Abstract
M1 velocity is, approximately, the permanent component of the short-term rate. This implies that agents—in deciding how much wealth to allocate to non interest-bearing M1, as opposed to interest-bearing assets—almost uniquely react to permanent shocks to the opportunity cost, essentially ignoring transitory shocks. This suggests that money-demand models must be modified to allow for such distinct reaction to permanent and transitory variation in the opportunity cost of holding M1. Under monetary regimes making inflation stationary, permanent fluctuations in M1 velocity uniquely reflect, to a close approximation, permanent shifts in the natural rate of interest.
Highlights
The information, does not pertain to variables such as inflation, or nominal GDP: Rather, it pertains to the natural rate of interest–which, conceptually in line with Laubach and Williams (2003), I define as the permanent component of the real rate–and it becomes starkly apparent under monetary regimes which cause inflation to be I(0), such as inflation-targeting regimes (see Benati (2008))
Evidence from the Euro area and several inflation-targeting countries is compatible with this notion, with velocity fluctuations being systematically strongly correlated with a Stock and Watson (1996, 1998; SW) time-varying parameters median-unbiased (TVP-MUB) estimate of trend real GDP growth
This means that the information contained in M1 velocity can be exploited in order to estimate the natural rate
Summary
Over the last several decades, the role of monetary aggregates in the conduct of monetary policy has been progressively downgraded, to the point that, at major central banks, they are today regarded as largely irrelevant. My main result is that M1 velocity is, to a close approximation, the permanent component of the short-term nominal rate, so that the time-series relationship between the two series is the same as that between consumption and GDP. Relationship between consumption and GNP, and dividends and stock prices, map, one-for-one, to the bivariate system for M1 velocity and the short rate This means that the information contained in M1 velocity can be exploited in order to estimate the natural rate.
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