- 19 -

residents' holding of the particular asset. For currency, it would be
appropriate to include as well measures of foreign prices, transaction
scale and/or wealth; but it is not clear how this could be done with
presently available data.) I shall refer to this entire issue of for-
eign rate of return variables playing a significant role in determining,
in this case Swiss, demand for monetary assets as the issue of currency
substitution, although some may prefer to restrict that term to the case
where strictly non-interest bearing assets denominated in foreign currency
are effective substitutes for domestic assets. (See Girton and Roper for
a theoretical model of currency substitution and Miles for an empirical
discussion with respect to the Canadian dollar.) '

The demand for Swiss asset i in the case of currency substitution can

be written as:

(1) Dj = ayn; - a5%; “te (-e) ~dpp(R-e) +62 +u
where 0, is the demand for Swiss asset i, v is the rate of return on that
asset (which may be zero), v5 is the rate of return on a competing Swiss franc
asset, e is the expected rate of appreciation of the Swiss franc, R is the
foreign rate of interest, and Z is a vector of all other variables included

in the equation. Each of the coefficients, including OE (for foreign
currency) and rp (for foreign interest-bearing deposits) is assumed to be
positive. The difficulties of estimating (1) are that there are in fact
numerous alternative foreign currencies, not just one, and that it is not
possible to observe e (either bilateral or weighted-average) directly. Ifa
single R were chosen and e could be measured directly, then (1) would simplify

to:


SD-F

SD-M

SD-A

SD-M

SD-J

SD-J

SD-A

SD-S

SD-0

SD-N

SD-D

Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 8 - Demand for Log of Real MI

Equat. 1 Equat, 2 Equat. 3
+0214 -0239 0234
(.0094) (.0091) (.0091)
-0347 +0354 0335
(.0079) (.0077) (.0079)
-0178 -0180 0164
(.0078) (.0077) (.0079)
-0100 -0106 -0097
(0078) (.0076) (.0077)
-0326 +0333 +0319
(.0078) (.0077) (.0078)
-0050 -00679 +0055
(0086) (00840) (.0085)
-0194 +0219 -0197
(0095) (00906) (0093)
+0445 0472 -0445
(0095) (0089) (.0093)
-0374 -0383 +0354
(.0080) (.0077) (.0082)
-0303 0294 0264
(.0089) (0089) (.0093)
-0281 .0222 -0182
(.0200) (.0198) (0202)


-13-

Table 5

Estimated Term Deposit Equations: 6/75 - 12/80

Dependent Variable: Log of Real Term Deposit Holdings
Equation 1 Equation 2 Equation 3 Equation 4

Variable
Constant. 1.412 1.917 1.834 1.718
(.251) (.305) (.305) (.315)
Lagged Dependent -689 -602 643 -647
Variable (.052) (.059) (.069) (.061)
3-Month Term -046 -037 -034 -.013
Deposit Rate (.007) (008) (.008) (.022)
3-Month Term Deposit -027 +030 -020
Rate 1978-80 (.010) (.011) (.011)
Thrift Deposit Rate -.017
(020)
Euro-Swiss Franc -045
3-Month Rate (.019)
Trend -0009 -.0005 -.0015 -.0002
(.0003) (-.0006) (.0014) (0006)
Real Retail Sales -.110 -.077 -.076 -028
(.208) (.201) (.200) (.213)
SE 034 -033 -033 -034
Re .980 .982 .982 .980
h 1.449 -433 052 842
n 66 66 66 66

Note: Figures in parenthesis are standard errors, Coefficients for seasonal
dummies are reported in the appendix.


- 23 -

The estimates on Table 7 suggest that currency demand responds to
foreign rate of return variables (including that on foreign currency).
Recall that currency is the one component asset measured inclusive of non-
resident: holdings. For demand deposits and term deposits the results are
less persuasive, but indicate that further work on this question might be
fruitful. For thrift deposits, the estimates which included alternative
specifications of the foreign variables never yielded any indication of
significant roles for those variables. The additional inclusion of shift
variables (1978-1980) for the foreign rate of return variables succeeded
only in producing estimates in which the standard errors for all foreign
rate of return variables were very large relative to the estimated coeffi-
cients.

The results reported here clearly do not exhaustively test the issue
of currency substitution as it applies to Swiss franc-denominated assets.
Improved measures of e and the consideration of non-dollar denominated foreign
alternatives are two obvious areas where further work appears warranted but
is beyond the scope of this paper.

Estimation of Ml Demand Functions

In order to compare the success of the disaggregated approach taken in
this paper in predicting Ml to that of the standard money demand for M1
approach, the estimates on Table 8 were calculated. In these regressions the
dependent variable is the log of real Ml. The explanatory variables were
chosen in the light of what had been learned about Swiss money demand in the
disaggregated estimates reported above. The specification and structural
differences between the component assets that had been revealed in the dis-
aggregated equations were suppressed in these equations, however, as the
underlying assumption of such an equation is that a single behavioral structure

explains the movement in M1.


Table 2
Switzerland
Percent change - December over December Year Earlier
M3
Mo
My Term Deposits + *
Demand Foreign Currency Thrift
Currency Deposits Deposits of Residents Deposits
1973 10.2 -2.2 14.3 9.4
1974 7.9 -2.9 20.7 4.1
1975 -1.1 10.5 -7.8 15.8
1976 3.6 10.7 -10.4 13.0
1977 2.5 4.6 9.4 10.3
1978 10.6 29.9 -17.0 10.4
1979 4.0 -12.0 72.7 6.0
1980 3.0 -2.0 37.6 -4.1

* Throughout the remainder of the paper this component will be referred
to simply as term deposits.


Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 6 - Demand for Log of Real Thrift Deposits

Equat. 1 Equat. 2 Equat. 3

-.0109 -.0066 -.0062
SD-F (0039) (0031) (.0033)
-.0074 -.0089 ~ 0089
SD-M (0032) (0025) (0026)
-.0022 -.0049 -.0049
SD-A (.0032) (.0026) (.0026)
- .0096 -.0107 -.0107
SD-M (.0032) (.0025) (.0026)
-.0151 -.0165 -.0165
SD-J (.0032) (0026) (.0026)
-.0096 -.0099 - 0097
SD-J (.0038) (.0030) (.0031)
-.0125 -.0109 -0106
SD-A (0041) (.0033) (.0034)
~.0153 -.0140 -.0137
SD-S (.0041) (.0033) (.0034)
~ 0055 -.0098 ~ 0098
SD-0 (0033) (.0027) . (.0028)
-.0004 -.0073 -.0076
SD-N (0034) (.0028) (.0030)
+0445 0248 0238

SD-D (.0068) (.0061) (.0069)


- 20 -

(2) D, = ary - ars + (oF toep)e - GppR + BZ + UL
Notice that in (2) one would expect a negative coefficient on the foreign
interest rate, R, and a positive coefficient on the expected rate of Swiss
franc appreciation, e, that is a composite of the effects from foreign
currency and foreign deposits.

If the foreign asset is a very close (even perfect) substitute for an

interest bearing Swiss asset, then a possible measure of e would be given by

(3) e=R-ry.

Expression (3) is the open interest arbitrage condition that would hold
exactly only if the foreign asset were viewed as a perfect substitute for the

Swiss asset by portfolio holders, Substitution of (3) into (1) yields:

(4) D, = ary - (a, + dee + Ory) tore R+ BZ + U,
In (4) the expected sign of the coefficient on the foreign interest rate is
positive and the coefficient represents the impact of the yield on foreign
currency on demand for the domestic asset. The coefficient on the alternative
Swiss asset, j, is now the sum of all the cross effects, domestic and foreign,
and is expected to be negative.

Estimates of both form (2) and (4) were calculated for each of the four
Swiss monetary assets examined in this study. For currency and demand deposits
r, was set equal to zero. For term deposits, expression (3) was replaced by

1

(3') e=R--r,.


- 26 -

compared to the values implied by Equation 3 of Table 8. Each of the four
series of "predicted" Ml were then compared to the actual levels, and the

root mean square error was calculated. Table 9 contains these figures.

Table 9
Closed Open
Root Mean Square Error: Version Version_
M1 formed from disaggregated 733 725
estimates
m1 formed from Ml equations 751 744
on Table 8

One might expect that currency and demand deposits are very close
substitutes for portfolio-holders and that the variables which induce sub-
stitution between them are not explicitly captured in the estimated equations
but are, rather, in the context of these models, random shocks. In that
case it would follow that the sum of currency plus demand deposits would
behave in a more stable, easily predictable manner than would the components.
This does not appear to be the case in Switzerland, at least during the 1970s.
In both the "closed" and "open" specifications of the demand functions, the
Ml path implied by the disaggregated equations had a lower RMSE than did
that implied by the Ml] equation of Table 8. The additional information con-
tained in the disaggregated equations about the differences between the
demand for currency and that for demand deposits appears to be more important
than whatever gains are achieved in reducing the net size of the stochastic

shocks by aggregating.


- 22 -

Table 7
Switzerland
Estimated Demand Functions - "Qpen-Economy" Case

Demand Term Thrift
Currency Deposits Deposits Deposits
Variable
Constant 16.973 858 2.369 1,112
(6.753) (.236) (.429) (.406)
Lagged Dependent .778 -843 «519 828
Variable (.063) (.043) (.082) (.063)
Thrift Deposit Rate -.791 -.012
(.194) (.006)
3-Month Term Deposit +012 -037 -.005
Rate (003) (.009) (.001)
3-Month Term Deposit .048
Rate 1978-80 (.015)
3-Month Eurodollar Rate - 106 -0016 -.0046 -.001
(.056) (.0015) (.0034) (.0004)
Expected Rate of Swiss 0006
Franc Appreciation (0003)
Trend -0004 - 0007 -0003
(.0002) (.0007) (0001)
Real Retail Sales 4.055 159 -.049 -.035
(2.262) (.082) (.220) (.020)
SE 864 022 036 -005
Re .969 .974 .978 .999
h 291 +952 1.109 230
n 96 96 66 96

Note: Figures in parenthesis are standard errors. Coefficients for
seasonal dummy variables are reported in the appendix.


Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 7 - "Open"-Economy Demand Functions

Equat. 1 Equat. 2 Equat. 3 Equat. 4

6.141 -0020 -.0180 - .0062
SD-F (.582) (.0134) (.0316) (.0033)
5.085 -0223 -.0076 - .0088
SD-M (.602) (.0112) (.0234) (.0025)
5.382 -.0042 -0316 -.0048
SD-A (.606) (.0111) (.0243) (.0026)
4.395 - 0093 ~.0216 -.0107
SD-M (.570) (.0109) (.0249) (.0025)
5.684 -0175 -.0169 -.0164
SD-J (.591) (.0110) (.0257) (.0026)
3.540 -.0119 -0224 - .0094
SD-J (.575) (.0123) (.0301) (.0034)
5.074 -00057 -0093 -.0104
SD-A (.671) (.0134) (0339) (0038)
6.014 0333 +0153 0134
SD-S (.683) (.0133) (0357) (0038)
4.482 0275 -0093 - 0094
SC-0 (.666) (.0115) (.0252) (.0031)
7.063 0012 ~ 0039 -.0071
SC-N (.746) (.0128) (.0258) (.0029)
9.452 -.0225 -0061 +0243
Sst-D (.993) (.0285) (.0691) (.0064)


-W7-

demand more currency and lower thrift deposit balances, In addition, thrift
deposits are second only to currency in the strength of the seasonal factors
(see appendix). Moreover, the seasonal factors for the thrift deposit
equation are in a very loose sense the opposite of those for the currency
equation.

It may be that the inclusion of additional rates of return on alternative
assets would yield an estimated thrift deposit equation with a positive
coefficient on the own rate of return. Further research on this problem is
clearly called for but beyond the scope of this paper.

Summary of "closed" economy results

Tables 3-6 present a set of similar traditionally structured

relationships that can explain the monthly movements of Swiss monetary
assets in the 1970s. While there are some unresolved problems and
further research is likely to prove fruitful, it does appear that these
relationships can be estimated successfully and that their private
offer potentially useful insights into the process of Swiss money demand and
monetary control. Moreover these results establish that there is a great deal to
be gained by estimating demand functions for the component assets rather than for
the aggregates. The demand functions for the components differ from each other
in many important respects, and these underlying structural differences are lost
when one considers only the aggregated measures.

