What Was Behind the M2 Breakdown? - FEDERAL RESERVE BANK of NEW YORK

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Staff Reports

What Was Behind the M2 Breakdown?

August 1999Number 83

JEL classification: E4, E5, G2

Authors: Cara S. Lown, Stavros Peristiani, and Kenneth J. Robinson

A deterioration in the link between the M2 monetary aggregate and GDP, along with large errors in predicting M2 growth, led the Board of Governors to downgrade the M2 aggregate as a reliable indicator of monetary policy in 1993. In this paper, we argue that the financial condition of depository institutions was a major factor behind the unusual pattern of M2 growth in the early 1990s. By constructing alternative measures of M2 based on banks’ and thrifts’ capital positions, we show that the anomalous behavior of M2 in the early 1990s disappears. Specifically, after accounting for the effect of capital constrained institutions on M2 growth, we are able to explain the unusual behavior of M2 velocity during this time period, obtain superior M2 forecasting results, and produce a more stable relationship between M2 and the ultimate goals of policy. Our work suggests that M2 may contain useful information about economic growth during periods of time when there are no major disturbances to depository institutions.

Available only in PDF PDF

31 pages / 137 kb

For a published version of this report, see Cara Lown, Stavros Peristiani, and Kenneth J. Robinson, "Financial Sector Weakness and the M2 Velocity Puzzle," Economic Inquiry 44, no. 4 (October 2006): 699-715.

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