U.S. NARROW MONEY FOR THE TWENTY‐FIRST CENTURY

I. INTRODUCTION Though money retains its fundamental role in a market economy, money measures have been noticeably de-emphasized within the conduct of U.S. monetary policy. The Federal Open Market Committee (FOMC) stopped reporting annual growth objectives for monetary aggregates, although it states that money supply still has value for gauging economic conditions (Board of Governors 2000). However, a growing body of research calls for returning monetary aggregates to a more prominent role within monetary policy. Meltzer (1998) asserts that the view of persistent money growth as being the source of inflation is again widely accepted, perhaps more firmly held by some central bank governors now than at any time in the twentieth century. Nelson (2002) provides evidence that base money has a significant effect on output relative to potential in the United States and United Kingdom, even after controlling for the short-term real interest rate. Nelson (2003) argues that money growth governs the mean and dynamics of inflation in present-day new Keynesian models. Leeper and Roush (2003) find evidence of an essential role for M2 within the transmission of monetary policy, even after controlling for the nominal interest rate. (1) This article focuses on the role of sweep programs in properly measuring narrow money. In a sweep program, banks move a portion of funds from customer demand deposits (DDs) or other checkable deposits (OCDs) into instruments with zero statutory reserve requirements. We examine the effects of two types of sweep programs in the United States: retail sweep programs and commercial demand deposit sweep programs. Narrow, transactions-based money historically has played a key role in the conduct of monetary policy. As Hafer and Wheelock (2001) explain, M1 served as the measure of money within the St. Louis model, although monetarists had long been divided over whether a narrow or broad aggregate was the preferable target for monetary policy. The FOMC appeared to focus on M1 during the 1970s and early 1980s, publishing their target ranges for money growth in terms of M1. Hafer and Wheelock (2001), though, state that deviations in M1 velocity from its upward trend beginning in the early 1980s caused instability within the St. Louis model. Hoffman and Rasche (1991) and Hoffman et al. (1995) place dummy variables in their vector error-correction mechanisms to capture observed shifts in M1 velocity. What attention remains on the money supply seems to be focused on broad rather than narrow aggregates. But the broad aggregates have not escaped difficulties. Duca (2000) and Hafer and Wheelock (2001) document a deviation of M2 velocity from its long-run trend in the early 1990s, sometimes characterized as the missing M2 episode. Duca and VanHoose (2004) state that one response was to replace M2 with MZM, consistent with the view that heightened substitution between small time deposits and mutual funds other than money market mutual funds (MMMFs) largely accounted for the instability in M2 velocity. But as they go on to discuss, M2 and MZM velocity encountered problems in the early 2000s, plunging in ways not in line with opportunity cost variables. Duca and Van-Hoose (2004) state that broader aggregates may have become more vulnerable to portfolio substitution involving stock and mutual funds other than MMMF. Narrow money has also been used extensively in examining money demand. A sizable body of research has emerged that empirically investigates the demand for M1, especially using cointegration techniques. Hoffman and Rasche (1991), Hoffman et al. (1995), Dutkowsky and Atesoglu (2001), and Ball (2001) provide evidence of a stable long-run money demand equation using M1. Ball (2002) generates further support with M1 and establishes a correspondence between the partial adjustment formulation and the vector error-correction model. Yet research and policy making using narrow money is currently being hampered by the lack of an accurate measure of transactions-based money. …