Staff studies.

Staff Studies

The staff members of the Board of Governors of the Federal Reserve System and of the Federal Reserve Banks undertake studies that cover a wide range of economic and financial subjects. From time to time the results of studies that are of general interest to the professions and to others are summarized in the FEDERAL RESERVE BULLETIN.

The analyses and conclusions set forth are those of the authors and do not necessarily indicate concurrence by the Board of Governors, by the Federal Reserve Banks, or by the members of their staffs.

Single copies of the full text of each of the studies or papers summarized in the BULLETIN are available without charge. The list of Federal Reserve Board publications at the back of each BULLETIN includes a separate section entitled "Staff Studies" that lists the studies that are currently available.

M2 PER UNIT OF POTENTIAL GNP AS AN ANCHOR FOR THE PRICE LEVEL

The velocities of the monetary aggregates have been quite variable during the current decade, leading some economists to conclude that the monetary authority cannot use any of the aggregates as a reliable anchor for the price level. This study questions that conclusion as it applies to M2: its velocity relative to the gross national product, while somewhat variable in the short run, has shown a flat trend over most of the twentieth century. This stability has likely stemmed in recent years from the flexibility of most rates paid on M2 deposits and, in earlier decades, from the flexible administration of Regulation Q and the introduction of new instruments. As a consequence of this stability, a comparatively reliable long-run link between M2 and the price level exists.

The study's analysis of M2 and prices starts with the question, What long-run price level will current holdings of M2 support? The long-run equilibrium price level, P*, is defined as being consistent with the current value of M2 when V2 is at its long-run level, V*, and when real GNP is at its long-run potential level, Q*. Algebraically, P* = M2.V*/Q*

Thus, P* is proportional to M2 per unit of potential output. Operationally, the mean of V2 since 1955:1 is used as the estimate of V*.

Discrepancies between the long-run equilibrium price level, P*, and the actual price level, P, drive the inflation process. The realtionship is best modeled as an equation in which, with a lag, P - P* determines the change in the inflation rate (the acceleration or deceleration of the price level). If P* is greater than P, then the current level of M2, if maintained, will eventually yield a deceleration.

This approach to forecasting inflation allows one to disregard forecasts of interest rates, exchange rates, fiscal policy, real output, and the like. It requires estimates of the future courses of only M2, potential real GNP, and long-run velocity and thus provides a framework in which the future price level is determined by the level of M2.

The model forecasts well over periods of one year or longer, even outside various periods over which it has been estimated. In particular, the model outperforms a simple version of the more traditional approach that relates changes in inflation to the "output gap. Moeover, the model's coefficients are stable over a 33-year period.

Over periods of less than one year, factors outside the model--wage trends, interest rates, foreign exchange movements, and the gap between real and potential output--are of great importance in the inflation process and remain essential to the assessment of short-run inflationary developments. Another limitation of the approach concerns the future long-run value of V2; permanent shifts in V2 are always a possibility, especially if significant progress is made toward price stability and, correspondingly nominal interest rates decline markedly.

But the potential shortcomings of M2 should not deflect attention from the need for an analytic framework within which to formulate a long-term policy strategy and evaluate progress toward long-run price stability. In this regard, P* appears to be a simple empirical guidepost that can help the monetary authorities track the implications of short-and intermediate-term policies for achieving the long-term objective of stable prices.