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The NOW account experiment and the demand for money
Journal of Banking and Finance 6 (1982) 179-193. North-Holland Publishin,_, Company
THE NOW A C C O U N T EXPERIMENT AND THE D E M A N D FOR MONEY* Joanna H. FRODIN Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105, USA
Richard STARTZ University of Pennsylvania, Philadelphia, P A 19104, USA Received September 1981, fmal version received November 1981 The authors use the N O W account experience in New England from 1972 to 1978 to estimate the responsiveness of the demand for money to interest payments on checkableaccounts. Such an estimate is important in considering the effects on the demand for money of nationwide NOW's and of variations in interest rates on transactions balances in the future. With New England as the experimental region and the rest of the United States as a control group, the authors develop a cross-section, time-series framework to isolate and to estimate the interest rate responsiveness of money demand while accounting for effects of income, interest rates, and gradual adjustment.
1. Introduction
We estimate in this paper the responsiveness of the demand for money to interest payments on checkable accounts. We use the New England NOW account experience to compare the demand for interest-bearing checkable balances to the demand for non-interest-bearing checkable balances. From 1972 through 1978, institutions in New England offered NOW accounts, the equivalent of a personal demand deposit paying five percent interest. During the same period, the long standing prohibition against interest on demand deposits continued elsewhere in the country. Since 1978, limited variants of NOW's have existed outside New England, and as of January 1, 1981, NOW accounts have been permitted nationwide. The New England experience allows estimation of the own-interest responsiveness of money *We would like particularly to thank Nicole Neslusan, our research assistant, for displaying considerable ingenuity. Robert White and Marguerite Caughlin of the Federal Reserve Bank of Boston, as well as the Boston Federal Home Loan Bank Board and Business Week, were especially helpful in providing data. This draft benefited from extensive comments by Jeremy Siegel, Stanley Fischer, Mark J. Flannery, Anthony M. Santomero, and participants in the Wharton Finance Workshop. None of the above has any responsibility for our conclusions.
0378-4266/82/~/$02.75
© 1982 North-Holland
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J.H. Frodin and R. Startz, N O W account experiment and deraand for money
demand. With the spread of interest-bearing checkable accounts, the answers to two policy questions require such an estimate. 1 (1) How large an increase in demand for transactions balances will result from the general availability of N O W accounts? (2) As the rate of return to transactions balances varies in the future, what corresponding changes will occur in the demand for these balances? Under deregulation, a sharply increased fraction of the nation's transactions balances will bear interest. As a result, the demand for real balances will rise. If the monetary authority knows the magnitude of this shift, it can accommodate it and maintain a neutral monetary policy. If the interest rate on checkable deposits eventually floats freely, the monetary authority will require an estimate of the own-interest responsiveness as a permanent input to policy making. Fortunately, the New England experience allows us to estimate the effect of interest payments in advance of general deregulation. We approach the New England NOW account experience as a controlled experiment. New England, the experimental area, received a 5Y/o interest 'dose', while the rest of the United States served as a control group. To isolate and to estimate the response of money demand to this interest dose, we develop a cross-section, time-series framework in which we provide for the effects of income and interest rates and for a pattern of gradual adjustments to NOW's. In section 2, we review how the N O W account experiment developed, with a particular eye toward the growth pattern of NOW balances. We discuss the factors affecting money demand and make some simple estimates of the NOW effect in section 3. Section 4 contains our econometric estimates. We first consider the increase in total transactions accounts, essentially M 1 - B sans currency. Second, we focus directly on deposits of individuals, since only individuals could hold NOW's. The final section is a summary of our findings.
2. Regulatory and quantitative history In May 1972, the Massachusetts Supreme Judicial Court ruled that a new type of account proposed by a savings bank - - a savings account against which a customer could write a draft called a Negotiable Order of Withdrawal - - was essentially indistinguishable from existing withdrawal
1For some policy problems, demand increases are not the only question. Even if the payment of interest induced no increase in demand for transactions balances, the demand for the monetary base might still shift drastically as assets move from high reserve ratio (demand deposit) assets to low reserve ratio (NOW) assets.
J.H. Frodin and R. Startz, N O W account experiment and demand for money
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arrangements using counterchecks. With the permission of the Comptroller of the Currency, mutual savings banks in Massachusetts and New Hampshire began offering NOW accounts in September 1972. Congress authorized commercial banks, savings and loans, and cooperatives to offer NOW's as of January 1974. All such institutions in Connecticut, Maine, Rhode Island, and Vermont received permission to issue NOW's" in March 1976. Our New England experimental period runs from 1972:9 to 1978:4 for Massachusetts and New Hampshire and from 1976:3 to 1978:4 for the other four states. The FDIC and the Federal Reserve Board regulations limited the extension of NOW accounts to individuals and certain non-profit organizations and the payment of interest to 5%. Although NOW accounts generally offered higher returns than regular checking accounts, consumers adopted NOW's only gradually. For instance, NOW accounts represented only 10% of total checkable balances (gross demand deposits e plus NOW's) as late as July 1975 in New Hampshire and January 1976 in Massachusetts. By April 1978, NOW's in New Hampshire and Massachusetts reached 32.9% and 22.4% of total transactions balances, respectively. Fig. 1 shows the ratio of NOW's to total checkable balances in each of the six New England States. Initial adoption rates were faster in the four states where NOW's started in March 1976 than they had been in Massachusetts and New Hampshire. This difference suggests that the national adoption of NOW's may be faster than otherwise because of the New England experience, the existence of automatic transfer services, and the extension of NOW accounts to New York. Did NOW accounts simply displace demand deposits or did they cause real additions to total checkable balances? Since ownership of NOW accounts is limited to individuals and certain non-profit organizations, NOW's are necessarily a larger element of total individual checkable balances than of total balances. We constructed a series for individual demand deposits in New England, where they account for about one-fourth of total demand deposits, and a series for rest' of United States. Fig. 2 shows indivldual demand deposits, NOW balances, and total transactions balances in New England along with individual demand deposits in the rest of the United States. The level of real balances outside of New England was quite volatile, but relatively trendless. New England balances exhibited a large increase paralleling the growth in NOW's. This finding suggests that NOW's do indeed add to, rather than merely replace, demand deposits. 3. Measuring the shift in money demand In this section, we measure the increase in money demand due to NOW 2Gross demand deposits are total demand deposits before netting out cash items in process of collection.
