate called MZM (Money with Zero
Carlson and Keen examined the stability of MZM in the early 1990s.44 They
found that over the period 1975-1995 the velocity of MZM could be explained very
well by its opportunity cost, particularly by movements in interest rates. Since the
opportunity cost of MZM over this period varied from about 1% to 12%, MZM’s
velocity was highly variable, rising from about 2.5 in 1975 to 3.4 in 1980 and back
to 2.5 in 1995. Thus, knowledge of the movements in MZM by itself would be
unlikely to provide consistently good forecasts on the probable course taken by
money spending in the absence of good forecasts of the movements in interest rates.45

42It should be noted that the velocity instability experienced by the U.S. has also occurred
in some other countries. They have been so pronounced in Canada that the Canadian central
bank discontinued using monetary aggregates as intermediate target variables. See James
Boughton, “Recent Instability of the Demand for Money: An International Perspective,”
Southern Economic Journal, vol. 47, January 1981, pp. 571-597.
43William Poole, Statement Before the Subcommittee on Domestic Monetary Policy of the
Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives,
November 6, 1991, pp. 7–11. Poole has also analyzed the behavior of a variable called
expanded M2 (M2 plus Institution Only Money Market Funds). See also Brian Motley,
“Should M2 be Redefined?” Economic Review, Winter 1988, Federal Reserve Bank of San
Francisco, pp. 33–51.
44John Carlson and Benjamin Keen, “MZM: A Monetary Aggregate for the 1990s?” Federal
Reserve Bank of Cleveland Economic Review, Second Quarter 1996, pp.15-23.
45This is contrary to the case of M2 as an informational variable. Since the velocity of M2
was much less sensitive to movements in its opportunity cost, a fairly good forecast of the
probable course to be taken by money spending could be gleaned from observing the recent
growth rate of M2 itself. However, as noted earlier, the stability of M2's velocity has broken
down in recent years, and Carlson and Keen were unable to explain M2's velocity by its

This is borne out by experience in the 1990s. While the growth rate of MZM
decelerated prior to the peak in economic activity in July 1990 and began to
accelerate prior to the cyclical trough in March 1991 (as might be expected if money
leads or causes nominal GDP and velocity is stable), its growth rate during 1991 and
1992 was very high relative to the shallow recovery that took place. Moreover, the
sharp decline in its growth rate in 1993 and 1994 would lead one to expect a sharp
decline in the pace of economic activity which did not occur. Unless one had been
able to accurately predict the course of interest rates from 1991-1994, MZM would
not have been a useful informational variable over this period. However, the pace
of MZM growth accelerated noticeably from early 1995 to early 1999, a period of
very high growth of real GDP.
A second approach to defining money has been through the development of
what are called Divisia indexes. The notion behind these indexes, as applied to
monetary aggregates, is that the conventional way of defining M2 or any monetary
aggregate is likely to be flawed. When a collection of assets is put together as a
monetary aggregate, an implicit assumption is made: all of the assets in the aggregate
are perfect substitutes for each other. That is, they all yield identical money services
to their perspective holder. This is unlikely to be true, especially for the broader
A Divisia index results when the various components of an aggregate are
weighted by their degree of “moniness.” Defining moniness and assigning the
weights are complex and technical matters. Nevertheless, it can be done and the
results are Divisia M1, M2, and M3.46 For each of these aggregates, a related
velocity can be computed in exactly the same way as with the conventional Ms.
Unfortunately, these velocities have also proved to be unstable. Thus,
aggregates which are constructed to meet rigorous index number tests and are also
theoretically consistent in the sense that each component supplies identical monetary
services to its holder do not ensure that the resulting velocities will be stable.
However, in forecasting real GDP and prices, the Divisia aggregates generally
outperform their simple non-Divisia counterparts.47
Uses of the Alternative Measures of Money in the Conduct of
Monetary Policy. Two roles have been identified for the conventional monetary
aggregates in the conduct of monetary policy: intermediate target variables and
informational variables. At least three new monetary aggregates are suggested by the
discussion above: MZM, Divisia money and M2 plus dollars in bond and stock
mutual funds (M2+). Could these aggregates play either or both of the above roles?

