Money, Credit and VelocityMACK Ofl

Shakespeare: “Neither borrower, nor a lender he(Hamlet, 1, iii, 75, Polonius to Laertes)

Goethe: “Let us live in as small acircle as we will,we areeither debtors or creditors before we have had time to lookaround.” (Elective Affinities, Bk. II, Ch. 4)

R.ECENTLY, many critics of monetary policy,and some monetary policymakers as well, have as-serted that the links between monetary aggregatesand national economic policy variables—that is,GNP, inflation and real economic growth—havebeen severed by a host offinancial andcredit marketinnovations. If these critics are correct, then amonetary policy based on targetingthe growth of amonetary aggregate would become increasinglyineffective and inappropriate, as credit arrange-ments are substituted for monetary payments.1

The purpose of this article is to provide a theo-retical framework in which to assess these claims

The author, an associate professor ofeconomics at The Pennsyl-vania State University, isa visiting scholaratthe FederalReserveBankof St. Louis.

‘For examples, see Neil C. Berkman, “Abandoning MonetaryAggregates,” in Controlling Monetary Aggregates Jil, pro-ceedings ofaconference sponsored by the Federal Reserve Bankof Boston (October 1980), pp. 76-100; Benjamin M. Friedman,“The Relative Stability of Money and Credit ‘Velocities’ in theUnited States: Evidence and SomeSpeculations,” NBER Work-ing PaperNo. 645 (March 1981);Anthony M. Solomon. “Finan-cial Innovation and Monetary Policy” (remarks before the JointLuncheon of the American Economic and American FinanceAssociations, December28, 1981); James M. Tobin, “Inflation,”in Encyclopedia of Economics, Douglas Creenwald, ed.(McGraw-Hill, 1982), pp. 510-23. Forthe contraryposition—i.e.,that monetary policy should be undertaken through effectivecontrol ofa monetary aggregate—see Milton Friedman, “Mone-tar~’Policy: Theoryand Practice ,“foun,al ofMoney, Credit andBanking (February 1982), pp. 98-118; and Allan H. Meltzer,Robert H. Rasche, Stephen H. Axilrod, and Peter Sternlight,“Money, Credit, and Banking Debate: Is theFederal Reserve sMonetary Control Policy Misdirected?” Journal of Money,Credit and Banking (February 1982), pp. 119-47.

and to examine empirical evidence bearing on theirpurported policy consequences. The analysis pre-sented in this article does not support the critics’assertions. This conclusion rests on two arguments.First, the relation between money and creditrequires thatthe amount ofcreditgranted match theanticipated amount ofmoney thatwill be available tosettle the debtwhen it comes due. Thus, regulatingthe rate ofmonetary growth, which in turn regulatesthe anticipated future quantity of money, deter-mines the amount ofcreditand theconditions underwhich it is granted. This constraining influence ofmonetary growth on creditwould be undone only ifthe relation between money and income growthdeparted from its historical pattern.

That it has not is the second argument: the em-pirical evidence on velocity, the relation betweenmoney growth and income growth, reveals no sig-nificant change during the last two years from itsprevious history. Consequently, despite recentclaims to the contrary, the growth of the monetaryaggregates is still reliably linked to the economicvariables of interest to policymakers.

MONEY, CREDIT AND EXCHANGE

In contemporary societies, the exchange of goodsis indirect The purchase or sale ofgoods, whether inorganized markets or through informal arrange-ments, is almost always in exchange for money ormoney-denominated promises. Direct barteringof one good for another is either nonexistent orunimportant

The reason for this is at once obvious, yet theo-retically challenging to elucidate. In the intro-duction to his book, The Theory of Money, JurgNiehans observes:

Economists (and laymen) have always felt that theuse ofa medium of exchange increases the efficiency

21

FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

ofan economy. The gain was usually considered tohelarge. it hats both qualitative and quantitive aspects.The qnaliative aspects appear when monetary ex-change is compared with barter. Classical and nec)—classical economists were graphic in describing thedouble coincidence of wants of the hungry tailor

and the shivering baker which would he necessary foran e xchalt go ill a I~arte r eco nout van cI the narrowlimitations it imposes on the division of lahor. Theuse of’ us oncy wool cI increase cc-el hue by freeingexchange from the shackles of the double coinci’-dence of wants.

2

Robert Clower succinctly summarized the resultsof these advantages as imposing a constraint on ‘theexchange process: ‘Money buys goods and goodsbuy money; but goods do not bny goods.’’~In otherwords, it is the nature of a system of monetary ex-change to replace the cumbersome barter exchangeof goods with two non—synchronized monetizedexchanges: at sale of goods for money and a later

purchase of goods by money. This exchange attrib-ute in turn has implications for both the appropriatedefinition of money and for the monetary- arrange-ments used in exchange.4

First, the period between the sale of one good fbrmoney and the subsequent purchase of another goodmay be long ettonglt or predictable enough to allowthe interim holding of funds in a non—transactionaccount. This implies that the appropriate monetaryaggregate may not be narrowly defined money (i.e.,Ml), bitt a broader aggregate (e.g., M2) which con-

an0 sert \V. Clow Cr, ‘‘A Recoit siderastisSn of tlt e NI i e rolou it clation

of Nitti,ctarv The it rv,’’ Ue.s te,l butt it it Jo 01(1? (NI arc’lt 1967).~t6. Also, see Karl Brunner and Allan H, Meluer, ‘‘The Uses ofNI toca N loisti V iit Ut c Titeon of Ai Exchange Econctitsy,’’ A; car—a(~ossEcas ;iis;;i ic Rei - ic Ic (Decent her 1971), pp - 784—805.

NI i I ton Fric’di 0 am and A itI las 5(11w asrtz cI C Scri hecl tlt is attn ho te asstlte Se itarati rut of the act of ~torchase f rot it tlte act of sale,’’ hi It

critic-i red the itt c-cl ~II lit of cxcit ange attproach as Ite fog titi I narrowto calptsire the essential nature of lnonc’v:

In order ft ir the aict of purchase to be separated I rum the act of sale.ti i crc sooat iodeeci be sonieth ing that w i I be gunera] lv accepted ispayut ent—th is is Use feature ensphati red in the “os ccl tons of cx—cha! I ge’’ approach - o 1 a so there in tnt he something that! can serve asa te inporari abode of purchasing power, in whtc-h tIe seller hcslcls theproceeds in the in teri,n between sale ansi sobs teqi ‘cut Ito rclsase orirs) rn cdt icis sIte Is liver can extrascl the gels erasl porch asing power cv ithwhich he ~alysfor what he Iso vs - - - - Both fe alt’ rca are o ecessarv topenn it the asct csf porchat;e to he s eparateci frcsns the aset of sale, hot the-son’ eth in g’ that is gencrall v accepted in payment need not cot nc-i c

1c’

with tise ‘soloeclon g’ that s crc-es as a tengtcsrasrv all sssde of porch assing

power the lastter 01ay iItch ale the lcsr,sser aolci Ill! Ire he sides -

NiII ton Fricc1

, nan attic1

Aiii las Sc liw artz, oil’’ too~S to t itt fcc of

i/ic N,otcc? Stotcs: Estioiotcs. Soorce.s. Methods (NBEB, 1970).

