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FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1987

chart ro

Velocities of GNP/M1 and GNP/Currency

Ratio 26

25

24

23

22

21

20

19

18

17

1961

63

65

61

69

71

13

75

77

79

81

83

85

1987

relatively unresponsive to interest rate movements.

This could be mitigated by the fact that

deposits

appear

to have been

slow

changes

in other

market interest

rates.

r’ates on these to adjust to

CYCLICAL EXPLANATIONS OF THE VELOCITY PUZZLE

This velocit

view and

suggests that interest rates

the relationship between should have strengthened

since the financial innovations of the 1980s. Indeed, this pattern is reflected in Chart 11, which shows Ml

velocity and the three-month Treasury bill rate. Prior to 1981, velocity appears to be unrelated to move- ments in the T-bill r’ate. Since 1981, however, the two

have similar patterns. This is consistent with a nutn- ber of studies which report an increased interest sen-

sitivity of Ml balances during the 1980s.” (Additional analysis is provided in the appendix.) It remains to be

Until now, we have assumed implicitly that the supply of money passively expands to meet society’s

demand. Another interpretation argues that substan- tial exogenous changes in the supply ofMl can induce cyclical swings in measured velocity because of their lagged effect on the economy. Forexample, an accelen’- ation in the gr-owth rate of Ml initially may produce a less than proportionate rise in the level of nominal GNP, and, thus, an initial decline in velocity. Eventu- ally, however, when the monetary change has worked

its way thr’oughout the economy fully, the longer-run relationship between Ml growth and the rate of

seen whether the apparent change in Ml’s interest sensitivity alone can account for the aberrant behavior

of Ml velocity.

spending is reestablished, and velocity returns to its long-run path.

“For example, Hetzel (1987), Trehan and Walsh (1987) and Rasche (1986). Rasche reports mixed results and concludes that this argu- ment needs further study and analysis.

This analysis can explain a continuous fall in veloc- ity relative to its underlying trend only if Ml growth is

continuously accelerating. The “ever-and-ever-faster Ml growth” explanation for the velocity decline in the

17

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