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FEDERAL RESERVE BANK OF ST. LOUIS

rent relative to permanent income. Although the downtur-ns in the permanent income velocity mnea-

sur’e are less pronounced than those in the current income velocity measure, the general downwat-d shift

in velocity during the 1980s shows up clearly in the permanent income v’elocitv measure.

‘l’her’e is an explanation consistent with the per-ma- nent income or wealth approach to the demand for

money and the observed decline in the income veloc—

its’ of money in recent years. Suppose that a rise in per-manent income or wealth relative to current in-

come produced

a sharp rise in the demand

for

money.” In this event, depicted in ther’e would be am! associated drop velocity.

panel B in

figure 1,

in current

income

Because wealth is the present value of the expected future net income, it will incr’ease either’ if expected income increases or the expected real interest rate used to discount futur’eincome declines. If ther’ewas a

rise in expected income

withotit

a cor-r-esponding in-

crease in measured income during the 198Os, velocity would have fallen as the demand for- money increased relative to GNP. Eventually, mneasur’ed income will rise or expected income will decline as individuals realize that their expectations will be unfulfilled.” Conse-

quently, after sufficient time has elapsed, velocity will return to its fornier’ path.

If the r-ise in wealth is dire solely to a sharp fall in societ)”s preference for’ current relative to future con-

sumption, however, the path of measured income would he unaffected and the level of velocity would be

permanently below its former path. This possibility seems unlikely, because it implies a per-nmnent fail in

the real interest rate.”

“Rasche (1986). Santoni (1987) and Kopcke (1986) also consider the wealth explanation. Though their approaches are different, both Rasche and Santoni relect the wealth explanation for the velocity puzzle. Kopcke, on the other hand, finds evidence to support it. His wealth measure, however, includes financial assets that have off- setting liabilities; consequently, at best, it represents a proxy for

financial transactions.

“Since wealth is the discounted present value of the stream of expected future income, an exogenous increase in wealth relative to current income can result only from a tall in the “real” interest rate or a n i n c r e a s e i n t h e e x p e c t e d f u t u r e i n c o m e s t r e a m . I f t h e s e l a t t e r e x p e c t a t i o n s a r e c o r r e c t , m e a s u r e d i n c o m e w i l l e v e n t u a l l y i n c r e a s e , a n d v e l o c i t y w i l l e v e n t u a l l y r e t u r n t o i t s l o n g ~ r u n l e v e l a s e i t h e r t h e

nominal money stock expands or the price level falls. If the expecta- tions prove to be wrong, this too will be discovered and velocity will rise subsequently.

“The permanent tall in the real interest rate necessary to explain the

fall in velocity is inconsistent with recent estimates of the ex ante real interest rates during the 1980s. See Holland (1984).

AUGUST/SEPTEMBER 1987

Potential Problems with Using Ml

Some have suggested that using Ml as the mono stock measure when calculating velocity causes sig- nificant pr’oblems. ‘t’hev ar-gue that the relevant mone—

tan’ measur’e cannot together’ the stocks of

lie obtained simply var-ious ‘monetar’

by adding assets cur’—

r’ency, checkable deposits, and so on), because component may pr’ovidie differ’ent quantities of

each rnone-

tan’ services per unit. gested that an index

Consequently, cr’itics have of the monetary ‘‘services’’

sug- pro-

vided by the stock of all relevant financial pi-eferable to the use of Ml for evaluating the

assets is relation-

ship between money and ci-iticism is valid, changes

spending or- pr’ices.” If this in ‘‘simple—sum’’ monet~u’y

aggregates like Ml and M2 may deviate markedly fi’om changes in their underlying monetary services when- ever’ substantial shifts among various monetary assets occur’. In such cases, the usual measure of velocity may show sizable variations, while those based on the underlying monetary services measures should be relatively stable.”

Various measirr-e

monetary services indices )MSI) and the MO,

have

been

developed;

the)’

are

cur’r’ently

compiled and maintained by the Federal Reserve

Board on an experimental basis.” The MSI1 measure is an index of the monetary services associated with

components of the Ml money stock. The MQ measur-e is an index of all financial assets that can be directly used in transactions; it incorporates the components of Ml plus telephone tr’ansfer’s, money market mutual bind balances arid money mar’ket deposit accounts. Chart 8 shows velocity measures based on the MSI1 and MQ.” These velocity measur-es show the same general pattern for recent years as the usual Ml veloc- ity measure. Sinular’results hold forliroadermonetary services indices. Consequently, despite their theoreti- cal appeal, substituting monetary service tlows for Ml in measures of velocity does not explain the recent behavior of velocity.”

“See Batten and Thornton (1985) for a discussion of these issues.

“This need not be the case, however, See Milbourne (1986). “The monetary services indices originally were called Divisia mone-

tary aggregates; they were developed by William Barnett (1980). The MO measure was developed by Paul Spindt (1985). The current monetary services indices differ from the original Divisia measures in several respects; see Farm and Johnson (1985).

“These alternative money measures are only available since 1/1970.

“This interpretation is invariant to alternative measures of income (permanent income or GDFD).

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