Velocity variability: Directly an interest-rate driven phenomenon

Abstract

Unexpected declines in the United States M1 income velocity of money during the 1980s has received considerable attention. Some analysts argue that since the instability of velocity occurred in tandem with a “monetarist policy experiment” by the Federal Reserve, the fallacy of monetarists' policy prescriptions is now clear for all to see. Monetarists demure, arguing that the Federal Reserve never really conducted a test of monetarist policy doctrine. Rather the Federal Reserve by creating so much variability in money growth caused the velocity's dramatic declines. Hall and Noble (1987) provide evidence to support the monetarist position while Brocato and Smith (1989) offer evidence that supports the anti-monetarist view. We employ bi-variate and multi-variate tests of Granger causality to re-examine the issues. Of the variables considered—i.e., money growth variability, the money stock, the interest rate, real GNP, and the GNP implicit price deflator, the interest rate wins hands-down. That is, the interest rate Granger causes the MI income velocity of money for all samples that include some 1980s data. Nonetheless, the monetarist response may still be accurate, since money growth uncertainly helps to explain the movements m the interest rate during most of the 1980s.