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This paper investigates the effect of sweep programs on MI using dynamic simulations of money demand over 1994-2000. The postsample period constitutes when sweep programs have been in effect. All models generate predictions systematically above reported MI. Using data on newly initiated programs, test findings indicate that sweeps account for the overprediction within the conventional money demand model with a long-term interest rate. We construct a medium of exchange measure, MIS, equal to MI plus estimated holdings of sweep balances. MIS velocity compares favorably with that of broader aggregates. Evidence indicates cointegration within MIS money demand.
FROM THE TIME the Federal Reserve adopted monetary targeting, M I has played a central role in conducting policy. Long before then, the narrow aggregate's construction has emphasized money's medium of exchange function. This feature helped make MI an attractive candidate for an intermediate target from 1970 through the mid-1980s. Along the way, the Fed redefined the measure in 1980 to include NOW and ATS Accounts along with other checkable deposits (OCDs). Even with these financial innovations, MI retains its fundamental characteristic of including only assets that serve as a medium of exchange without transactions restrictions.
In recent years, though, MI has dropped precipitously out of favor. The FOMC stopped reporting target ranges for annual M1growth in 1987 (see, for example, Pakko 1995), even though they continued with M2 and M3. Over the years, money in general has been de-emphasized by the Federal Reserve in the conduct of policy. As stated in the Monetary Policy Report to the Congress for July 20, 2000 (which appears in the August 1993 issue of the Federal Reserve Bulletin), the FOMC stopped reporting annual growth objectives for money in 2000 and 2001 (Note 2, p. 540). But the text goes on to say that the FOMC still believes that money has value for gauging economic and financial conditions. The Report contains a detailed discussion regarding the recent behavior of M2 and M3.
The observed movement of MI over the past decade points to further instability. In the mid- 1990s, the aggregate abruptly ceased its general upward trend. The level of nominal MI decreased throughout 1995-97 and then rose at a much slower rate than before. MI in the first quarter of 2000...