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J.H. Frodin and R. Startz, N O W account experiment and demand for money
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accounts by comparing the relative growth of total transactions balances, before and during the N O W experiment, in New England and the rest of the United States. Given the relative growth, we can derive the own-interest semi-elasticity of the demand for money. For our measurement of money demand, we make two broad assumptions. We assume first that the same money demand function applies to both the New England experimental region and the non-New England control region (or at least that the functions differ by no more than a multiplicative constant). Thus, as an identifying restriction, we assume that no shift in money demand unique to New England occurred during the N O W experiment. In particular we must assume that the NOW experiment did not induce any substantial increase in New England balances by individuals living outside New England. The primary determinants of money demand are the general price level, interest rates, and income. To isolate the NOW account effect, we must control for any differential growth in these determinants. Since the consumer price indices for the U.S. and New England (Boston) rose by almost identical amounts during the N O W experiment period and since interest rates are essentially national, changes in these variables would have had no differential impact on New England and the United States. By contrast, the recession of 1974 and 1975 affected income in New England far more than in the rest of the nation. For this reason, we explicitly control for differential income growth. In the following representation of money demand, we observe total transactions balances (checking accounts plus NOW accounts) in both New England and the rest of the United States, before and during the experiment. Let M~ be the logarithm of real balances in region i at time t. M~ has four components: ai is a regional effect unique to each area, b, is a time effect representing those forces which change money over time but which do not have a differential impact on the two regions (market interest rates are a prime example), y[ is the logarithm of real income and affects money demand with an elasticity c, and N measures the increase in deposit balances attributable to the existence of N O W accounts. Taking 1972 and 1977 as illustrative end-points, we have (in logs)
M7u2s = a o s + b72 + cY72, us NE MNTE=aNF.+bTz+CY72,
M 7us 7 =
,Us aus+b77 + cY77
NE M77=aNE+b77+cy~E+N,
N = (M77NE~ zvJ 14NE) /AArUS 721 --~,zvJ 77 M72)US
-c[(Y~-- Y72)--(Y77 r~E u s _ yTus)].
(1)
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J.H. Frodin and R. Startz, N O W account experiment and demand for money
This formulation demonstrates the calculation required to estimate the N O W account effect. N measures the percentage increase in money demand attributable to N O W accounts (since the dependent variable M is in logs). N provides an answer to the first question posed in the introduction. To answer the second question, we need to translate N into a measurement of interest responsiveness. The most convenient 3 form is the own-interest semi-elasticity the percentage increase in transactions balances due to one percentage point increase in the interest rate. Since N O W accounts almost uniformly paid 5% interest, the estimate of the interest semi-elasticity is N/5. 4 To estimate c, we ran a demand deposit regression similar to Goldfeld's. s The resulting long-run income elasticity is 0.577. Since N is quite sensitive to this estimate, we calculate (1) for both c equal to 0.577 and a more monetarist assumption of c equal to 1.0. June 1972 and December 1977 are convenient end-points, given the timing of FDIC call reports. We treat Massachusetts and New Hampshire, where NOW's first existed, as one unit. Over this five year period, real demand deposits fell 2.65~ 6 in the United States and 25.7~ in Massachusetts and New Hampshire. However, real growth in NOW's caused total transactions balances to rise 3.69Y/o in the two states. Real personal income rose 16.8Y/o in the United States over this period versus the 8.24~ increase in the two state region. Applying an income elasticity of 0.577 in formula (1), the total increase in transactions balances due to the N O W account experience is 11.3yo. Because the recession was deeper in New England than in the rest of the nation, our choice of the income elasticity has a non-trivial effect on the N O W estimate. If we had used a zero income elasticity, the estimate of N would be only 6.34~. Assuming a unitary income elasticity would indicate an increase in money demand of 14.9~. -
-
3The semi-elasticity form is more convenient than using an elasticity because the zero to five point increase in deposit interest is an infinite percentage increase. 4Recently, attention has been given to the payment of implicit as opposed to explicit interest. We confine our attention to the latter. See Klein (1974), Santomero (1979) and Startz (1979). It should also be reco~niTed that the change in the explicit rate of return may have been accompanied by changes in non-price, or implicit, rates of return. To the extent that such changes also will accompany future shifts in the explicit rate of return, our estimates in this paper will be good predictors. sSee Goldfeld (1973, table 1). We regressed the log of real demand deposits on the log of real GNP, the levels of the time deposit rate and the Treasury Bill rate, and a lagged dependent variable. The regression was estimated on quarterly data from 1953:II through 1973:IV by iterated Cochrane-Orcutt. The implied long-run income elasticity is 0.577, log M = - 0.7443 + 0.1394 log Y - 0.0133RTD - 0.01M5RT B + 0.7586 log M_ 1We ran the equation on levels rather than logs of the interest rates in order to obtain an estimate of the total market interest rate semi-elasticity. According to the equation reported above, if market interest rates rise one point (both the Treasury Bill and time deposit rate go up one percentage point) the long-run drop in deposit demand will be 0.0737%. 6All 'percent changes' are actually changes in natural logarithms.
J.H. Frodin and R. Startz, N O W account experiment and demand for money
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We can make similar calculations for the remaining four New England states using December 1975 and December 1977 call reports. Income changes in this region were similar to those in the rest of the nation. Using the 0.577 income elasticity, we estimate N to be 4.77. Ignoring income changes or assuming a unitary income elasticity produces estimates of N equal to 3.93 and 5.38, respectively. Before proceeding to more sophisticated techniques, we would like to know whether our estimates are within a reasonable range. We can ask what change in demand one would expect from a five point change in market interest rates and see whether the estimated NOW account effect is roughly equal, but opposite to that change. As indicated in footnote 5, a reasonable estimate of the long-run interest semi-elasticity of deposit demand is -0.0737. The five-point interest rate differential can only be applied to holdings by individuals, which were approximately one-fourth of total New England deposits before the experiment. The expected change in deposits is therefore 0.0737 times five-fourths, or 9.2%. Our point estimates of N from the call report data are decidedly in the ballpark. In summary, the estimated N O W account effect in Massachusetts and New Hampshire is 11.3%, implying an own-interest semi-elasticity of 0.022. Our central estimate of the NOW effect for the four state region during the shorter experimental period is 4.77%. 4. Economic estimates
The estimates of the preceding section are limited by the use of only two data points. Since monthly fluctuations in the level of demand deposits can be the same order of magnitude as the NOW effect we are estimating, estimates based only on two points, while unbiased, are not likely to be very efficient. In moving from p o i n t estimation to statistical techniques, we broaden our source of evidence in two ways. First, we use monthly observations while using a more explicit specification of the money demand function. Second, we use data based on individual deposits, since the individual money demand is more directly related to the NOW account experiment. The cross-section/time series approach used here isolates the effect on money demand of the NOW account experiment from the effects of contemporaneous events. In principle, by assuming a stable money demand function in the experimental area over the entire sample period, one might estimate the N O W account effect by including a dummy variable for the period of the N O W experiment. However, deposit demand dropped across the nation more or less concurrently with the beginning of the N O W experiment. If we were to estimate the NOW effect solely through a timeseries regression on the experimental area, the unexplained shift, the so-called
J.H. Frodin and R. Startz, NOW account experiment and demand for money
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'Case of the Missing Money', [Goldfeld (1976)] would more than swamp the N O W account effect. With the combined cross-section/time series technique, the shift washes out as long as whatever caused the mystery operated proportionately in both the experimental and control area. We estimate a standard money demand equation for New England and the rest of the United States. The dependent variable is the log of real transactions balances. The logarithms of real income, the time deposit rate, and the treasury bill rate are explanatory variables. The use of real income controls for the differential impact of the recession in the two regions. The interest rate variables are 'nuisance' variables in that interest rates do not, by assumption, have a differential impact. However, the presence of the interest rate variables reduces the amount of unexplained variance in the regression and thus increases the power of estimation. Regional dummy variables, analogous to the as in the point estimation, are included in the equation. A series of dummy variables captures the gradual growth in NOW's. The equation also includes a series of time dummies, analogous to bt earlier. The time dummies and NOW dummies are 'matched', so that contemporaneous shifts in the control and experimental regions are picked up in the time effect rather than being attributed to NOW's. The regressions all take the general form of eq. (2), log M[ = N" ND[ + cl log Y[ + c2 log R T D t + Ca log R T B t + C+ a l R D i + b i T D t ,
(2)
dummy variables for the NOW effects, dummy variables for the regional effect, dummy variables for the time effect, - - overall constant.