opportunity cost in the 1990s, as they could do for MZM.
46For pioneering work in this area, see William A. Bartnett, “Economic Monetary
Aggregates: An Application of Index Number and Aggregation Theory,” Journal of
Econometrics, vol. 14, September, 1978, pp. 11–48; and “Developments in Monetary
Aggregation Theory,” Journal of Policy Modeling, vol. 12, Summer 1990, pp. 205–257.
47Donald Schunk, “The Relative Forecasting Performance of the Divisia and Simple Sum
Monetary Aggregates,” Journal of Money, Credit, and Banking, May 2001, pp. 272-283.

If the velocity of all three aggregates were stable and predictable, it is possible
that MZM could be an intermediate target variable. The Federal Reserve could
control it with no more difficulty than it currently controls M1 or M2. It is doubtful
that either M2+ or the Divisia measures could serve as intermediate target variables
since the Fed would have much greater difficulty controlling them.
All three money measures could potentially serve as useful informational
variables. Their usefulness in this role would be enhanced by stable and predictable
velocities. On the basis of current evidence, M2+ seems more suited to this role than
the others –– even though the Fed's ability to control this aggregate would appear to
be more difficult than for MZM, for example.
The Conduct of Monetary Policy and the Money
Thus far, this report has discussed the link between the money supply and
economic activity and chronicles the efforts to explain the breakdown in the link.
But ultimately, this exercise is useful to policymakers only in so far as it affects the
conduct of monetary policy. The remainder of the report will discuss different ways
that the money supply relates to (or could alter) the execution of monetary policy.
Can the Federal Reserve Control the Money Supply?
It has been established that for the supply of money to be useful in the conduct
of monetary policy, it must be stable related to money spending such that, given any
change in the money supply, policymakers can predict with reasonable certainty the
subsequent change in money spending. In this discussion, it was taken as a given that
the Fed could closely control the growth of the money supply if it so desired.
This raises the question as to whether the Federal Reserve can in fact control the
money supply over a reasonably short period of time, say on a quarterly basis. In
other words, do open market operations lead to direct and predictable changes in
some measure of money, say M2? Lack of control is not due to an absence of timely
data on M2. Orphanides and Porter report that currently the Board of Governors
receives micro data on over 92% of the components of M2 in dollars with a lag of
eight days.48
An answer to this question must begin with the observation that the Federal
Reserve does not directly control the various measures of money discussed in this
paper. What the Federal Reserve controls are the reserves available to depository
institutions (mainly commercial banks) on the basis of which they can make loans
and buy assets and, in the process, create money.

48Athanasios Orphanides and Richard Porter, “Making Sense of the Monetary Aggregates,”
preliminary draft, Federal Reserve, December 2001.

However, there are two other groups that can play an important role in
determining how much money is created: individuals (households, business firms,
and other financial intermediaries), and the banks themselves. Individuals decide
how they wish to hold their wealth and assets (currency, demand and saving deposits,
MMDAs, CDs, stocks, bonds, etc.). These decisions determine the composition of
any aggregate identified as money (e.g., M1, M2, M2+, MZM).
Banks themselves can play an important role in determining their own liabilities
(whether they take the form of demand or savings deposits, CDs, or MMDAs). In the
process, a given dollar of reserves supplied by the Federal Reserve can result in a
different amount of M2, for example. This arises because the reserves banks hold for
their various liabilities are not uniform. The law requires reserves of approximately
10% for demand deposits. No legally required reserves are specified for the other
types of liabilities and banks typically hold lower reserves for them. Since reserves
are typically held in a currency or non-interest earning form, banks have an incentive
to minimize their liabilities in the form of demand deposits. This incentive increases
as interest rates rise.
The crucial point is that the ability of the Federal Reserve to control money
depends on the relationship of bank reserves and money. If the relationship is tight
over a relatively short period of time, the Fed can be said to control the money
supply. And control is necessary to use the money supply in the role of an
intermediate target. It would appear that for some of the measures of money
proposed above, control would not be very tight. If this is the case, sharp and
unpredictable swings in bank reserves would be required for the Fed to control the
money supply, and this would place a considerable hardship on the banking sector.
This would not preclude those measures of money from performing an informational
role. 49
Rule-Based Monetary Policy and the Money Supply
Suppose that a measure of money is shown to be stable and predictably related
to money spending and that the Federal Reserve can, by manipulating bank reserves,
control this measure of money on a timely basis. How should it conduct monetary
An early answer to that question was provided by Friedman and Schwartz.
Looking at the evidence from the early years in table 1 and from figure 3 (which was
available at the time they wrote) they argued that since the velocity of M2 was a near
constant, a steady growth of money spending could be maintained by a constant rate
of growth of M2. They concluded that discretionary monetary policy as practiced
by the Board of Governors should be replaced by a rule based policy: M2 should
grow by whatever fixed rate was required to keep the price level constant. The
historic evidence they had available suggested that since real output grew on average

