-19-

implications for the demand for bank deposits. Therefore, any
explanation of the U.K.'s monetary performance in 1980 must take the
effects of the termination of the SSD scheme into account. Finally,
the significant exchange rate expectations effect in the sight deposit
equation is quite interesting because of its implication that U.K.
nonbanks appear to engage in some form of "currency" substitution in
the sense that when there is a change in expectations about exchange
rate changes, U.K. nonbank residents adjust their demand for sterling
denominated sight deposits .9/ Following the discussion of equation
(5), the lack of significance of the Eurodollar interest rate and the
significance of the exchange rate expectations term would appear to
indicate that the relevant substitute for sterling denominated sight
deposits is foreign notes and coin only, not Eurodollar deposits .10/
(It should be noted that a binary variable representing the operation
of British exchange and capital controls has no impact on the estimated
equations.) Furthermore, the significance of the exchange rate effect
in the sight deposit equation means that the behavior of the
dollar-sterling exchange rate is another potentially important factor
contributing to the recent divergence in U.K. monetary growth.

In Charts 1 and 2 the actual and predicted paths of Ml and
sterling M3 are plotted; the predicted values are those implied by the
estimated currency, sight deposits, and other bank deposits equations
reported in Table 2. The closeness of the fit, especially in the

turbulent 1979-1980 period, is heartening and means that the


-38-
Literature Cited
. A. Allen, "Recent Developments in Monetary Control in the United
Kingdom," paper presented at "Improving Money Stock Control," a
conference cosponsored by the Federal Reserve Bank of St. Louis and
Washington University, St. Louis, Missouri, October 30-31, 1981.
. D. Bordo and E. U. Choudhri, "Currency Substitution and the Demand

for Money," Journal of Money, Credit, and Banking, February 1982,

‘14, 48-57.
. M. Boughton, "Recent Instability of the Demand for Money: An

International Perspective," Southern Economic Journal, January

1981, 47, 579-597.
. Brittain, "International Currency Substitution and the Apparent
Instability of Velocity in Some Western European Economies and the

United States," Journal of Money, Credit, and Banking, May 1981, 13,

135-155.
. Dornbusch, and others, "The Black Market for Dollars in Brazil,"
unpublished paper, 1981.
. T. Farr, "The Monthly Money Market Model," unpublished paper, 1981.
. Girton and D. Roper, "Theory and Implications of Currency
Substitution," Journal of Money, Credit, and Banking, February 1981,
13, 12-30.

. J. Hamburger, “The Demand for Money in an Open Economy: Germany

and the United Kingdom," Journal of Monetary Economics, January

1973, 3, 25-40.


-34-

other components (owing to the differences in adjustment parameters) ,
the continued increases in Ml during the last third of the period cause
the percentage effect of the lower interest rates on M2 to decline

toward the end of the period.


-13-

expected rate of appreciation of the foreiyn currency, and that on
Eurodeposits is the sum of their nominal rate of interest and the
expected appreciation. Thus, if asset n - 1 is a foreign currency
Eurodeposit and asset n is foreign notes and coin,

R z=rte,

n-1
Ry =e,

where r is the nominal rate of interest on the Eurodeposit and e is the
expected rate of appreciation of the foreiyn currency. Equation (4)

can be rewritten as:

n-2
(5) aj = Big + ja BiiRy + By pal + (8 nt Binde
+ Biyy + (1 - ai) ay tv, T= 1, wees me

-1

In equation (5), the coefficients of r and e are expected to be
negative for all assets denominated in domestic currency.

Since e is not observable, a proxy for it must be used.
Several alternative measures for e are used in this study. One
possible method is a calculation of e based on the actual path of the
exchange rate, which enables equation (5) to be estimated directly.
Another specification for such a proxy is e = Ryo"? where

Rio is the interest rate on a bank deposit similar to


C. Switzerland

In the Swiss case, the volume of retail sales is used as the
scale variable because Swiss GNP is available on an annual basis only.
There is little to be gained from converting the monthly retail sales
data to quarterly averages and so monthly observations are used to
estimate the Swiss equations. The volume of retail sales would seem to
be a good choice for the scale variable in the currency demand
equation, but perhaps is less suitable in the demands for the other
assets. Except for the currency equation, the dependent variable and
retail sales variable are natural logarithms of the real value of the
variable; in the currency equation, these variables are levels of the
real value. Each of the Swiss equations includes eleven binary
seasonal variables.

In Table 3, the estimated equations -- derived and discussed
in Johnson -- for the Swiss nonbank demands for currency, demand
deposits, and term deposits. are presented. Two domestic short-term
bank interest rates, the rate on thrift accounts and the rate on
three-month term deposits in Zurich banks, are used as measures of the
opportunity cost involved in holding currency and demand deposits,
respectively. The term deposit rate is, of course, used as the own
rate in the demand for term deposits. The three-month Eurodollar
interest rate is included in all three equations and in the tern
deposit equation the expected rate of dollar appreciation --
proxied by the annualized actual rate of change in the dollar-Swiss
franc exchange rate in the subsequent three months -- is included
also.

A possible source of the divergent growth of the narrow and

broad Swiss monetary agyregates is a structural change in one or more


-39-

. H. Howard, “The Demand for Monetary Assets in the United Kingdom,"

unpublished paper, 1982.

- H. Johnson, "The Demand for Swiss Monetary Assets," unpublished

paper, 1982.