ND[ m RD i ~ TDt --
c
The dependent variable is the log of real transactions balances. The independent variables are the log of real personal income and the logs of the time deposit rate and o f the three-month treasury bill rate. Separate regressions are run for the two experimental regions: Region 1, Massachusetts and New Hampshire, where NOW's started in September 1972 and Region 2 including Connecticut, Maine, Rhode Island, and Vermont in which NOW's started in March 1976. In each case, the United States outside of New England serves as the control region. Each regression includes an overall constant term and regional dummy for each New England state concerned and covers the period 1964:1 to 1978:4. The NOW account experiment developed gradually, especially in Massachusetts and New Hampshire. Therefore, we use a series of dummy variables, ND~ to estimate the NOW effect. Five subperiods, with the last two
J.H. Frodin and R. Startz, N O W account experiment and demand for money
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corresponding to the experimental period for the four state area, make up the N O W account period. The number of subperiods represents a compromise between a desire to estimate the timing effect most accurately and the need to have enough months within each subperiod to estimate the coefficient accurately. Time effect dummies, TD, exactly match the N O W effect dummies except that they apply to both the experimental and control regions. Regression estimates of the NOW account effect appear in table 1. The income and interest elasticities are all of the expected size and have small confidence intervals, although the income elasticity and the time deposit rate elasticity (0.9 and -0.56, respectively) are perhaps somewhat larger in absolute value than is usual. The long-run downward, 'missing money', shift in the money demand function, as measured by the time effect dummies, is 13%. The N O W effect coefficients show a long-run increase in money demand of 6.8% with a standard error of 1.9% for Massachusetts and New Hampshire. The final N O W coefficient for the four state region is 0.7% with standard error of 1.7%. Thus this first econometric estimate shows a smaller NOW effect than predicted by our use of FDIC data. The regional effects for the experimental areas are negative and highly significant. While it is not surprising that there is some relative difference in money demand between New England and the rest of the United States, the population difference accounts for part of the estimated regional effect. If the true money demand equation is specified in per capita terms, with money demand and income divided by population, then the equation as we estimate it should include the term ( 1 - c ) l o g P O P , where c is the income elasticity. This population effect can explain most of the Massachusetts dummy, but only a small part of the New Hampshire dummy. The joint hypothesis that the population effect can account for both dummy variables can be rejected at any reasonable level of significance. Feige (1974) made the same finding in a broader time-series, cross-section study. All the preceding procedures mix the estimation of the NOW account effect with the estimation of the structural parameters of the money demand equation. In other words, we use all available data from the experimental and control regions and from both the experimental and pre-experimental periods. The most efficient statistical procedure requires the use of all available data generated by the true model. However, such joint estimation may generate incorrect estimates of some of the parameters, particularly the income elasticity. The income elasticity of N O W accounts, which share some characteristics with time deposits, may be larger than the income elasticity for true demand deposits. The latter is the desired parameter. In addition, we have observed that money demand equations estimated with data that includes the period of the 'mysterious shift' in money demand tend to show income elasticities decidedly different from previous estimates. Since our
Table 1 Transactions balance demand. 64:1 to 78:4
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
Demand variables Log Y Log RTD Log TB
Regional effects Constant MA NH
Eq. (1) MA, NH
Eq.(2) CT, ME, RI, VT
0.0558 (0.0176) 0.01813 (0.0194) 0.05357 (0.0194) 0.05088 (0.0194) 0.06786 (0.0194)
-0.01003 (0.0178) 0.00705 (0.0178)
0.9248 (0.0434) -0.5632 (0.0657) -0.04777 (0.0133)
0.6445 (0.0366) --0.05900 (0.0510) -0.03521 (0.0109)
2.949 (0.397) -0.3454 (0.149)
5.236 (0.339)
- 1.016
(0.244) CT
- 1.827 (0.145) - 2.443 (0.199) - 2.283 (0.195) - 2.664 (0.228)
ME RI VT
Time effects 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-0.2766 (0.0158) -0.05417 (0.0189) -0.1377 (0.0182) -0.1355 (0.0182) -0.1299 (0.0182) R-squared: 0.9996 S E R : 0.054
0.03970 (0.00827) -0.05982 (0.0111) -0.1153 (0.0103) -0.1546 (0.0175) -0.1350 (0.0175) R-squared: 0.9995 S E R : 0.055
J.H. Frodin and R. Startz, N O W account experiment and demand for money
189
estimate of the income elasticity significantly affects our estimate of the NOW effect, we would like to use data which avoids these two problems. To obtain clean parameter estimates, we ran our demand equation on U.S. data from 1964 through August 1972. Using these parameter estimates, we constrained the coefficients on income and interest rates in a regression covering the period 1964 to 1978:4. These estimates are unbiased even if the NOW experiment itself changed the elasticities of transactions accounts. With the income and interest elasticities constrained, the long-run change in money demand is 6.2%, with a standard error of 2.3%, for Massachusetts and New Hampshire. The results for the remaining four states are not significantly different from zero, as shown in table 2. NOW accounts are held only by individuals and individuals hold only one-fourth to one-third of gross demand deposits. For some questions, such as the change in the overall monetary aggregates, the total deposit figure used so far is the relevant one. However, estimation on individual deposits yields the most direct estimates of the NOW effect. Using survey data made available by the Boston Federal Reserve, we constructed a series for individually held deposits for New England. 7 By parallel method, we also built a series for the rest of the United States from published Federal Reserve data. Table 3 reports the regression results of our standard equation for the U.S. and New England as a whole. The income elasticity is 0.88, in line with usual estimates, but the standard errors on the interest elasticities are too large for meaningful results. The NOW account effect is trivial in the first two periods because total NOW balances were in fact fairly small and because the percentage increase in New England is a weighted average of an increase in two states and a zero change in the other four states where NOW's did not yet exist. The remaining three periods show highly significant and progressively larger NOW account effects. The long-run estimate of the change in personal transactions balances because of the NOW experiment is 38.8%. The standard error is 3.74%. The statistical significance of our econometric results based on deposits by individuals shows a 't-statistic' of over 10 as compared with the t- of 3 for our regressions based on all deposits. However, we expected this outcome, since only individuals own NOW balances. The 38.8% point estimate indicates about a one third greater NOW effect than the estimates in table 1. Although we have assumed homoskedastic errors throughout, it seems unlikely that the error terms are truly independently and identically distributed. Even though ordinary least squares estimates are unbiased, a generalized least squares approach is more efficient and also leads to correctly reported standard errors. In the second column of table 3, we 7Details available from the authors.