]t]t- 106—07,

tam s what NI ilton Friecimain characterizes astemporary abodes of purchasing power that are

reatdilv convertible at low cost into an exchangemedium .~

Second, if the purchase of tlte good to be financedby the proceeds front the sale of another good pre-cedes the sale of that other good, then the anticipatedfuture sale proceeds may he used to ntediate theearlier purchase. Of cotuse, an exchange arrange-ment like this is a fitmiliar part of modern economies;such purchases are said to he macic “on credit.’’Credit is granted b sellers or other third partylenders to buyers precisely on the basis of thebuyers anticipattecl future receipts (with the lenderconcurring) and, of course, is measured in utonetaryunits. As a consequence. credit is as much of amedium of exchange as is money-.8

While both credit and money atre used to mediateexchainge, they are obviously different entities. The

qttautity of money circulating in ant economy is at

stock; its units are used repeatedly itt at sequeitce of

exchamges. Credit, on the other hand, is a flow and istransaction—specific; it can only mediate the trains—action fkr which it was created.~

tTwo good s tISalt are Pc ii ec-t sobs tito tes atre ectsn Ont ical Iv tltt’ saltic’good. If two dluraslsle goods are cssstlessly translorosalsle. sloe inttshe cstls c-’ r, tlteis tlsc v are pe rfec:t oils st i totes i It ails Ityento i-v - On

tlsis criterion, if the cost of trasnsferrisg funds froloasaviogsascc 000 t to a’ dIe itt all id ascd ow) t (Sr tts cat rid’ nc-v cv crc’ xc’to. t Iteli,

cleat rI v, sasvhtgs scudssiitts wot tIc1be eco ‘soiss i call v in cli itingu is1

able flsno dci I and aicco outs tsr dill-re!)c-v at nd cviso Ici hc’ cxc I sailigr-istccl iat - Cooce rse lv, if th cc cit sts of trat)) STi~cv crc’ pro Is il si ti ye1~lasrgc’. sasc-iogs ascconitts would not Its’ at closc’ sohstitote fordeinaotcl deposits. llencc’, ass Fniedloaso and Schwasrtz aarglls’, tlsc’qnes tict is of cc-I tact in~n c-v is caoti sot be sc ttli’d on an at pri sri I sat s’s.

]s sit is as,) c’inparic:asI it’ stion xv it i cIt, iii pairt, dlepc’Id 5 015 liowc:o stlv ill te r—dlepOsit trasi n ft. rs a,rd -

°‘l’lsis olsservastion li its I ccl Clocvc’ r ails cI oth cr5 tss asrgtt t’ tI last sIllnd

IIseal Snrc’ of c-s-cdit tic ~ii/c?~ /ftp or1ist c’ of c-red it be’ in c-lu c

1ccl an t ltd

p0 lit-v ri-I c’vasn t conc:ept of 111011ev: ‘‘for mdlsat pratcticasl l~poses, ‘ntis rs c’ v’ shcsul cI ht-’ tint sit lc’recI tcs md sidle Iraid e c-ri-cl it asswell as c-u nt’s d’V a, Ic1 dIe It) sn dl dcc piss its. litsI sc- rt IV. Clocvc’

Tlsecsrc’ticasl F; son dlast sins of Nit5

ltd tasr>- Pol ic:v,’’ in hissIt’ tc; 5-if

T/~c’oojcis~c?Mossetos-sj Pcs?it-sy iii t?sc’ 1970.s, (;ecsrgi- Clasytisu, jcslsnC. Gilbert audI Rohert Seclgccic:k, ecls - (Oxford University Press.1971), p. 18. Sc-c- aIIm Ai-thor B. I.asffer.’’Trasde Credit abc

1tltd’

Money Market’’ tNIarch 1970). ~sp 239—67: audI I. Stephen Ferris.A Trati’ sasd’tiolis ‘l’ls tory ssfTrascle Creclit U sc’,’ (so cai it’1/1/ Joor; to?

v/ Lroossisoc-s (Nlasv 1981i, pp. 243—70.

7]t bass bee o as rgn ccl tliaid c-i-cs cii t is I ictt at)) c-xcltasItge nie cli oils, Isontcrelv ails atrrallgc’lIti’itt tlsast rasises tltc’ vcelocity csf osoisey.lronic-asllv. the sable asrgstissettt cc-ass Once osc’d algasirlst includingdcn i asia

1clc-pcssits in 0 lonc’ - As 1”ii I-cl maIn am cl Scbwas rtz ~0 int ctsit,

011db of tlse 19th c-c) Iliirv clc’hastc lsetcvc’en tbc’ Isasliking ails ci clii—

rencv sc:hcso Is c-c’n tc-red isis wIt te tIter Isatik n cstc’ s anal clcpsssits werd

none’- onnserely ‘‘nlc-asns cdraising tlit- vclcscitv ssf Isatltk vasoltcassbIso t ii ot ass asclcl ing tct the qs Ian I titv s sI 011515 e - ‘‘ Fri s-cfits all I all dlSchccatrtae,hionc’tostj Stotfstirs of t/tt’ Us,/tet? Stoic’s-, p. 95.

burg Niebasits, the ?heor o/i/oslc-lf (jtslsits Hopkins Universityltrcss. 1978), is 2.

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FEDERAL RESERVE BANK Of ST. LOUIS MAY1962

BOTH CREDIT AND MONEY ARENECESSARY FOB MONETIZEDEXCHANGE

The epigraphs from Shakespeare and Goethe rep-resent conflicting views on the desirability andinevitability ofcredit; to wit, while money andcreditare alternative exchange media, would either besufficient to mediate all exchanges without theother? Could any of us, as Polonius suggests, avoidcredit transactions completely? Conversely, couldcredit function as we know it without a monetaryframework? Not surprisingly, the answer to bothquestions is no. Hence, the advice of Polonius is asfatuous as the character offering it Both credit andmoney are necessary in the exchange process, eachfulfilling functions that the other could not

In order to establish this complementarity ofmoney and credit, consider the exchange process asa contractual arrangement between buyer andseller.’ Under this characterization, the exchangeand the settlement ofthe contract need not coincidein tOne sothateither credit or money can mediate anexchange. In the case of a credit transaction, at thetime of the exchange the buyer incurs a contractualliabilityforasubsequent settlement to clearhis debtUsing this contractual approac.1i, we can now dem-onstrate why Goethe’s claim of the inevitability ofcredit in any society is correct

Credit and the Exchange of Services

Two types of goods are voluntarily offered forexchange in markets: commodities and services. Bydefinition, a commodity is a tangible physical entitynot intrinsically dependent on time (e.g., an apple, aphonograph record or an automobile), while a ser-vice is an activity or process that is intangible andintrinsically sensible only with the passage of lime(e.g., a gardener’schores, aconcertora taxi ride). In amonetized economy, sellers of either type of good

‘Under Anglo-American law, an enforceable contract must havethree elements:

(1) There must be an offer;(2) There must be an acceptance precisely matching the offer—

else it is a counter-offer;(3) There must be consideration—i.e., the olTeror or acceptor

must make some perfonnance that would be a detriment tohim if the agreement were not fulfilled.

