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FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1987

chart 9

Ratio

Velocities of GNP/M1 and GNP/M1A

9.5

8.5

7.5

6.5

5.5

4.5

3.5

1961

63

65

67

69

11

13

75

77

19

81

83

85

1987

realigned, however, the prior’ currency and MM veloc- ity relationships should be restored.

interest r’ate will cause the demand for money to rise relative to GNP and, hence, velocity will decline.

Charts 9 and 10 show the MM- and currency- velocit measures. The MIA-velocity measure and, to a

The theoretical basis for this argument stems from basic consumer’ demand theory, which argues that

lesser extent, the cur’rency-velocitv measure rose sharply in the first quarter of 1981 when NOWs were

the responsiveness of the demand for a commodity to changes in its price increases with the number and

introduced nationwide. Contrary to this structural shift explanation, however’, both measures subse- quently declined.”

closeness of substitute goods. The financial innova-

tions of the 1980s produced new and close substitutes for traditional demand deposit and cur-rency compo-

Another explanation for the change in Ml velocity is an increased r-esponsiveness of various Ml compo-

nents to changes in the interest rate. According to this explanation, the financial innovations of the 1980s did

not necessarily cause adownward shift in velocity due to a shift of savings balances into transactions ac- counts; instead, they altpred the sensitivity of Ml bal- ances to interest rates. Since the demand for money is inversely related to the interest rate, a decline in the

nents of Ml. While the interest rate is not the price of

money, it represents a significant opportunity cost for holding it. Consequently, the financial innovations of

the l980s should have increased the responsiveness of

some of the components of Ml to changes in the interest rate, The “other-checkable-deposit” compo-

nent ofMl bears inter’est, and the interest rate paid on these deposits is now free to change with market rates.” Consequently, this component of Ml should be

2eBusinesses cannot hold interest-bearing checking accounts. See

“This is the basis for Rasche’s (1986) rejection of this explanation. The introduction of these new accounts, however, may have increased the interest elasticity of the demand for the M1A components.

Gilbert and Holland (1984) for a summaryof the major innovations and deregulations of the I 980s, Also, the currency component of Ml generally is more closely tied to real income than to interest mate movements,

16

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