Two-Year Forecast of Money Supply

Based on the Quantity Theory

JACK METCALF and JASON SPAINHOUR

College of Business

Western Carolina University

Abstract

Over the next two years, the level of the nationís M1 money supply is forecasted to have minimal volatility.This forecast is based on the Monetarist Theory, assuming that the M1 money supply is influenced greatly by the monetary base and money multiplier.The forecast uses two-year-lagged long-term interest rates and variable real GDP measured in chained 1996 dollars, adjusted annual rates, and seasonally adjusted money stock from prior quarters.The U.S. economy is currently operating in a period of low inflation while growing tremendously. The ideal economic environment, has been closely monitored by the Federal Reserve.The Fedís responsibility lies in its ability to keep inflationary pressures from causing consumer prices to skyrocket.One such way the Federal Reserve is able to fight inflation is through monetary policy combined with either raising or lowering interest rates.The most effective way in which the Federal Reserve is able to impose the corrective measures necessary is through the use of accurate forecasts.Forecasts are necessary since there is a time lag involved between the time monetary and interest rate changes are issued and the period upon these measures will effect.Interest rate data from the period January 1995 through December 1999 was used to forecast was used to forecastintereto either help spur economic growth or induce a slow down gives The Federal Reserve will pull

Part 1. Introduction

This paper forecasts the U.S. Money Supply quantity for the years 2000 and 2001.The explanatory variable in our model is real GDP chained in 1996 dollars (GDPC 96) for the years 2000 and 2001.The approach is based on the Monetarist model using the Quantum Theory: the variables are the Federal Funds rate (FEDFUNDSR) and the seasonally adjusted money supply (M1SL) which are both lagged by eight periods.The Monetarist Theorem helps forecast economic peaks and troughs related to inflationary and recession periods.The amount of GDP is a dependent variable with the quantity of the money supply.

According to our data obtained from the Federal Reserve Bank of St Louis, the M1 money supply is forecasted to have low volatility during the forecasted period of 2000 - 2001.The forecast horizon of two years lowers the risk of an inaccurate forecast. Due to the complex variables involved, a large margin of error is present in any forecast dealing with the money supply.The forecast horizon is short enough to avoid seriously overstating or understating the transactional velocity of the money supply. 

The rest of the paper is organized as follows: Part 2. Presents the data used to forecast the money supply; Part 3. Presents the theoretical basis for the approach adopted in forecasting the money supply; Part 4. Presents forecasts of money supply for 2000 and 2001; Part 5. Evaluates the importance of the forecast for the economy; and Part 6. Discusses conclusions for economic policy. 

Part 2. Data

All variables are taken from the Federal Reserve Bank of St Louis Federal Reserve Economic Data (FRED). The measures of M1 money supply, gross domestic product, and interest rates are FRED variables M1SL, GDPC96, and FEDFUNDS, and are all quarterly adjusted nominal rates.The variable GDPC96 was listed quarterly while the data for M1SL and FEDFUNDS were both given by monthly variation.The seasonally adjusted nominal variable M1 and Federal Funds rate were converted to a real variable by averaging the three month period which comprised the four annual quarters. This sample data includes the variables contained within the period of 1993-99.The forecast horizon is two years (eight quarters) into the future. Regression analysis was first done on the original data to establish that a relationship exists between the variables. 

Part 3.The Monetarist Variables Effect on M1 Money Supply

The long run level or change in the M1 supply is largely determined by the level or change in the monetary base along with the currency ratio.However, on a short term basis the M1 supply is influenced by economic variables such as interest rates, income, and wealth.

Part 4. The Money Supply: A Short but Accurate Projection Through 2001

The equation used to estimate M1 money supply for the years 2000 and 2001 were done by a regression formula for the years 1993-1999. The data input was the Federal Funds Rate, GDP, and the M1 money supply lagged eight periods for these years. The R-squared of the estimate is 0.919. This indicates that approximately 92% of the variations in the Federal Funds Rate and GDP are explained by the lagged M1.The t-statistic is less than one, indicating a slight rejection of the null hypothesis. The t-statistic of the intercept is greater than ten, indicating a strong rejection of the null hypothesis that the intercept equals zero.The F-statistic for the hypothesis is 60.89.