See “Contract” and other referenced citations thereunder inHenry Campbell Black, Black’s Law Dictionary, 5th ed. (WestPublishing Co., 1979), pp. 291-94, Vi.

receive money or a promise to deliver money at aspecified future time.

Ifonly commodities were exchanged, it wouldbepossible always to use money alone and never incura debt Services, however, by their very nature,cannotbe exchanged without one party, either selleror buyer, extending credit to the other. Hence, a lawattempting to enforce Shakespeare’s admonitionwould not prohibit the sale ofapples, automobiles orclothing; itwould, however, prohibit therenting ofahouse, the purchaseof a ski-lift ticket or thehiring oflabor, In each of these latter examples, the trans-actionentails the exchange ofmoney before or afterthe completion of the activity with, necessarily, aconcomitant issuance of credit.9

Thus, Goethe was right each of us inevitablyengages in credit transactions every day. For ex-ample, we extend credit to our employerand receiveit from our electric utility. Ifservices ofany form areto be exchanged, credit mustbe offered eitherby theseller—as in the typical employment arrangementwhere wages are received after the services havebeen delivered—or by the buyer—as in entertain-ment activities where the purchase of a ticket pre-cedes the concert, game or movie.10

Clearly, credit is inextricably bound up with sell-ing services in a monetized economy in order toavoid the problem of making an indefinitely largenumber of infinitesimal cash payments. Yet moneyand credit are simply alternative means ofloweringthe cost of exchanging goods relative to a primitivebarter system. Thus, even some commodities mightbe too costly to exchange in customary ways ifcreditwere ruled out (e.g., home-delivered newspapers orraw materials purchased by fiims).11

‘Note that this would also mleout theexistence Many firm otherthan owner-operated producers of commodities.

“Baiter exchange of services is conceivable as suggested in themaxim, “You scratch myback and Ill scratch yours.” Yet, evenhere, credit sneaks in unless the exchange is simultaneous.

“Credit extended by sellers of raw materials is an especiallyimportant example. Ifcredit were not extended to producers,either deliveries would have to be made more frequently (insmallerlots) to matchproducers’ cash flow from sales ofoutput,or the material-using finns would have to tie up ñlore oftheircapital in rawmaterial inventories and, hence, less In thecapitalto process these materials. Alternatively, finns would find itmoreadvantageous to be vertically integrated—i.e..to own theirsuppliers—them to acquire these materials from other finns. See“Credit Allocation: An Exercise in the Futility of Controls”(Citibank Economics Dept., 1979), p. 40. In any case—morefrequentdelivery, larger inventories in capital, or more verticalintegration—resources would be less productively allocatedthan when credit is extended.

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FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

•The Reln.tion.ship Betu~ecniVio•ne~and Credit

Monevanci credit are both substitutes and corn—pleinents in the exchange process. On the individuallevel, money and credit are potential substitutes formediating any exchange of commodities. On thesocietal level, money and credit are complements inthe exchange process; each provides a functionnecessary to some exchanges that the other cannotfulfill. In fhct, credit is a more general inedhmi ofexchange than money in that it facilitates exchangeinvolving time—both in permitting the sale of ser-vices and in permitting difftaing delivery dates inexchanges of commodities; mone without creditcan act as the exchange medium only for a corn—moditv. Yet, money is likewise crucial to the func-tioning of credit through its role as the primarymeans of settlement.

Monetary theorists generally have agreed thatmoney in modern economies is anything that fulfillsall of the loll owing functions:

1. Medium of exchange,2. Store of value.3, Unit of account,4. Standard of deferred payment.

Most economists have argued that the crucial char-acteristic in this list is its functioning as a medium ofexchange. Typically, they have argued that anydurable good can fulfill the remaining three func-tions, hut only money can fulfill the first.

However, we have seen that credit also fulfills themedium of exchange function. Credit in our dis-cussion has taken a special form—namely, creditmeasured in units of money and, implicitly, with thedeferred payment to be made in units of money. Inexchange systems with money and credit acting asexchange media, the other three functions inmoney’s repertoire take on an importance not ap-parent in the conceptual monetary exchange models

without credit.

Without agreement on the unit of account, credittransactions would have all the disadvantages ofbarter except simultaneity. Anthropologists, in con-trast to economists, have placed more emphasis onthe unit of account function because their focus is onhow a monetized exchange system evolves from abarter system rather than how an extant monetized

exchange system functions.12 From this vantage,

they have documented that, in moving from barter toindirect exchange, the most useful function ofprimitive monies is the commonly—agreed—uponvaluation unit.t3

Finally, credit mediation of exchange is facilitatedby the unix-ersal acceptability of money as a means ofsettlement—the standard of dekrred payment fine—tion. All credit contracts can be settled (directly orthrough civil courts) by means of a money payment;that is, money is legal tender in our economy. Thisgeneral agreement on the means of settlementmakes credit less costly to extend, thereby increas-ing its availability for exchange mediation. A decen-tralized use of credit requires that individuals andfirms be able to clear their debts individually (i.e.,pairwise) with some mutually agreeable means ofsettlement; without such agreement on the means ofsettlement, credit clearing would reqnireacostlvcentralized system of record—keeping much like a‘barter cInl).

THF BFIATIflN• OF CBFOITFXP.AN S.IO]N TO) MO.N FTA.RY POI.d.F: Y

Credit is not mone, bitt the promise of futuremoney to the lender in return for the temporary useof current pnrchasing power—goods or money—extended to the borrower. Two errors that violatethis logic occur every day in the financial press:

e Philip C rierson, ‘TIIc Origins of Money.’’ Resc’o re/I i I

Lcono HI It’ Ant/i rs,poiogi), Vol. 1 (JAI Pre ss, Inc., 1978), C spe-cial lv pp. 9—12 for evidence on the i osportancc of standai’d ofvalue in explaining early monetary systems. See also CeorgeDalton, ‘‘Prinsitive Monev,’’A,,ic’ric’on Anthropologist (1965:1),pp. 44—65: and Denise Sehniandt—Besserat, ‘‘The Farl iest Pre-cursors of Writing,’’ Scientific’ Aenericon (june 1978), pp.5O-59.

‘‘In tlsi 5 eo,etc xl, it is ironic and revealing that content porary‘I sartc, r cloiss’’ use dollars as tlse unit of account Iin t not as an

exchange medium, Consider these description s from “As BarterBoom Keeps Crowi,sg,’’ (iS .\ews out! Si:oc/c! Report (Sep-tember 21, 1981), p. 58:

A participant lists items for sale, and they are advertised to the cstheInossli stirs. II a Ii sterl item is sold, the former owner is issued tradecredits—’soosetinse s called trade c

1n liars. ‘these credits Ca,, later he

sed tcs purcls ase goods and services fmoiss sstlier 01 ~i11hers. ‘‘Wedon‘I make outri gltt trades; we perforsss a banking ft. ,scti o,,.