190
J.H. Frodin and R. Startz, NOW account experiment and demand for money Table 2 Using constrained income and interest coefficients. 64:1 to 78:4
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 • 76:3 to 77:3 77:4 to 78:4 Constant
Regional effects MA NH
Eq. (1) MA, NH 0.0535 (0.02O9) 0.0123 (0.0229) 0.0400 (0.0229) 0.0471 (0.0229) 0.0622 (0.0229) 8.178 (0.0062)
--2.8313 (0.0069) -3.8189 (0.0069) - 3.6320 (0.0069) - 4.2400 (0.0069)
ME RI VT
74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-0.0166 (0.0199) -0.0046 (0.0199) 8.161 (0.0052)
-2.1845 (0.0083) -4.0122 (0.0083)
CT
Time effects 72:9 to 73:12
Eq. (2) CT, ME, RI, VT
0.0334 (0.0171) - 0.0290 (0.0187) -0.1057 (0.0187) -0.0853 (0.0187) - 0.0511 (0.0187) R-squared: 0.9985 SER: 0.0637
0.1045 (0.0073) 0.0136 (0.0080) -0.0436 (0.0080) -0.0682 (0.0178) - 0.03406 (0.0178) R-squared: 0.9984 SER: 0.0615
report generalized least squares results. The stochastic specification allowed for a cross-sectionally heteroskedastic, serially correlated, and contemporaneously correlated error structure. The increase in transactions balances attributable to the existence of N O W accounts is 35.3%, with a standard error of 3.2%.
J.H. Frodin and R. Startz, N O W account experiment and demand for money Table 3 New England individual deposits 72:4 to 78:4
OLS
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
GLS 0.0289 (0.0329) -0.0038 (0.0336) 0.0998 (0.0355) 0.2725 (0.0355) 0.03883 (0.0374)
0.0125 (0.0271) -0.0163 (0.0282) 0.0774 (0.0300) 0.2452 (0.0300) 0.0354 (0.0321)
0.8822 (0.2555) 0.0499 (0.2154) 0.0123 (0.0411) 1.1446 (2.798)
0.4537 (0.2356) 0.0649 (0.2321) - 0.0121 (0.0436) 5.704 (2.5637)
Demand variables Log Y Log R TD
-
Log TB Constant Regional effect N.E. Time effects 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-
--0.7891 (0.693 -0.0221 (0.0288) -0.0562 (0.0316) -0.0951 (0.0304) -0.1188 (0.035) -0.1333 (0.0425) R-squared: 0.9993 SER: 0.0440
-
1.9508 (0.6411)
0.0144 (0.0264) -0.0284 (0.0305) -0.0720 (0.0282) -0.0888 (0.0220) -0.0766 (0.0385) R-squared: 0.9993
USNET
SER 0.0431
RHO 0.0449
NE
0.0373
0.0389
191
192
J.H. Frodin and R. Startz, N O W account experiment and demand for money
5. Summary and conclusions With the goal of estimating the effect of the institution of interest-paying NOW accounts nationwide on the demand for money, we have measured the impact of NOW's on checkable balances in New England from 1972:9 to 1978:4. The first estimate used FDIC call reports predating and postdating the above period. The second estimate used monthly data on transactions balances. The third used monthly, Survey-based, data on personal demand deposits plus NOW's. For the purpose of comparison, we used an existing estimate of the market semi-elasticity of the demand for money to generate an a priori estimate of the N O W account effect. This estimate of a 9.2~ increase in the demand for money, caused by payment of interest of 5~, corresponds approximately to a 37~ increase in personal deposits. The estimates from the call reports showed an increase in checkable balances in Massachusetts and New Hampshire of between 11.3 and 14.9~. The indicated increase in the shorter experimental period for Connecticut, Maine, Rhode Island, and Vermont ranged from 4.8 to 5.4~. The results for the two states are in line with our a priori estimate while those for the four states are somewhat smaller. The second approach, using ordinary least squares regressions on the monthly gross transactions balance data, yielded a long-run N O W account effect in Massachusetts and New Hampshire of 6.8~, with a reported standard error of 1.9~. For the other four New England states, an ordinary least squares regression shows no appreciable NOW account effect with a standard error of 1.8~. We can conclude that the NOW account effect measured against total deposits was small. Even if the true effect is two standard errors above the point estimates, the total increase in money demand is no more than 10~. Such an effect, when due to a large 5 point interest increase, must be considered very small. This response took several years to develop. Thus interest payments limited to individual checkable balances (about one-third of the U.S. total nationwide) are unlikely to change aggregate money demand abruptly or by very much. Our third estimate, using regressions on the individual deposit data, yielded an increase in transactions balances of 38~ with an associated standard error of 4 ~ and therefore a t-statistic of ten. While this effect is more clearly established than that on total deposits, the 38~ increase in demand corresponds to an own-interest semi-elasticity of 0.076. We conclude that the own-interest responsiveness of money demand is small, but, statistically, highly significantly different from zero. Our results, therefore, are noteworthy for their strong empirical reaffirmation of conventional predictions of economic theory. The estimated 38~ increase in individuals' checkable balances is large on an absolute scale, but modest relative to the change in the interest rate which induced the shift.
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193
We have demonstrated statistically that the demand for money does respond to the payment of interest but that that response is fairly inelastic.
References Becker, W.E., 1975, Determinants of the United States currency-demand deposit ratio, Journal of Finance, March. Crane, Dwight B. and Michael J. Riley, 1978, NOW accounts (Lexington Books, Lexington, MA). Federal Deposit Insurance Corporation, n.d., Assets and liabilitiesof commercial and mutual savings banks, various years. Federal Reserve Bank of Boston, n.d.,Functional cost analysis,various years. Federal Reserve Board, n.d.,Federal Reserve Bulletin,various issues. Feigc, Edgar L., 1974, Temporal cross-sectionspecificationson the demand for demand deposits, Journal of Finance, June. Goldfeld, Stephen, 1973, The demand for money revisited, Brookings Papers on Economic Activity, 3. Goldfeld, Stephen, 1976, The case of the missing money, Brookings Papers on Economic Activity, 3. Klein, Benjamin, 1974, Competitive interest payments on bank deposits and the long-run demand for money, American Economic Review, Dec. Santomero, Anthony, 1979, The role of transaction costs and rates of return on the demand deposit decision, Journal of Monetary Economics 5. July. Startz, Richard, 1979, Implicit interest on demand deposits, Journal ol Monetary Economics 5, Oct.
