THERE HAS BEEN GROWING recognition of the importance of money in the determination of income, the level of employment, and prices in recent years. Much of this interest in the role of money seems to have been fostered by the experience that few countries have succeeded in suppressing inflation without controlling the supply of money during the postwar period and by the lack of success of fiscal restraints in curbing excessive spending in the United States in the late 1960’s.
Along with these developments has come “the revival of the quantity theory and the rise of the associated ‘monetarist’ approach to economic policy—an approach which stresses the explanatory and controlling power of changes in the quantity of money.”1 The essential aspect of the monetarist view appears to be the assumption that “velocity rather than the multiplier is the key relationship in the understanding of macro-economic developments in the economy.”2 It has long been suggested that the Quantity Theory holds in the long run, though it may not be an appropriate framework for short-run analysis.3 The Quantity Theory has also been suggested as the more applicable—or more feasible—hypothesis for analyzing the monetary problems in less developed economies.4 Practical considerations may also make it desirable for monetary authorities to base their policy decisions on a simple hypothesis, such as the constant velocity of money. In many countries, and particularly in the less developed countries, the construction of econometric models for policy and forecasting purposes is difficult in the absence of detailed knowledge of the structure of the economy and, most of all, of reliable and consistent data. Even in countries where elaborate econometric models are available, it may be questioned whether the analysis of monetary phenomena, based on such models, is more accurate and useful than the corresponding ones based on a simple hypothesis, such as the Quantity Theory. It is true that by adopting the constant velocity assumption one is not only ignoring some functional relationships that are important in understanding the workings of the economy but also forgoing the useful structural information that econometric models can yield. However, it may also be true that the theoretical and econometric problems associated with constructing economic models are so formidable that one can never judge whether the loss of the structural information is not outweighed by the advantages of simplicity inherent in the Quantity Theory.
In view of these considerations, it would be worthwhile to investigate, as a first step, how velocity has behaved during the postwar period in many countries. We shall begin our study in Section I with a brief discussion of reasons for the variability in velocity and a review of the relevant empirical work in this area. In Section II we examine the facts on the year-to-year variability for three different definitions of velocity, over the period 1953-68, in 30 countries, classified into three groups: (1) industrial, (2) other developed, (3) less developed. A 15-year period is chosen because of the availability of reasonably consistent data. In Section III we provide some explanations for the differences in the variability of velocity found between the less developed and the developed countries. Some concluding remarks will be found in Section IV.
Mr. Park, economist in the Financial Studies Division of the Research Department, is a graduate of Seoul National University and of the University of Minnesota.
Harry G. Johnson, “Recent Developments in Monetary Theory—A Commentary,” in Money in Britain, 1959-1969, ed. by David R. Croome and Harry G. Johnson (Oxford University Press, 1970), p. 84.
Ibid., p. 89.
See Karl Brunner and Allan H. Meltzer, “Predicting Velocity: Implications for Theory and Policy,” The Journal of Finance, Vol. XVIII (1963), p. 319. See also Milton Friedman, “A Theoretical Framework for Monetary Analysis,” The Journal of Political Economy, Vol. LXXVIII (1970), p. 222.
See R. J. Ball’s review of George Horwich’s Money, Capital, and Prices in The Economic Journal, Vol. LXXV (1965), p. 146. See also J. J. Polak, “Monetary Analysis of Income Formation and Payments Problems,” Staff Papers, Vol. VI (1957), p. 39, and V. C. Shah, “Monetary Analysis in India, 1948-49–1958-59,” The Indian Economic Journal, Vol. IX (1962), p. 306.
The distributed lag hypothesis is consistent both with the permanent income hypothesis and with the partial adjustment process in the money market. Suppose that the demand for money is a function of permanent income Yp, Md = mYp where Ypt = bYt + b(1—b)Yt-1 + b(1—b)2Yt-2 + …. Permanent income is a weighted average of current and past incomes. The sum of the coefficient is equal to 1. Friedman gives b a weight of 0.33. See Milton Friedman, A Theory of Consumption Function (National Bureau of Economic Research, 1957), p. 147.
Suppose, on the other hand, that the public are slow to adjust their money balances to desired levels as specified in the following equation,
where c is an adjustment coefficient (0 < c < 1) and
which is completely equivalent to equation (3) in the text. It is difficult to discriminate empirically between the two entirely different hypotheses.
Note that the coefficient for Mt-i is negative. Thus, the distributed lag form of the demand function with geometrically declining weights implies that an exogenous increase in M has a positive effect in the current period, and this is followed by a depressing effect in the next period. If we do not assume geometrically declining weights, the distributed lag hypothesis implies an oscillating monetary multiplier. For a verbal rationalization of this process, see Alan A. Walters, “Professor Friedman on the Demand for Money,” The Journal of Political Economy, Vol. LXXIII (1965), pp. 545-51.
