Academic journal article American Economist

Determinants of Income Velocity in the United Kingdom: Multivariate Granger Causality

Academic journal article American Economist

Determinants of Income Velocity in the United Kingdom: Multivariate Granger Causality

Article excerpt

1. Introduction

The behavior of the income velocity of both narrow and broad measures of money in the United Kingdom in the 1980s was a surprise to many monetary economists. After an upward trend during the 1970s, income velocity showed virtually no growth during the 1980s.(1) This decline in income velocity has been interpreted as undermining a basic principle of monetarism, that is, the generally well-established predictable link between prior changes in money stock and in nominal income.(2)

Discussion of the behavior of velocity has focused upon whether the process generating velocity underwent a shift, perhaps due to the financial innovation and deregulation in the 1980s or whether the behavior of velocity merely reflects the underlying variability in its determinants. Goodhart (1989:318-322) and Temperton (1991) provide summaries of this debate.

A different explanation for the decline in income velocity is to be found in the work of Milton Friedman (1983). This was written in the context of the decline in income velocity that occurred in the United States from 1981. Friedman rejects the argument that the decline in income velocity in the United States undermines the case for a monetary policy which emphasizes controlling the growth of M1. Rather, he attributes the velocity decline, in part, to the unprecedented volatility of money growth following the Federal Reserve's 1979 shift to targeting nonborrowed reserves. Friedman's main argument is that increased volatility of money growth raised the degree of perceived uncertainty with regard to standard economic measures, such as interest rates, output, and prices and thereby contributed to increasing the demand for money or, equivalently, reducing the velocity of money.(3) This argument appears consistent with the recent money demand literature that has stressed the role of money as a shock absorber which temporarily smooths the response of the economy to unexpected changes in the money supply. See, for example, Boughton and Tavlas (1990:434). From this viewpoint, declines in velocity associated with an increased growth in money supply are seen as temporary, and the money growth as a predecessor of future inflation. Poole (198), B. Friedman (1988) and others argue that a significant weight must be given to such factors as: (a) declining inflation (and presumably inflationary expectations); (b) interest rate volatility; (c) the introduction of interest payments on transaction accounts; (d) decreasing cost of intermediation as a result of increased competition and innovation in the financial sector; and (e) the rise in the real exchange value of the domestic currency. Existing empirical work on U.S. data, such as Hall and Noble (1987), find a causal relation between monetary variability and velocity, as suggested by Friedman. However, their results have recently been questioned by Mehra (1989) and Brocato and Smith (1989). Mehra found that first differencing the volatility measure (as is indicated by tests for a first-order unit root) led to the conclusion that money growth volatility does not Granger-cause velocity. A similar conclusion was reached by Brocato and Smith using monthly (instead of quarterly) data. Nonetheless, in the case of the United States, this issue is by no means resolved. A recent study (Fisher and Serletus, 1989) using nine measures of velocity and monthly data has concluded that monetary growth variability did in fact Granger-cause velocity over the 1970-1985 sample period. Furthermore, Belongia (1984) found that increased quarter to quarter variation in the growth of M1 has some permanent reductions on the level and growth rate of nominal GNP. There is also evidence that Friedman's hypothesis is supported by data from selected developing economies over the period, 1974Q1 through 1985Q4. See Shams (1989) for details. To our knowledge, Friedman's hypothesis has not been examined for the United Kingdom, an economy that also experienced substantial declines in income velocity on both narrow and broad measures of money beginning in 1980. …

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