How much money do you want?

The question sounds odd.  Surely the answer is:  “All the money in the world.”  But economists are literal-minded:  To them, “money” refers to the number of tenge available for spending, and “money demand” is the number of tenge that we want to hold, not spend.  Suppose that you had 5,000 tenge in your purse this morning and spent 1,000 on lunch.  Then your money demand fell from 5,000 tenge to 4,000.  Of course, the demand depends mainly on how much you’d like to spend later.

Money demand can determine whether the central bank can navigate the economy to harbor.  Normally, during a recession, creating tenge will spur spending and thus production.  But if people are willing to hold any amount of money, then they won’t spend the new tenge.  Such a “liquidity trap” may have blocked recovery from a long depression in Japan and in other countries where households save an unusually large share of their income.  In any case, we’d like to know how much money people want.

 

That question is hard to answer.  We know what the answer should look like.  Your demand for money should increase with your income, since people who earn more now will want to spend more later; and with prices in general, since you must pay more to buy your usual groceries when prices rise.  Also, money demand should fall as interest rates increase, since you would rather hold bonds, which pay interest, than money, which doesn’t.  (Money in this sense is usually defined as cash and checkable accounts, or M1 money.)  Indeed this model works pretty well in the long run – but not in the short. 

 

The next-door solution

 

Kazakhstan is no exception to this conundrum.  A 2010 study finds that the demand for money (broadly defined) in this country depends in predictable ways on output (which generates income), the interest rate, and on foreign exchange rates (which affect global demand for Kazakhstani exports), in the long run.  But this sensible model breaks down in shorter periods.  The authors speculate that rising interest rates, for example, may have induced people to move their wealth from dollars to tenge.  Thus the relationship between interest rates and tenge demand may be positive, contradicting the usual money-demand model.

 

The difficulty of short-run predictions hinders monetary policy.  Four or five decades ago, macroeconomists led by Milton Friedman argued that the central bank could reduce uncertainty in the economy, and thus spur purchases and production, by targeting the money supply.  The bank should create no more money than is needed to buy new output at the usual prices.  In October 1979, the central bank of the United States, the Federal Reserve, adopted this policy.  But money demand suddenly skyrocketed, outstripping money supply.  Interest rates rose, spending fell, and a wintry recession set in.  By the late 1980s, the Fed had stopped targeting the money supply.  Since then, it has usually targeted interest rates.

 

Sweep stakes

 

New research suggests that we may be able to explain short-run money demand after all.  In 2012 Lawrence Ball of Johns Hopkins University studied American demand for M1 from 1959 to 1993.  He found that it depended less on general short-run interest rates such as the Treasury bill rate than on the rates paid on such close substitutes for M1 as savings accounts and mutual funds in the money market.  In the late 1970s, money holders were sensitive to rises in the interest rate on mutual funds because the Fed’s Regulation Q capped the interest rates paid for conventional bank accounts.    

Should central banks again target money?  Ball notes an intriguing new complication in measuring M1.  Most central banks, including the Fed, require commercial banks to set aside a given share of their demand deposits; otherwise, the amount of money created by new loans, in the form of checking accounts, may get out of hand.  Beginning in the early 1990s, the banks got around the Fed’s reserve requirement by shifting money from demand deposits to money-market accounts.  (This cut in demand deposits reduced the amount of money that the banks were prohibited from lending out.  Suppose that the reserve requirement ratio is 10%.  If a bank reduces its demand deposits from $2 million to $1 million by shifting a million into money-market accounts, then its reserve requirement will drop from $200,000 to $100,000.  Voila!  The bank now has another $100,000 to lend out.)  Since money-market accounts were not part of M1, the banks’ “sweep” campaigns artificially reduced that measure of money supply.  After 1993, M1 data became unreliable. 

In Kazakhstan, could sweeps help account for the stagnation of M1 over the past two years?  -- Leon Taylor, tayloralmaty@gmail.com

 

References

 

Lawrence Ball.  2012.  Short-run money demand.  Journal of Monetary Economics 59:  Pages 622-633.  Informative.   

Mesut Yilmaz, Yessengeli Oskenbayev, and Abdulla Kanat.  (2010). Demand for money in Kazakhstan: 2000-2007.  Romanian Journal of Economic Forecasting 13: Pages 118-129.