This is also the mcthcscl by which every ‘‘barter exchange”prcsfilecl in the article appears to he organized:

Besides credits, nIost harte r exchanges issIse hsarter cards that ca’she n sed (tsr purchases at participating cli erch suits Through the TradeBassk International exchange. a NI esuphi s dentist hegao receivingeustssm ems wh s, ci sec

1their barter c ardls for dental work. Wi thin a

year’s time, tl,e de,stist acenmu late d coon gil Cache riollars tcs buyarpetin g for his office, in stall new sign sand pay (tsr flying

1eison 5.

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FEDERAL RESERVE BANK 0 ST. LOUIS MAY1902

1. Referringto the interest rate as the price of money;2. Identifying available credit as money.”

The first error is so commonplace that its repeti-tion makes it seem valid; nonetheless, the interestrateis not the price butthe rental rate for a dollar or,properly expressed, any other good. The price of adollar is a dollar’s worth of something—certainlymore than a mere percentage of a dollar. No onewould refer to the rental rate at Hertzas thepriceofanew Ford, or to the rent on a house as its purchaseprice, but the confusion ofinterest on credit with theprice ofmoney has become socommon thatthe errorno longer jangles our sensibilities. Yet the distinc-tion is not only obvious but as important for moneyand credit as for owned and rented automobiles.

Similarly, the second error, referring to availablecredit as money, also escapes rebuke through fre-quent use. The annual total of credit extensions ismany times larger than the year-to-year increases ineitherMl or M2, and, in recent years, has been largerthan the stock of Ml. Considering the consumersector (which accounts for over 60 percent of na-tional income), a large share of credit extensions,almost two-thirds, are by institutions other thancommercial banks and, therefore, do not entailmonetary expansion. Considering only installmentconsumer credit, about 40 percent of such credit isextended by non-depository institutions with about20 percent being extended by retailers and gasolinecompanies. In theseretail extensions, money affectsthe transaction only through the anticipated mone-tar>’ settlement.15

These errors are substantive for they focus thepublic’s evaluation ofmonetary policy on regulatingthe flow ofcredit instead ofcontrolling the growth ofthe stock ofmoney. Controlling the rate ofgrowth ofthe money stock in a predictable fashion enhancesthe predictability of the future availability of themeans of settlement. This regularity of monetaryexpansion makes for better-informed, intertemporaldecision-making and, therefore, contributes to thestabilization ofcredit markets. When non-monetaryshocks occur, the predictable availability of quan-tities of money in the system allows market-

“Recent examples are (1) “The price of money—the interestrate—reflects, therefore the interaction of millions of partici-pants in the credit mnaricet Henry Kaufman, WashingtonPost, September 23, 1981; (2) “As long as the Federal ReserveBoard maintains its cnrrent cOltfle, credit—or money availableto lend—will remain tight.” Harry B. Cuis, Christian ScienceMonitor, September 21, 1981.

1Souive: Federal Re.serre Bulletin (January 1982), Tables 1.21,1.56. 1.57, 1.58, 2.16.

determined signals—that is, interest rate changes—to allocate credit efficiently to adjust to the shocks.

Conversely, attempting to control interest ratesrequires the monetary authority, in effect, to allocatecredit at the cost ofmaking thegrowth rate ofmone-tar>’ expansion less predictable;since this makes thereal future value of the means of settlement morevariable, credit transactions become riskier, andcredit markets less stable. When non-monetaryshocks occur, the less predictable quantities ofmeans of settlement with relatively fixed interestrates impede market signals from efficiently allo-cating credit.

Since both money and credit are exchange media,the key to effectively controlling either or both ofthem must be first to isolate their interconnectionsand mutual dependencies. This article has arguedthat credit is unavoidableand thata money means ofsettlement is necessary for a decentralized creditsystem. What it now addresses is how monetary andcredit expansion relate to each otherand howboth ofthese relate to national income.

Credit and Money Creation

In contemporary market economies, the moneysupply grows through two types of credit transac-tions: thecentral bankcreating deposits (money) andbankreserves by buying government securities, anddepository institutions creating deposits (money)from increased reserves by granting loans.hS

Of course, not all credit extensions entail mone-tary expansion. There are three distinct sources ofcredit extension: (1) bank and non-bank depositoryinstitutio~’s(commercial banks, savings and loans,credit unions, mutual savings banks); (2) non-depository financial intermediaries (finance com-

50In other words, modem monetary systems have a flat base—literally money by decree—withdepository institutions, actingas fiduciaries, creating obligations against themselves with theflatbase acting In part as reserves. The decree appears on thecurrency notes: “This note Is legal tender for all debts, publicand private.” While no individual could refuse to accept suchmoney for debt repayment, exchange contracts could easily becomposedto thwart its use in everydaycomme,ve. However, aforceful explanation as to why money Is accepted is that thefederal government requires it as payment for tax liabilities.Anticipation ofthe need to clear this debt creates a demand forthepure flat dollar, guaranteeing its exchange value. See AbbaP. Lerner, “Money as a Creature of the State,” American Leo-nosnic Ret~iew(May 1947), pp.3I2-17; and Ross NI. Stan, “ThePrice of Money in a Pure Exchange Monetary Economy withTaxation,” Eco,un,ietrlca (January 1974), fl). 45—54.

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FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

parties, investment banks, brokerages, insurancecompanies); and (:3) sellers ofgoocls (retail and tradecredit). In the first case, a depository institutionlends money to a borrower who in turn uses thesefunds to purchase goods or repay debts; the creditextension entails monetary expansion of purchasingpower because it consists of checkable depositexpansion. During the last three decades, loans bysuch depository institutions have accounted forbetween 35 and 50 percent of the annual total ofcredit market francis extended to the non—financialsector.17 Alternatively put, more than half of thecredit extended annually in U.S. financial marketsdoes not entail ciepos it expansion.

In the second case, a non—depository institution(e.g., a consumer finance company) issues the creditor buys the accounts receivable of a credit—issuingseller. The latter method of credit extension is calledfactoring, and non—depository institutions fund thisactivity by either selling debentures directly or byacting as an agent for a depository institution. tindereither method, the extension of credit does stoi entailan expansion of deposits but a t’cdllocdlI ion of exist-ing deposit holdings. 18

Finally, in case three, credit may be extendeddirectly by the seller of goods and held as accountsreceivable. Often this credit is financed by the sale ofcommercial paper issued by the seller/credit—issuer(e.g., firms with their own financial subsidiaries suchas Sears or General Motors). In these instances,whether the firm holds its own accounts receivable,factors its accounts receivable or sells commercialpaper, the extended credit represents an increase inpurchasing power not created by checkable depositexpansion.