The demands for the various Swiss monetary components are all interest
sensitive, but they are sensitive to different rates and in different degrees.
In addition these asset demands appear to have different adjustment speeds,
different seasonal properties, and to have been affected differently by structural

shifts in the 1970s. Because of the lagged adjustment specification, there is


Table 3

Switzerland
Estimated Currency Demand Equations: 1973-80

Dependent Variable: Level of Real Currency Holdings
Equation 1 Equation 2 Equation 3 Equation 4

Variable
Constant 6.776 4.177 6,834 8.634
(4.032) (5.390) (4.119) (4.190)
Lagged Dependent 872 891 «875 844
Variable (.038) (.046) (.042) (.042)
Thrift Deposit Rate -.610 -.519 -.623 -.499
(.171) (.209) (.205) (.182)
3-Month Term Deposit -.051
Rate (.073)
Thrift Deposit Rate +237
Shift 1978-80 (.149)
Real Retail Sales 3.840 4.262 3.510 4.727
(2.295) (2.398) (3.136) (2.355)
Trend -.0013
(.0087)
S.E. 877 -879 -883 873
R .968 .968 .968 .969
h -0.230 -0.530 -0.277 -0.206
n 96 96 96 96

Note: Figures in parenthesis are standard errors. Coefficients for seasonal
dummy variables are reported in the appendix.


Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 4 - Demand for Log of Real Demand Deposits

Equat. 1 Equat. 2 Equat. 3

.00199 -.00133  .00347

SD-F (101344) (.0136) (01353)
20244 .0236 .0241

SD-M (10110) = (.0171),—(0110)
-.0025 -.00270  -.00289

SD-A (10110) (.0110)_~—(.0110)

-.0087 -.00945  _-.00884

SD-M (10109) (.01095) —-(.0109)
.0189 £0179 .0188

sD-J (10109) (.0110)_~— (0110)

-.0107 -.0131 ~.00982

SD-J (10122) (.0123) (0123)

.00305 — -.00056 .00415

SD-A (101323) (10135) (0133)
.0364 20325 .0374

SD-S (10130) (0135) (0130)
.0309 .0297 .0307

$D-0 (Jo110) = (.0112) (0111)
.00446 .00618  —.0030

SD-N (01238) (.0124) (0126)
-.0176 -.00878  -.0227

SD-D (.0281) (.0283) (.0286)


- 29 -

The choice of a particular monetary aggregate as the focus of
monei:ary policy depends on the linkage between a given aggregate and
the path of nominal GNP (as well as issues such as the degree of control by
the central bank over that aggregate). Therefore empirical knowledge of
the demand for money is not necessarily enough by itself to allow one to
draw conclusions about the merits of alternative aggregates or targets for
some. In the Swiss case this study has shown that changes in term deposit
rates induce movements in M1 and M2 in the opposite directions .2/ It may be
that changes in the term deposit rate are a major channel by which monetary
policy affects nominal GNP and that, for example, a smooth growth rate for
Ml would imply a path for that rate that yields a smooth path for nominal
GNP. I suspect that it is more likely, however, that the term deposit rate
is one of several very flexible short-term money markets rates (e.g. inter-
bank rates) whose movements do not in any simple, direct way bear on the
path of nominal GNP. In that case a rise in this rate will induce changes
in the outstanding stock of monetary assets that overstate (substantial de-
cline in M1) or even contradict (increase in M2) the degree of monetary
tightness. In this regard it is interesting to note that Swiss officials
abandoned their M1 target in 1979; and, when they resumed a policy of target-
ing a monetary aggregate in 1980, they chose instead to target on a monetary

base measure.


-6-

of the non-resident demand for Swiss franc deposits (such as those that
might follow from the special taxes levied on such deposits in the late
1970s) need not be modeled here as both the demand and supply refer to
holdings by Swiss residents. An exception to this, of course, is
currency outstanding, which will in general include both resident and non-
resident holdings. This distinction should be kept in mind when the two
alternative estimations are discussed below. Since the authorities took
actions which heavily penalized foreignors who sought to increase their
holdings of franc deposits within Switzerland during most of the period
1978-1980, it is unlikely that significant international substitution into
Swiss franc assets took the form of non-resident deposits at Swiss banks.
Although the four demand schedules were viewed as part of one system,
they were estimated separately with judgments concerning structural form
made on a equation by equation basis. Since the model was a monthly one, it
seemed unreasonable to impose total adjustment within the period. Thus a
partial adjustment structure, with the lagged dependent variable included among
the explanatory variables, was used (see Santomero and Seater). The monthly
period of observation also dictated that the variable included to capture the
role of total income or wealth be retail sales. While this measure a priori
appeared reasonable for currency demand, it seemed less appropriate for the
other components. Neither industrial production nor GNP are measured monthly
in Switzerland and the latter is not even available quarterly.
All equations were estimated in both level and semi-logarithm form.
The criteria applied in order to choose amongst alternative versions of the
same demand schedule were the absence of serial correlation in the residuals,
estimated coefficients of the expected sign, and reasonable values for the lagged

adjustment parameter. The dependent variable and retail sales variable in all


Estimation

The information revealed in Table 2 indicated that there was no
a priori reason for believing that the same structural equation was
appropriate for any two, three, or all four of the monetary components.
Therefore the research strategy used was that of modeling the demand for
each component asset rather than for the aggregates as currently defined.

In principle these four asset demand schedules are part of a much larger
system of asset demand functions, including those for long-term financial
assets, stocks, physical capital, real estate etc. A general formulation
of such a system would include all rates of return in each demand schedule.
In the estimations that follow, that was not done. In part this is because
all the appropriate data are not available. In part it results from prior
judgment that the assets in question are sufficiently poor substitutes for
the short-term financial assets being studied here that it is not economic-
ally important to include their rates of return. Because these four demand
schedules are just part of a larger system, no "adding-up" constraints or
cross-equation restrictions apply.

