FEDERAL RESERVE BANK OF ST. LOUIS
Solving the 1980s’ Velocity Puzzle: A Progress Report
Courtenay C. Stone and Daniel L. Thornton
HE velocity of money measures the relationship between nominal income and the money stock. In its simplest for-m, the quantity theory of money states that nomtiinal income is equal to the money stock multiplied by its velocity. If velocity is reasonably stable, changes in the money stock have predictable consequences on nominal income; if the money stock is controllable as well, the quantity theory has useful imnplications for’ economic policy. The relationship between money growth and inflation can he derived from the quantity theory framework by “breaking LII)” nominal income into its two components — the pr-ice level and r’eal output. Thus, the stability of the money- price link, holding real output constant, is also related closely to the stability of velocity.
For over’ a third of a centtuy — from 1946 to 1981
to the rise of mnonetarism and the adoption of mone— tan’ aggregate tar-gets by the Federal Reserve and other central banks around the world. Its stability also re- sulted in two empirically based r’ules of thumb that came to be used fair’ly successfully as guides to money growth’s effects on income and inflation. Now, how- ever’, analysts believe that these rules have failed to explain the course of income and inflation during the 1980s, due to a relatively sudden and unanticipated drop in velocity.
Given the important role that velocity plays in eco- nomic and policy analysis, it is not surprising that
considerable effor’t has been devoted to solving this velocity puzzle. tinfortunately, these efforts have pro-
duced a welter’ of competing and occasionally confus- ing explanations. To bring some or’der to this disarr’av,
the growth of ratio of gross
the velocity of money, measured as the
money stock MU, was stable. Its stability contributed
this article highlights the problemns that have resulted
from the puzzling behavior of velocity in recent years and examines the more pronhinent explanations of the
Courtenay C. Stone is a senior economist and Daniel L. Thornton is a research officer at the Federal Reserve Bankot St. Louis. Rosemarie V
Mueller provided research assistance. The authors would also like to thank Michael Darby for helpful suggestions on an earlier draft.
‘The money stock need not be perfectly controllable; neither, for that
matter, must velocity be constant. Movements in velocity (or its growth), however, must be explainable by the behavior of the variables that influence it. This idea, fundamental to macroeconomic policy, was developed by Friedman (1956). See Thornton (1983) for a discussion of the role of velocity for policy purposes.
Because the concept of velocity stems dir’ectl fr’om the theory of the demand for money, anything that
affects velocity can be related to some aspect of the demand for money. See shaded insert on the follow- ing page.) Because the demand-for-money approach is likely to be less intuitive to the general reader, however’, we will discuss the various explanations of the velocity puzzle in terms of velocity itself.