A Forecast of the Money Supply for the Years 2001 Through
2002 Using the Quantity Theory of Money

MICHAEL H. FISHER JR.
College of Business
Western Carolina University

Abstract

U.S. money supply is forecast to remain virtually unchained in the next two years within 1 trillion and 1.2 trillion US dollars. The trend of the money supply has no real change in the next two years, especially when compared to the large increase in M1 during 1991-1994. This forecast is based on a Monetarist model which assumes a continuous natural rate of unemployment of 6% and a healthy inflation rate of around 2%, estimated from past figures. A very slight decrease in the money supply over the next two years, however, will help the FED in its desire to continue to slow down the economy from its boom that extended into the year 2000. The FED should very gingerly continue to slow down the economy, for in truth, if the US economy is to grow infinitely than it must wait a moment to breathe. (JEL: E42, E51)

This paper will forecast the money supply in the United States for the term 2001 through 2002. The explanatory variables used to forecast will be the price level (P) and the gross domestic product (GDP). The approach of the forecast will utilize the monetarist model, otherwise known as the quantity theory of money. The drawback to this approach is that the price level of the economy in question must be stable; however the price level in the U.S. has been stable enough in the past twenty years to construct a valid model in regards to this question.

The money supply is an integral part of the US economy. A change in the supply of money may induce inflation or deflation, the price level, and also effect gross domestic product. In other words the money supply effects the way we spend money. The more T-notes in possession of the people, the less money there will be to change hands. In the early 1990s, the was a small supply of money, around eight hundred billion. Over the decade this figure increased rather dramatically with the increase of the velocity of money, after the collapse in the mid 1980s. The Fed, after having had a restrictive keep on the M1 supply, suddenly loosened its grip and the economy would later blossom into the boom of the 1990s. The research material for this forecast reflects this increase in velocity and money supply.

The range of years examined in this forecast is a good measure because a long run measure could be very inaccurate, due to the fact that no one knows when a change in monetary policy will occur; much like trying to predict the outcome of a trip to the dentist—one can prepare for the worst and that is about all.

The remainder of this report is organized as follows: part 2. presents the data used to forecast GDP, estimate MPC and MPI, and estimate the investment function; part 3. presents the theoretical basis for the approach adopted in forecasting GDP; part 4. presents forecasts of GDP for 1999 and 2000; part 5. evaluates the importance of the forecast for the economy; and part 6. discusses conclusions for economic policy.

All data for this forecast come from the Federal Reserve Bank of St. Louis Economic Data (FRED) located online at http:// http://www.stls.frb.org/fred. The measures of GDP, the money supply (M), and the consumer price index (CPI) are FRED variables GDPC96, M1SL, and CPIAUCSL respectively. All variables are in billions of chained 1996 US dollars. Both M and CPI were recorded monthly. The GDP, however was recorded quarterly and thus averages were taken to compute the monthly M and CPI data into useable quarterly data that could be compared and calculated to and with the GDP. In using the documentation software, the first month of each quarter was used as an indication of each quarter (January, April, July, and October).

The CPI was used as a measure of the price level because it is known to be a good indicator of P. The variable used to indicate the money supply was M1, because it encompasses the money used most—that which is used by Mr. and Mrs. John Q. Taxpayer.

The velocity of money (V) is assumed to remain stable in the next two years. This is a safe assumption because the velocity of money can really only increase due to technology advances. At this point in time technology has improved to the point where all one has to do for money to change hands is pick up the phone or point a mouse on a computer screen and within seconds the transaction has been completed. Therefore the only true reason V could change in the future would be a breakdown of modern communication systems or something along the lines of wide-spread telepathy and telepathic ATM receivers.

This forecast assumes that there will be no change in price level over the next two years. The term of two years was chosen because it was a good estimation block for the money supply. There was a great increase in the money supply since 1991, where the money supply grew by around two hundred million dollars (Anabtawi

and Smith, 1994). This increase also correlates to the increase in V over the 1990s as ATM usage became more prevalent.

After the boom of money supply in the early 1990s began to wane in the later months of 1994, it becomes apparent that the FED was actually trying to maintain a supply of money around 1.1 trillion dollars. The money supply, after the second quarter of 1993, begins to hover around that mark, even to the current year. This shows a direct relation between V and M.

The monetarist theory relies on the function:

where the price level is a function of the money supply and gross domestic product (quantified by the abbreviation Q). This function is based on the assumption that unemployment stays in a natural rate of 6%. Monetarists believe this to be the constant, long-run rate of unemployment.

A simple two year regression function equation is used to forecast the money supply. The regression estimate equation is:

The adjusted R² result of the regression data is 0.03156, indicating that 3% of the variance of M1 is explained by the three lagged explanatory variables: GDP, CPI, and M1. This is not a good R² rating. The 3% rating signifies that the GDP and CPI have little to do with the monetary function’s prediction.

The T-statistics also have little variance. They range from 1.3 to –1.3, indicating that the variables fail to reject the null hypothesis that each individual regression coefficient is equal to zero, meaning that they affect the outcome of M.

The following table illustrates the regression outcomes along with expected inflation to illustrate some validity.

The forecast area of the graph is little help without an examination of the data in a closer view, since it’s variance is small when compared to the change in M1 supply during the early 1990s. The following graph shows a close-up view of the forecast region:

The graph shows a very slight fall in the money supply over the next two years. This change is minuscule compared to the rapid change of the early 1990s, but the downward trend at the end of the forecast could suggest a slow-down in the economy; something that the FED is trying to do right now.

This graph, however low the net change in M is, may be more accurate than it would appear. Since the beginning of the year (2001), the FED has decreased interest rates, which may slow the velocity of money or the marginal propensity to save (MPS); both of which would decrease the money supply. This lowered MPS would decrease the amount of money in money markets, slowing the economy as well.

As for unemployment, it is safe to say that the current "natural rate" of 6% may be maintained with the present economy if economical conditions become slowed but not stagnant.

The money supply is a tricky issue. On one hand the FED may want to restrict the amount of money available in order to continue the slowing of the economy. On the other hand who is to say that there is an end to the rainbow of good economic conditions found in the 1990s.

Restricting the money supply, however, could have bad long term effects. If the FED, combined with its lowering of interest rates, also lowers the money supply, the economy could find itself more bearish than the FED had intended. This brings up a good question of whether the FED should plan recessions or not. It certainly has the power to do so. Most Americans, however, seem to maintain a prosperous mood, even though the economy shows no more signs of a boom. Consumer confidence, although proved comparatively lower over the holiday shopping season, seem to believe that the state of 1990s boom never ended—that we are simply in a state of transition between booming eras.

The end of the forecast graph, however, could signal the end of such booming times. If the M1 trend line continues in such a downward trend, then it is quite possible that a real recession is on the way. Such a continued trend line, however, is easily nullified by the fact that a long-term monetary model is useless, because monetary policy change is bound to happen every few years. As for any suggestions for the FED to ratify the monetary policy, there are none. That is why they are on the board of governors of the FED, and this is a simple economic forecast.

Anabtawi, Iman, and Smith, Gary. "Macroeconomic Modeling of Money, Credit, and Banking," Eastern Economic Journal, Summer, 1994. pp. 275-290. Available at <http://www.economics.pomona.edu/Iman.html>.

Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED) (2-01-01), http://www.stls.frb.org/fred/ (2-20-01).