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Financial Sector Weakness and the M2 Velocity Puzzle

  • Cara Lown
  • Stavros Peristiani
  • Kenneth J. Robinson

Deterioration in the link between M2 and GDP, along with large prediction errors, led the Federal Reserve to downgrade M2 as a reliable indicator in 1993. We argue that the financial condition of depository institutions was a major factor behind this unusual pattern of M2 growth. When constructing measures of M2 based on banks' and thrifts' capital positions, we obtain superior M2 forecasting results and a more stable relationship between M2 and the ultimate goals of policy. M2 may contain useful information when there are no major disturbances to depository institutions. (JEL E4, E5, G2) Copyright 2006, Oxford University Press.

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Article provided by Western Economic Association International in its journal Economic Inquiry.

Volume (Year): 44 (2006)
Issue (Month): 4 (October)
Pages: 699-715

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Handle: RePEc:oup:ecinqu:v:44:y:2006:i:4:p:699-715
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