- E. Lindsey, "Nonborrowed Reserve Targeting and Monetary Control,"

Paper presented at “Improving Money Stock Control," a conference
cosponsored by the Federal Reserve Bank of St. Louis and Washington

University, St. Louis, Missouri, October 30-31, 1981.

. E. Lucas, dJr., "Econometric Policy Evaluation: A Critique,"

in K. Brunner and A. H. Meltzer, eds., The Phillips Curve and
Labor Markets, Amsterdam, 1976.

- I. McKinnon, "Currency Substitution and Instability in the World

Dollar Standard," American Economic Review, forthcoming.

Meese and K. Rogoff, “Empirical Exchange Rate Models of the

Seventies: Are Any Fit to Survive?" International Finance

Discussion Papers, no. 184, June 1981.

. A. Miles "Currency Substitution, Flexible Exchange Rates, and

Monetary Independence," American Economic Review, June 1978, 68,

428-436.

. B. Slovin, "On the Relationships Among Monetary Aggregates,”

Journal of Money, Credit, and Banking, August 1974, 6, 353-366.

D. Thomson, J. L. Pierce, and R. T. Parry, "A Monthly Money Market
Model," Journal of Money, Credit, and Banking, November 1975, 7d

411-431.



Table 1

Monetary Growth in Major Industrialized Countries

Percentage Change over Twelve Moni:hs Earlier

December 1979 December 1980 December 1981

U.S.: M1-B (shift adjusted) 7.1 6.6 3.4
M2 8.2 9.0 10.0

Japan: M1 3.0 -1.7 10.8
M2 9.2 7.5 11.1
Germany: Ml 3.9 4.4 -0.9
M2 8.2 8.8 8.4

U.K: M1 8.7 6.4 8.1
STGM3 12.4 19.9 13.7

Canada: M1 3.3 10.2 -2.4
M2 17.7 16.0 16.9
Switzerland: M1 -7.0 -0.2 -7.3
M2 12.2 13.7 12.6


~32-

then computed and expressed as a percentage deviation from the actual
level so that an elasticity-like number is obtained.

In the U.K. case, the actual path of money is compared to
that implied by the equations if the U.K. local authority rate (and,
implicity, foreign interest rates 14/) had been 1 percentage point
lower than the actual path starting in 1979:Q3.15/ The effect of the
change -- expressed as a percentage deviation -- is traced through to
the end of 1980 in Table 4. The effects by the end of the six quarters
are an Ml some 2-1/2 percent higher than actual Ml and a sterling M3
about 1/2 percent higher than the actual sterling M3 outcome. Thus
interest rates have a substantial effect on the U.K. demand for Ml, but
only a small effect on sterling M3 demand. The modest interest
sensitivity of sterling M3 is attributable to the positive interest
elasticity in the demand for the bank deposits that are included in
sterling M3 but not in Ml.

For Swiss Ml and M2, the hypothetical path is calculated
starting in January 1979. In this calculation, the thrift deposit
rate, term deposit rate, and Eurodollar rate are postulated to have
values 1 percentage point lower than their actual historical values.
Table 4 also presents the percentage deviations implied by the
estimated equations for such an interest rate path. The lower level of
term deposits implied by the lower interest rates dominates the higher
Jevel of Ml and produces an absolute decline in M2 (from the historical
path) throughout the 24-month period. Because the full effect o* the

lower rates is approached much sooner for term deposits than for the


- 20-

— CHART 1: British Ml (sterling billions)

Solid Line = Actual
Dashed Line = Predicted

f4

Ratio
— Scale

— 28

Lijipty

1974 1976

1978

- 1980


- 26 -

Ratio
— —, Scale
CHART 3: Swiss M1 (SF Billions)
Solid Line = Actual
Dashed Line = Predicted
—7 65
U
ie
U
155
445
{ereeeenrel eeeren erry

1974 1975 1978 1980


explanatory variables included in the Table 2 equations constitute a
reasonably complete list of the factors contributing to the pattern of

British monetary growth in 1979-1980.


- 33 -

Table 4

Effect of a 1 Percentage Point Decrease in Interest Rates

United Kingdom:

Percentage Deviation Percentage Deviation
Quarter in ML in Sterling M3
1 (1979:93) 0.5 0.1
3 1.4 0.4
6 2.4 0.7
Switzerlanc:
Percentage Deviation Percentage Deviation
Month in M1 in M2
1 (January 1979) 0.9 1.1
5 3.3 -1.7
10 4.6 -1.8
15 5.0 ~4.3
20 5.2 4.3

24 5.2 3.9,


-17-

representing the entire period during which the SSD scheme was
available as a policy instrument (1974:Q1-1980:Q2) and the expected
noninal yield on equities (including expected capital gains as proxied
by the actual outcome) are added to the basic demand function. Table 2
presents the estimated equations, excluding the coefficients of the
seasonal variables.

