Academic journal article Economic Inquiry

Institutional Change and the Velocity of Money: A Century of Evidence

Academic journal article Economic Inquiry

Institutional Change and the Velocity of Money: A Century of Evidence

Article excerpt


The study of the long-run behavior of velocity has intrigued many researchers who have sought to link it to the evolution of financial systems over time. Indeed, the approach taken by Bordo and Jonung [1987] (BJ) explains the long-run portion of velocity in five countries by institutional factors including monetization and financial development, while the seminal study by Friedman and Schwartz [1982] (FS) argues that financial sophistication is an important determinant of the long-run behavior of velocity in the U.S. and the U.K. The aim of this study is to further explore the connection between long-run velocity movements across several countries, as well as the relationship between countries of its principal institutional and economic determinants.

This line of research is important for a number of reasons. It allows us to demonstrate that the demand for real balances cannot be adequately expressed by a few aggregates alone and that institutional variables need be included. If technological changes in the financial system are found to influence the demand for money, this has implications for the question of whether the demand for real balances is likely to be stable over time. This also impinges on the links which are thought to exist between monetary aggregates and economic activity. Finally, as Boughton [1992] argues, international comparisons of the demand for money reveal not only that institutional factors represent an important determinant of velocity, but that these appear to differ in the short-run across countries. Given the increasingly global nature of financial markets, it is of interest to explore whether the common development of long-term institutional changes among selected countries represents only a postwar phenomenon.

BJ [1981; 1987] suggest that institutional changes explain much of the long-run behavior of velocity. Siklos [1993], following upon BJ, confirms that in order to generate a long-run statistical model of velocity, a conventional model of velocity (as a function of real income and the nominal interest rate) needs to be augmented with institutional change proxies. Many economists now contend that institutional change represents an important element in explaining the long-run behavior of velocity or the demand for money (e.g., Laidler [ 1993]).(1)

This study examines the long- and short-run relationship of velocity for a sample of five industrialized countries using annual data beginning in 1870. Since the "long run" in economics need not be the same for all problems, an important issue is the selection of the sampling frequency of the data (e.g., Perron [1991]). In particular, the effects of technological or institutional changes in the financial sector occur slowly, necessitating as long a sample as possible.

Given recent findings by BJ [1990] and Siklos [1993], which empirically demonstrate that institutional change is common to each country, it would seem natural to ask whether there are common features in financial changes across countries. To investigate such a possibility, we perform a variety of tests to determine if velocity, and each of its individual determinants are, separately, cointegrated across countries. We also examine the short-run dynamics and the stability of any unique cointegrating relationship which is detected using some recently developed statistical tests. Finally, we attempt to estimate a joint velocity function by pooling data for all the countries in our sample.(2) In so doing, we improve on the earlier studies of long-run common movements in velocity and its conventional and institutional determinants, presented by BJ [1987, ch. 4] and FS [1982, ch. 7].

In performing time-series tests our objectives are three-fold. First, we wish to explore whether the common features of financial systems across countries are as significant as FS [1982, ch. 7] found them to be for the U.S. and the U.K., based on more sophisticated measures of correlation. …

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