Financial Markets and the Economy
Demand, Supply, and Equilibrium in the Money Market
Case in Point: Money in Today's World
The models of the money and
bond markets presented in this chapter suggest that the Fed can control
the interest rate by deciding on a money supply that would lead to the
desired equilibrium interest rate in the money market. Yet, Fed policy
announcements typically focus on what it wants the federal funds rate to
be with scant attention to the money supply. Whereas throughout the
1990s, the Fed would announce a target federal funds rate and also
indicate an expected change in the money supply, in 2000, when
legislation requiring it to do so expired, it abandoned the practice of
setting money supply targets.
Why the shift? The factors that
have made focusing on the money supply as a policy target difficult for
the past 25 years are first banking deregulation in the 1980s followed
by financial innovations associated with technological changes - in
particular the maturation of electronic payment and transfer mechanisms -
thereafter.
Before the 1980s, M1 was a fairly reliable measure
of the money people held, primarily for transactions. To buy things, one
used cash, checks written on demand deposits, or traveler's checks. The
Fed could thus use reliable estimates of the money demand curve to
predict what the money supply would need to be in order to bring about a
certain interest rate in the money market.
Legislation in the
early 1980s allowed for money market deposit accounts (MMDAs), which are
essentially interest-bearing savings accounts on which checks can be
written. MMDAs are part of M2. Shortly after, other forms of payments
for transactions developed or became more common. For example, credit
and debit card use has mushroomed (from $10.8 billion in 1990 to $30
billion in 2000), and people can pay their credit card bills,
electronically or with paper checks, from accounts that are part of
either M1 or M2. Another innovation of the last 20 years is the
automatic transfer service (ATS) that allows consumers to move money
between checking and savings accounts at an ATM machine, or online, or
through prearranged agreements with their financial institutions. While
we take these methods of payment for granted today, they did not exist
before 1980 because of restrictive banking legislation and the lack of
technological know-how. Indeed, before 1980, being able to pay bills
from accounts that earned interest was unheard of.
Further
blurring the lines between M1 and M2 has been the development and
growing popularity of what are called retail sweep programs. Since 1994,
banks have been using retail-sweeping software to dynamically
reclassify balances as either checking account balances (part of M1) or
MMDAs (part of M2). They do this to avoid reserve requirements on
checking accounts. The software not only moves the funds but also
ensures that the bank does not exceed the legal limit of six
reclassifications in any month. In the last 10 years these retail sweeps
rose from zero to nearly the size of M1 itself!
Such changes in
the ways people pay for transactions and banks do their business have
led economists to think about new definitions of money that would better
track what is actually used for the purposes behind the money demand
curve. One notion is called MZM, which stands for "money zero maturity".
The idea behind MZM is that people can easily use any deposits that do
not have specified maturity terms to pay for transactions, as these
accounts are quite liquid, regardless of what classification of money
they fall into. Some research shows that using MZM allows for a stable
picture of the money market. Until more agreement has been reached,
though, we should expect the Fed to continue to downplay the role of the
money supply in its policy deliberations and to continue to announce
its intentions in terms of the federal funds rate.