Hallman, Jeffrey J., Porter, Richard D., Small, David H., Federal Reserve Bulletin
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M2 PER UNIT OF POTENTIAL GNP AS AN ANCHOR FOR THE PRICE LEVEL
The velocities of the monetary aggregates have been quite variable during the current decade, leading some economists to conclude that the monetary authority cannot use any of the aggregates as a reliable anchor for the price level. This study questions that conclusion as it applies to M2: its velocity relative to the gross national product, while somewhat variable in the short run, has shown a flat trend over most of the twentieth century. This stability has likely stemmed in recent years from the flexibility of most rates paid on M2 deposits and, in earlier decades, from the flexible administration of Regulation Q and the introduction of new instruments. As a consequence of this stability, a comparatively reliable long-run link between M2 and the price level exists.
The study's analysis of M2 and prices starts with the question, What long-run price level will current holdings of M2 support? The long-run equilibrium price level, P*, is defined as being consistent with the current value of M2 when V2 is at its long-run level, V*, and when real GNP is at its long-run potential level, Q*. Algebraically, P* = M2.V*/Q*
Thus, P* is proportional to M2 per unit of potential output. Operationally, the mean of V2 since 1955:1 is used as the estimate of V*. …