An Examination of Implicit Interest Rates on Demand Deposits

This article focuses on various ways that the implicit rate on demand deposits can be measured, and the effects of using these implicit rates in analyzing the demand for money. The presence of implicit payments on demand deposits is a likely result of the competitive nature of the banking system. Deposits are a primary source of funds that banks can use to earn a market rate of return. Competitive pressures should force banks to offer depositors something in return for the use of transactions balances. Since the payment of explicit interest on transactions accounts was forbidden until the introduction of NOW accounts in 1973, and was regulated prior to the advent of "Super NOW” accounts in 1983, banks were forced to compete for all transactions balances in a nonprice manner. This type of competition continues to occur with respect to demand deposits and smaller NOW accounts. Some ways that this can be done is by remitting service charges, providing cash management services at subsidized rates, and giving preferential treatment on loans to depositors. Since the competition for deposits by the banking system is likely to result in some form of implicit payment, it is important to incorporate this behavior when studying the demand for money. Omitting the implicit return on demand deposits in a money demand equation is likely to result in misspecification, therefore biasing at least some of the estimated coefficients. Potentially, this bias could be serious enough to substantially affect the ability of the equation to predict future money demand. This could lead to the unwarranted conclusion that the demand for money is unstable and that the Federal Reserve should accommodate shifts in the money demand curve when in fact no shifts have taken place. Another related area where knowledge of implicit interest payments is of importance is in understanding the effects of deregulation in the banking industry. The relative desirability and growth of new types of accounts, such as “Super NOWs,” will depend on the advantages they have over existing accounts. This will involve a comparison between the current implicit payments made on demand deposits and the explicit (as well as any implicit) payments accompanying the new accounts. In order to analyze implicit interest rates and their effects on money demand, three different estimates of the implicit rates on demand deposits are examined. Specifically, the studies of Startz [12], Barro and Santomero [1], and Klein [8] are reviewed. Each of these articles provides very different methods of arriving at an estimate of implicit rates. Startz uses accounting data to calculate a measure of services remitted, while Barro and Santomero use a private survey to derive a marginal rate of remittance. Klein, on the other hand, assumes that banks costlessly evade regulations and pay a competitive rate. Given the differences in methodology, it is not surprising that the actual estimates differ. However, all three estimates are highly correlated and show movements in the same direction. One may, therefore, have more confidence in the way in which implicit rates have changed than in their actual level. An analysis of the effects of implicit interest rates on the demand for money is also presented. The rate derived by Barro and Santomero performs especially well. The competitive rate calculated by Klein also seems useful although there exist econometric problems in interpreting its effect. The paper proceeds as follows. Section II discusses the derivation of each of the three implicit rates and indicates some of the problems with each construction. Section III compares the time series properties of the various rates while section IV discusses the use of implicit rates in studying the demand for money. Section V contains a brief conclusion. Michael Dotsey