A Shift-Adjusted M2 Indicator for Monetary Policy

Abstract

of fiat money (currency and bank reserves) and the monetary aggregates. This influence is more predictable and is easier to observe when there is a stable relationship between the monetary aggregates and the public’s dollar expenditure or output. The monetary aggregate M2 in particular has exhibited a long-term stable relationship with dollar output (Hetzel 1989, 1992; Ireland 1993). In the early 1990s, however, this relationship apparently disappeared. Over the three-year period 1990Q4 through 1993Q4, nominal GDP grew at an annualized rate of 5.2 percent, while M2 grew at an annualized rate of only 2.0 percent. We first review regulatory and technological changes affecting financial intermediation that could be reducing the public’s demand for M2. Specifically, we review the events that have encouraged bank depositors to place their funds in bond and stock mutual funds, which are not part of M2. We then investigate whether a version of M2 that adjusts for net flows into bond and stock mutual funds can reestablish the previous stable relationship with nominal output growth. This latter aggregate, “shift-adjusted ” M2, consists of regular M2 plus cumulative net inflows from households into bond and stock mutual funds. The article concludes with a discussion of the likely future stability of money demand. The views expressed are those of the authors and not necessarily those of the Federal Reserve