The Case of the Missing Money

Abstract

TheCase of t he Missing Money THE RELATION between the demand for money balances and its determinants is a fundamental building block in most theories of macroeconomic behavior. Since it is also a critical component in the formulation of monetary policy, it is not surprising that the money-demand function has been subjected to extensive empirical scrutiny. The evidence that emerged, at least prior to 1974, suggested that only a few factors (essentially income and interest rates, with due allowance for lags) were needed to explain adequately the quarterly movements in money demand. There were episodes that, during their course, gave the impression that the moneydemand function was shifting. On the whole, however, in the time allowed for final data revisions by a "wait and see" attitude, the apparent puzzles tended to clear up.' As has been widely documented,2 the U.S. economy is once again experiencing an apparent shift in the money-demand function. In particular, when money-demand functions that have been successfully fitted to pre-1974 data are extrapolated into the post-sample period, they consistently and significantly overpredict actual money demand. Furthermore, as the economy has moved into the upturn phase of the business cycle, the forecasting errors have mushroomed. While one might hope that subsequent data revisions could "solve" the present puzzle, this sanguine attitude seems unwarranted for a variety of reasons.First, the sheer magnitudes of the forecasting errors suggest that im-1. Such econometric "benign neglect" begs the real problems facing the monetary authorities, who are striving to make reasonable policy choices during these episodes.2. See, for example, Jared Enzler, Lewis Johnson, and John Paulus, "Some Problems of Money Demand," BPEA, 1:1976, pp. 261-80. 684Brookings Papers on Economic Activity, 3:1976 plausibly large data revisions would be required to explain current developments with equations of the sort I reported earlier. Second, the large forecasting errors for 1974-76 coincide with unusual conditions. Among other things, that period saw the most severe recession of the postwar era; an extended bout of double-digit inflation; the highest interest rates in many years; and many institutional changes in the financial structure. While the failure of an empirical macro relationship under such extreme conditions is perhaps not surprising, it should at least prompt the question of whether the specification was adequate to cope with them. In short, a reassessment of the current state of knowledge on the demand for money balances seems called for. OutlineThe plan of the paper is as follows. The next section reviews the forecasting experience with "conventional" money-demand equations, documenting the source and magnitude of the recent errors. It also considers whether the deterioration in the money-demand equation observed in the current cyclical episode had any counterpart in previous periods of recession and recovery. The second section reexamines the specification of the conventional equ...

A Microeconomic Approach to Estimating Demand: The Asymptotically Ideal Model

“…Perhaps the most dramatic example of this phenomenon occurred in the early l9BOs with the yet unexplained break in the income velocity of Ml. For this and other examples, see Goldfeld (1976), Friedman (1984), Lucas (19BB) and Rasche (1990).…”

“…The cross price elasticity, vj,,, dropped 30 percent in 1979, implying that the demand for A 1 34 5ee Goldfeld (1976) andFriedman (1984 was less sensitive to changes in the user cost of A,. Hence, the shift of funds from A 3 to A, should have been moderate despite a substantial increase in the user cost of A~.…”

“…This suggests that ignoring the substitution effects of non-Mi components of M2 might be one of the factors that discredit reliability of the conventional Mi demand function. 37 5ee Goldfeld (1976). tions to nonlinear demand functions.…”

Contrats de salaire, croissance endogène et fluctuations

“…Elle est obtenue en supposant que l'élasticité de la demande de monnaie par rapport au taux d'intérêt est égale à -0,20 comme dans l'étude de Goldfeld (1976) et que le taux d'intérêt nominal moyen est de 8 %.…”

La politique monétaire des années 90 : leçons et enjeux

“…C'est une situation dans laquelle une baisse du taux d'inflation et des taux d'intérêt nominaux donne lieu à une accélération temporaire 15. Le «missing money» de Goldfeld (1976).…”