THE NOW A C C O U N T EXPERIMENT AND THE D E M A N D FOR MONEY* Joanna H. FRODIN Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105, USA
Richard STARTZ University of Pennsylvania, Philadelphia, P A 19104, USA Received September 1981, fmal version received November 1981 The authors use the N O W account experience in New England from 1972 to 1978 to estimate the responsiveness of the demand for money to interest payments on checkableaccounts. Such an estimate is important in considering the effects on the demand for money of nationwide NOW's and of variations in interest rates on transactions balances in the future. With New England as the experimental region and the rest of the United States as a control group, the authors develop a cross-section, time-series framework to isolate and to estimate the interest rate responsiveness of money demand while accounting for effects of income, interest rates, and gradual adjustment.
1. Introduction
We estimate in this paper the responsiveness of the demand for money to interest payments on checkable accounts. We use the New England NOW account experience to compare the demand for interest-bearing checkable balances to the demand for non-interest-bearing checkable balances. From 1972 through 1978, institutions in New England offered NOW accounts, the equivalent of a personal demand deposit paying five percent interest. During the same period, the long standing prohibition against interest on demand deposits continued elsewhere in the country. Since 1978, limited variants of NOW's have existed outside New England, and as of January 1, 1981, NOW accounts have been permitted nationwide. The New England experience allows estimation of the own-interest responsiveness of money *We would like particularly to thank Nicole Neslusan, our research assistant, for displaying considerable ingenuity. Robert White and Marguerite Caughlin of the Federal Reserve Bank of Boston, as well as the Boston Federal Home Loan Bank Board and Business Week, were especially helpful in providing data. This draft benefited from extensive comments by Jeremy Siegel, Stanley Fischer, Mark J. Flannery, Anthony M. Santomero, and participants in the Wharton Finance Workshop. None of the above has any responsibility for our conclusions.
0378-4266/82/~/$02.75
© 1982 North-Holland
180
J.H. Frodin and R. Startz, N O W account experiment and deraand for money
demand. With the spread of interest-bearing checkable accounts, the answers to two policy questions require such an estimate. 1 (1) How large an increase in demand for transactions balances will result from the general availability of N O W accounts? (2) As the rate of return to transactions balances varies in the future, what corresponding changes will occur in the demand for these balances? Under deregulation, a sharply increased fraction of the nation's transactions balances will bear interest. As a result, the demand for real balances will rise. If the monetary authority knows the magnitude of this shift, it can accommodate it and maintain a neutral monetary policy. If the interest rate on checkable deposits eventually floats freely, the monetary authority will require an estimate of the own-interest responsiveness as a permanent input to policy making. Fortunately, the New England experience allows us to estimate the effect of interest payments in advance of general deregulation. We approach the New England NOW account experience as a controlled experiment. New England, the experimental area, received a 5Y/o interest 'dose', while the rest of the United States served as a control group. To isolate and to estimate the response of money demand to this interest dose, we develop a cross-section, time-series framework in which we provide for the effects of income and interest rates and for a pattern of gradual adjustments to NOW's. In section 2, we review how the N O W account experiment developed, with a particular eye toward the growth pattern of NOW balances. We discuss the factors affecting money demand and make some simple estimates of the NOW effect in section 3. Section 4 contains our econometric estimates. We first consider the increase in total transactions accounts, essentially M 1 - B sans currency. Second, we focus directly on deposits of individuals, since only individuals could hold NOW's. The final section is a summary of our findings.
2. Regulatory and quantitative history In May 1972, the Massachusetts Supreme Judicial Court ruled that a new type of account proposed by a savings bank - - a savings account against which a customer could write a draft called a Negotiable Order of Withdrawal - - was essentially indistinguishable from existing withdrawal
1For some policy problems, demand increases are not the only question. Even if the payment of interest induced no increase in demand for transactions balances, the demand for the monetary base might still shift drastically as assets move from high reserve ratio (demand deposit) assets to low reserve ratio (NOW) assets.
J.H. Frodin and R. Startz, N O W account experiment and demand for money
181
arrangements using counterchecks. With the permission of the Comptroller of the Currency, mutual savings banks in Massachusetts and New Hampshire began offering NOW accounts in September 1972. Congress authorized commercial banks, savings and loans, and cooperatives to offer NOW's as of January 1974. All such institutions in Connecticut, Maine, Rhode Island, and Vermont received permission to issue NOW's" in March 1976. Our New England experimental period runs from 1972:9 to 1978:4 for Massachusetts and New Hampshire and from 1976:3 to 1978:4 for the other four states. The FDIC and the Federal Reserve Board regulations limited the extension of NOW accounts to individuals and certain non-profit organizations and the payment of interest to 5%. Although NOW accounts generally offered higher returns than regular checking accounts, consumers adopted NOW's only gradually. For instance, NOW accounts represented only 10% of total checkable balances (gross demand deposits e plus NOW's) as late as July 1975 in New Hampshire and January 1976 in Massachusetts. By April 1978, NOW's in New Hampshire and Massachusetts reached 32.9% and 22.4% of total transactions balances, respectively. Fig. 1 shows the ratio of NOW's to total checkable balances in each of the six New England States. Initial adoption rates were faster in the four states where NOW's started in March 1976 than they had been in Massachusetts and New Hampshire. This difference suggests that the national adoption of NOW's may be faster than otherwise because of the New England experience, the existence of automatic transfer services, and the extension of NOW accounts to New York. Did NOW accounts simply displace demand deposits or did they cause real additions to total checkable balances? Since ownership of NOW accounts is limited to individuals and certain non-profit organizations, NOW's are necessarily a larger element of total individual checkable balances than of total balances. We constructed a series for individual demand deposits in New England, where they account for about one-fourth of total demand deposits, and a series for rest' of United States. Fig. 2 shows indivldual demand deposits, NOW balances, and total transactions balances in New England along with individual demand deposits in the rest of the United States. The level of real balances outside of New England was quite volatile, but relatively trendless. New England balances exhibited a large increase paralleling the growth in NOW's. This finding suggests that NOW's do indeed add to, rather than merely replace, demand deposits. 3. Measuring the shift in money demand In this section, we measure the increase in money demand due to NOW 2Gross demand deposits are total demand deposits before netting out cash items in process of collection.
