Interest rate, R Real money holdings Aggregate real money supply MS P R1 Aggregate real money demand, L (R, Y) Interest rate, R Real money holdings Aggregate real money supply M S P R 1. The increase in the euro zone’s money supply reduces interest rates in the euro zone, reducing the expected return on euro deposits. Income, interest rates, and consumption all fall, whil einvestment rises. Income falls because at every level of the interest rate, planned expenditure falls. The interest rate falls, because the fall in income reduces demand for money; since the supply of money is unchanged, the interest rate must fall to restore money-market equilibrium. For given values of real interest rate r, output Y, and money supply M, if the expected inflation rate Eπ increases, price P will. Group of answer choices.

A decline in the real interest rate stimulates both consumption and investment demand. Many economists believe the link running from the money supply through interest rates to aggregate demand is the main channel by which monetary policy affects real output in the short run. Some of the models discussed by Mankiw imply interest. In the money market Real money demand and the real money supply as functions of the real interest rate are illustrated in the above graph. Real money demand is graphed holding fixed real income and expected inflation. The real money supply is equal to the nominal amount of M1.

Your question highlights a common misconception about how the Fed conducts monetary policy. For a period of time, the Fed did in fact implement monetary policy by controlling the monetary aggregates (the quantity of money). However, developments in the financial services industry, changes in the relationship between the money supply and the economy, as well as changes in views on monetary policy, eventually led to the Fed reverting back to implementing monetary policy through changes in interest rates (the price of money). 1

What are the monetary aggregates, and why does the Fed still care about them?

Though the Fed no longer implements changes in monetary policy by controlling the growth rate of the money supply, the monetary aggregates are still monitored by economists as an indicator of future economic activity. One measure of the money supply, real or inflation-adjusted M2, is classified as a leading economic indicator. In order from most narrow to most broad, the three nominal monetary aggregates published weekly by the Federal Reserve Board in the H.6 Release,Money Stock Measures are: 2

M1: The most liquid forms of money including currency in the hands of the public, travelers checks, demand deposits, and other deposits against which checks can be written.
M2: M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.
M3: M2, plus large-denomination ($100,000 or more) time deposits, balances in institutional money market mutual funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks and at all banks in the United Kingdom and Canada.

When the money supply grows, consumers and businesses have relatively more money in their hands with which to purchase goods and services. Therefore, in theory, faster money supply growth should be associated with faster economic growth after a short lag of perhaps two or three quarters. However, many important changes in how financial assets are held by the public have changed over time and the relationship between money supply growth rates and the economy has deteriorated.

Why doesn’t the Fed still conduct monetary policy by controlling the size of the monetary aggregates?

Money Supply And Real Interest Rate Definition

The Fed’s Purposes and Functions (2005) publication describes the change that has occurred over time in the relationship between monetary aggregates and Gross Domestic Product (GDP):

“[T]he relation between the growth in money and the growth in nominal GDP, known as ‘velocity,’ 3 can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. Indeed, in the United States and many other countries with advanced financial systems over recent decades, considerable slippage and greater complexity in the relationship between money and GDP have made it more difficult to use monetary aggregates as guides to policy. In addition, the narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time.”

Historical growth of money and the economy

Below is a simple comparison of the growth rates of the real M2 and real growth rates of the U.S. economy; the gray bars represent periods of recession as defined by the National Bureau of Economic Research (NBER). This graph illustrates how the relationship between money growth and the economy has changed over time.

The chart displays the “before” period, when monetary policy focused on the monetary aggregates, which ended in the mid-1980s, as well as the “after” period, when the importance of monetary aggregates as indicators of future economic performance diminished. From 1960 until the mid-1980s, each recession is preceded by a sharp decline in the growth rate of real M2. However, in the period after the mid-1980s, the correlation between the growth rate of real M2 and the economy is much weaker.

Changing financial services

One of the key factors behind the change in the relationship between money and the economy has been the significant changes in the financial services industry over the years. New banking laws and the development of new types of financial assets and products have blurred the distinctions between balances counted in the monetary aggregates and other types of financial assets. In short, these developments brought about significant changes in the way people hold money and other types of financial assets. For example, monitoring the monetary aggregates for clues to future economic performance became much more difficult once savers could frequently and cheaply shift between balances counted in M2 (like money market mutual fund shares) and other financial balances that are not counted in the money aggregates (such as mutual fund shares). Moreover, even the relationship between the aggregates changed since the early eighties.

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'Depositors moved funds from savings accounts—which are included in M2 but not in M1—into [Negotiable Order of Withdrawal] accounts, which are part of M1. As a result, M1 growth exceeded the Fed's target range in 1982, even though the economy experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.

By the early 1990s, the relationship between M2 growth and the performance of the economy also had weakened. Interest rates were at the lowest levels in more than three decades, prompting some savers to move funds out of the savings and time deposits that are part of M2 into stock and bond mutual funds, which are not included in any of the money supply measures.'4

Broken relationship between money and the economy

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