49For a discussion of the ability of the Federal Reserve to control M2, see Daniel L.
Thornton, “Targeting M2: The Issue of Monetary Control,” Federal Reserve Bank of St.
Louis Review, July/August 1992, , pp. 23–35.

about 3% per year, price stability could be maintained by keeping M2 growing at the
same rate.50
Implicit in this rule was an assumption that is often overlooked: that the
dominant cause of cyclical instability in the U.S. is due to an erratic rate of growth
of the money supply. Thus, if money growth could be stabilized, Friedman and
Schwartz argued, most of the cyclical instability could be eliminated.
What happens if this monetary theory of business cycles is not true? Suppose
instead, that, while the Federal Reserve could control the supply of money, cyclical
instability was due to such factors as business expectations about the future
profitability of their capital outlays? Such a belief gave rise to an argument for
monetary fine tuning. In this framework, discretionary monetary policy was seen
playing a stabilization role – the Federal Reserve would vary the growth rate of the
money supply in a way to offset changes in money spending that originated in the
private sector due to changing expectations. This view of business cycles seems
prevalent with the Federal Reserve’s Federal Open Market Committee, which has
always used and supported discretionary policy.
For this to work, timely decisions had to be made and the lag between those
decisions and subsequent changes in aggregate spending had to be predictable. In
particular, for discretionary monetary policy to work as intended, the major cause of
cyclical instability must be due to changes in private sector spending unrelated to
monetary policy, the Federal Reserve had to be able to recognize those changes and
act upon them in a timely fashion, and the lag between Federal Reserve action and
the economy’s spending response must be predictable. If that is not the case, it
strengthens the case for a rule based regime, although not necessarily a rule based
regime based on money growth. Faced with mounting evidence of the instability of
money velocity, some rule proponents have shifted their support towards rules based
on interest rates instead of money growth.51
Thus, the ability of the Federal Reserve to control the supply of money in a
timely fashion does not necessarily lend itself to a rule based policy. Using the
money supply as an intermediate target can equally well be applied to discretionary
policy, just as an interest rate target can equally well be applied to a rule-based
policy. Of importance is the cause of cyclical instability.
An Alternative to the Ms as an Indicator of Monetary Policy
If the instability of the velocity of money makes the currently defined monetary
aggregates both undesirable intermediate targets and of limited usefulness as

50A growth rate rule could have been derived from the behavior of M1 as well. Given the
trend rate of growth of its velocity over the period 1959-1970, about 3%, price level stability
could have been achieved by holding the M1 stock of money approximately constant.
51For more information, see U.S. Library of Congress, Congressional Research Service,
Formulation of Monetary Policy: Rules vs. Discretion, by Marc Labonte, CRS Report

