Research Reports

Research Reports AMERICAN INSTITUTE for ECONOMIC RESEARCH www.aier.org Vol. LXXIX, No. 11, June 18, 2012 The Changing Nature of Money Once upon a time, current policy would have yielded stronger growth and more inflation. by Steven R. Cunningham, PhD, Director of Research and Education he same financial and techno- and inconvenience: savings accounts, in different accounts moves through Tlogical innovations that have money market accounts, and CDs. the economy in different ways. But contributed so much to our lives help M1 and M2 are the most commonly more about that later. explain why monetary policy stimu- discussed aggregates. During the inflationary environ- lus hasn’t been working, and why the When interest rates and infla- ment of the 1970s and early 1980s, broad-based price inflation everyone tion are low, as they are now, many the opportunity cost of holding is expecting hasn’t arrived yet. people hold all of their money in money in non-interest-bearing For more than three years, gross checking accounts. They aren’t accounts rose. Over time, as much domestic product has struggled to giving up much interest for the as possible, people moved into sav- maintain a growth rate in the 2-3 convenience, and they need interest ings accounts and CDs. Limited by percent range, and inflation has re- income less to offset inflation. When Regulation Q, created in 1933, banks mained surprisingly tame. Sustained interest rates or inflation rise, many paid no more than 5.25 percent in- expansionary monetary policy by people will move money from the terest on savings. Savings and loans the Federal Reserve over the same checking accounts in M1 to the sav- paid no more than 5.5 percent. period should have yielded stronger ings accounts and CDs, which are Eventually, inflation exceeded short-term GDP growth followed only in M2. Because M2 includes these amounts, and depositors by inflation. But it didn’t. M1, M1 changes, but M2 does not. sought higher returns. In the late To understand why requires a This matters because money held 1970s, the quest for interest prompt- deeper look at the phenomenon we call money. Innovation has changed Chart 1: Velocity of M1 money and the way it functions in Velocity of M1 money stock (M1V) 11.0 the economy. quarterly, seasonally adjusted Money has many attributes that 10.0 are inseparable. It is a collection of 9.0 assets; it is a medium of exchange; it changes hands. 8.0 Economists have created an array of definitions for money as a collec- 7.0 tion of assets. M1 measures narrowly Pre-1981 Trend → 6.0 defined assets that can be used directly for transactions and bear little 5.0 or no interest (cash and checking 4.0 accounts, for example). Broader aggregates, M2 to M4, include interest- 3.0 bearing assets that can be converted 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 into transactions money at some cost Source: Federal Reserve Inside this report In countries from Canada to Kenya, digital currencies and mobile payment systems are making transactions faster and more convenient. A virtual currency, Bitcoin, crosses national lines and is testing the viability of money that is backed by nothing. These high-tech alternatives to cash and cards are paving the way to the future. See back page. Also A few simple precautions can help summer travelers avoid rental frauds and hotel hackers. See Ask the Expert, page 3. Research Reports, June 18, 2012 Chart 2: Velocity of M2 linked directly to bank accounts, al- Velocity of M2 money stock (M2V) lowing individuals to sell securities quarterly, seasonally adjusted 2.2 and deposit the proceeds instantly into M2 accounts. Money changes 2.1 hands more quickly, but also shifts 2.0 between aggregates instantly. As it’s become more difficult to say 1.9 which aggregate funds belong to, it’s Pre-1994 Trend ↓ also become harder to gauge how mon- 1.8 ey works as a medium of exchange. Monetary policy creates incen- 1.7 tives for people to change their demand for goods and services, which 1.6 affects prices. The incentives operate along specific channels that econo- 1.5 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 mists call transmission mechanisms. Quarterly The channels have changed. If we Source: Federal Reserve know less about how money oper- ates in the economy, we certainly ed people to move out of M2 entirely ters even less predictable, since late know less about the impact of policy and into what was then a fairly new 2008 the Fed has been paying inter- or money supply changes. financial instrument: money market est on bank reserves, which reduces Behavioral shifts and financial accounts in brokerage houses. the payoff on bank sweeps. All innovation have weakened the Depositors’ actions