One might normally expect that an increase in M would generate an expansionary effect that would taper off gradually in subsequent periods. Indeed, this appears to be the basic assumption of most of the studies on the lags in monetary policy.
Whether the distributed lag hypothesis is a good approximation to behavior or not is essentially an empirical question. Walters finds no conclusive evidence on the oscillating monetary multiplier from U.K. data (ibid., pp. 550-51). The results of the Friedman and Meiselman study also hardly support the hypothesis. See Milton Friedman and David Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897-1958,” in Stabilization Policies (Commission on Money and Credit, Englewood Cliffs, N.J., 1963), pp. 165-268. We have estimated the first difference version of equation (3) with data for the 30 countries under consideration. Our results do not provide convincing evidence on the distributed lag form of money demand.
We have estimated equation (4) in the text for all three definitions of money. In most countries the fit was not satisfactory, and there was evidence of significant serial correlation in the error term.
Milton Friedman, “The Demand for Money: Some Theoretical and Empirical Results,” The Journal of Political Economy, Vol. LXVII (1959), pp. 327-51.
This point may be clarified as follows: Assuming that Md = Ms, the demand for money function in footnote 6, Md = mYp, which is shown to be equivalent to equation (1), can be transformed as
For a lucid account of this, see Alvin H. Hansen, Monetary Theory and Fiscal Policy (New York, 1949), pp. 49-53.
William C. Brainard and James Tobin, “Pitfalls in Financial Model Building,” The American Economic Review, Papers and Proceedings of the Eightieth Annual Meeting, Vol. LVIII (1968), p. 103.
Harry G. Johnson, “Monetary Theory and Policy,” The American Economic Review, Vol. LII (June 1962), pp. 335-84.
Gregory C. Chow, “On the Long-Run and Short-Run Demand for Money,” The Journal of Political Economy, Vol. LXXIV (1966), pp. 111-31.
Harry Allen Latané, “Cash Balances and the Interest Rate—A Pragmatic Approach,” The Review of Economics and Statistics, Vol. XXXVI (1954), pp. 456-60.
Allan H. Meltzer, “The Demand for Money: The Evidence from the Time Series,” The Journal of Political Economy, Vol. LXXI (1963), pp. 219-46.
Brunner and Meltzer, op. cit., pp. 319-54.
James Tobin, “The Monetary Interpretation of History” (A Review Article), The American Economic Review, Vol. LV (June 1965), pp. 464-85.
Ronald L. Teigen, “Demand and Supply Functions for Money in the United States: Some Structural Estimates,” Econometrica, Vol. 32 (1964), pp. 476-509.
The only conflicting study for the United States is the one by Friedman, “The Demand for Money: Some Theoretical and Empirical Results” (cited in footnote 9); his methodological approach, however, was faulty. He introduces the rate of interest only to account for the residuals from an equation explaining real money balances by real permanent income.
Robert J. Ball, “Some Econometric Analysis of the Long-Term Rate of Interest in the United Kingdom, 1921-61,” The Manchester School of Economic and Social Studies, Vol. XXXIII (1965), pp. 45-96; only a very small selection from a large number of estimated equations.
N. J. Kavanagh and A. A. Walters, “Demand for Money in the United Kingdom, 1877-1961: Some Preliminary Findings,” Bulletin of the Oxford University Institute of Economics and Statistics, Vol. 28 (1966), pp. 93-116.
Douglas Fisher, “The Demand for Money in Britain: Quarterly Results, 1951 to 1967,” The Manchester School of Economic and Social Studies, Vol. XXXVI (1968), pp. 329-44.
George Macesich, “Determinants of Monetary Velocity in Canada, 1926-1958,” The Canadian journal of Economics and Political Science, Vol. 28 (1962), pp. 245-54.
Albert Breton, “A Stable Velocity Function for Canada?” Económica, New Series, Vol. XXXV (1968), pp. 451-53.
B. N. Anderson, “The Demand for Money in Denmark, 1921-62,” Nationaløkons. Tids., Vol. 104 (1966), pp. 223-43 (in Danish). (The abstract of the article appears in The Journal of Economic Abstracts, Vol. V (1967), p. 841.)
Joseph O. Adekunle, “The Demand for Money: An International Comparison,” The Indian Economic Journal, Vol. XVI (July-September 1968), pp. 22-43.
G. C. Kaufman and C. M. Latta, “The Demand for Money: Preliminary Evidence from Industrial Countries,” Journal of Financial and Quantitative Analysis, Vol. 1 (September 1966), pp. 75-89.
