A Review of the Recent Behavior of M2 Demand

Abstract

It is now known that the public’s M2 demand experienced a leftward shift in the early 1990s. Since about 1990 M2 growth has been weak relative to what is predicted by standard money demand regressions. It is widely believed that this shift in money demand reflected the public’s desire to redirect savings flows from bank deposits to long-term financial assets including bond and stock mutual funds. Recognizing this, policymakers have not paid much attention to M2 in the short-run formulation of monetary policy since July of 1993. 1 In this article, I review the recent behavior of M2 demand. I then evaluate the hypothesis that the recent shift in M2 demand can be explained if we allow for the effect of the long-term interest rate on money demand. The longterm interest rate supposedly captures household substitutions out of M2 and into long-term financial assets. The evidence here indicates that a standard M2 demand regression augmented to include the bond rate spread can account for most of the “missing M2 ” since 1990 if the estimation includes the missing The author wishes to thank Robert Hetzel, Roy Webb, and Alex Wolman for many helpful comments. The views expressed are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System. 1 See Greenspan (1993). The issue of the stability of money demand is central in assessing M2’s usefulness for formulating policy. If M2 weakens, policymakers have to determine whether this weakness has resulted from a shift in money demand or whether it indicates that the Fed has been supplying an inadequate amount of money to the economy. If it’s the latter, weak M2 growth may portend weakness in the economy. To remind readers, the current definition of M2 includes currency, demand deposits, other checkable deposits, savings deposits, small-denomination time deposits, retail money market mutual funds and overnight repurchase agreements and Eurodollar deposits.

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