The period of observation selected was 1973-1980. This interval seems
to be one in which the exchange rate regime was stable, and thus shifts in
asset demand because of changes in international monetary arrangements are
unlikely. The model was estimated on a monthly basis in order to take full
advantage of all the information available about changes in money holdings .2/

Two basic versions of each equation were considered: one that would be
appropriate if the set of assets available to Swiss portfolio-holders consisted
entirely of domestic assets, another for the case that foreign assets were also
available. The bank deposit data reported by the SNB includes only deposits

held by Swiss residents with banks in Switzerland. Thus special characteristics


~ 18 -

not just one interest semi-elasticity for each asset, There is a short-run
(one-month) effect given by the interest rate coefficient, and there is the

final very-long term effect that results after all adjustment through the

lagged dependent variable has occurred. For example, the coefficients on

Tables 4 and 5 imply that a one percentage point rise in the term deposit rate
after 1978 would, within the first month, decrease demand deposits by about

one percent but increase term deposits by about six percent. The speeds of
adjustment implied by the coefficients on the lagged dependent variable differ
in the two equations, with adjustment occurring much faster in term deposit
holdings. The long-run impact of such a change in the term deposit rate is about
a seven percent decrease in demand deposits and a sixteen percent rise in term de-
posits. This change in relative values occurs because the impact effect of the
interest rate change on term deposits represents a much larger fraction of the
total effect than is the case for demand deposits.

Foreign-Currency Denominated Assets

In an economy without capital controls limiting the acquisition of foreign
assets or the sale abroad of domestic assets, there is no reason to limit the
consideration of alternative assets to those denominated in domestic currency
alone. Swiss portfolio-holders were free to substitute short-term nominal
assets denominated in other currencies for short-term Swiss franc monetary
assets. They would thereby acquire comparable liquidity, slightly different
transactions services, and a yield which would consist of a capital gain or loss
due to exchange rate change plus, if relevant, the foreign market rate of
interest. If such substitution was empirically important during the 1970s, then
measures of expected exchange rate change and foreign interest rates should be in-
cluded as explanatory variables in the demand functions for Swiss monetary assets.

(Recall that except for currency, the dependent variable in each case is the Swiss


-8-

The coefficient for the thrift deposit interest rate is always
negative and strongly significant in the equation for currency while in-
cluding that for 3-month term deposits (equation 2) contributes no sig-
nificant explanatory power to the equation. (Substituting the 3-month
term deposit rate for the thrift rate yields estimates that are clearly
inferior to those reported in Table 3.) This finding lends support to the
hypothesis discussed above concerning the asset substitution behavior of
households.

The coefficient on real retail sales is positive (as expected) but
generally not statistically significant by the usual criteria. In part this
is probably because retail] sales does not exactly correspond to the concept
of a transactions variable called for by theory. In addition, the retail
sales variable displays a strong seasonal pattern over time. Indeed, one
reason we expect currency holdings to vary seasonally is precisely the
seasonal variation in retail sales. When the seasonal dummies (which vary
across the months and are all significant) are omitted from the currency
equation, the coefficient on retail sales becomes larger and much more signif-
icant. However, clear evidence of serial correlation in the errors in that
case suggests that something systematic has been omitted from the equation.

It thus seems that the seasonal dummies belong in the equation but that those
variables and retail sale are jointly capturing the effects of seasonal
variation in transactions.

Comparison of equations 1 and 2 indicates that the 3-month term deposit
rate does not play an important role by itself and that its presence affects the
coefficients on other variables very little. On this ground, equation 1 was selected
and tested for two further alternatives in the closed-economy form, the presence
of a trend term and of a shift in 1978. Equation 3 shows the results obtained

when a trend term is included. The trend term is not significantly different


~ 24 -

Equation 1 in Table 8 contains all the variables that appeared to be
significant in the "closed" versions of the demand for currency and for
demand deposits. Despite the fact that the evidence reported on Table 3
indicates the importance of the thrift deposit rate in currency demand, that
rate does not come through as significant for M1 demand in equation 1 here.
For the purposes of comparison, equation 2 was calculated. Omitting the
thrift rate had negligible effect on the remaining coefficients. Equation 3
is the more successful of the two versions of the "open" economy specifica-
tion, as described above. While it is reasonable to suppose that a researcher
seeking an estimated Ml equation could improve upon the equations reported in
Table 8, they are typical of the kind of Ml equations found in the literature.
They do reflect the strong negative interest elasticity found for the Swiss
component assets and imply approximately the same speed of adjustment.

Because of the specification of the dependent variables on Tables 3
and 4, i.e., currency is in levels and demand deposits in log form, one cannot
simply compare the residuals of the equations on Table 8 to the (appropriate)
sum of those on Tables 3 and 4. (Indeed, since log is not a linear operator,
the disaggregated equations could not be simply summed to obtain a "predicted"
value for the log of real Ml even if currency were in log form.) Instead,
the fitted values of the currency, demand deposit, and Ml equations were trans-
formed back to the implied nominal levels for these assets. The predicted
levels of currency and demand deposits so-calculated were then summed to
form an Ml value. Equation 1 from Table 3 and from Table 4 produced in this
way a vector of MI values to compare with those implied by Equation 2 on Table
8, i.e., a "closed" economy comparison, The appropriate equations cn

Table 7 were used to calculate an "open" economy version of M1 that. could be


International Finance Discussion Papers
Number 210

June 1982

THE DEMAND FOR SWISS MONETARY ASSETS
by

Karen H. Johnson

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications 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.


-lle-

Table 4

Estimated Demand Deposit Equations:

Variable

Constant

Lagged Dependent
Variable

3-Month Term Deposit
Rate

Thrift Deposit Rate

3-Month Term Deposit
Rate 1978-80

Trend
Real Retail Sales

S.E.
RZ
h

n

Dependent Variable:

1973-80

Log of Real Demand Deposit Holdings

Equation 1 Equation 2 Equation 3
714 -820 «739
(.191) (.290) (.191)
871 +855 -866
(.034) (.048) (.035)
-.0099 -.0092 -.0097
(.0023) (0023) (.0028)
-.0056
(0083)
-.0011
(.0034)
0004 -0002 +0005
(0002) (0002) (0003)
152 +123 167
(.082) (.083) (.083)
022 022 022
+974 +974 974
0.843 1.144 748
96 96 96

Note: Figures in parenthesis are standard errors.

dummies are reported in the appendix.