“Source: Board of Governors, Federal Reserve System. OfColtrse, this credit cx pars sion is limited b bank rese ne s nn dler agiven set of rest’ n’e requirements and is eonsequ end v ci ireetl~controlled by the monctarv authority - F or this f/srni of ered it,

additional credit control a,ith on tv w onl ci be si spe rflsimis, Tbisease also Covers bank credit card usage sin Ce credit is anccl by aseller to a buyer against a bank card becomes a demand depositincrement as soon as the seller/credit—issuer submits the creditinvoice to the agent bank. In both types of credit extension,direct or credit card, a depository institrition ei’eates moneymatch ing the extenderl credit,

t~lI a depository insti tution is soes a I man to a crc cii tor using theaccounts or debt as Co Ilaterail, then the crc cli t exten Ion has thesame one—for—one expan sion of deposits its if the loan weredirectly placed, From 1977 through 1980, the percentage ofinstallment loans by non—depository institutions was .39, .37,.40, .45 respectively; son ree: Feclcro 1 Rescrce B olleti ii (Sep-tember 1981), table 1.57. A breakdown fcsr non-installmentcredit has iiot iseeii present in the Bit lie diii sin Ce 1975, but fin iii1965 to1975, commercial banks extended only about one—thirdof single—payment ncsn—instal Intent loans.

In the second and third cases, credit extensionssubstitute for monetary mediation, while, in the firstcase, a dollar of money is created by each dollar ofcredit extended. Thus, for the case of loans by’ dc—

posit creation, credit expansion has no apparentimpact on the relation between the narrowly definedmoney supply and income since Ml and credit movetogether; however, in the latter two cases, creditsubstitutes for money which apparently wouldchange the ratio of income to money supply.

Yet, to the extent that credit arrangements in-creasingly pros’ide as ready a source of purchasingpower as narrowly defined money (Ml), the ap—peanmces of these cases are sonaewhat misleading.There should be an incentive to reduce Mi holdingsand to increase the non—NIl portion of M2 holdings.For example, given the rising acceptability of bankcredit cards—about 30 percent of U.S. retail andservice establishments accepted them in 1972, ap-proximately 50 percent in 1981—the utihty of hold-ing a reserve of currency or demand deposit balancesin order to mediate unforeseen or spur—of—the—moment purchases has been significantly reducedfor consumers.’° Still, to clear the short—term creditcarci debt at months end, a ready source of funds toshift to demand or other checkable deposits remainsnecessar. Consequently, even if the proportions ofcash and credit purchases were constant, given theincreasing acceptability of crerht as an exchangemedium, it would not he surprising to see consumerholdings of demand deposits decline relative topurchases (i.e., to have had a rising velocity).

‘as~f a ~ x’a~ ‘a’aas\f’ cf~j)5

“(‘a 7j% ~ ‘a’a”’

.I.~(D.t.NO.\.iI{.../Af~’I’iV1Yj’

If all credit extensions represented monetary ex-

pansion, then controlling monetary growth wouldcontrol credit. The same constraint that limitingreserves imposes on deposit expansion also limits

I ‘The total no mher of’ merchant (i.e., retail anci service) estails—I istnnents in the Utsited States rose less than 2 percent per yearduring the 1

960s’ and 1970s, while the nnmiser of oserchant

outlets accepting MasterCard and VISA rose at over $ percentaudi 9 percent per year, resliective Iv- ( Ssurees: S taOstint IAhstroc:t oft/ic C/oiled! State,s, 1980 LJ,S, Dept. csf Commerce,Bairean ofthe Ceo sus), id)lst ed andl data supplied by VISA all) diMasterCard). To e stiinate the percentage of merelsaists accept—i ng hank cards, we estimated total merchants for 1981 by’ cx-trapdslatmg the 2 percent annual growth rate Irons 1977 forward,Tbis was dien divi dccliii to the nnit]’) er d) I nscrcliaist outlets thataccept MasterCard,

26

FEDERAL RESERVE BANK OF ST. LOUIS MAY1982

credht extensions, audi inflation policy can properlyfocus ois controlling money growth, leaving themarket to allocate credit. As we have seen, however,dlepository institutions account for less than half ofthe credht assnuallv extessnieci in the United States.Consequently, might not the purchasing powercreated by non—dieposit credht extensions rendermonetary policies unelertaken through control ofmonetary growth rates ineffrctive? The answer isno: money iii its role as the means of settlementconstrains non—depository as well as depositorycrecht.

Ifan increase in the use ofcrediit alters the money—income relationship, tile income velocity of moneywill rise. That is, if a larger share of transactions byhouseholdis or firms can he medhated by credilt, thosehouseholds andl firms, relative to their incomes, will

plan to holdi less Nil and more ofother assets, issclud—ing non—M 1 deposits. As this substitution occurs, theratio of nominal income to Ml (velocity) will rise.Whether such a change will occur for all monetaryaggregates, narrow anel broad, depends ois the extentto which substitutions of non—M 1 assets for NIlcousprise elepos its includeel in other monetaraggregates.2°

Velocity, v, which is the ratio of nominal grossnational prodluct, Y, to money, NI,

(1)YyNi

measures the turnover rate of the average diollar inNi, that is, how many times a dollar was usedl in atransaction involving Y during the year.2’ Express-ing nominal income as the prodluct of the price level,P, and real output, y,

(2) Y = Ps’,

we obtain an edjuation fbr the growth rate of velocity,

ssenti all ‘‘, tls is is again F’riedxssan’s argiixsieist tls at tlse al sa His i —

tinsis of us omsey is isnst an at p ni din iscit ails d~lisp i neal issri e, ‘‘Theselection [nsf mdi icy’‘s slehisit inns I is to I Se regardlerl ass am] ens —

pi deal hypothesis asserting that a particulso’ defin itinsms will benm st n-n isve is i exit for a ~sairticnlair

1imm ipo se lie cam,mse the ns isgis i tni de

Isasedl ois tlsat defiiii tini is Isears a inore cnsis sisten t airs ni regix1air

mel astion to otbse r yariahl e s relevant for tlse pu i-pose ths as is dssasl terisastiye Inasgmiitodes ns

1the saisse gei ieral classs - - , . It Osay

well he tisast die spec i He nsean i isg it is 01051 cssn Ye is ie ut tns aittasc:bsIns tims, temiss ml lois c> cli lie rs for dl ifleremit peni nids, rnsnler ciiffere uti isstiti atinnsasl arran geisse is ts, or for ci if’ferent purposes ‘‘ Fricml-ii tails ansd S cli wasrtx, Mo tic’ mi i—i, Stdi tastid’s of the Caiito I St di ts’ 1. P91.

2 ‘TISC reciprocal of velocity nseastires tlseaive rage iso I dliiig lserionl

nsf a dollar, how lisisg hetweeis flusal iiscnsisse traissaetissn s, ‘Fbilie ri nsd is’gemixian is’ to the Friemlissais msotion of’ tempns mary aisnsde nsfPu rclsas ixsg P

555’ car,

(3) v “a P ± Ni,

from equation 1, where indicates the annualizedigrowth rate of each variable. From equation 3, weobtam

(4) P v — v + Ni,

which shows the significance of’ velocity for mosse—tary policy with the inflation rate, P, as its target.

