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FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1987

chart ni

Velocity of GNP/M1 and the Three-Month Treasury Bill Rate

Re tie 7,5

ouarterry Data

Rate 16

7.0

6.5

6.0

$sCA’E

GNP/

)

\1\\.1 1 J I I It I i f i

I

:\

14

12

10

5-5

t\

5.0

till \I 4 , 0 3 , 5 I I , 4,5 ____ / I 4 r \ / , ~ _ s / r ~ ---- A 4 Ill Ill . ~ C

1961

63

65

67

69

71

I I /

  • I

I ~ 1 o . A I

1

~

4

Ill

73

75

~

I

I

,I~ I

I‘I I

Ifl 11

79

~j

‘I

1-Bill role

~

sCAtE~

8

6

~ II

‘I

\/

4

2

III

Ifl

0

81

83

85

1981

1980s is examined in chart 12. Although money growth has been rapid since 1982, it does not appear to have been accelerating fast enough relative to previous years to produce the recent sharp decline in velocity?

Expected Inflation and Velocity

Another explanation is that velocity’s recent behav- ior results from changes in the public’s expectations of

inflation. According to this view, the demand for money is inversely related to the expected rate of

~eTher is a 4 percentage point spread between peak trend-MI

growth in the 1980s and the late 1 970s. Hence, even if there were no nominal output response to the more rapid Ml growth overthe entire period, the acceleration in Ml growth, at most, could account for a 4 percentage point decline in trend velocity growth; that is, from about 3 percent to about I percent. In addition, this explanation implies a significant lengthening in the estimated lag on money growth in the

St. Louis equation during the 1980s, which has not been confirmed. Another cyclical explanation not considered explicitly in the text

has been suggested by Friedman (1983), Mascaro and Meltzer (1983) and Tatom (1983a, i983b); in their view, an important

inflation. Thus, when inflation (and presumably in- flationarv expectations as welL is declining, the de- mand for money should rise, and the velocity of

money should fall. Since the nominal interest rate can be thought of as composed of the real r’ate plus a

rate of

inflation,

to the

interest

this expla- sensitivity

pr’emium nation is

for the expected closely aligned

argument.

The

principal

difference

between

them

is

that pr-oponents of the expected-inflation explanation do not argue that the relationship has undergone a

structural change.” Judd (19831, Tatom i1983a, l983h1 and Friedman (19831 have argued that the decline in velocity in the 1981—83 period can he attributed pri- manly to disinflation and the associated decline in market interest rates that substantially lowered the opportunity costs of holding money relative to GNP.

In one sense, this explanation is specious or, at the very least, suspicious if extended to velocity move- ments in more recent yeans. If inflationary expecta-

influence on the demand for money is monetary uncertainty. Sup- pose that people increase their money holdings relative to their current income when they become more uncertain about their future incomes. If monetary uncertainty increased sufficiently in recent

years, this could explain the velocity puzzle,

“The expected rate of inflation also could have an independent effect

“1’ where trr is the o n t h e d e m a n d f o r m o n e y , e . g . , m f ( i , e x p e c t e d r a t e o f i n f l a t i o n . T h i s i s s u e h a s n o t b e e n r e s o l v e d .

18

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