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 nation’s 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
Fed’s 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
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Coefficients
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Intercept
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1369.94
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10.63
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X Variable 1
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-0.201
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-2.76
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X Variable 2
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0.00852
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0.857
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X Variable 3
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-23.25
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-6.48
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Forecast
for M1 from the regression estimate is presented in Table 1.
Table 1
1999.1
– 2000.4 (billions of 1993-1999 dollars) |
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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 Reserve’s increase of the Federal Funds and Discount Rate.Our prediction may be valid according to the Federal Reserve’s 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.