South-Western College Publishing - Economics  

Money Matters
Subject Money Supply
Topic(s) Monetary Policy; Money Supply; Federal Reserve System
Key Words Money Supply, Federal Reserve System, Money Multiplier, Velocity of Money, Growth, GDP, Interest Rates
News Story

Monetarists have long argued that there is a strong relationship between money supply and the growth in gross domestic product (GDP). Starting in the late 1970s, the relationship between money supply and GDP growth became more volatile because of changes in U.S. financial markets. The increase in importance of stock and bond mutual funds and the decrease in certificates of deposit and savings accounts in a consumer's portfolio had a significant impact on measures of the money supply. Stock and bond mutual funds are not included in any of the measures of money. Prior to the late 1970s, the Fed used to announce target levels of money growth and the Fed's performance was graded by comparing actual money growth with the targets. The now muddied relationship between money and growth has caused the Fed to announce their monetary objectives in benchmark ranges rather than as a specific target.

The Fed had listed benchmark growth in M2, a measure of the amount of money, to be between 1% and 5% for 1997. Actual growth in M2, however, was above the 5% range. Furthermore, M2 growth has stayed above 5% in 1998 even though the Fed has advertised the same benchmark. The growth in M2 above the upper benchmark has caused some groups to argue for interest rate hikes to prevent a rekindling of inflation. The Fed in its defense argues that the efficacy of using a single monetary aggregate like M2 to guide policy is a mistake. The Fed's rationale is that the link between money and GDP growth--the velocity of money--is unstable.

While some Fed officials make note of the growth of M2, the majority set policy based on a number of economic variables. Included in this list is current dollar GDP. If the growth in current dollar GDP doesn't slow, interest rates may have to increase. (Updated May 19, 1998)

Questions
  1. What is M2? What is included in this monetary aggregate?
  2. What is the velocity of money? Whay are changes in the velocity important to understanding the relationship between money growth and GDP growth?
  3. What is the relationship between money supply and changes in the interest rate?
  4. Why would the Fed want to increase interest rates if the growth in current dollar GDP is excessive?
Source John M. Berry, "Contending That Money Growth Causes Growing Pains," Washington Post, March 19, 1998.

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