Reserve Requirements and the Indicator Properties of Monetary Aggregates

Targeting of broadly based monetary aggregates, such as M2, continues to play an important role in U.S. monetary policy. Yet the average reserve requirement on M2 assets has fallen dramatically in recent years, a trend which may hamper the ability of the central bank to control such large aggregates. This paper explores the controllability and information content of monetary aggregates in a simple, flexible-price macroeconomic model, with specific attention to the role played by reserve ratios. It is found that although reserve ratios influence the conditional expectations of both the price level and real output, they do not influence the variance of these variables conditioned on observations of nominal monetary aggregates. The best indicator of real income is a deposit aggregate whose income elasticities differ the most from the income elasticity of currency while, in general, a deposit aggregate with a very low income elasticity is the best indicator of the aggregate price level. These results suggest that broad monetary aggregates such as M2 may be better indicators of the price level while narrow aggregates such as M1 may be better indicators of real income. Finally it is shown that the factors which make deposits more controllable by the central bank are often incompatible with the factors that make these aggregates good indicators of real income and prices.