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The 1981-82 Velocity Decline: A Structural Shift in Income or Money Demand?

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  • Robert J. Gordon

Abstract

The velocity of both M1 and M2 appears to have experienced a sharp and persistent downward shift during 1981 and 1982. The implications of this shift are reexamined within the context of the previous literature on quarterly econometric equations explaining the demand for money. The traditional specification of money demand equations popularized by Chow and Goldfeld relates real balances to output, interest rates,and lagged real balances, all expressed as log levels. A consistent finding has been a large coefficient on the lagged dependent variable.While this has been interpreted as indicating substantial adjustment costs in portfolio behavior, it is also consistent with lags or"inertia" in price adjustment due to the presence of long-term wage and price contracts. The fact that the traditional Chow-Goldfeld money demand specification encountered large post-sample prediction errors at the time of the first oil shock in 1973-75 may suggest that a new interpretation of adjustment costs is required. It may be costly to adjust nominal balances by shifting to alternative assets, but it is costless for agents to allow real balances to shrink in response to an unanticipated price shock, as in 1973-75. A substantial amount of evidence is provided on the relationship between money, income, and interest rates, using alternative dynamic specifications. The post-1973 prediction error in a demand equation for M1 is reduced by three-quarters when the equation is specified in nominal first-difference form rather than in the form of real levels in logs. Results indicate much smaller post-1979 prediction errors for equations describing "simple-sum" M2 than for simple-sum M1, Divisia M1,or for Divisia M2 measures of the money supply.

Suggested Citation

  • Robert J. Gordon, 1984. "The 1981-82 Velocity Decline: A Structural Shift in Income or Money Demand?," NBER Working Papers 1343, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1343
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    References listed on IDEAS

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    1. Laidler, David, 1980. "The demand for money in the United States-- Yet again," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 219-271, January.
    2. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-282, June.
    3. Granger, C. W. J. & Newbold, P., 1974. "Spurious regressions in econometrics," Journal of Econometrics, Elsevier, vol. 2(2), pages 111-120, July.
    4. Robert J. Gordon, 1983. "Using Monetary Control to Dampen the Business Cycle: A New Set of First Principles," NBER Working Papers 1210, National Bureau of Economic Research, Inc.
    5. Stephen M. Goldfeld, 1973. "The Demand for Money Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 4(3), pages 577-646.
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    Cited by:

    1. V. Vance Roley, 1985. "Money Demand Predictability," NBER Working Papers 1580, National Bureau of Economic Research, Inc.
    2. Subramanian S Sriram, 1999. "Survey of Literature on Demand for Money; Theoretical and Empirical Work with Special Reference to Error-Correction Models," IMF Working Papers 99/64, International Monetary Fund.
    3. Werner, Richard A., 2012. "Towards a new research programme on ‘banking and the economy’ — Implications of the Quantity Theory of Credit for the prevention and resolution of banking and debt crises," International Review of Financial Analysis, Elsevier, vol. 25(C), pages 1-17.
    4. Chen, Yi-Ting, 2006. "Non-nested tests for competing U.S. narrow money demand functions," Economic Modelling, Elsevier, vol. 23(2), pages 339-363, March.

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