As is obvious from equation 4, if velocity is con-stant (v = o), thess the inflation rate will he equal tothe difference between the growth rates of realoutput, ~, and money, Ni; if v is relatively’ constassthut non—zero, then inflation would be the differencebetsveen the growth rates of money’ audi real output

plus that of velocity’. If~’does not elepenni on M orthen equation 4 implies that if ~‘ is simply’ pre—dlid,table, even if not constant, thesi controlling themoney supply is tantamountto controlhinginflation.22

This interpretation abstracts from variations in

real output, but, to the extent tlsat fluctuations in thegrowth rate of money exacerbate such variations,setting a constant growth rate of’ money reduces thatsource of disturbance. Non—monetary’ disturbancesto real output growth (e.g., the OPEC oil embargo),of cotirse, may cause inflation to nleviate from itsanticipatedl path, hut over longer periodls of time, asteady’ growth rate of mosiey’ will smooth real incomegrosvth as well as facilitate inflation prenlictabihty.This is the rationale for a policy of targeting on thegrowth rate 0f money’ and why’ its effectivenessdlependls upors the predictability of velocity..2a

Assessing the preehctahihity of a variable involvestwd) separate evaluations: point forecasts and vari-ability. The shorter the time period coassidlered, therelatively more iissportant is the latter characteristic;that is, while a short—russ fbrecast of a variable assayrarely’ lie precise, if that variable eloes not fluctuatewildly in a hishion out of keeping with its history,then descrihissg it as predictable is sensible.

22N ott’ th at fir pns lie y sin mposes “e neenl tinst kisow lsrn’ci seI y’ sc Isvthe gmnswth rate of velocity- is predictable; fir the purpnise nsffnsrissul ati isg an n5 flatini is pnsl icy’ tIm mdi ugh c-n istmnsl nsf a us oisetarvaggregate, it is sufficient that it is pmedlictaisle,

n F’nsr as 0mm’ nhc’ t,ai len! s taste use ut, see MiI tnin Frienlosam , ‘‘A l’hse ci—

retical F’ masiss ewnsrk for Ni ois claim>’ rkisaiy’ s is,’~fns itt-nc,I naf Pail itico II’,d’noasalaq (Nharcbs/Apmii 1970). p~i. 193—235. Friedissais alsnsan-gi Se 5 that Osnisetan-v iiis

1icy is n nit rmsef’oI in n:ss iiiste r—cyclical

policy lien’adnse of laigs 5 is its i nspac ts aim1

that, cnsis sn sin emit!y, it isissdire ii sd ~d if steasnly or jsmd’nl ictable ; see isis Ans e rieais Fens’ii hissic As snciati mx Pm,s isis’ is tiasl AnIni i-c ss, - Tb e Rnsl e nsf Msi iset,u’yPnilin’y,’’ ,‘liitea’ac’ciii l’a’noniaaon’ Rn’i’in’n: (March 1968), pp 1—17,as un

1Ins ‘‘Niisisetary’ Psi1 icy’’ Iecti ire citedl its finstisott’ 1

27

FEDERAL RESERVE BANK OF ST. LOtUS MAY1982

Chort 1~ncome, Money and Credit

Billiouts of Doflors3000

2000

1000

800

600

400

200

100

80

60

40

H AS RISING GRFI)IT SIGNIFIGANIU V

~J ~ C s I) b ‘J Fr I %r R)’a’acbtcp

•BE”IA%rFI:Gc ?vIOrSFY 4\iJ INGONIF?

There are several was’s to assess the i]sspact ofrisissg credhit on the monev—isscossse link. Tisree ehif—ferent procedures are used hsere: (1) a cosssidheratinsnof thse Ie’n’els esi’ GNP, nsnsssev’andl credit; (2) ass ex-am issation nsf consumer deposit Isolelings, creditextesssions and purclsases; (3) observations of thegrniwths rates of Ml assd M2 velocities.

First, we’ cass see whether the relatiossship be-tween sssoney anel iiscnsisse grnswths appears to hsavechsassgenl in re’e’esst years hiy simply hookissg at time dlatadiii inccsnsc, nsosses’ -,tisd credit presented us cisart IChsart 1, usissg a sensi—log scale, depicts annual GNP,NIl annl M2 lsolnhissgs, aisd credit flows, witls the hastdhehssedl as the quasstitv nif fuisels raised in credit

markets by’ finsis, coissnismers’ -assnl the governuiesit,plus trade crenhit extessdecl lietcc’een firms.24 On aseusi—lssg chart, constant growths rates graph asstraigist lines, and equal growth rates appear asparallel lines. Its this fonssat, it is plain that frosss 1959to 1981 credit’s growth was the fastest nsf the aggre-gates, that CNP annl M2 have grnswn at roughly equalrates, andl that all tlsree grecs’ sonsewlsat faster tisassMl. The crenhit magssitunle gre’s.c’ at ass average rate nsf9.2 percesst per ~ear, wisile M2 grew at about tisesaissc rate as GNP niuriisg the last two decades—8.3

2mNastn’ th,st it is thin’ fussy <sf’cmn’nlit—i,n’,, n’xls’nsinmns—nnst thin’ stnc’knsf debit that is mn’lessust isn’mn’, Credit, ass nhsn-ussenh earlier, istmansasn-tinis—spn’n-ilin- ainnl cant nun’nliane tsnl theft traimsasn’linn mix’wfiin-h it is exteonienl, Evets if the hsmnsnissnsmy nails’ fmnsns a hire’yinns cl-ed it hraaxisan’ti on icc’mc’ sit hi seaji tel it] y atsenT ass cailI ahn’iani foraisisti scm n,i-enlit trans sast- tinsis, tim i-a ic cciii m

1ni lsn’ as is ni tImer emen

1it n’s—

tn’nsinsti fair that traissan_-tiols, I_nlikn’ liadst lnnsmlc’y’ cxfianssinsn, tIm’stock of past cxtn-nsions is, in itself, irrelevant,

Billiouts of Dollars3000

2000

1000

800

600

400

200

h959 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 801981

100

80

60

40

28

FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

Chart 2

Ve’ocities of M~and M2

pereesst asid 8.2 1iercesmt per year, respectively. Incontrast, Ml grew at a 5.2 percent rate.

In chart 2, the velocities of Nil and NI2 arc clis—played. The approximate constaisc of tise M2 veloc-ity is clearly evident iscre, as cveli as the persistentrise nsf Ml velocity .~< ot so evinlcnt. ilowever, is therelatis-elv n:nstt-s’laat( rats~ofM 1 c’elocit grnswtis. Overtime 1959—81 perininl, Nil velocity gresc’ at arottudi3.2 percent. Indeed, except for a isoticeable showingin time late ‘60s, time s-elnicitv grniwtim rate of hiotis old1

NIl and new Ni 1 has lieeus between 3 percent aisnh 4

1iercent since 195025

~~Iln’c-n-tstly-,linimert F, W’n-intraanlm, sn’snnsr ea’isnntnnit bar disc JmntEe-nsisamutin’ Cnsmissmmittee nsf time iS’ Cnaumgress, niasale a similarpasiistium aaicttcrtasthie U amlf Street jaini’nol,OetssIier 14, 1981: “Asas tasasttn’m nI’lasgic. nmffsbsnsmn- mini nsthn’r new hisaammeial devchns

1iissents

n-a’s c-osmtnilsntn’ Ins iisflatinsn nasmhv if they s-nsumtmshiute to (lie matn’ auiisn’ nsf a soon’ Vs ye incity - ilnswevi’m’, tIme y h ai yn’ ni it - S mice thin_-n-air!>- 1950’s, tlsa’ rate nsr miss’ au i’d lB’s a’c’laaeitv Imas linen n~nitn’steady, 3 ,2’4 ycaadv,’

Time ratio of credit to isscdsussc, u-lmile persistentlyrising, prohahl~’understates time importance nil crediths explaining tine rise ofMI 1 velcicit . The erenhit totaiis aim isieadismghy low siild’e it represents quarterlybalance simeet n’/aauugn’-s iii debt. If credit is extcnnlenlaudi repaid witbsism the period of nshiservatiosm (osmedluarter far time data iss chart 1), timere is no cisassge inthe credit lialance and, thus, no evidence that timiscredit extension took place; smonethehess, suds cx—tensiosss of erenhit cc’oukl have umediateel excisassgesand contributed tni spending and ecnsssoumic activity.