182
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J.H. Frodin and R. Startz, N O W account experiment and demand for money
183
accounts by comparing the relative growth of total transactions balances, before and during the N O W experiment, in New England and the rest of the United States. Given the relative growth, we can derive the own-interest semi-elasticity of the demand for money. For our measurement of money demand, we make two broad assumptions. We assume first that the same money demand function applies to both the New England experimental region and the non-New England control region (or at least that the functions differ by no more than a multiplicative constant). Thus, as an identifying restriction, we assume that no shift in money demand unique to New England occurred during the N O W experiment. In particular we must assume that the NOW experiment did not induce any substantial increase in New England balances by individuals living outside New England. The primary determinants of money demand are the general price level, interest rates, and income. To isolate the NOW account effect, we must control for any differential growth in these determinants. Since the consumer price indices for the U.S. and New England (Boston) rose by almost identical amounts during the N O W experiment period and since interest rates are essentially national, changes in these variables would have had no differential impact on New England and the United States. By contrast, the recession of 1974 and 1975 affected income in New England far more than in the rest of the nation. For this reason, we explicitly control for differential income growth. In the following representation of money demand, we observe total transactions balances (checking accounts plus NOW accounts) in both New England and the rest of the United States, before and during the experiment. Let M~ be the logarithm of real balances in region i at time t. M~ has four components: ai is a regional effect unique to each area, b, is a time effect representing those forces which change money over time but which do not have a differential impact on the two regions (market interest rates are a prime example), y[ is the logarithm of real income and affects money demand with an elasticity c, and N measures the increase in deposit balances attributable to the existence of N O W accounts. Taking 1972 and 1977 as illustrative end-points, we have (in logs)
M7u2s = a o s + b72 + cY72, us NE MNTE=aNF.+bTz+CY72,
M 7us 7 =
,Us aus+b77 + cY77
NE M77=aNE+b77+cy~E+N,
N = (M77NE~ zvJ 14NE) /AArUS 721 --~,zvJ 77 M72)US
-c[(Y~-- Y72)--(Y77 r~E u s _ yTus)].
(1)
184
J.H. Frodin and R. Startz, N O W account experiment and demand for money
This formulation demonstrates the calculation required to estimate the N O W account effect. N measures the percentage increase in money demand attributable to N O W accounts (since the dependent variable M is in logs). N provides an answer to the first question posed in the introduction. To answer the second question, we need to translate N into a measurement of interest responsiveness. The most convenient 3 form is the own-interest semi-elasticity the percentage increase in transactions balances due to one percentage point increase in the interest rate. Since N O W accounts almost uniformly paid 5% interest, the estimate of the interest semi-elasticity is N/5. 4 To estimate c, we ran a demand deposit regression similar to Goldfeld's. s The resulting long-run income elasticity is 0.577. Since N is quite sensitive to this estimate, we calculate (1) for both c equal to 0.577 and a more monetarist assumption of c equal to 1.0. June 1972 and December 1977 are convenient end-points, given the timing of FDIC call reports. We treat Massachusetts and New Hampshire, where NOW's first existed, as one unit. Over this five year period, real demand deposits fell 2.65~ 6 in the United States and 25.7~ in Massachusetts and New Hampshire. However, real growth in NOW's caused total transactions balances to rise 3.69Y/o in the two states. Real personal income rose 16.8Y/o in the United States over this period versus the 8.24~ increase in the two state region. Applying an income elasticity of 0.577 in formula (1), the total increase in transactions balances due to the N O W account experience is 11.3yo. Because the recession was deeper in New England than in the rest of the nation, our choice of the income elasticity has a non-trivial effect on the N O W estimate. If we had used a zero income elasticity, the estimate of N would be only 6.34~. Assuming a unitary income elasticity would indicate an increase in money demand of 14.9~. -
-
3The semi-elasticity form is more convenient than using an elasticity because the zero to five point increase in deposit interest is an infinite percentage increase. 4Recently, attention has been given to the payment of implicit as opposed to explicit interest. We confine our attention to the latter. See Klein (1974), Santomero (1979) and Startz (1979). It should also be reco~niTed that the change in the explicit rate of return may have been accompanied by changes in non-price, or implicit, rates of return. To the extent that such changes also will accompany future shifts in the explicit rate of return, our estimates in this paper will be good predictors. sSee Goldfeld (1973, table 1). We regressed the log of real demand deposits on the log of real GNP, the levels of the time deposit rate and the Treasury Bill rate, and a lagged dependent variable. The regression was estimated on quarterly data from 1953:II through 1973:IV by iterated Cochrane-Orcutt. The implied long-run income elasticity is 0.577, log M = - 0.7443 + 0.1394 log Y - 0.0133RTD - 0.01M5RT B + 0.7586 log M_ 1We ran the equation on levels rather than logs of the interest rates in order to obtain an estimate of the total market interest rate semi-elasticity. According to the equation reported above, if market interest rates rise one point (both the Treasury Bill and time deposit rate go up one percentage point) the long-run drop in deposit demand will be 0.0737%. 6All 'percent changes' are actually changes in natural logarithms.
J.H. Frodin and R. Startz, N O W account experiment and demand for money
185
We can make similar calculations for the remaining four New England states using December 1975 and December 1977 call reports. Income changes in this region were similar to those in the rest of the nation. Using the 0.577 income elasticity, we estimate N to be 4.77. Ignoring income changes or assuming a unitary income elasticity produces estimates of N equal to 3.93 and 5.38, respectively. Before proceeding to more sophisticated techniques, we would like to know whether our estimates are within a reasonable range. We can ask what change in demand one would expect from a five point change in market interest rates and see whether the estimated NOW account effect is roughly equal, but opposite to that change. As indicated in footnote 5, a reasonable estimate of the long-run interest semi-elasticity of deposit demand is -0.0737. The five-point interest rate differential can only be applied to holdings by individuals, which were approximately one-fourth of total New England deposits before the experiment. The expected change in deposits is therefore 0.0737 times five-fourths, or 9.2%. Our point estimates of N from the call report data are decidedly in the ballpark. In summary, the estimated N O W account effect in Massachusetts and New Hampshire is 11.3%, implying an own-interest semi-elasticity of 0.022. Our central estimate of the NOW effect for the four state region during the shorter experimental period is 4.77%. 4. Economic estimates
The estimates of the preceding section are limited by the use of only two data points. Since monthly fluctuations in the level of demand deposits can be the same order of magnitude as the NOW effect we are estimating, estimates based only on two points, while unbiased, are not likely to be very efficient. In moving from p o i n t estimation to statistical techniques, we broaden our source of evidence in two ways. First, we use monthly observations while using a more explicit specification of the money demand function. Second, we use data based on individual deposits, since the individual money demand is more directly related to the NOW account experiment. The cross-section/time series approach used here isolates the effect on money demand of the NOW account experiment from the effects of contemporaneous events. In principle, by assuming a stable money demand function in the experimental area over the entire sample period, one might estimate the N O W account effect by including a dummy variable for the period of the N O W experiment. However, deposit demand dropped across the nation more or less concurrently with the beginning of the N O W experiment. If we were to estimate the NOW effect solely through a timeseries regression on the experimental area, the unexplained shift, the so-called
J.H. Frodin and R. Startz, NOW account experiment and demand for money
186
'Case of the Missing Money', [Goldfeld (1976)] would more than swamp the N O W account effect. With the combined cross-section/time series technique, the shift washes out as long as whatever caused the mystery operated proportionately in both the experimental and control area. We estimate a standard money demand equation for New England and the rest of the United States. The dependent variable is the log of real transactions balances. The logarithms of real income, the time deposit rate, and the treasury bill rate are explanatory variables. The use of real income controls for the differential impact of the recession in the two regions. The interest rate variables are 'nuisance' variables in that interest rates do not, by assumption, have a differential impact. However, the presence of the interest rate variables reduces the amount of unexplained variance in the regression and thus increases the power of estimation. Regional dummy variables, analogous to the as in the point estimation, are included in the equation. A series of dummy variables captures the gradual growth in NOW's. The equation also includes a series of time dummies, analogous to bt earlier. The time dummies and NOW dummies are 'matched', so that contemporaneous shifts in the control and experimental regions are picked up in the time effect rather than being attributed to NOW's. The regressions all take the general form of eq. (2), log M[ = N" ND[ + cl log Y[ + c2 log R T D t + Ca log R T B t + C+ a l R D i + b i T D t ,
(2)
dummy variables for the NOW effects, dummy variables for the regional effect, dummy variables for the time effect, - - overall constant.