For present purposes, there are three interesting features of
the equations reported in Table 2.8/ First, the demands for the two
components of Ml display negative interest rate coefficients, and,
although the coefficient for currency is not statistically significant,
that for sight deposits has a very large t-ratio in absolute value --
5.440. On the other hand, the demand for other bank deposits, that is,
the demand for those deposits that are included in sterling M3 but not
in Ml, has a positive interest rate coefficient, although its t-ratio
is only 0.891. The neyative interest sensitivity of the Ml components
as well as the positive interest sensitivity of the demand for those
assets in sterling M3 but not in Ml strongly suggest that interest rate
developnents can have an important role in explaining divergent
monetary growth, particularly during a period of substantial interest
rate changes. Another interesting feature of the Table 2 estimates is
the presence of the SSD4 and SSD5 variables. For the second quarter of
1980, these variables equal unity but in the third quarter, that is,
afer termination of the SSD scheme, they become zero. The negative
coefficients reported in the table indicate that the removal of the

Bank of England's "corset" -- that is, the SSD scheme -- had important


-9-

of the individual component assets. In general, these assets are
currency in the hands of the public, demand deposits, and one or
more categories of time deposits.3/

In order to compare the properties of these assets and
to understand how a given set of market conditions can induce very
different responses in different assets, it is necessary to ;
estimate the demand function for each asset. These demand
functions have interacted over time with the money supply process
(including policy actions) and external economic forces to produce
the observed path of the outstanding stocks of monetary assets.
With such estimated functions, one can compare interest rate
responses across assets in order to see if and in what way
interest rate changes are a suitable explanation for the recently
observed divergence of the aggregates. On the basis of the
resulting estimated coefficients, it is possible to infer whether
two assets are similar in their response to changes in the rate of
return on some third asset (and are therefore somewhat
homogeneous). It is also possible to look directly for the very
high cross-rate elasticities that can signal the presence of very
close substitution between two assets.4/ In addition,
diséggregated demand functions allow the analyst to identify the
roles of various other factors such as differential adjustment
speeds, structural changes, and rates of return on other assets,
including assets denominated in foreign currencies, in determining
the behavior of the components of the monetary aggregates.

Elsewhere this disaggregated approach is used to

estimate demand functions for monetary assets in the United


~30-

the estimated demand functions as well. The degree of disaggregation
in this study is limited by the availability of data.13/ It may be
that even further disaggregation, if possible, would reveal additional

differences in the structure of the underlying demand functions.


- 27 -

Ratio

— — Scale

CHART 4: Swiss M2 (SF Billions) A

Solid Line = Actual 1
[~ Dashed Line = Predicted
= 100
= 90
= 80
— 70

| | | [PUTT ATTEN YOTTTTTITT

1976 1978 1980


-6-

II. Divergent Monetary Growth

One implication of divergent monetary growth is that the
decision concerning which particular monetary aggregate to use as
an intermediate target is an important one. Extensive analysis is
required before the aggregate and its target are chosen.
Furthermore, after the aggregates policy is underway, it is
necessary to monitor developments for any behavioral changes
induced by the new policy which may have a bearing on the choice
of target(s).2/ In fact, when rates of growth diverge for the
various measured aggregates as much as they have in recent years,
the implementation, as well as justification, of a monetary policy
focused on the path of the money stock may be called into
question. For both the policymaker and the outside observer the
usefulness of the rate of money growth, or changes in the rate of
money growth, as an indicator of monetary policy is lessened when
different measures of money growth provide different signals.

The 1980 experience of the United Kingdom is an example
of the policy problem that can result when one measure (sterling
M3) is growing rapidly while another (M1) is growing slowly. The
fact that sterling M3 was expanding so rapidly was used as
evidence by some critics that the Bank of England was not pursuing
a tight monetary policy. The slow growth of Ml led others to
claim that the Bank of England was tightening monetary policy.

The British experience in 1980 is particularly interesting because

in 1980 the United Kingdom was in a severe and prolonged


-5-

increases). . By this criterion, monetary policy in the United
States and the United Kingdom was tighter in 1980 than it was in
1979 if the narrow aggregate is used, but easier if the broad
Measure is the standard. This is again the case for the United
States in comparing 1981 to 1980. Just the opposite is true for
Canada for 1979 to 1980 and for the United Kingdom from 1980 to
1981.

For the most part, Ml excludes interest-bearing
deposits while the broader aggregates include such deposits. This
fact suggests that the general increases in nominal interest rates
in recent years may be largely responsible for the generally
sluggish growth of (primarily non-interest-bearing) Ml relative to
the growth of the broader monetary aggregates. However, many
other factors are also likely to have been at work, and it is
necessary to examine these possible influences systematically
before any conclusions can be drawn. In this paper, the monetary
experiences of two countries -- the United Kingdom and Switzerland
-- are studied, and the roles played by the various factors are
ascertained. The experiences of the other four countries
discussed in this section are beyond the scope of the present

paper.


-~ 18 -

Table 2

Estimated U.K. Demand for Monetary Assets Equations: 1973-1980

Sterling M3

M1
Variable Currency Sight Deposits Other Bank Deposits
Constant -4.001 -0.004 9.735
(1.882) (1.614) (4.939)
Lagged Dependent Variable 0.811 0.897 C.677
(0.117) (0.062) (C.110)
Local Authority 3-month -0.192 -0.697 0.262
Interest Rate (0.140) (0.137) (C'.198)
Real GDP 0.557 0.100 -0).638
(0.232) (0.179) (1.392)
Deposit Classification Variable 0.004 -0.069
(0.015) (0.025)
Expected Rate of Dollar -0.078
Appreciation (0.036)
Expected Rate of Return on +0031
Equities (0,014)
SSD4 -0.035
(0.011)
ssD5 -0.045
(0.020)
Trend -0.003
(0.001)
a 0.912 0.939 0.972
SE 0.017 0.020 0.029
h -0.696 -1.012 ~1..496
n 32 32 32
Note: Figures in parentheses are the standard errors. The above equations also include

seasonal binary variables. Sight deposits include some interest-bearing bank
liabilities, such as overnight money, as well as non-interest-bearing derand
deposits; other bank deposits are interest bearing and include certificates of
deposit. The rates of return used for the U.K. estimates are expressed as decimals;
in the Swiss estimates they are expressed in percentage points. Therefore the

U.K, rate-of-return coefficients are 100 times greater than comparable Swiss
coefficients.