A secoimd way to assess time immpact nsfcrenlit use is tnihicus on time heimavior of innlivinluals annh fairs ii ies—ins particuiar, to exaisHne tiseir hold issgs nsf nlemannland other cii eckahie nleposits as coumparecl to creditins useeliating coimsusmmcr purebsases. lalile I preseimtsdata nm cnsimsuismer deposit hold usgs , credit exten—s muss assd purchases ism time U.S. ecnsssoumy nlnring timeI 970s. By’ fkicusmsmg nsum time cousumsier sector, tlmree

7.0

6.5

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.01•01959 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 801981

29

C.) 11C in

Cin

r

m0in

Table 1Consumer Deposits, Credit, Expenditures and Deposit Velocities (amounts in billions of dollars)

Consumer Deposits and Credit Consumer Expenditures and Mediations Velocities(1) (2) (3) (4) (5) (6) ( ) (8) (9) (10) (11) 12) ‘1

Total —4Other otal consumer Personal Tot I Percent 5

Demand checkable checkable Consumer M2 credit consumption cash cash 6 1 6 3 7 3 6 4 cYear deposits deposits deposits deposits extensions expenditures purchae purchases

1970 $ 536 $ 0.4 $ 54.0 $ 4555 187,1 $ 6341 $ 4470 705% 11,83 11.74 8.27 1381971 586 05 591 532.3 2158 592.6 476,8 688 1 .82 1112 807 130

1972 654 0.6 660 609.8 2408 7670 5262 686 1173 11.62 797 1261973 701 0.5 709 6546 2690 834.3 565.3 67.8 1 90 117 97 1.27

1974 73,3 09 74 2 6944 2694 914 1 644.7 70 5 12.47 12.32 8.69 1 32

1975 780 16 7a6 7962 280.7 10169 7362 724 1304 1278 925 128

1976 82.6 32 858 9212 318.2 11279 8097 71.8 1365 1315 9,44 21977 91.0 4.8 95.8 10348 3735 12545 881.0 702 1379 1309 920 .21

1978 97.4 78 105.2 11175 4242 14166 9924 701 1454 1 47 943 127

1979 992 17, 1169 12001 4658 15823 11165 706 1595 1354 955 132

1980 1024 74 1298 12862 449.3 17510 13017 743 1710 1349 10.0 1.36

1981 666 74,4 16 0 14008 477.2 19095 1432.3 741 2205 86 890 1.36

Note . (1) Gross IPC Con umer demand deposits ye rend figu e . Source (5) Consumer installment credit exten ion plus non installmenFederal Reserve Bulletin Figure tor 1981 i preliminary con umer credit outstanding The in tallment figure is 12 time

(2) NOW and ATS accounts credit union share drafts and demand the Decembertotalforthatyear while the non in tallm nt igureisdepositsatmutualsavingsbanks ource Federal Reserve Board two time the December total (under the assumption of a six

month t rm to maturity st ucture of non~installmentcredit, on(3) IPC consumer demand deposits plus other checkable deposits average). Source’ Federal Reserve Board(4) M2 minu overnight urodollars minu overnigh RPs minus (6) xpre sed at annual rate . Source Department of Commerce

money market mutual funds minus currency minu demand depo its plus IPC consumer demand deposit plus other heckable (7) Personal consumpfion expenditu es less total con ume creditdeposits Source ederal Re en,e Bulletin Col (6) Col (5)

(8) The ratio of total h purcha e to per onal con umption expenditures ICol ( ) Col (6)

0

FEDERAL RESERVE BANK CF ST. LOWS

technical national income accounting and com-parability problems are avoided. First, all personalconsumption expenditures are final goods trans-actions and appear in GNP; in &ct, they are over60percent of this measure. Hence, all the credit ex-tensions to consumers are used for final goodspurchases. In contrast, commercial credit and tradecredit may be financing intermediate goods. Second,a direct comparison of credit use and demand de-posit holdings for an identifiable set of buyers ismade possible; hence, characterizations about therelative use of credit and demand deposits in rela-tion to income are facilitated. Third, data on creditextensions are available so that a truer picture ofcredit utilization can be obtained than when usingbalance sheet changes in debt.

The data in table 1 characterize the manner inwhich households have made their purchases andheld their deposits during the last 12 years; thesedata are based on fourth quarter and Decemberobservations in each year. Clearly evident is therecent substitution of non-bank checkable depositsfor demand deposits (colwnns 1 and 2),as wellas thesteady decline in holdings ofdemand deposits rela-tive to total purchases (column 6) measured by theirvelocity (column 9). Conversely, the ratio of pur-chases to total consumer checkable deposits, thevelocity oftotal checkable deposits (column 10), rosemuch more gradually and fell abruptly in 1981 toabout its level in 1970.

As the data indicate, the proportions ofconsumertransactions initially mediated by money and credit(column 6) varied only slightly duringthe 1970s; theshare ofpurchases that were mediated by currencyand demand deposits remained around 70 percent(assuming a six-month term to maturity in non-installment credit) over the decade. Thus, over thisperiod ofrough constancy in thedistribution oftypesof mediation, the ratio of consumer expenditures todemand deposit holdings by consumers (column 9)increased by almost 45 percent Conversely, theratio of purchases to total checkable deposits roseonly 15 percent through 1980 (column 10). More-over, in 1981,demand deposits fellabruptly (column1) and other checkable deposits rose even moresharply (column 2) after the institution of NOWaccounts nationwide. As a result, thevelocity oftotalcheckables fell in 1981 to approximately its 1970value.

If we assume a narrow or transactions mediumdefinition ofmoney, Ml, the observations over 1970-80 would be evidence of a decline in thequantity of

MAY1962

money demanded by households. On the otherhand, if we consider total checkables in 1981 orassume a broader temporary-abode-of-purchasing-power definition, M2, then the ratios of consumerexpenditures to the consumer depositholdings pro-vide contrary evidence. As shown in column 12 ofthe table, the ratio of consumer expenditures to thesum of household demand deposits, saving andsmall timedeposits, and money marketmutual fundsvaried comparatively little relative to the demanddeposit and total checkables ratios. Thus, under thebroader definition, the quantity ofmoney demanded—at least the consumerportion—does not appear tohave declined during the 1970s. In particular, 1980and 1981 do not appear to be qualitatively differentthan the earlier years.