It is not surprising to find that studies for the less developed countries are far more ambiguous. Adekunle (loc. cit., p. 28) finds that the interest rate is not a significant variable in the demand for money function in studies for three less developed countries (Ceylon, India, and Pakistan). For India there are conflicting studies on the significance of the interest rate in the demand for money. See, for example, Damodar Gujarati, “The Demand for Money in India,” The Journal of Development Studies, Vol. Five (October 1968), pp. 59-64; D. Biswas, “The Indian Money Market: An Analysis of Money Demand,” The Indian Economic Journal, Vol. IX (January 1962), pp. 308-23; V. K. Sastry, “Demand for and Supply of Money in India,” The Indian Economic Journal, Vol. X (July 1962), pp. 29-38. Gujarati and Biswas show that both the short-term and long-term interest rates are statistically insignificant, whereas Sastry finds that interest rates play a significant role in velocity.
David E. W. Laidler, The Demand for Money: Theories and Evidence (Scranton, Pennsylvania, 1969), p. 91.
E.g., the United States and the United Kingdom. This, however, may not be true for the last two years or so in the United States.
Phillip Cagan, “The Monetary Dynamics of Hyperinflation,” in Studies in the Quantity Theory of Money, ed. by Milton Friedman (University of Chicago Press, 1956).
Arnold C. Harberger, “The Dynamics of Inflation in Chile,” in Measurement in Economics: Studies in Mathematical Economics and Econometrics in Memory of Yehuda Grunfeld, by Carl F. Christ and others (Stanford University Press, 1963), pp. 219-50.
Adolfo César Diz, “Money and Prices in Argentina, 1935-62” (unpublished doctoral thesis, University of Chicago, 1966).
Allan Hynes, “The Demand for Money and Monetary Adjustments in Chile,” The Review of Economic Studies, Vol. XXXIV (1967), pp. 285-93.
Paul F. McGouldrick, “A Sectoral Analysis of Velocity,” Federal Reserve Bulletin, Vol. 48 (1962), pp. 1557-70.
This behavior of velocity during the cycle is consistent with at least three other hypotheses: first, the procyclical movement in interest rates; second, the Friedman explanation in terms of measured and permanent income; third, the notion that precautionary demand for money falls in the boom and rises in the recession.
Allan H. Meltzer, “The Demand for Money—A Cross-Section Study of Business Firms,” The Quarterly Journal of Economics, Vol. LXXVII (1963), pp. 405-22.
Ibid., and Edward L. Whalen, “A Cross-Section Study of Business Demand for Cash,” The Journal of Finance, Vol. XX (1965), pp. 423-43.
George Garvy and Martin R. Blyn, The Velocity of Money (Federal Reserve Bank of New York, 1969), Chapter 6, pp. 67-77. The four major influences discussed are, in the author’s words, “compensating arrangements to settle payments which tend to reduce the demand for cash balances as well as the volume of debits; second, important and rapidly developing policies and arrangements designed to decrease the amount of balances required to meet a given flow of business payments; third, the related efforts of corporations to invest temporarily redundant cash; and, finally, recent developments that tend to lessen the demand for cash balances on the part of consumers.” These influences are mainly on the secular behavior of velocity.
In Section I it was pointed out that shifts in confidence or expectations may account for observed variations in velocity. To the extent that this is true, the impact of these factors on velocity would be relatively greater in less developed countries.
For some evidence of higher variability in their rate of inflation, see Joseph O. Adekunle, “Rates of Inflation in Industrial, Other Developed, and Less Developed Countries, 1949-65,” Staff Papers, Vol. XV (1968), pp. 531-57.
In terms of Friedman’s permanent income explanation (see footnotes 9 and 10), this implies that less developed countries are subject to greater discrepancies between current and permanent income, and hence to greater variability in velocity than industrial countries.
In a recent cross-section study of velocity, Melitz and Correa use Goldsmith’s classification of countries as a proxy for the rate of monetization and find it a significant variable (Jacques Melitz and Héctor Correa, “International Differences in Income Velocity,” The Review of Economics and Statistics, Vol. LII (1970), pp. 12-17).
Joseph O. Adekunle, “The Demand for Money: Evidence from Developed and Less Developed Economies,” Staff Papers, Vol. XV (1968), p. 230.
Polak, op. cit., p. 39.
Regression of money income on current and past levels of the stocks of money has been a standard method of measuring the monetary multiplier and lags of monetary policy. Although the technique has been used extensively, it is not altogether clear whether this specification is consistent with theories on macroeconomics. For instance, it is not obvious what equation (5) implies about the nature of the demand for money. Within the Quantity Theory framework, we have shown that either the permanent income hypothesis or the partial adjustment hypothesis gives rise to a lagged relationship between income and money. (See footnotes 6 and 7.) However, both hypotheses imply that the sign of the coefficient for M,t-1 is negative.
Albert Ando, “Money and Banking: Discussion,” The Journal of Finance, Vol. XVIII (1963), pp. 355-56.