Coefficients for seasonal


-10-

from zero, but this may in part be due to the fact that the equation is
linear in levels not logs and so the trend specification is not equivalent
to a constant growth rate. The structural shift of most interest that might
lie behind the very large changes in growth rates from 1977 to 1978 of Swiss
currency, demand deposits, and term deposits (see Table 2) is that of a change
in the interest rate response of demanders for these assets. For this reason,
equation 1 was reestimated with a dummy shift variable included for the
thrift deposit rate from 1978 to 1980. The results, reported in equation 4,
suggest that currency demand became less interest sensitive after 1977. This
rather surprising result is far from firmly established since the coefficient on
the dummy shift term is of rather low order significance. While I do not reject
the findings of equation 4 and believe some further work on the question of a
shift is warranted, I regard equation 1 as the most successful of those reported
in Table 3 and as a representative expression of the demand for Swiss currency.
The equations for the demand for demand deposits are reported in Table 4.
The 3-month term deposit rate is negative and strongly significant in all of the
specifications that were tried. When the thrift deposit interest rate is included
in the equation, its estimated coefficient does not appear to be significant and
the coefficient for the term deposit rate changes almost not at all. Comparison
of equation 2 in Table 3 to that of Table 4 reveals rather powerful evidence
that the two component assets, currency and demand deposits, are sensitive to
different short-term interest rates. The estimated coeffcients are consistent
with the characterization given above of households substituting between currency
and thrift deposits and firms, between demand deposits and term accounts. Equation
1 was modified as before to test for a shift in the interest rate coefficient in
1978. As can be seen in equation 3, no significant evidence for such a shift was

found.


Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 3 - Demand for Real Currency

Equat. 1 Equat. 2 Equat. 3 Equat. 4

6.752 6.904 6.743 6.656
SD-F (.489) (.534) (.497) (.491)
5.721 5.834 5.739 5.575
SD-M (.504) (.527) (.518) (.511)
6.023 6.131 6.044 5.868
SD-A (.508) (.528) (.526) (.515)
4.952 5.070 4.969 4.820
SD-M (.493) (.519) (.505) (.498)
6.301 6.424 6.317 6.149
SD-J (.497) (.525) (.510) (504)
4.151 4.287 4.151 4.058
SD-J (.480) (.517) (.483) (.482)
5.910 6.092 5.909 5.785
SD-A (.508) (.569) (.512) (.512)
6.881 7.069 6.881 6.761
SD-S (.510) (.574) (.513) (.513)
5.304 5.450 5.324 5.158
sD-0 (.507) (.545) (.523) (.513)
7.978 8.115 8.024 7.750
SD-N (.571) (.600) (.641) (.587)
10.219 10.218 10.341 9.841
SD-D (.919) (.921) (1.207) (.947)


Appendix

Sources of data

All Swiss currency, demand deposit, term deposit, and thrift deposit
data were taken from the Swiss National Bank Monthly Bulletin (Table 9) as
reported through mid-1981. Back data were obtained from the special
August 1975 supplement. All Swiss interest rates (end of month observations)
were likewise from the SNB Monthly Bulletin. The term deposit rate used
was the rate on 3-month deposits at large Zurich banks, The Eurodollar rate
was the 3-month rate on interbank deposits as reported by the U.S. Federal
Reserve, The Swiss consumer price index, discount rate and monetary base
were available in the SNB Monthly Bulletin. Swiss retail sales were taken

from the OECD, Main Economic Indicators. The data were not seasonally

adjusted.

Definitions of Swiss monetary variables

Currency - notes and coin in the hands of the non-bank public
(including non-residents).

Demand deposits - Swiss franc checkable accounts (sight deposits)
at banks due to non-bank residents.

Ml = Currency + demand deposits.

Quasi-money - Swiss franc term deposits plus foreign currency -

denominated sight deposits due to non-bank residents.

M2 = M1 + Quasi-money.

Thrift deposits - interest-bearing Swiss franc savings deposits
due to non-bank residents.

M3 = M2 + thrift deposits.

These measures are all end-of-month, not seasonally adjusted.


-7-

cases were first deflated by the Swiss consumer price index. Since the
Money supply data (and the retail sales series used) are not seasonally
adjusted, all equations contained eleven monthly dummy variables as
additional explanatory variables. All estimates were done using an
instrumental technique, with all Swiss rates of return treated as endogenous
variables .2/
Results

Table 3 contains the estimates for the currency equation which are
obtained when one regards the Swiss economy as "closed" in the sense that
only domestic monetary assets are considered as alternatives by Swiss port-
folio-holders.4/ The two short-term interest rates, the thrift deposit rate
and the 3-month term deposit rate,are the own rates of return for the thrift
deposit and term deposit components, respectively, but are opportunity cost
measures for currency and demand deposits. Both rates were tried individually
and jointly in all four functions. Household use of currency (rather than
credit cards or checks) is greater in Switzerland than in the United States.
Thus there was a prior expectation that households for the most part substitute
between currency and thrift deposits while firms substitute between demand
deposits and term deposits. The estimated results (discussed below) somewhat
confirmed this characterization.

The currency equation is the only one of the four that consistently
performed better when estimated in level rather than semi-logarithmic form. As
a result in Table 3 (and again in Table 7) the dependent variable, lagged

dependent variable and retail sales variable are in (deflated) level form for

the currency equation.