informational variables, there remains the possibility that interest rates might perform
these roles.
The reason for using interest rates in these roles is that they are an important
channel by which changes in the money supply cause changes in spending. Indeed,
for some economists, interest rates are said to be the “price of money.” Essentially,
with all else constant, an acceleration in money growth reduces interest rates and a
fall in rates raises household and business spending on interest sensitive goods.
Alternatively, when money growth is decelerated, interest rates rise and interest
sensitive spending is curtailed. In this framework, rising interest rates are taken as
a sign of “tight money” while falling rates are a sign of “easy money.”
Thus, movements in interest rates could be used to control total spending and
they could provide useful information about monetary policy and the future course
of economic activity. And, indeed, the Federal Reserve has used interest rates in
these roles. There is no doubt that, except possibly during the brief period October
1979 to about October 1982, the Federal Reserve has used interest rates as
intermediate targets. In recent years this has meant controlling the Federal Funds rate
and, through it, a range of short term interest rates. Moreover, the Federal Reserve
has given interest rates an important informational role in communicating the posture
of monetary policy to the public.
Such a role for interest rates is suggested by a widely used macroeconomic
model when there is instability in the velocity of money.52 However, the interest
rates suggested by economic theory as relevant are not the rates used by the Federal
Reserve. Economic theory suggests that real interest rates (or market rates less the
expected rate of inflation) are the link from money supply changes to changes in
spending and economic activity.
Even if the expected inflation rate could be calculated, the resultant real interest
rates would not necessarily be a good informational variable about monetary policy.
The reason is that other factors can influence the real rate independent of Federal
Reserve action. Important among these other forces is the budget position of the
federal government. It is generally acknowledged that the 1980s was a decade of
high real interest rates. These were not due to a policy of tight money, but rather to
the unprecedented large peacetime Federal budget deficits. Thus, the high real
interest rates of the 1980s convey little useful information about monetary policy and
may be a very poor means for forecasting the future state of the economy.
Real interest rates can also be influenced by at least two other factors. First, the
pace of economic activity can cause the real rates to vary. During economic
upswings, real rates are thought to rise and to fall during slumps. Second, since
capital flows between major countries with considerable ease, developments in
foreign countries can affect real interest rates in the U.S. and vice versa. Thus, since
rising or falling real rates may be due to the budget position of the federal

52See William Poole, “Optimal Choice of Monetary Policy Instruments in a Simple
Stochastic Macro Model,” Quarterly Journal of Economics, vol. 84, May 1970, pp. 197-216.
Technically, this choice is correct only if investment demand is more stable than velocity.

government and cyclical and international factors, they may tell us little about the
posture of monetary policy.
Alternatively, using market or nominal interest rates as an informational variable
does not get around the problem with real rates since nominal rates can move with
real rates. Additionally, their behavior is substantially influenced by expectations of
inflation. Since it is, easy money, paradoxically, can lead to high market interest
rates. This can happen if easy money causes the public to fear that the inflation rate
will accelerate. Similarly, tight money can lead to low market interest rates if, as a
result, the public comes to expect the inflation rate to decline.
For all these reasons, the informational content about the posture of monetary
policy that comes from either market or real interest rates may be very little.
Movements in interest rates must be read with great care if they are to provide any
information about monetary policy.
Consequences of Ambiguous Indicators for the Conduct of
Monetary Policy
It is now widely accepted that monetary policy is a powerful tool in the short run
for affecting the pace of economic activity and employment and, over the longer run,
the rate of inflation. Moreover, in the present international monetary system, it is a
more powerful tool than fiscal policy. Thus, for those exercising oversight
responsibilities for monetary policy, it is both imperative and desirable that they have
the most objective and unambiguous possible indicator of that policy.
With monetary aggregates that convey little information about monetary policy
and interest rates that can be equally devoid of information, those exercising
oversight are left in the position of having to rely heavily on the nation's central
banker as the conduit of information about and judgments on the policy that he or she
is responsible for formulating and executing. From an oversight perspective, this is
unlikely to be a healthy situation and one conducive to an arms length evaluation of
monetary policy.
Moreover, without unambiguous indicators of monetary policy, those
formulating policy are more likely to rely on current developments in the economy
in making their decisions on what policy should be even though the effects of that
policy may be felt at some distant time, perhaps as long as 2 years in the future.
“Don't fire until you see the whites of their eyes” may have been good advice on the
field of battle during the Revolutionary war, but it is not good advice for the conduct
of monetary policy. By the time you see the “whites of their eyes,” it is long past the
time when policy initiatives should have been undertaken.
Nevertheless, one must contend with the fact that monetary policy seems to have
been quite successful over the past 20 years in bringing the U.S. economy to full
employment and keeping it there. The U.S. has had only two short and shallow
downturns since the early 1980s. On the basis of this record, a case might be made
that central banking is an art and its success depends crucially on the abilities of the