~8-
aygregates. This explanation suggests that the components are not
homogeneous, that the aggregates defined over them are somewhat
arbitrary, and, therefore, that one would not necessarily expect
such aggregates, per se, to play a stable role in the transmission
mechanism through which monetary policy affects the economy or to
be suitable as intermediate targets for policy. Alternatively,
widely divergent behavior among the assets may result fron failure
to recognize that two assets are very close substitutes and that a
small change in the own rate of return on one asset relative to
that of the other induces very large shifts in portfolios. If the
process of aygyregation at some point includes one of these assets
and not the other, the ayyregate so defined may vary a great deal
without that variation having any implications for the future path
of nominal income. In order to know whether this is the case, one
must have detailed information about the demand for money function
and the mechanism that links monetary developments to nominal
income.

In order to resolve the ambiguities resulting from the
disparate behavior of the various aggregates, it is necessary
first to understand what is causing this behavior, and then to
examine the questions of appropriate definitions for the
aggregates and the proper role of the aggregates in monetary
policy formulation. Since divergent behavior over time of the
aggregates clearly must indicate even more divergent behavior for
at least some of the component assets, and since the current
definitions of the aggregates also are in question, it would seem

that the appropriate way to proceed is to explore the properties


- =

Table 3

Estimated Swiss Demand for Monetary Assets Equations: 1973-1980

M2
M1
Demand Term
Variable Currency Deposits Deposits
Constant 16.973 0.858 2.369
(6.753) (0.236) (0.429)
Lagged Dependent Variable 0.778 0.843 0.519
(0.063) (0.043) : (0.082)
Thrift deposit interest rate -0.791
(0.194)
3-month term deposit -0.012 ().037
interest rate (0.003) (0.009)
3-month term deposit rate 0.048
1978-1980 (0,015)
3-month Eurodollar rate 0.106 - 0.0016 0.0046
(0.057) (0.0015) (9.0034)
Expected rate of dollar -().0006
appreciation (0.0003)
Real Retail Sales 4.055 0.159 -0.049
» (2,262) (0.082) ().220)
Trend 0.0004 1.0007
(0.0002) (0.0007)
Re 0.969 0.974 0.978
S.E. 0.864 0.022 0.036
h 0.291 0.952 1.109
n 96 96 66

Note: Figures in parentheses are standard errors. The above equations also include
monthly binary variables. Unlike the other equations, the currency demand equation
is not in logarithmic form. Term deposit equation is estimated over. the tnterval
June 1975-December 1980 because monthly data on term deposits. are not available for
January 1973-April 1975, These components are as defined tn the Swiss National
Bank Monthly Bulletin, except that the label "term deposits" is used to refer to
the component. "quasi-money", which includes in addition to term deposits foreign
currency deposits held by Swiss residents at Swiss banks. The rates of return

are expressed in percentage points; see note to Table 2.


International Finance Discussion Papers
Number 207

May 1982

THE BEHAVIOR OF MONETARY AGGREGATES IN MAJOR
INDUSTRIALIZED COUNTRIES

by

David H. Howard and Karen H. Johnson

NOTE: International Finance Discussion Papers are preliminary materials
circuleted to stimulate discussion and critical comment. References in
publicetions to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


-ll-

III. The Demand for Monetary Assets

A. Methodology

In the general case, there are n assets, aj»

i= 1, «++, , where a; is the real value of the stock of
asset i, and each asset has an expected rate of return, Rie
There are n demand functions:

*

(1) a; = +

j

tums

R. tay t Uj» i=l, ..., 0

%i0 1 S455) 7 iy:

where the asterisk denotes what demand for a; would be if

adjustment to changes in the various right-hand-side variables
were complete in one period, y is a scale variable such as real
income, and the u, are error terms. In order to allow for
partial adjustment, it is specified that:

* -
(2) a. - at a, (a i 74 )+ We i=l, ...,n

where the subscript denotes a lag of one period, the 4
are the adjustment parameters, and the Ww; are error terms.

Equations (1) and (2) can be combined to yield:


Kingdom and Switzerland (see the papers by Howard and by Johnson).
The experiences of these two countries are especially relevant to
the issues being raised in this paper because growth rates of the
monetary aggregates in each country have diverged sharply in
recent years (see Table 1) and because during the 1970s both the
British and Swiss monetary authorities adopted monetary aggregate
growth rates as the intennediate target for monetary policy.
Moreover, these two examples should provide insights into the
general problem of explaining divergent growth among monetary

aggregates.


-41-

In the United Kingdom, Ml consists of sterling denominated

notes and coin in circulation with nonbanks (including,
presumably, some nonresidents) plus sterling sight deposit
liabilities of U.K. banks held by the U.K. nonbank private sector
(that is, U.K. residents only). In addition to demand deposits,
sight deposits include money at call and money placed overnight,
which are interest bearing. Sterling M3 consists of Ml plus

all other sterling deposit liabilities (including certificates of
deposit) of U.K. banks held by U.K. nonbank residents, including
the public sector. In Switzerland, Ml consists of Swiss franc
notes and coin in circulation (including that held by
nonresidents) plus Swiss franc sight deposits held by residents at
Swiss banks. M2 adds to these Swiss franc term deposits plus
foreign currency deposits held by residents at Swiss banks.

