Economic Review — Second Quarter 1993 1 John V. Duca Senior Economist and Policy Advisor Federal Reserve Bank of Dallas Regulation, Bank Competitiveness, and Episodes of Missing Money I n setting monetary policy, most central banks look at a number of economic indicators, includ- ing data on monetary aggregates. The motivation for monitoring monetary aggregates comes from the equation of exchange: () , 1 M V P Y × = × where M = money, V = velocity [nominal gross domestic product (GDP) / M )], P = the price level, and Y = transactions (usually measured by inflation- adjusted GDP). Typically, people reduce their holdings of money as the spread between a risk- less short-term market interest rate (such as the three-month U.S. Treasury bill rate) and the average yield earned on monetary assets rises. As a result, the velocity of money rises as this spread or “opportunity cost” of money increases. If velocity is predictable, then money and its predicted velocity can be used to infer nominal GDP (P × Y ). Under these circumstances, a monetary aggregate is useful for policymakers as an indicator of nominal GDP. This is especially true because data on GDP are available after a long lag, whereas information on money and interest rates is more readily available. However, in three of the past four recessions (1973–74, 1979–80, and 1990–91), the monetary aggregate most closely monitored by the Federal Reserve has been much weaker relative to income and opportunity cost measures than previous experience predicted. This unusual weakness, or “missing money,” 1 poses a serious problem for policymakers because it means that the monetary aggregate in question is less useful as an indicator of nominal activity at a critical point in the business cycle. Furthermore, analysts often need at least several quarters of data to discern whether such a money demand shock has occurred and whether any particular shock is permanent or temporary. Consider a permanent downward shift in the level of demand for a monetary aggregate; such a shift would result in a fall of that aggregate’s growth rate relative to GDP growth over a period of time at each level of opportunity cost. There are two choices that a responsible central bank would consider. If the central bank stabilized the growth rate of that aggregate at the previous average, nominal GDP growth would temporarily accelerate and then return to its previous growth rate. Even- tually, the spurt in nominal GDP growth would result in a temporary acceleration in inflation. As a result, the price level would be permanently raised relative to its path had the money demand shock not occurred. While the price level would post only a once-and-for-all rise, such an episode would create uncertainty about whether the central bank was committed to controlling inflation. Such uncertainty would likely depress real economic activity for awhile because inflation uncertainty discourages firms and households from committing to long-run projects. I would like to thank, without implicating, Anne King and Steven Prue for providing excellent research assistance, and Michael Cox, Ken Emery, Evan Koenig, Ken Robinson, and Harvey Rosenblum for their suggestions during the progress of this research. Any remaining errors are my own. 1 Throughout this study, the term “missing money” describes episodes in which the level of a monetary aggregate has been smaller than predicted based on past relationships, income, and the opportunity cost of money.