RDP 8703: Money Demand, Own Interest Rates and Deregulation 1. Introduction

One objective of monetary policy is the stabilisation of nominal demand, and hence inflation, over the medium term. Monetary aggregates can be an important indicator of potential inflationary pressures, so their behaviour is generally considered in the policy formulation process.

Growth of monetary aggregates has played an important (though by no means exclusive) role in conditioning policy decisions in Australia over the past decade. Prior to January 1985 a conditional projection for M3 was announced. In the early 1980s it became apparent that M3 growth was being affected by financial deregulation, and in December 1984 the projection was suspended. Nevertheless, the growth of monetary aggregates continues to be one of the items on the Reserve Bank's checklist approach to monetary policy.

Chart 1 shows the behaviour of M1, M3 and broad money (BM) in recent years. M1 growth fell from just under 17 per cent in 1981, to −0.8 per cent growth by the end of 1982. It then rose very sharply in 1983, and fell equally markedly again in 1985. M3 grew noticeably more slowly than BM in the late 1970s and early 1980s. By the end of 1982, however, its growth had accelerated relative to BM. In the second half of 1984, there was an even more dramatic acceleration of M3 growth compared to BM. BM did not begin to grow noticeably more quickly until the second half of 1985, when the economic upturn had been under way for some time.

The behaviour of these three aggregates appear to paint quite different pictures of recent monetary growth. In its Annual Reports and Bulletin the Bank has downgraded emphasis on M3 relative to BM. The Bank has never given much weight to M1 and, indeed, has ceased to publish this narrower aggregate. The primary aim of this paper is to examine whether or not any of these aggregates are, in the face of financial deregulation, suitable indicators for the formulation of monetary policy.

The usefulness of monetary aggregates as indicators for policy purposes can be approached from a number of perspectives. The most basic issue is whether the demand for the aggregate is stable. The relationship between money and variables influencing demand (such as real income, the price level and interest rates) must be predictable if money growth rates are to convey information to policy makers. Issues concerning the econometric stability of money demand functions are examined in Section 2.

A second issue is whether control of monetary aggregates is sufficient to stabilise nominal demand in the economy. Even if money demand is stable, it does not always follow that achieving a particular growth rate for a chosen aggregate will influence nominal demand and inflation in the desired way. Certain additional conditions must be satisfied before this can be established. It is possible, for example, that interest rate policies may slow monetary growth in a predictable fashion while inflation continues accelerating. The parameters of the money demand function and the presence or absence of an own rate of interest are shown in Section 3 to have an important bearing on the relationship between monetary growth and nominal demand.

A related issue is the relative effectiveness of monetary aggregates as intermediate targets. Stable money demand coupled with some assurance that controlling the aggregate in question will influence inflation in the medium term does not guarantee that monetary targeting is the optimal policy rule. Real interest rates affect economic activity. Consequently, there may be costs associated with adjusting interest rates to restrain the growth of monetary aggregates in the face of increasing inflationary pressures. The characteristics of the money demand function and the role of own interest rates on money are again shown to be important in determining the extent of these cost Some concluding remarks are made in Section 4.