In most cases, a t-ratio of 2 or more is used as the criterion for
statistical significance, although there are some exceptions made
to this rule of thumb.

Under rational expectations, this measure should differ from the
true expected rate of exchange rate change by an error term

that is independent of information available at the time of the
observation. The error will not, however, be independent of the
asset demands and rates of return being determined
simultaneously. The expected rate of exchange rate change (as
measured by the actual change) is treated in this study as an
endogenous variable.

See Howard for a more detailed discussion of the equations.


-29-

D. Summary and Comparison

The results shown in Tables 2 and 3 confirm the
appropriateness of estimating separate equations for each component
asset. The two components of Ml in each country are inversely related
to short-term interest rates, but to differing extents. While in the
U.<. currency demand equation the interest rate coefficient is not
significant, it is impressively so in the Swiss equation; in both
cases, demand or sight deposits are significantly negatively related to
interest rates. In each country the Ml component assets combine with
assets that are positively related to the short-term interest rate to
form the broader aggregates of sterling M3 and Swiss M2. Since the
speed of adjustment (as measured by the coefficient for the lagged
dependent variable) differs across the components as well, the interest
rate response of the broader aggregates results from the complex
interaction of all these factors in both the United Kingdom and
Switzerland.

In addition to the differences in estimated interest
elasticities, the demand functions for the component assets in each
country reflect different structural shifts during this period (as
measured by the differential effects of the SSD variables for the
United Kingdom and by the significant shift of the interest rate
coefficient in one equation in the Swiss case). A trend variable is
present significantly in one U.K. function and one Swiss function. For
both countries the effects of other variables, such as the expected
rate of return on equities, the expected exchange rate change, and the

interest rate on foreign-currency deposits, differ importantly across


-28-

versa.) Following the discussion of equations (5) - (7), the positive
signs of the coefficients for the Eurodollar rate in the currency and
demand deposit equations suggest that the relevant foreign currency
substitute is foreign currency, per se, rather than foreign currency
denominated interest-bearing bank deposits. In contrast, the negative
coefficient for the Eurodollar rate in the term deposit equation along
. with the negative coefficient for the exchange rate expectations
variable indicates that Eurodollar deposits, and perhaps dollar
currency as well, are relevant substitutes for term deposits. This
interpretation of the coefficients is interesting but, unfortunately,
it implies that exchange rate expectations proxies differ across
equations. Nevértheless, the roles of the external variables in all
three of the Swiss monetary assets equations suggest that currency
substitution between Swiss francs and foreign currency denominated
Monetary assets cannot be dismissed. Further work on this question in
both the Swiss and U.K. cases is warranted, particularly with regard to
measuring the expected rate of exchange rate appreciation; expansion of

the set of possible currencies might also be useful 12/


-J-
recession. Since sterling M3 was the U.K.'s targeted aggregate
and its 1980 growth exceeded the target by a wide margin,
achievement of the monetary growth target presumably would have
implied a significant tightening of policy during a recession. In
fact, the British authorities accepted the overshooting and
justified this decision in part by referring to the much slower
growth of Ml. A similar policy dilemma confronted the U.S.
monetary authorities in 1981. David Lindsey, of the Federal
Reserve Board's staff, states (p. 12) the problem succintly:

The other major episode in which M1-B has strayed from

its annual range has been in 1981, when it has generally

been below its lower bound. However, M2 has been near

or above its upper bound in every month since February.

Is one to conclude that the [monetary authorities]

should have expanded nonborrowed reserves more rapidly

over this period in an attempt to attain the lower

bound for M1-B sooner, but in so doing drive M2 above

its upper bound? Or should growth of nonborrowed

reserves have been more restrained so as to bring M2

well within its range, but in the process forcing M1-B

further below its lower bound?

The fact that the monetary aggregates of a particular
country are growing at widely differing rates means that as the
aggregation proceeds from the narrowest to the broadest measure, at
least some of the assets that are included at each step are behaving
very differently from those already included. One possible explanation
for this divergent behavior is that different economic processes are

determining the paths of the individual components of the monetary


-21-

Ratio
Scale

[CHART 2: British Sterling M3 (sterling billions)

Solid Line = Actual

Dashed Line = Predicted

. ! 1 pure tiu iy
1974 1976 1978 1980



-36-

One of the interesting features of recent monetary experience
in the major industrialized countries is the problem confronting
policymakers when divergent monetary growth transmits conflicting
signals about the restrictiveness of monetary policy. The empirical
results reported in this paper indicate that the demand functions for
the narrow monetary aggregates in the United Kingdom and Switzerland
are quite sensitive to interest rate changes. Whether this interest
sensitivity constitutes a problem for the use of Ml as a monetary
target or indicator depends on the nature of the interest rate effect
involved as well as on the relationship between Ml and ultimate policy
goals. If the interest rate effect is simply reflecting a shift
between close substitutes that happen to fall on different sides of the
dividing line between narrow and broad money, then perhaps a more
useful monetary aggregate would include the substitutes; that is, a
measure broader than Ml would be appropriate. In present
circumstances, however, the broader aggregates include more than <ust
very close substitutes for sight deposits: in the U.K. case,
certificates of deposit and time deposits of all sizes are included in
sterling M3; in Switzerland, term deposits of all sizes and maturities
are included in M2. Thus, it might well be the case, in the United
Kingdom and Switzerland, that Ml is too narrow and the broader
aggregates are too broad to be useful as monetary targets or
indicators. In this regard, it is interesting to note that the Bank of

England is now collecting data on "retail deposits" in order to be


-37-

able eventually to construct and publish a monetary aggregate somewhere
in between M1 and sterling M3,16/ and that the Swiss National Bank
switched from an Ml target to a monetary base target in part because of

the problems with Ml that are discussed in this paper.