- 21+

In effect, the foreign asset became the only alternative asset, and "5
equalled zero. (Recall the discussion above of the Euro-Swiss franc rate

in the closed-economy version of the term deposit equation.) Substitution
of (3') into (1) would yield an expression with a composite coefficient on
Len but with the coefficient on R still Ore as in (4), The open-economy
specifications were also modified to allow for shifts in the coefficients of
rate of return variables in 1978 and estimated in that form,

Table 7 reports the most successful of these open-economy specifications
for each of the four assets. The dollar exchange rate and Eurodollar inter-
est rate were chosen as representative foreign variables. While ambiguities
and difficulties are clearly present, the evidence is suggestive of some
currency substitution behavior being relevant as part of the explanation of
the demand for Swiss monetary assets, The specifications reported in Table 7
in effect use different measures for e, The variable defined as a direct
measure of e was a proxy based on the assumption that the expected value of
the rate of appreciation (over a three-month horizon) would differ from the
realized value by forecast errors that were independent of any information
available to portfolio holders at time t. Thus the actual rate of appreciation
(expressed at an annual rate) could be used as a measure of the expected rate.
The expected rate of appreciation is implicitly determined simultaneously with
the asset demands and rates of return modeled here, and therefore the forecast error
is not independent of the contemporaneous values of the endogenous variables.
As a result, the proxy measure of the actual rate of change of the exchange rate
was regarded as an endogenous variable and an instrumental technique was used

for it (see footnote 3).


Footnotes (continued)

5/ A change in the term deposit rate produces opposite movements in demand
deposits and term deposits. Whether the latter exceed the former (and
thus move M2 opposite to Ml) depends on the size of outstanding de-
posit balances at the time (which in turn depends on the level. of
interest rates). In January 1979 demand deposits were over twice the
size of term deposits. Nevertheless, the impact effect of a one per-
centage point rise in the term deposit rate, ceteris paribus, at that
time would have been a fall in demand deposits by 455 million Swiss

francs but a rise in term deposits of 1280 million, for a net rise in M2,


References

J.M. Boughton, “Recent Instability in the Demand for Money: An Inter-

national Perspective," Southern Economic Journal, January 1981,

47, 579-597.
B. 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.
L. Girton and D. Roper, "Theory and Implications of Currency Substitu-

tion," Journal of Money, Credit, and Banking, February 1981,

13, 12-30.

D.H. Howard and K. Johnson, "The Behavior of Monetary Aggregates in
Major Industrialized Countries," unpublished paper, 1982.

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

Independence," American Economic Review, June 1978, 68, 428-436.

A.M. Santomero and J.J. Seater, "Partial Adjustment in the Demand for
Money," American Economic Review, September 1981, 71, 566-578.



- 27 -

Because term deposit, and thus M2, data were available for only the
later part of the sample period, I did not calculate a similar comparison
for precicted M2. That would seem to require, even for this ad hoc, indica-
tive comparison, a reestimation of the equations of Tables 3 and 4 over the
same period that demand for M2 could be estimated. In view of the pronounced
differences between the estimates of Table 5 and those of Table 3 and 4, I
believe it is extremely likely that the additional information provided by
the disaggregated equations would again prove to be most important.

Summary and Conclusions

The results obtained in this study clearly show that it is possible to
model ard estimate the demand for Swiss monetary assets and that these
estimates offer some very interesting insights. Except for thrift deposits,
each of the monetary assets appears to be related to Swiss interest rates
in the expected way. The interest rate effects are strong, but different
across the assets. Indeed, different rates figure in different equations.

In addition, the demand functions appear to have different underlying structures

and very different seasonal patterns of behavior,

Because of the lagged adjustment specification, there is no single
interest semi-elasticity implied by the results for each asset. The short-run
effects of an increase in the term deposit rate are substantial for both demand
deposits and term deposits, especially after 1978. While in both cases the
implied long-run response exceeds that in the short-run, the long-run effects
do tend to converge somewhat. Overall the interest rate coefficients confirm
the hypothesis of substitution between demand deposits and term deposits and
between currency and thrift deposits, These coefficients appear to have re-

mained stable in the late 1970s except for the term deposit shift,


Table 1

Swiss Monetary Aggregates
Percent change - December over December

ML M2 M3
1973 2.0 5.9 7.6
1974 1.1 7.8 6.0
1975 5.9 0.7 7.8
1976 8.1 1.6 7.4
1977 4.1 5.6 8.1
1978 22.9 10.2 10.4
1979 -7.0 12.2 8.8
1980 -0.2 13.7 4.3

This paper will seek to determine whether or not there exist (on
the basis of econometric evidence) a set of stable structural relation-
ships which can explain the observed behavior of the Swiss monetary
components during the 1970s and what the properties of these relation-
ships are. The period since 1978 is of particular importance with re-
spect to the issue of stability. During 1978 the world-wide demand for
assets denominated in Swiss francs was such that the franc appreciated
very sharply. This appreciation induced a response in the policy of the
SNB. It does not necessarily follow that the structure of the relation-
ships describing the demand for Swiss assets shifted or was unstable at
this time. Nevertheless, 1978 marks the beginning of a period during which
the Swiss franc has played a somewhat more conspicuous international role
than it did earlier. Thus the question of a possible structural change in

1978 will be examined in detail.


-14-

For an interest-bearing asset such as term deposits, one (or more)
cross rate of return measure should be included in addition to the own rate
of return. Equations 3 and 4 are the results obtained when rates of return
on alternative Swiss-franc denominated assets are added to the equation. In
equation 3 the thrift deposit rate enters with the expected negative sign, but
the estimated standard error is very large relative to the coefficient. The
rolesof the other variables do not appear to be affected by the inclusion or
exclusion of the thrift deposit rate. In equation 4 the effect of including
the 3-month Euro-Swiss franc rate is quite different. In that equation the Euro
rate enters with a positive, significant wefficient and the 3-month term deposit
rate variable largely breaks down. From mid-1976 these two rates are highly
collinear. There is then first a question of whether there is enough independ-
ent variance of the two rates in the sample for the separate (and presumably
opposite) roles of the two in determining demand for term deposits to be
estimated. Secondly, it may be that these two assets are close, almost perfect,
substitutes. In that case, the demand for term deposits given the Euro-Swiss
franc rate does not have the structure of equation 4 at all, but rather is
essentially infinitely elastic at the going Euro-Swiss franc rate. =quation 4
would then be the result of estimating a misspecified equation. A demand
equation with the structure of those in Table 5 would then exist for the aggre-
gate of term deposits plus Euro-Swiss franc deposits. The lack of monthly
observations on Euro-Swiss deposits (held primarily at London banks) prevented
further exploration of this possibility. Until further research resolves these
issues, a reasonable interpretation of equations 1, 2, and 3 would be that the
term deposit rate coefficient is capturing the impact on term deposit holdings

of joint movements in the term deposit and Euro-Swiss franc rates.


