RDP 8703: Money Demand, Own Interest Rates and Deregulation 4. Concluding Remarks

In a period of deregulation great uncertainty attaches to the role that monetary aggregates should play in the formulation of monetary policy. A primary requirement for a major role is that the demand for money should be stable – that money should have a predictable relationship with income, interest rates and prices. A careful analysis of demand functions for M1, M3 and BM, has shown that M3 exhibited important evidence of instability in the early and mid 1980s, but this was less so for M1 and, particularly, for BM. This evidence provides some support for the decision taken in January 1985 to suspend the M3 projection.

Estimates of the demand for M1, M3 and BM also shed light on the issue of real interest rate dynamics and the effectiveness of aggregates as intermediate targets. The estimated parameters suggest that M1 would be more likely to be subject to the problem of dynamic instability because of its high interest sensitivity and the absence of an own rate effect. This problem is one whereby an acceleration of inflation expectations pushes up nominal competing interest rates, reducing ex-ante money demand by more than the decline in real money balances. To avoid a sharp downturn in money growth, real interest rate cuts would be needed. But this would add to inflation pressures.

These difficulties are unlikely to be associated with either M3 or BM because of the presence of own interest rate effects. As competing nominal interest rates rise, tending to reduce money demand, the own rate also rises offsetting this effect.

Similarly, the presence of an own rate effect reduces the extent of real interest rate overkill associated with monetary aggregates as intermediate objectives. As rising real interest rates are eventually successful in reducing inflation and inflation expectations, there would be an incipient decline in nominal interest rates. This could lead to increased money demand at a time when the economy was turning down and real interest rates were increasing. The tendency for the own rate of interest to decline sympathetically with the competing rate would reduce this danger.

Taken together, the above findings might constitute an argument in favour of targeting broad money. This conclusion, however, has some limitations. In the first place, the estimates of the broad money equation are new and are still based on a relatively small sample size. Deregulation is still very much in progress, and firmer conclusions will have to await a few more years of data. Secondly, the lag structure with respect to interest rates is particularly complex and no contemporaneous effect is apparent. BM behaviour is dominated by the past pattern of economic activity. In practice, targeting BM would amount to little more than directly targeting nominal income. Finally, it is by no means clear that monetary targets are the optimal way of conducting monetary policy. Even if the demand function is stable in an econometric sense, there are risks of real interest rate overkill, even for broad money, which could destabilise other aspects of economic performance.

In a period of deregulation it would seem wise to take account of a number of indicators in addition to monetary aggregates. The evidence from this paper suggests only that BM may be a better candidate for a monetary aggregate indicator.