central banker. Alternatively, it might be argued that the Federal Reserve has had an
incredible run of good luck. It has managed to steer a ship with two compasses that
often fail to yield unambiguous readings.
For some three decades, the United States has seen rapid changes in its financial
system. These changes have been spurred in part by a clash between rising interest
rates and regulations that inhibited banks from being competitive players in financial
markets. The desire to survive as intermediaries motivated them (and other
depository institutions) to innovate ways to get around these regulations. This
involved finding ways to pay interest to depositors and potential depositors. In some
cases this meant bringing into being new types of financial instruments such as NOW
accounts, money market accounts, money market mutual funds, and repurchase
Gradually, governments came to realize that the interest rate regulations were
counterproductive if not harmful. Deregulation of interest rates made bank deposits
better substitutes for a variety of other financial instruments.
It should come as no surprise that these changes have had an effect on the
velocity of various measures of money. Trying to explain what these effects have
been and how to adjust to them has been part of a large and ongoing research effort
involving the specification of new monetary aggregates, new measures of opportunity
cost and risk, and new measures of total spending. In addition, a host of technical
issues related to econometric estimations of velocity equations have arisen and been
dealt with.
Because of the continued instability in the velocities of the conventionally
defined aggregates and the tentative and unsettled nature of current research, it is not
possible to use the existing or newly formulated monetary aggregates as intermediate
control variables. More, their role as preeminent information variables is also
limited. It is, however, desirable to continue to monitor the existing aggregates and
some of the new ones that have demonstrated promise for forecasting such relevant
economic performance variables as nominal GDP.
In addition, interest rates can play a potentially useful information role.
However, since their movements are subject to influences other than the Federal
Reserve, they must be interpreted with great care.

Glossary: Definitions of the Aggregates
M1 is the sum of the following:
1. Currency held by the public
2. Outstanding traveler’s checks of nonbank issuers
3. Demand deposit balances
4. Negotiable Order of Withdrawal (NOW and Super-NOW) accounts
and other checkable deposits.
M2 is the sum of the following:
1. M1
2. Time and savings deposits in amounts under $100,000
3. Individual holdings in money market mutual funds

4. Money market deposit accounts (MMDAs).

M3 is the sum of the following:
1. M2
2. Time deposits at commercial banks in amounts of $100,000 or more
3. Term repurchase agreements
4. Institution-only money market mutual funds

5. Term Eurodollars held by U.S. residents in Canada and the U.K.

6. Overnight retail purchase agreements (Repos)

7. Overnight Eurodollars held by U.S. residents.

Nonfinancial debt is the sum of the following sectors’ outstanding debt:
1. U.S. government
2. State and local governments
3. Nonfinancial domestic businesses

4. Households.

Additional Selected Readings
Anderson, Richard, ed. Symposium on Mutual Funds and Monetary Aggregates.
Federal Reserve Bank of St. Louis Review, vol. 76, Nov/Dec. 1994.
Brunner, K. and A. H. Meltzer, ed. “Money Demand in the United States: A
Quantitative Review,” by Robert E. Lucas, Jr. Amsterdam, North Holland,
Carnegie–Rochester Conference Series on Public Policy, vol. 29, 1988, pp.


-----. “M1–Velocity and Money Demand Functions: Do Stable Relationships Exist?”
by Robert H. Rasche. Amsterdam, North Holland, Carnegie–Rochester
Conference Series on Public Policy, no. 27, 1987, pp. 9–88.
Carlson, John B. “The Stability of Money Demand, Its Interest Sensitivity, and
Some Implications for Money as a Policy Guide.” Federal Reserve Bank of
Cleveland Economic Review, 3rd Quarter, 1989, pp. 2–13.
-----, and Susan M. Byrne. “Recent Behavior of Velocity: Alternative Measures of
Money.” Federal Reserve Bank of Cleveland Economic Review, vol. 28, no. 1,
pp. 2–10.
Collins, Sean and Cheryl Edwards. “Redefining M2 to Include Bond and Equity
Mutual Funds.” Federal Reserve Bank of St. Louis Review, November 1994,
pp. 7-30.
Dotsey, Michael and Christopher Otrok. “M2 and Monetary Policy: A Critical
Review of the Recent Debate.” Federal Reserve Bank of Richmond Economic
Quarterly, vol. 80, Winter 1994, pp. 41–60.
-----, Carl Lantz, and Lawrence Santucci. “Is Money Useful in the Conduct of
Monetary Policy?” Federal Reserve Bank of Richmond Economic Quarterly,
vol. 86, Fall 2000, pp. 23-48.
Dwyer, Gerald and R.W. Hafer. “Are Money Growth and Inflation Still Related?”
Federal Reserve Bank of Atlanta Economic Review, Second Quarter 1999, pp.