-27-

Ratio

— —, Scale

CHART 4: Swiss M2 (SF Billions) A

Solid Line = Actual 1
[— Dashed Line = Predicted
= 100
=
= 90
— 80
—
= 70

| | | | FPPEVOTYO TY] PYVTTTTTAT

1976 1978 1980


I. Historical Experience

In Table 1, annual monetary growth rates in the United
States, Japan, Germany, the United Kingdom, Canada, and
Switzerland are presented for the 1979-1981 period. The general
pattern mentioned earlier in this paper is clear: in every
country included in the table, growth of the narrow monetary
aggregate (Ml) is exceeded by that of the wider aggregate. The
differences in growth rates vary and at times are substantial.

Divergent monetary growth is not necessarily remarkable;
different trend growth rates can, of course, produce such a
result. However, when monetary aggregates are used as indicators
and/or targets of monetary policy, divergent monetary growth
across aggregates may create problems for the setting,
implementation, and interpretation of monetary policy. For
example, in Canada, Germany, and Switzerland, consumer prices rose
in each of the twelve-month periods reported in Table 1 at a rate
in between the rates of growth of narrow and broad money. Thus if
one used the rate of growth of the "real" money supply as a
criterion, one could characterize recent monetary policy in those
three countries as being either restrictive -- using a narrow
monetary aggregates measure -- or expansionary -- using a wider
measure. For Japan, the United Kingdom, and the United States,
such a criterion is ambiguous in one or two of the years reported
in Table 1.1/ Alternatively, one might look at the direction
of the change in money growth from one interval to the next as an

indication of tightening (if growth slows) or easing (if growth


9/ Recent papers on currency substitution include Marc Miles, Lance
Girton and Don Roper, Bruce Brittain, Michael Bordo and Ehsan
Choudhri, and Ronald McKinnon. See also Rudiger Dornbusch, and
others.

10/ The Eurodollar interest rate has a t-ratio of less than unity in
absolute value when added to the equations reported in Table 2.
See Howard for further discussion of the evidence of currency
substitution as well as possible alternative explanations for
these results.

11/ Note that the Swiss currency equation is in levels, not natural
logarithms, and that the estimated coefficients must be
interpreted accordingly.

12/ Other empirical studies have included external variables in the
demand for money in some countries. See, for example, the papers
by Michael Hamburger and by James Boughton.

13/ The U.K. data now separate interest-bearing and non-interest-
bearing sight deposits, but these data are not available for the
entire sample period.

14/ This implicit assumption is made so that it is reasonable to leave
the path of the exchange rate term unchanged.

15/ Because of the nature of the calculation, the result depends on
the starting points as well as the subsequent actual paths of the
component assets over the interval. This, of course, is also true
for the Swiss case.

16/ William Allen presents the definition being used for retail

deposits.


-14-

ay_y but denominated in domestic currency. In this case equation

(5) becomes:

: n-3

(8) 4° Bio * Bagky * (Binz * 8iyn-a * Pin)Rn-z
-Biyt + Biyy + (1 - Aya; tv, T= 1, oe, ne

-1

In equation (6), the coefficients of Rao and r are predicted

to be negative and positive, respectively, for all assets denominated in
domestic currency other than a2? and indeterminate and positive,
respectively, for that asset. Note that in equation (6) the coefficient on
r refers to the effect of the rate of return on foreign notes and coin
(asset n), not to that of a foreiyn currency denominated Eurodeposit (asset
n-1). Alternatively, Richard Meese and Kenneth Royoff argue that the best
predictive model of the exchange rate is a random walk time series model.
If such a model is used to yenerate exchange rate expectations, then e = 0

and equation (5) becomes:

n-3

(7) = Bio FE BGG * Pi sn-eMn-2 * Pine

r

+

A i i i=, oe, ne

In contrast to equation (6), in equation (7) the coefficients of

Rae and r are both negative for domestic currency assets other

than ay22 and positive and negative, respectively, for a2

In addition, in equation (7), the coefficient of r refers to the effect
of the rate of return on foreign currency Eurodeposits rather than that

of foreign notes and coin as in equation (6).


-16-
B. The United Kingdom

The "basic" U.K. demand for monetary assets function is
specified to include a constant term, the lagged dependent variable, a
representative three-month nominal interest rate, tne natural logarithm
of real GDP, three binary seasonal variables, and, in the demands for
siyht deposits and other bank deposits, a binary variable refl ecting a
imajor change in the method of classifying bank deposits which was
instituted in the second quarter of 1975. The dependent variable is
the natural logarithm of the real value of the monetary asset. There
are several additional variables that might be expected to belong in
these demand functions, including other rates of return and various
binary variables representing the operation of the Bank of England's
supplementary-special-deposits (SSD) scheme (a system of quantitative
limits on the expansion of banks' interest-bearing liabilities). An
SSD variable in a demand for money function can be interpreted as
representing changes in rates of return ‘(implicit as well as explicit)
-- other than those specifically included in the function -- which are
attributable to the SSD scheme's effects on bank behavior.