ND[ m RD i ~ TDt --
c
The dependent variable is the log of real transactions balances. The independent variables are the log of real personal income and the logs of the time deposit rate and o f the three-month treasury bill rate. Separate regressions are run for the two experimental regions: Region 1, Massachusetts and New Hampshire, where NOW's started in September 1972 and Region 2 including Connecticut, Maine, Rhode Island, and Vermont in which NOW's started in March 1976. In each case, the United States outside of New England serves as the control region. Each regression includes an overall constant term and regional dummy for each New England state concerned and covers the period 1964:1 to 1978:4. The NOW account experiment developed gradually, especially in Massachusetts and New Hampshire. Therefore, we use a series of dummy variables, ND~ to estimate the NOW effect. Five subperiods, with the last two
J.H. Frodin and R. Startz, N O W account experiment and demand for money
187
corresponding to the experimental period for the four state area, make up the N O W account period. The number of subperiods represents a compromise between a desire to estimate the timing effect most accurately and the need to have enough months within each subperiod to estimate the coefficient accurately. Time effect dummies, TD, exactly match the N O W effect dummies except that they apply to both the experimental and control regions. Regression estimates of the NOW account effect appear in table 1. The income and interest elasticities are all of the expected size and have small confidence intervals, although the income elasticity and the time deposit rate elasticity (0.9 and -0.56, respectively) are perhaps somewhat larger in absolute value than is usual. The long-run downward, 'missing money', shift in the money demand function, as measured by the time effect dummies, is 13%. The N O W effect coefficients show a long-run increase in money demand of 6.8% with a standard error of 1.9% for Massachusetts and New Hampshire. The final N O W coefficient for the four state region is 0.7% with standard error of 1.7%. Thus this first econometric estimate shows a smaller NOW effect than predicted by our use of FDIC data. The regional effects for the experimental areas are negative and highly significant. While it is not surprising that there is some relative difference in money demand between New England and the rest of the United States, the population difference accounts for part of the estimated regional effect. If the true money demand equation is specified in per capita terms, with money demand and income divided by population, then the equation as we estimate it should include the term ( 1 - c ) l o g P O P , where c is the income elasticity. This population effect can explain most of the Massachusetts dummy, but only a small part of the New Hampshire dummy. The joint hypothesis that the population effect can account for both dummy variables can be rejected at any reasonable level of significance. Feige (1974) made the same finding in a broader time-series, cross-section study. All the preceding procedures mix the estimation of the NOW account effect with the estimation of the structural parameters of the money demand equation. In other words, we use all available data from the experimental and control regions and from both the experimental and pre-experimental periods. The most efficient statistical procedure requires the use of all available data generated by the true model. However, such joint estimation may generate incorrect estimates of some of the parameters, particularly the income elasticity. The income elasticity of N O W accounts, which share some characteristics with time deposits, may be larger than the income elasticity for true demand deposits. The latter is the desired parameter. In addition, we have observed that money demand equations estimated with data that includes the period of the 'mysterious shift' in money demand tend to show income elasticities decidedly different from previous estimates. Since our
Table 1 Transactions balance demand. 64:1 to 78:4
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
Demand variables Log Y Log RTD Log TB
Regional effects Constant MA NH
Eq. (1) MA, NH
Eq.(2) CT, ME, RI, VT
0.0558 (0.0176) 0.01813 (0.0194) 0.05357 (0.0194) 0.05088 (0.0194) 0.06786 (0.0194)
-0.01003 (0.0178) 0.00705 (0.0178)
0.9248 (0.0434) -0.5632 (0.0657) -0.04777 (0.0133)
0.6445 (0.0366) --0.05900 (0.0510) -0.03521 (0.0109)
2.949 (0.397) -0.3454 (0.149)
5.236 (0.339)
- 1.016
(0.244) CT
- 1.827 (0.145) - 2.443 (0.199) - 2.283 (0.195) - 2.664 (0.228)
ME RI VT
Time effects 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-0.2766 (0.0158) -0.05417 (0.0189) -0.1377 (0.0182) -0.1355 (0.0182) -0.1299 (0.0182) R-squared: 0.9996 S E R : 0.054
0.03970 (0.00827) -0.05982 (0.0111) -0.1153 (0.0103) -0.1546 (0.0175) -0.1350 (0.0175) R-squared: 0.9995 S E R : 0.055
J.H. Frodin and R. Startz, N O W account experiment and demand for money
189
estimate of the income elasticity significantly affects our estimate of the NOW effect, we would like to use data which avoids these two problems. To obtain clean parameter estimates, we ran our demand equation on U.S. data from 1964 through August 1972. Using these parameter estimates, we constrained the coefficients on income and interest rates in a regression covering the period 1964 to 1978:4. These estimates are unbiased even if the NOW experiment itself changed the elasticities of transactions accounts. With the income and interest elasticities constrained, the long-run change in money demand is 6.2%, with a standard error of 2.3%, for Massachusetts and New Hampshire. The results for the remaining four states are not significantly different from zero, as shown in table 2. NOW accounts are held only by individuals and individuals hold only one-fourth to one-third of gross demand deposits. For some questions, such as the change in the overall monetary aggregates, the total deposit figure used so far is the relevant one. However, estimation on individual deposits yields the most direct estimates of the NOW effect. Using survey data made available by the Boston Federal Reserve, we constructed a series for individually held deposits for New England. 7 By parallel method, we also built a series for the rest of the United States from published Federal Reserve data. Table 3 reports the regression results of our standard equation for the U.S. and New England as a whole. The income elasticity is 0.88, in line with usual estimates, but the standard errors on the interest elasticities are too large for meaningful results. The NOW account effect is trivial in the first two periods because total NOW balances were in fact fairly small and because the percentage increase in New England is a weighted average of an increase in two states and a zero change in the other four states where NOW's did not yet exist. The remaining three periods show highly significant and progressively larger NOW account effects. The long-run estimate of the change in personal transactions balances because of the NOW experiment is 38.8%. The standard error is 3.74%. The statistical significance of our econometric results based on deposits by individuals shows a 't-statistic' of over 10 as compared with the t- of 3 for our regressions based on all deposits. However, we expected this outcome, since only individuals own NOW balances. The 38.8% point estimate indicates about a one third greater NOW effect than the estimates in table 1. Although we have assumed homoskedastic errors throughout, it seems unlikely that the error terms are truly independently and identically distributed. Even though ordinary least squares estimates are unbiased, a generalized least squares approach is more efficient and also leads to correctly reported standard errors. In the second column of table 3, we 7Details available from the authors.