M1SL =(1369.937)-(.20148)( 1068.47)M1t-8+(.008518)(8277.27)Yt-8-(23.245)(5.52)It-8

 

Regression Statistics
Multiple R
0.9589
R Square
0.9195
Adjusted R Square
0.9044
Standard Error
8.4978
Observations
20
 

Coefficients

t Stat
Intercept
1369.94
10.63
X Variable 1
-0.201
-2.76
X Variable 2
0.00852
0.857
X Variable 3
-23.25
-6.48

Forecast for M1 from the regression estimate is presented in Table 1.

 

Table 1

Forecast M1 in Relation to the Federal Funds Rate, GDP, and Lagged M1

1999.1 Ė 2000.4 (billions of 1993-1999 dollars)

Quarter
Percent Change in M1SL
Projected Change in M1SL
Projected M1SL
2000.1
1.34%
-14.69
1096.25
2000.2
-0.03%
0.33
1096.58
2000.3
-0.09%
1.02
1097.59
2000.4
0.86%
-9.32
1088.27
2001.1
-2.28%
25.39
1113.66
2001.2
0.18%
-2.04
1111.62
2001.3
0.51%
-5.61
1106.01
2001.4
0.59%
-6.45
1099.56


This represents a minimal variation in the amount of M1 available to consumers with two explanatory variables, Being the Federal Funds Rate and GDP. These are reasonable projections as long as the unemployment rate continues to decline and there are no real changes in wages or inflation.

The following chart illustrates our predictions:

Figure 1

The chart illustrates that throughout the year 2000 the M1 money supply will decrease which may coincide with the Federal Reserveís increase of the Federal Funds and Discount Rate.Our prediction may be valid according to the Federal Reserveís economic policy.In 2001, our prediction shows a huge increase in the first quarter and then a correction in the last three quarters of the year.Interest rates will affect the overall quantity of the money, which is determined by the Federal Reserve.

Part 5. Forecast Implications: Steady as She Goes 

The M1 money supply is important to forecast because it indicates the amount of money in circulation. The forecast of increasing and decreasing M1 indicates economic activity will grow steadily in the future bearing mild corrections in the market. There will be a constant argument for the Federal Reserve to raise interest rates, leading to a decrease in the money supply. Higher interest rates equals less borrowing, which constitutes lower investment.Investment variations which will highly effect new housing starts because of the increased cost, which may decrease the overall marginal propensity to consume. Lower rates constitutes the opposite effect which increases investment and the marginal propensity to consume

With higher demand for investment mainly for retirement, investors can use these trends to estimate potential gains and losses in the market. Depending on the predicted outcome, increases and decreases may be sustainable because of the constant growth. 

The assumption that the M1 money supply is forecast to have an overall decrease in years 2000 through 2001 indicates a decrease in real income, real wealth, and a rising standard of living, for the U.S. throughout the forecast period.

Part 6. Policy Conclusions

The Federal Reserve is responsible for monitoring the supply of the U.S. money supply.Changes in policy can be implemented in three different ways.The control of the supply of U.S. treasury securities, required reserve deposit ratio, and the interest rate level.Due to the minimal change in the quantity of the money supply, government monetary policy changes should not be required for the next two years.

M1 is forecast to be approximately 1110.94 billion dollars in the year 2001. This is a 5% increase from 1999. This value is based on the forecast of GPD to be 9026.946 billion dollars, and Federal Funds Rates to be 5.31.The Federal Funds Rate has already surpassed that to 5.75 percent, which indicates a conservative, forecast.

This forecast assumes the Federal will not raise rates any higher during the forecast period. Which illustrates an inadequate prediction our forecast.However the overall forecast seams relatively believable from past economic data.

References

Federal Reserve Bank of St. Louis, Federal Reserve Economic Database (FRED), http://www.stls.frb.org/fred/ 

Thomas, Lloyd B. Money, Banking, and Financial Markets, New York NY: McGraw-Hill Company, 1996.