Economics Update (January-March 1998)

Velocity Trends Are Influenced
by Policy Expectations

T he velocity of money — the average number of times that a unit of money changes hands during a specified time period — and what determines this velocity are central to a long-running debate about the effects of macroeconomic policies. Various studies have proposed with different explanations of why velocity rises and falls over time, but sources of these movements are still not well understood.

For example, from 1950 to 1980 the U.S. velocity of base money — paper currency and coins issued by the government and the liabilities of the central bank — rose steadily. In the '80s it flattened out only to fall substantially in the '90s. Some scholars have proposed that the changes in the '80s were the result of technological improvements. Other scholars suggest that monetary policy affects velocity.

In a recent Atlanta Fed working paper, David B. Gordon, Eric M. Leeper and Tao Zha explored whether the observed long-term or trend movements in the velocity of base money could be accounted for exclusively by responses to changing expectations about monetary and fiscal policy.

Using a model with two key features — a substitute for money in transactions and an array of assets that includes money, nominal bonds and physical capital — the researchers mapped policy expectations into portfolio decisions, making equilibrium velocity a function of expected future money growth, tax rates and government spending. The researchers found that, when the public's expectations were consistently reestimated on the basis of added information about the economy, simulated velocity matched the trends in actual velocity.

The results of the study suggest that empirical velocity studies that fail to include policy expectations other than through the nominal interest rate are likely to be misspecified and the results biased. Also, analyses that do not account for changes in velocity arising in response to changes in expectations of policy will produce misleading predictions of policy effects.

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