-~ 16 -

Table 6

Switzerland
Estimated Thrift Deposit Demand Equations: 1973-80

Dependent Variable: Log of Real Thrift Deposit Holdings

Equation 1 Equation 2 Equation 3

Variable

Constant -.491 1.185 1.178
(.262) (.314) (.318)

Lagged Dependent Variable 1.075 .816 818
(.040) (.048) (.049)

Thrift Deposit Rate .0074 -.013 -.013
(.0047) (.005) (.005)
Thrift Deposit Rate -.00015
1978-1980 (.0010)
3-Month Term Deposit Rate - 0047 -.0047
(0007) (.0008)
3-Month Term Deposit Rate -.00017
1978-1980 (0008)
Trend - .0003 -0003 0003
(.00007) (.0001) (.0001)

Real Retail Sales -.088 -.037 ~ .034
(.021) (.018) (.020)

SE -0063 -005 005

R .998 .999 .999

h 2.67 246 296

n 96 96 96

Note: Figures in parenthesis are standard errors. Coefficients for seasonal
dummy variables are reported in the appendix.


prices, and which performs best as an intermediate target for policy makers
would not be of great concern if all the monetary aggregates tended to

move together. In fact their movements during the past decade have been
extraordinarily dissimilar, particularly during recent years. From

March 1979 to July 1980, Swiss Ml fell by 17 percent while M2 grew by 20
percent. While perhaps extreme, this episode is not unique. Table 1

gives the December to December annual rate of change for the Swiss monetary
aggregates in 1973-1980. From year to year the rates of change of the
aggregates frequently move in opposite directions, and in some years the
rates are even of opposite sign.

These differences in behavior over time of the narrow and broad
money measures are even more startling when one remembers that the broad
money aggregates contain the narrow money measure. Thus it must be the
case that the underlying components of the aggregates are moving in even
more extreme ways. That this has been the case for Switzerland is shown
in Table 2. There the growth rates for the four basic components of the
aggregates are given for 1973-1980. As expected, the differences across
components of their behavior over time are even more extreme.

Inspection of Table 2 suggests a tendency for demand deposits ana
term deposits to move inversely to one another. Such movement could well
be the result of shifts between deposit categories induced by interest rate
changes. If such behavior is stable and predictable, it would mean that
actual declines in Ml at the same time as rapid growth in M2, as we observed
during 1979 and 1980, are not in any economic sense contradictory. At the
same time, however, serious questions would remain about the appropriate

role of either aggregate in the policy-making process.


*

Footnotes

Economist, Board of Governors of the Federal Reserve System.

The views expressed in this paper are those of the author and

do not necessarily reflect the views of the Board of Governors

or other members of its staff. I wish to thank David Howard

for his many helpful comments and suggestions.

For a general discussion of the recent behavior of the various
monetary aggregates in the major OECD countries and a more de-
tailed comparison of the Swiss and United Kingdom experience,

see Howard and Johnson.

See the appendix for more complete definitions of the monetary
assets and a listing of the sources for the data.

Contemporaneous Swiss retail sales and consumer prices were
assumed to be statistically exogenous for the problem under con-
sideration. All Swiss rate of return variables, including the
exchange rate capital gain defined below, were treated as endogen-
ous. The instruments used in the two-stage calculation included:
the exogenous and predetermined variables in the equation, lagged
values of the respective Swiss interest rates, and the exogenous
variables that could be expected to appear in the money supply/
central bank reaction function. The latter were the Eurodollar rate,
the recent rate of Swiss inflation, the discount rate, and the
monetary base,

The specific variables listed on Table 3 and subsequent tables are

further defined in the appendix.


-~ 25 -

Table 8

Switzerland

Estimated Ml Demand Equations: 1973-80

Dependent Variable: Log of Real Ml Holdings

Equation 1 Equation 2 Equation 3
Variable
Constant -705 -628 178
(.267) (.185) (.233)
Lagged Dependent 879 891 -864
Variable (.043) (.031) (.040)
Thrift Deposit Rate -.003
(.006)
3-Month Term Deposit -.006 ~ .006 -.008
Rate (.001) (.001) (.002)
3-Month Eurodollar 001
Rate (.001)
Real Retail Sales -089 -108 -114
(.058) (.057) (.057)
Trend .0002 -0003 -0003
(.0002) (0001) (0001)
SE .015 -015 -015
Re .977 .977 .977
h 1.558 1.300 1.398
n 96 96 96

Note: Figrues in parenthesis are standard errors. Coefficients for seasonal
dummy variables are reported in the appendix.


THE DEMAND FOR SWISS MONETARY ASSETS

by Karen H. Johnson *

Since the breakdown of the Bretton Woods system and the change to
flexible exchange rates, the Swiss franc has come to play an increasingly
important role on international financial markets. The Swiss franc is
generally included among the group referred to as "newly-emerging reserve
currencies," and the Swiss National Bank (SNB) is often cited as an
example for others to follow in prudent monetary policy management. Since
1975 the SNB has chosen to formulate its policy objective in terms of a
monetary aggregate and has, as a result, raised the international import-
ance of fluctuations in the Swiss money supply.

