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Has the money-GNP relationship fallen apart?

  • Economics


Rose McElhattan* During the first year of the current economic recovery (1975.1-1976.1), the nation's gross national product, in nominal terms, increased by 13 percent. This rapid rate of economic ex- pansion occurred along with relative ease in financial markets; interest rates were lower in the first quarter of 1976 than when the expan- sion began in 1975. Surprisingly, however, the growth in the economy and the decline in inter- est rates have been accomplished with a relative- ly moderate rate of growth in the money supply. The actual M , rate of growth was 5.1 percent from 1975.1 to 1976.J1-about half the rate which standard money demand models estimate as necessary to support the observed income growth and decline in interest rates. This over- prediction of money demand constitutes an un- usually large forecast error, since standard money demand functions (which relate the pub- lic's demand for money balances to the level of GNP and interest rates) generally have per- formed well in estimating the growth in money." However, beginning with the third quarter of 1974, these equations began overestimating the public's demand for money by relatively large and increasing amounts. The demand for money is an important com- ponent in the final relationship between money and GNP. Changes in money have had fairly predictable, although not exact, effects over time on the gross national product. 3 Because of this relationship, the money stock has be- come a significant variable in economic anal- ysis. The central bank, in turn, has a degree of control over the stock of money, making it an important Federal Reserve policy variable. "Economist, Federal Reserve Bank of San Francisco. 34 The recent large forecast errors in the estimated demand for money suggest a deterioration in the ability of policymakers to predict the impact of changes in money upon economic activity. This in turn suggests that less emphasis should be placed upon the money supply as a guide in the conduct of monetary policy

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