Fair, Ray C. “International Guidance on the Demand for Money.” Review of
Economics and Statistics, vol. 69, August 1987, pp. 473–480
Fitzgerald, Terry J. “Money Growth and Inflation: How Long is the Long Run?”
Federal Reserve Bank of Cleveland Economic Commentary, August 1999.
Friedman, Benjamin M. “Lessons on Monetary Policy from the 1980s. Journal of
Economic Perspectives, vol. 2, Summer 1988, pp. 51–72.
Haslag, Joseph H. “Monetary Aggregates and the Rate of Inflation.” Federal
Reserve Bank of Dallas Economic Review, March 1990, pp. 1–12.

Hetzel, Robert L. “How Useful is M2 Today?” Federal Reserve Bank of Richmond
Economic Review, vol. 78, Sept/Oct. 1992, pp. 12–26.
Higgins, Bryon. “Policy Implications of Recent M2 Behavior.” Federal Reserve
Bank of Kansas City Economic Review, Third Quarter 1992, pp. 21–36.
Ireland, Peter. “Endogenous Financial Innovations and the Demand for Money. “
Journal of Money, Credit, and Banking, vol. 27, February 1995, pp. 107-123.
Laidler, David, ed. “Understanding Velocity: New Approaches and Their Policy
Relevance.” Journal of Policy Modeling, vol. 12, Summer 1990.
-----. “The Demand for Money in the United States––Yet Again.” Amsterdam,
North Holland, Carnegie–Rochester Conference Series on Public Policy, no.

12, 1980, pp. 219–271.

Mehra, Yash P. “Some Further Results on the Source of Shift in M1 Demand in the

1980s.” Federal Reserve Bank of Richmond Economic Review, Sept/Oct. 1989,

pp. 3–13.
-----. “A Review of the Recent Behavior of M2 Demand.” Federal Reserve Bank of
Richmond Economic Quarterly, vol. 83, Summer 1997.pp. 27–43.
Miyao, Ryuzo. “Does a Cointegrating M2 Demand Relation Really Exist in the
United States?” Journal of Money, Credit, and Banking. vol. 28, August 1996,
pp. 365-380.
Orphanides, Athanasios, Brian Reid, and David H. Small. “ The Empirical Properties
of a Monetary Aggregate that Adds Bond and Stock Funds to M2.” Board of
Governors of the Federal Reserve Discussion Paper 93–42, December 1993.
Porter, Richard D., Thomas Simpson, and Eileen Mauskopf. “Financial Innovation
and the Monetary Aggregate.” Brookings Papers on Economic Activity, no. 1,

1980, pp. 213–229.

Siegel, Diane F. and Steven Strongin. “Can Monetary Models be Fixed?” Federal
Reserve Bank of Chicago Economic Perspectives, Nov/Dec. 1986, pp. 3–14.
Small, David H. and Richard D. Porter. “Understanding the Behavior of M2 and V2.
“ Federal Reserve Bulletin, April 1989, pp. 244–254.
Stone, Courtenay C. and Daniel L. Thornton. “Solving the 1980s' Velocity Puzzle:
A Progress Report.” Federal Reserve Bank of St. Louis Review, vol. 69,
Aug/Sept. 1987, pp. 5–22.
Wenninger, John and John Partlan. “Small Time Deposits and the Recent Weakness
in M2.” Federal Reserve Bank of New York Quarterly Review, Spring 1992,
pp. 21–35