Global monetarism and the behavior of post-war velocity of money

Abstract

This study empirically tests a monetarist model of nominal income growth in the United States during the period of fixed (1966.1-1973.2) and flexible (1982.1-1991.4) exchange rates. It argues that domestic money is still an important variable in managing domestic aggregate demand. However, in a world where national economies have become increasingly more integrated, domestic monetary aggregates must be incorporated with other economic variables to influence nominal income. The unstable M1 velocity in 1982 and the large and persistent change in dollar exchange rates in the 1980s have immediately raised concerns to implement domestic policy taking into account international considerations. The influence of international factors on domestic income is analyzed in this study in terms of two important channels of transmission: exchange rate and world money supply. While the wide range of variations in dollar exchange rate in recent years has been seen as useful indicator of economic conditions, it is also argued that the dollar value of world money supply shocks are an important influence on nominal income. The results of fitting a distributed lag or an Almon lag in a monetarist model of nominal income reveal that M2 is a better predictor of nominal income growth in the US after 1982. The M2 velocity in the 1980s is found to be stable in contrast to M1 velocity. In addition to independent effect of domestic money (M2) on income, the dollar exchange rate and the dollar value of world money supply exert significant influence on aggregate demand during the flexible rate period. In fact, these variables have more lasting impact than standard money demand variable like the opportunity cost of money. Moreover, the income regressions based on exchange rate and world money are able to forecast the growth rate in M1 and M2 velocities reasonably well. The paper concludes that both domestic money as well as foreign money should be considered in analyzing fluctuations in nominal aggregate demand in the United States especially during the flexible exchange rate period.