190
J.H. Frodin and R. Startz, NOW account experiment and demand for money Table 2 Using constrained income and interest coefficients. 64:1 to 78:4
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 • 76:3 to 77:3 77:4 to 78:4 Constant
Regional effects MA NH
Eq. (1) MA, NH 0.0535 (0.02O9) 0.0123 (0.0229) 0.0400 (0.0229) 0.0471 (0.0229) 0.0622 (0.0229) 8.178 (0.0062)
--2.8313 (0.0069) -3.8189 (0.0069) - 3.6320 (0.0069) - 4.2400 (0.0069)
ME RI VT
74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-0.0166 (0.0199) -0.0046 (0.0199) 8.161 (0.0052)
-2.1845 (0.0083) -4.0122 (0.0083)
CT
Time effects 72:9 to 73:12
Eq. (2) CT, ME, RI, VT
0.0334 (0.0171) - 0.0290 (0.0187) -0.1057 (0.0187) -0.0853 (0.0187) - 0.0511 (0.0187) R-squared: 0.9985 SER: 0.0637
0.1045 (0.0073) 0.0136 (0.0080) -0.0436 (0.0080) -0.0682 (0.0178) - 0.03406 (0.0178) R-squared: 0.9984 SER: 0.0615
report generalized least squares results. The stochastic specification allowed for a cross-sectionally heteroskedastic, serially correlated, and contemporaneously correlated error structure. The increase in transactions balances attributable to the existence of N O W accounts is 35.3%, with a standard error of 3.2%.
J.H. Frodin and R. Startz, N O W account experiment and demand for money Table 3 New England individual deposits 72:4 to 78:4
OLS
N O W effect 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
GLS 0.0289 (0.0329) -0.0038 (0.0336) 0.0998 (0.0355) 0.2725 (0.0355) 0.03883 (0.0374)
0.0125 (0.0271) -0.0163 (0.0282) 0.0774 (0.0300) 0.2452 (0.0300) 0.0354 (0.0321)
0.8822 (0.2555) 0.0499 (0.2154) 0.0123 (0.0411) 1.1446 (2.798)
0.4537 (0.2356) 0.0649 (0.2321) - 0.0121 (0.0436) 5.704 (2.5637)
Demand variables Log Y Log R TD
-
Log TB Constant Regional effect N.E. Time effects 72:9 to 73:12 74:1 to 75:1 75:2 to 76:2 76:3 to 77:3 77:4 to 78:4
-
--0.7891 (0.693 -0.0221 (0.0288) -0.0562 (0.0316) -0.0951 (0.0304) -0.1188 (0.035) -0.1333 (0.0425) R-squared: 0.9993 SER: 0.0440
-
1.9508 (0.6411)
0.0144 (0.0264) -0.0284 (0.0305) -0.0720 (0.0282) -0.0888 (0.0220) -0.0766 (0.0385) R-squared: 0.9993
USNET
SER 0.0431
RHO 0.0449
NE
0.0373
0.0389
191
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J.H. Frodin and R. Startz, N O W account experiment and demand for money
5. Summary and conclusions With the goal of estimating the effect of the institution of interest-paying NOW accounts nationwide on the demand for money, we have measured the impact of NOW's on checkable balances in New England from 1972:9 to 1978:4. The first estimate used FDIC call reports predating and postdating the above period. The second estimate used monthly data on transactions balances. The third used monthly, Survey-based, data on personal demand deposits plus NOW's. For the purpose of comparison, we used an existing estimate of the market semi-elasticity of the demand for money to generate an a priori estimate of the N O W account effect. This estimate of a 9.2~ increase in the demand for money, caused by payment of interest of 5~, corresponds approximately to a 37~ increase in personal deposits. The estimates from the call reports showed an increase in checkable balances in Massachusetts and New Hampshire of between 11.3 and 14.9~. The indicated increase in the shorter experimental period for Connecticut, Maine, Rhode Island, and Vermont ranged from 4.8 to 5.4~. The results for the two states are in line with our a priori estimate while those for the four states are somewhat smaller. The second approach, using ordinary least squares regressions on the monthly gross transactions balance data, yielded a long-run N O W account effect in Massachusetts and New Hampshire of 6.8~, with a reported standard error of 1.9~. For the other four New England states, an ordinary least squares regression shows no appreciable NOW account effect with a standard error of 1.8~. We can conclude that the NOW account effect measured against total deposits was small. Even if the true effect is two standard errors above the point estimates, the total increase in money demand is no more than 10~. Such an effect, when due to a large 5 point interest increase, must be considered very small. This response took several years to develop. Thus interest payments limited to individual checkable balances (about one-third of the U.S. total nationwide) are unlikely to change aggregate money demand abruptly or by very much. Our third estimate, using regressions on the individual deposit data, yielded an increase in transactions balances of 38~ with an associated standard error of 4 ~ and therefore a t-statistic of ten. While this effect is more clearly established than that on total deposits, the 38~ increase in demand corresponds to an own-interest semi-elasticity of 0.076. We conclude that the own-interest responsiveness of money demand is small, but, statistically, highly significantly different from zero. Our results, therefore, are noteworthy for their strong empirical reaffirmation of conventional predictions of economic theory. The estimated 38~ increase in individuals' checkable balances is large on an absolute scale, but modest relative to the change in the interest rate which induced the shift.
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We have demonstrated statistically that the demand for money does respond to the payment of interest but that that response is fairly inelastic.
References Becker, W.E., 1975, Determinants of the United States currency-demand deposit ratio, Journal of Finance, March. Crane, Dwight B. and Michael J. Riley, 1978, NOW accounts (Lexington Books, Lexington, MA). Federal Deposit Insurance Corporation, n.d., Assets and liabilitiesof commercial and mutual savings banks, various years. Federal Reserve Bank of Boston, n.d.,Functional cost analysis,various years. Federal Reserve Board, n.d.,Federal Reserve Bulletin,various issues. Feigc, Edgar L., 1974, Temporal cross-sectionspecificationson the demand for demand deposits, Journal of Finance, June. Goldfeld, Stephen, 1973, The demand for money revisited, Brookings Papers on Economic Activity, 3. Goldfeld, Stephen, 1976, The case of the missing money, Brookings Papers on Economic Activity, 3. Klein, Benjamin, 1974, Competitive interest payments on bank deposits and the long-run demand for money, American Economic Review, Dec. Santomero, Anthony, 1979, The role of transaction costs and rates of return on the demand deposit decision, Journal of Monetary Economics 5. July. Startz, Richard, 1979, Implicit interest on demand deposits, Journal ol Monetary Economics 5, Oct.