As reported elsewhere (Howard), the only supplementary
variable added to the basic demand for currency equation is a linear
trend term. In the sight deposit equation, the supplementary variables
are a binary variable (SSD4) representing each of the three SSD
episodes (1974:Q1-1975:Q1, 1976:Q4-1977:Q3, and 1978:Q2-1980:Q2) and
the expected rate of change of the exchange rate, proxied by the actual
rate of change of the dollar-sterling exchange rate during the
subsequent three-month period.// For the demand for sterling bank

deposits other than sight deposits, a binary variable (SSD5)


In this paper, recent monetary growth in the United
States, Japan, Germany, the United Kingdom, Canada, and
Switzerland is examined. The implications of the general pattern
of divergent monetary growth rates are then discussed. Perhaps
the two most dramatic instances of divergent monetary growth ‘in
recent years occurred in the United Kingdom and Switzerland. The
U.K. and Swiss cases are particularily interesting because these
two countries have taken their monetary growth targets quite
seriously in recent years, and because in the U.K. case the
targeted aggregate was the one showing buoyant growth. In this.
paper, disaggregated demand for money functions derived in
separate studies (Howard and Johnson) are used to examine in
detail the U.K. and Swiss experiences. It is concluded that
although the behavior of interest rates played an important role
in the determination of the paths of the monetary aggregates in
the United Kingdom and Switzerland, several other factors also
were operating. The disaggregated demand functions, by allowing
differential adjustment speeds, impact effects, and structural
shifts, enable the analyst to assess more accurately the forces at

work during recent years.


-35-

V. Conclusion

In this paper, the recent behavior of the monetary aggregates
in several of the major industrialized countries is examined, and the
pattern of markedly slower growth of narrow money relative to the
growth of broad money in each country is discussed. Two interesting
examples -- the United Kingdom and Switzerland -- are chosen for closer
analysis. It is found that the behavior of interest rates is an
important factor in determining the behavior of narrow and broad
monetary growth. Between mid-1979 and mid-1980, short-term nominal
interest rates in both the United Kingdom and Switzerland rose some 5
percentage points. Thus it is clear that an important part of the
explanation of the recent divergence in monetary growth rates has been
the behavior of interest rates. The disaggregated demand for monetary
assets functions that are used in this study enable the analyst to
model some of the complexity of the process by allowing adjustment
speeds and interest rate elasticities to differ across monetary assets.
The implicit demand for money equations thus exhibit a more detailed
transmission mechanism between interest rates and the monetary
aggregates than would equations estimated using the narrow or broad
Monetary aggregates directly. It is found that variables other than
interest rates also contributed importantly to the determination of
recent monetary growth in the United Kingdom and Switzerland; it is
noteworthy that in both countries these additional explanatory
variables include structural shifts (the removal of the Bank of
England's supplementary-special-deposits scheme in the U.K. case) and

external variables such as exchange rate expectations.


-25-

of the underlying behavioral functions. The extraordinary appreciation
of the Swiss franc during 1978 suggests the possibility that at about
that time some major shift in the demand for Swiss franc. assets
occurred. However, of the three equations reported in Table 3, there
isa significant: shift in an interest rate coefficient in the term
deposit equation only. Finally, trend terms are included in both
deposit equations.

In Table 3 both currency and demand deposits are
, Significantly inversely related to short-term Swiss interest rates, but

Superior results are obtained when different rates are used in
each.ll/ Term deposits are positively related to the (own)
short-cenn rate, and: there is strong evidence of a shift to even
greater interest elasticity in early 1978. These three assets display
quite different speeds of “adjustment, with term deposits completing
approximately one half of the response to a change in interest rates in

the first month. Charts 3 and 4 show the paths of actual Ml and M2 and
the fitted values over the sample period that are implied by the

: equations reported in Table 3.the closeness of the fit suggests that
the forces identified in the estimated eqiat ions can account for the

‘ divergent behavior of Ml and M2 during the sample period.

The Eurodollar rate appears positively in both the currency
and demana deposit equations and in each its ‘copf ficient is about
one-eichth the magnitude of the Swiss interest rate coefficient. . The
t-ratic for the Eurodollar rate is much higher in the currency
equation. (Recall that only the currency equation reflects the response

of nonresiv'ent as well as resident asset-holders to the opportunity to

substitute foreign currency assets for Swiss currency and vice


THE. BEHAVIOR OF MONETARY AGGREGATES IN MAJOR
INDUSTRIALIZED COUNTRIES

by

David H. Howard and Karen H. Johnson*/

In recent years, most of the major industrialized
countries have adopted some form of monetary growth target as a
guide or intermediate objective of monetary policy. For all but
the United States, this approach has involved picking one
aggregate from the two or more "money supply" totals regularly
compiled, and focusing policy primarily on that measure. The
aggregates thus selected range fron very narrow (Swiss monetary
base) to very broad (U.K. sterling M3). A puzzling feature common
to most industrialized countries in recent years (1979-1981) is
the markedly divergent behavior of the various monetary aggregates
in each country, which made the setting, implementation, and
interpretation of a growth target for a particular monetary
aggregate extremely difficult. In general, narrow monetary
aggregates grew much more slowly than did broader monetary
aggregates. The U.S. experience in 1981 is an example of this
fhenomenon: in the twelve months to December, M1-B (shift
adjusted) increased only 3-1/2 percent while M2 rose 10 percent.
There are much more dramatic examples in foreign countries.
Eetween December 1979 and December 1980, M1 in the United Kingdom
grew 6-1/2 percent and sterling M3 increased nearly 20 percent;
during the same period, Swiss Ml actually fell slightly while M2

rose 13-1/2 percent.