ultimately led to this makes it harder to know how interest rate channel. All else equal, the repeal of Reg Q in 1986. But the sweeps distort our understanding of an increase in the money supply flow of dollars, driven by the quest the economy. usually lowers interest rates, making for interest, continues to this day. In the early 1990s, world events it cheaper to finance large purchases. In January 1994, the Federal Re- created another monetary shock. The This stimulates demand and is ulti- serve began retail sweep programs fall of the Soviet Union and the de- mately inflationary. In the 21st cen- that increased the movement of mocratization and marketization of tury, credit card interest rates often money among accounts that had dif- Eastern block nations led to hyperin- exceed 20 percent, and people still ferent impacts on the economy. flation in these countries and distrust use them. Firms, for their part, are The new Fed rule allows banks of their currencies. The solution for no longer so reliant on bank financ- to transfer balances from (M1) many was to turn to U.S. currency. ing. They have a wider selection of household transactions accounts Many dollars created during the pe- securities and derivatives than ever into (non-M1 M2) savings accounts, riod did not remain in the U.S. and before to turn to. which are subject to different reserve were not part of the domestic money Another key transmission requirements. As needed, the funds supply, skewing the data. mechanism, the liquidity channel, automatically shift back into transac- By making money easier to has been altered by the easy money tions accounts. The banking innova- move around, technology has fur- of the Greenspan Federal Reserve. tion allows depositors to earn higher ther confused matters. As money Today, with a money-supply expan- rates of return than they would moves more quickly among ag- sion of about $2.3 trillion since the otherwise. It also allows banks to gregates that behave differently, it end of 2007, we are still in such an reduce reserves, which, until recently, has become harder to predict how economy. The presence of so much did not earn interest for them. funds will impact growth, employ- cash has substantially reduced the Because the movements between ment, and inflation. effects of changes in available cash M1 transactions accounts and M2 In 2012, individuals can transfer balances in individual accounts and interest-bearing accounts affect bank funds in and out of M1 or interest- reserves in bank-owned accounts. reserve requirements, they affect bearing M2 accounts with a The speed at which money bank lending. This, in turn, affects smartphone app. But it doesn’t stop changes hands is called velocity. economic activity and employment. there. Banking services available That’s changed, too, from posting a The problem for economists, via ATMs, telephones, hand-held fairly steady rate of change to erratic policy makers, and the rest of us is computing devices, and comput- growth that makes predictions more that banks are not required to report ers make it easy to move money unreliable than ever. on sweeps. The amount of funds between M2 and broader aggre- The U.S. economy is producing involved is unknown. Making mat- gates. Brokerage accounts are often about $15.4 trillion per year in goods 2 Research Reports, June 18, 2012 and services, while the total amount As shown in Chart 2 on page 2, of money readily available for trans- velocity growth of M2 is also becom- ASK THE EXPERT actions (M1) is about $2.2 trillion. To ing more erratic. M2 velocity has been buy $15.4 trillion of goods and ser- much more stable than M1 velocity Summer Scams vices with $2.2 trillion dollars, each over the last 50 years or so, which is dollar has to be spent seven times. one reason why the Federal Reserve cam artists never go on vacation— Accordingly, we say that the velocity switched to using this aggregate when Sand some are looking for ways to of circulation, or simply velocity, of formulating policy. But M2 velocity is profit from yours. But there are steps you M1 is currently seven. (There is a moving a lot more money. The insta- can take to protect yourself. different velocity for each measure bility of this “more stable” aggregate is A lot of legitimate websites, including of money—M2 has its own, which is also confounding a clear understand- Craigslist, allow users to advertise vaca- different from M1’s.) ing of the economy. If money moves faster, it takes less Technology may be the dominant tion homes for rent. But a website cannot of it to stimulate activity and less of it factor in the decline in M2 velocity guarantee that a posting is authentic.

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