The third mannerofassessing credit’s impact is todetermine whether the trends in the income veloc-ities of the monetary aggregates have changedsignificantly in recent years. As we saw in the slopesof Ml and M2 velocities in chart 2, monetary aggre-gate velocities had strongtrends in their growth overthe two decades 1959-81, While on a quarter-to-quarter basis velocity growth rates exhibit signifi-cant variability, chart 2 suggests that over longerperiods velocity growth is fairly regular. This trendregularity is substantiatedin chart 3, which plots thegrowth rates of Ml and M2 velocities. In this chart,quarter-to-quarter (QQ), four-quarter moving aver-age (4QMA) and 20-quarter movingaverage (Trend)growth rates appear. While QQ is highly variable forboth Ml and M2, the 4QMA for each has a markedlysmaller amplitude; considering ±4 percent bands,only one observation for Ml’s velocity growth andthree observations for M2’s velocity growth liebeyond them. Also, the trend for each stronglyunderscores the apparent tendencies in chart 2; ineach case, Ml and M2 velocities have stable trends,especially when measured over periods longerthana year. In particular, the charts do not reveal recentvelocity growth to have been qualitatively differentthan in earlier years.

This lackofchange in Ml and M2velocity growthis even more apparent in table 2, which displaysvelocity growth rates, their standard deviations, andtheir ranges for 1961-81, for five-year subperiods,and finthe year 1981; growth rates are computed fortwo observation frequencies: quarter-to-quarter(QQ) and four-quarter moving average (4QMA).

Consider the behavior of Ml velocity computedon aquarterlybasis. Over the entire 1961-81 period,it has had an average growth rate of 3.16 percent per

31

‘0

~oo

Ittin

—C

—o

C0

1.3

c~

o.

mc

-,0

C!~

2a C

’U

I

0•

o 0 (0fl

~o

—~ a’ 0o 0’ 0

Ca

~.

.30

v..~

aa-

~1 ~1 p., -a C’,

,

a b-a U,

-4 a’

-4 CO

-4 ‘a 00 0 ‘a 00

&.

Sb

p.,o

p.~~

a’

Co

o

(0

——

—

ap.,

0s~

aa-

a,

0P

4~

(A)

‘TI rn a Ill r Ill ci, m I 11 z 0 t (4~ r 0 C (p (0 P0

I

FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

Table 2Annual Growth Rates of Ml and M2 Velocities During 1961-81

Observatten Ve!owty Growth at Annua’ Percentage Rates duringAggrega a frequency 1961-81 1961 65 1966-70 1971 75 1976-80 1981

Ml 00 Mean 325 371 1.95 364 339 474SD 3.52 262 302 364 349 913Range 447, 13 90 118, 944 —4.06 7.05 336 900 —4.16 1002 448 1390

4QMA Mean 312 317 236 2.94 3.77 4.35SD 1.58 179 152 116 151 139Range 101 6.98 101 5.86 09, 515 70, 547 186 698 261,601

M2 00 Mean 17 59 68 28 SI 47SD 405 262 354 413 487 803Range 8.23 11 75 4 32 4.36 7 81 5.75 —8.23 626 6 09 11 75 7.00, 10.83

4QMA Mean .04 1 25 1 06 65 .60 2 06SD 235 1.87 172 241 268 141Range 5.32 631 5 32. 2.29 2.76 3 01 446, 3.96 3 84, 6 31 23 3 66

year. As was-apparent in chart 3, qllarter-to-(luarterfluctuations can be significant; vet, over the twodecades, the standard deviation of its growth i’ate hasremained about 3.00. \Vhile extrapolating the long—run velocity growth rate of Ml to 1981 underesti—mates the observed growth rate, the 4.74 percent rateis ~vel1 within one standard (leviation of either the1976—80 mean or that of the hill 1961—81 period, andrepresents-a fluctuation that is comparatively snia]lin terms of the range of observed growth rates duringeither the suliperiod or the fi[II period as ~ho~vn iiichart 3.

For NIl, QQ and 4QMA have roughly the sameaverage growth rates; f~rM2, the 4QMA growth rateis relatively more volatile than the QQ growth rate.Yet, in absolute terms the difference between QQand 4QMA is about equal for Ml and M2 for theentire 1961—81 Period (—.13) ~md for each suhpeuioclexcept 1976-80 and 1981. For both Ml and M2, thevariabilit (SI)) of 4QMA is naturally significantlyless than that of QQ. The standard deviations ofveloc tv growth computed on a tour—quarter movingaverage are about one—half of the quarterly versionfor MI and the base and between one—half and two—thirds for M2. Moreover, the standard deviation for1981 is smaller than for the preceding subperiod.ihe implication is, as usual, that (lUarterlV monetarystatistics are a less useful guide to the longer—runbehavior of money than averages over longerperiods.

In Summary, whether we look at Ml or M2, theinformation (Iisp~aved in chart 3 and compiled intable 2 conveys the same message: namely, thebehavior of monetar aggregate velocities in 1981 isi~otqualitativdv different than over the preceding20-year penoci or an of the subpenocls. This isclearest when considering the four—quarter movingaverage growth rates. though the more vo]atiI ~quarter—to—quarter rates tell essentially the samestory. %hile velocity growth rates were higher in1981 than in preceding subpenocls during 1961—81,there is no evidence that credit use and financia’innovations have severed the link between mofle-tarv aggregates ~wd the inflation rate,

Ni uch of the current debate over U.S. economic

policy has focused on the wisdom of targeting amonetary aggregate to control inflation. Some criticsof such policies have alleged that financial innova-tions have 1~othmade money uncontrollable andsevered its predictable link with national i~uom~and prices. Others have argued that iion—monetaryassets or liabilities ma~ have a closer link thanmone to income over the long run. This article hasfocused on the predictable linkage issue by exam-ining the principa] function of money-and credit, themediation of exchange. Since credit’s mediation

33

FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982

fiwetion depends crucially on the prec1ictable sourceof monetary settlement, there is no theoretical sup-port for assertions that the increasing use of credithas severed money’s link to income, In terms oftheempirical evidence for the year 1981, both Ml andM2 velocities grew reasonably close to their trendrates.This is grossly inconsistent with assertions thatmonetary policy is ineffective.

While the controllability issue has not been ad-dressed in this article, an analysis of the changes inmonetary aggregates in relation to Federal OpenMarket Committee (FOMC) directives during 1981suggests that both Ml and M2 movements were

strikingly in accord with the intentions of theFOMC.26

Consequentlv there appears to he no reasonablefbunclation—theoretjcal or empirical—for ~tb~lfldO1F~ing the use of a monetary aggregate as the vehicle formonetary policy. Unless or until velocity becomesmore unprechetable 01’ fluctuates over ranges notpreviously observed, the usefulness of monetaryaggregates in controlling inflation and maintainingeconomic stability will be undiminished.26See Damel L. Thornton The FOMC in 1981: Monetary Corn

tro] na Cliatiiging Finaiicia~Envuonineul. this Rcuicz,; (April1982), pp. 3~22.

—

34