-31-

IV. The Responsiveness Over Time of British and Swiss Money Demands
to Changes in Interest Rates

The demand for monetary assets functions reported in the
preceding section do not provide directly a simple measure of the
interest rate semi-elasticity of the demands for narrow and broad
money. This is the case primarily because the monetary aggregates are
the sum of the component assets for which demand functions are
estimated in this study. Since percentage change (i.e., change in
natural logarithms) is not a linear operator, the percentage effect of
a change in the interest rate on Ml, for example, does not equal the
sum of the estimated coefficients of the effects on currency and demand
(sight) deposits. In the Swiss case, the fact that the currency
equation is estimated in level form while the deposit equations are in
logarithmic form further complicates the calculation of an elasticity
measure from the estimated coefficients reported in Tables 2 and 3.
Furthermore, because of the lagged adjustment specification, the effect
of a change in the domestic interest rate is distributed over time.
There is an initial impact effect and then continued additional effects
until the long run is reached and adjustment is complete.

Altogether these various factors mean that the equations
reported above imply that there is no single constant interest rate
seni-elasticity. In this paper, in order to obtain some sense of the
size of the net impact of a change in the interest rate on the narrow
and broad aggregates, the estimated equations are used to calculate
the effects over time on the component assets of a change in the

interest rate. The implied effects on the monetary aggregates are


-40-

Footnotes
International Finance Division, Federal Reserve Board. This paper
represents the views of the authors and should not be interpreted
as reflecting the views of the Board of Governors of the Federal
Reserve Systan or other members of its staff. We would like to
thank our colleagues in the International Finance Division for
their many helpful comments and sugyestions.
The sign of the rate of growth of real money is not a
satisfactory criterion for monetary policy because, among other
things, it does not take trend rates of monetary growth into
consideration and ignores income growth. The real money criterion
can be misleading -- e.g., during a hyperinflation, when velocity
is increasing rapidly, negative real money growth does not
necessarily imply a restrictive monetary policy -- and is used
here for illustrative purposes only.
On the general point that significant changes in behavioral
relationships can be induced by changes in policy, see Robert
Lucas.
This disaggregated approach to the estimation of demand for money
equations is used in the Federal Reserve Board's inonthly model.
See Helen Farr for a summary of the Federal Reserve Board's
model. An early version of a disaggreyated monthly model is
reported in Thomas Thomson, James Pierce, and Robert Parry. For
an alternative approach see Myron Slovin.
However, measurement and collinearity problems often make it
difficult to estimate these cross-rate elasticities with much

reliability or precision.


-28-

versa.) Following the discussion of equations (5) - (7), the positive
signs of the coefficients for the Eurodollar rate in the currency and
demand deposit equations suggest that the relevant foreign currency
substitute is foreign currency, per se, rather than foreign currency
dénominated interest-bearing bank deposits. In contrast, the negative
coefficient for the Eurodollar rate in the term deposit equation along
with the negative coefficient for the exchange rate expectations
variable indicates that Eurodollar deposits, and perhaps dollar
currency as well, are relevant substitutes for term deposits. This
interpretation of the coefficients is interesting but, unfortunately,
it implies that exchange rate expectations proxies differ across
equations. Nevertheless, the roles of the external variables ir all
three of the Swiss monetary assets equations suggest that currency
substitution between Swiss francs and foreign currency denominated
monetary assets cannot be dismissed. Further work on this question in
both the Swiss and U.K. cases is warranted, particularly with regard to
measuring the expected rate of exchange rate appreciation; expansion of

the set of possible currencies might also be useful 12/


-12-

n

(3) ao TE aig) t ayy * aa

+ AG4y +w i=l, ..., n

P
Thus in general the demand functions are of the form:

n
(4) ay Big t EB

sh wR. + Biyy + (1 - a + ve, 1 = 1, vooy Me

ij i i

Equation (4) is a standard specification of a demand for money
function and is the specification used in this study for the

demand for monetary assets in the United Kingdom and Switzerland.

In some instances, it is necessary to supplement this equation with a
trend term and variables representing various structural changes.

In this study, two of the alternatives to domestic currency
denominated monetary assets are considered to be foreign currency
denominated notes and coin, that is, foreign currency, per se, and
foreign currency denominated Eurodeposits. It is useful to examine
the nature of the expected nominal rates of return in these cases: the

expected nominal return on foreign notes and coin is simply the


-15-

The two main British monetary aggregates -- Ml and sterling
M3 -- can be separated into three components: currency, sight deposits
(M1 less currency), and other bank deposits (sterling M3 less Ml); the
two main Swiss aggregates -- Ml and M2 -- similarly can be decomposed
into currency, demand deposits (Ml less currency), and term deposits
(M2 less ML).9/ In this study, nonbank demand functions for these six
monetary assets are estimated and analyzed. Demand functions based on
equation (4), in which a and y are specified to be natural logarithms
unless otherwise stated, are estimated using a two-stage least-squares
technique. The data used in this study are not seasonally adjusted;
tus seasonal binary variables are included in the equations. The
estimated equations reported in this paper are selected on the basis of
the behavior of the error terms and the signs and significance levels
of the coefficients, although variables that figure prominently in most
demand for money formulations are included regardless of the signs and
t-ratios of their estimated coefficients.6/ (See the papers by
Howard and by Johnson for more extensive discussions of the estimating

procedures used to obtain the equations reported in this study.)