For Switzerland, as for other countries, there is no one measure that
corresponds to "the" money supply; there are now three publicly-held aggregates
regularly published by the SNB. To understand the observed fluctuations in
these monetary aggregates, it is necessary to have knowledge of the structure
underlying the demand for several Swiss assets. In this paper I propose to
contribute to that knowledge by formulating and then estimating econometric-
ally a model of the demand for Swiss monetary aggregates. These estimates are
of general interest because of the intrinsic importance of the Swiss franc on
international financial markets, because within Switzerland (as elsewhere)
issues of the appropriate definition of monetary aggregates and subsequent
choice of an intermediate target for monetary policy arise, and because these
estimates will contribute to the on-going debates of international comparisons
of the stability of the demand for money (see, for example, Boughton) and of
the existence of economically important cross-country substitution of
currencies within private portfolios (see Brittain) _/

The questions of which aggregate accurately reflects the thrust of

monetary policy, which better predicts the future path of nominal spending or


SD-F

SD-M

SD-A

SD-M

SD-J

SD-J

SD-A

SD-S

SD-0

SD-N

SD-D

Seasonal Dummy Coefficients
(figures in parenthesis are standard errors)

Table 5 - Demand for Log of Real Term Deposits

Equat. 1 Equat. 2 Equat. 3 Equat. 4
-.0312 - .0233 ~ .0243 - 0306
(.0297) (0287) (.0288) (.0302)
-.0027 -.0004 -.0017 -.0275
(.0217) (.0209) (0210) (.0248)
0406 0449 +0442 0121
(.0217) (.0209) (.0210) (.0259)
-.0160 -.0052 -.0061 - .0346
(.0218) (.0214) (.0214) (.0256)
-.0156 -.0011 -.0021 -.0137
(.0224) (.0223) (.0223) (.0238)
0111 -0270 -0277 00324
(.0276) (0273) (.0273) (0303)
-.0174 +0027 -0027 - .0036
(.0308) (.0306) (.0306) (.0320)
-.0124 0068 -0073 -.0161
(.0325) (.0321) (0321) (.0349)
-.0150 -.00003 -0003 - .0236
(.0223) (.0222) (0222) (0251)
-.0196 = = -.0089 » .0064 -.0471
(0235) (.0230) (.0233) (.0287)
0116 0084 0147 -.0263
(.0656) (0631) (.0633) (0673)


- 28 -

The currency substitution hypothesis is far from resolved in the
Swiss case by the results of this study. Inclusion of opportunity cost
Measures based on the Eurodollar appear to improve the ability of esti-
mated equations to fit the sample data. Individual estimated coefficients
and the fact that on Table 9 the "open" specification has a lower RMSE than
the closed for both calculated M1 series suggest that further work on this
question is warranted in the Swiss case,

The estimates reported in this paper show the value of the disaggre-
gated approach to money demand modeling. This lesson seems particularly
valuable now when the divergent behavior of various monetary aggregates is
a problem confronted by policy makers in several industrial countries. For
the Swiss Ml case the predictive power of this approach appears as good or
better than that of the single equation technique and much additional informa-
tion is gained. Because of the pronounced differences between the estimated
structures of the currency and demand deposits functions on the one hand and
that of term deposits on the other (particularly with regard to the speed of
adjustment) it seems questionable to me whether there is an economic justifi-
cation for aggregating these assets to form Swiss M2 and unlikely that a
stable, well-defined single behavioral function of the usual sort exists for
M2 demand. While tradition and international comparability dictate somewhat
standard definitions of the monetary aggregates, these definitions are by no
Means uniform across countries or unchangeable by the respective central banks,
Indeed, U.S. and Swiss procedures with respect to forming M2 and M3 are,
loosely speaking, opposite. Results of the sort reported here are tne first
steps necessary for a more conceptual, original approach to the problem of

defining aggregates and suggest that such work would be worthwhile.


-12-

Real retail sales and the trend term both contribute positively to
demand deposit holdings. The coefficients for both appear somewhat sensitive
to the specification of the rest of the equation. Retail sales is probably
less suitable as a scale variable in this equation than it was in the currency
equation, particularly in view of the distinction suggested above in house-
hold versus firm behavior. Demand deposit behavior is far less seasonal in
its fluctuations than is currency (see appendix).

Table 5 contains the estimated equations for the demand for term de-
posits. Because of data limitations, these equations can be estimated only
over the period June 1975 to December 1980. In these equations the lagged
dependent variable has a consistently lower coefficient than is the case on
Tables 3 and 4. This implies a more rapid speed of adjustment in term deposit
holdings, an intuitively plausible finding since these deposits tend to be held
by firms, who are presumably more sophisticated in their asset management than
households.

For these deposits, the term deposit rate is the own rate of return. In
equation 1 it can be seen that term deposits clearly are strongly positively
related to the own rate of return. Tests of the dummy shift variable for this
rate (equation 2) yielded evidence that such a shift had occurred, thereby
raising the own-interest sensitivity of term deposits in 1978. Because of this
finding, subsequent tests of the term deposit equation were done including the
shift term. Comparison of Tables 4 and 5 confirms the proposition that a rise
(fall) in the term deposit rate leads asset-holders to switch from (into) demand

deposits into (from) term deposits.


- 15 -

From the results reported on Table 5 it would seem that no true
residual trend effects are significant in the equation. The trend term
in equation 1 reflects the effects of omitting the dummy shift variable.

Real retail sales appear to be a poor proxy for the appropriate scale
variable and have essentially a zero effect.

The final component asset examined in this study is thrift deposits.
Estimated equations for the demand for these deposits are reported in Table
6. For these equations the thrift deposit rate is the own rate of return
while the term deposit rate is a cross rate. While the thrift deposit rate
enters positively in equation 1, it is clear from the statistics reported
for that equation that problems arise with that specification. In equation 2
several of these problems appear resolved; the lagged adjustment coefficient
falls below one to a level similar to that for currency and demand deposits, and
there is no longer clear evidence of serial correlation in the residuals. Un-
fortunately, when the term deposit rate is included in the equation, the
coefficient on the own rate measure switches to negative. If one regards
equation 1 as a constrained version of equation 2, the evidence clearly rejects
the constraint in favor of the specification in equation 2. This negative rela-
tionship to the own rate of return cannot be dismissed as some kind of spurious
statistical result because of collinearity between the two rates. The two
rates do not in fact move closely together over this interval and were both
included in equations reported on Tables 3 and 4 without difficulty.

While the negative estimated coefficient on the thrift deposit rate is
troublesome, other aspects of equation 2 do tend to support the notion that
households systematically substitute between currency and thrift deposits. Real
retail sales are negatively related to thrift deposits, a property which is con-

sistent with the interpretation that increased retail sales cause households to