1. Sweep accounts were invented in the 1990s. In this financial innovation, bank
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Question
1. Sweep accounts were invented in the 1990s. In this financial innovation, banks automatically move excess funds from a customer’s demand deposit account into a Money Market Deposit Account. How does M1 change as a result? How does M2 change as a result? (2 points)
2. Name a reason why retail Money Market Mutual Funds are not included in M1 but demand deposits and other checkable deposits accounts are. What specific function of money does this analysis pertain to? (2 points)
3. Passbook savings accounts and NOW accounts are interest bearing deposits, but NOW accounts have checkable privileges and passbook savings deposits do not. Then why would anyone have a passbook savings deposit? Provide the economic concept behind the argument
Explanation / Answer
The fall in M1 velocity in the 1980s has occasionally been attributed to the payment of interest on M1. But M1 velocity movements up to the late 1980s appear to be well captured by the declining opportunity cost of holding money as recorded in market interest rates, without recourse to an explanation that involves a changing own-rate on M1. (Generally speaking, therefore, the whole of M1 is interest sensitive, and a rise in securities market interest rates promotes flows out of M1 balances. The overall interest sensitivity of M2 arises primarily from the fact that the rates on several classes of deposit, such as retail certificates of deposit, within M2 adjust to securities market interest rates only with a delay.
A different means through which financial innovation affects M1 behavior has proved to be much more significant in practice. "Sweeps" programs allow routine transfers, at the banks' initiative, between M1 deposits and non-M1 deposits. An embryonic version of this arrangement developed during the 1970s in the form of the automatic transfer system (ATS) (see Hafer, 1980), but extensive adoption of retail sweep deposit programs on the part of banks did not take effect until January 1994 (Anderson, 2003). The arrangement is attractive to depositors because of the better returns on non-M1 ; M2 deposits, and appeals to banks as a means of avoiding the more onerous reserve requirement on M1 deposits. The resulting portfolio behaviour is believed to have created variations in M1 that have little macroeconomic meaning, with Anderson (2003, p. 1) arguing, "Retail-deposit sweep programs are only accounting changes: they do not affect the amounts of transaction deposits that banks' customers perceive themselves to own." . A series of studies (including Jones, Dutkosky, and Elger, 2005, and Cynamon, Dutkowsky, and Jones, 2006) has attempted to correct the U.S. monetary aggregates for the effect of the sweep program leading to a more moderate decline in M1 growth during the late 1990s.The apparent resumption of an upward M1 velocity trend in the late 1990s is largely illusory, reflecting the sweeps programs .One argument that has been advanced to explain the stability of M2 velocity is that the sweeps program itself tends to produce variations in M1 that cancel within M2. Beyond this more or less mechanical basis for favouring M2, it is also possible that M2 might be preferable even from the perspective of standard theories of money demand. While the M1 definition was intended to capture the concept of transactions balances, some of the non-M1 components of M2, such as money market deposit accounts, might be used routinely for performing transactions. In that case, the medium-of-exchange concept of money might better be represented by M2. Dorich (2009) argues that M2 should be used as the empirical measure of transactions money, and Reynard (2004) does so excluding one class of M2 deposit (namely, small time deposits, in recent years about one-seventh of M2). Arguing somewhat against the use of M2-type series as measures of transactions money, at least for studies using long sample periods, are the empirical results coming from the Divisia procedure, which Lucas (2000) argues is the best way to construct monetary aggregates. The Divisia procedure produces a series that down weights much of the non-M1 component of M2, and leads to quite different behaviour of M2 and Divisia M2 during key episodes in the 1970s and 1980s (see Barnett and Chauvet, 2008).Nominal income growth/inflation relation also differs from those previously depicted, as nominal income growth does not begin to decline until after the decline in inflation.
2.A money market fund (also called a money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely (though not necessarily accurately) regarded as being as safe as bank deposits yet providing a higher yield. Therefore, with regard to measure of money supply that includes cash and checking deposits (M1) as well as near money. “Near money" in M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid and not as suitable as exchange mediums but can be quickly converted into cash or checking deposits.
3.A savings account is a deposit account held at a bank or other financial institution that provides principal security and a modest interest rate. Depending on the specific type of savings account, the account holder may not be able to write checks from the account (without incurring extra fees or expenses) and the account is likely to have a limited number of free transfers/transactions. Savings account funds are considered one of the most liquid investments outside of demand accounts and cash. In contrast to savings accounts, checking accounts allow you to write checks and use electronic debit to access your funds inside the account. Savings accounts are generally for money that you don't intend to use for daily expenses. To open a savings account, simply go down to your local bank with proper identification and ask to open an account.
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