The Effect of Disinflationary Policies on Monetary Velocity

The U.S. economy in the 1980s saw a decline in the trend growth rate of monetary velocity, the ratio of nominal GNP to the money supply. This unexpected development was reflected in the systematic overprediction of inflation and nominal GNP growth by econometric models and economic forecasters. Robert Lucas (1976) showed that econometric models would err when simulating policy alternatives or when forecasting overa horizon in which policy had changed. Was the recent decline in monetary velocity the result of deregulation or disinflation? Studies of this issue have found little effect from the disinflation policy. These studies have focused on U.S. data from 1959 to the 1980s. Robert Rasehe (1987, 1988) and V. Vance Roley (1985) find that including inflation or inflation expectations as explanatory variables does not pick up the changes in velocity that occurred in the early 1980s. Both authors attribute the shift invelocity to deregulation, because the shift is explained by dummy variables entered for periods of regulatory change. The problem, of course, is that the disinflation policy and the deregulation occurred over the same period. William Poole (1988) argues that including long-term interest rates in a standard log-linear, money-demand function tends to capture the effect of changing inflation trends. These equations, however, also made large errors in forecasting money demand in the 1980s. But perhaps we should not be convinced by the standard regression results. It does not seem appropriate to use short-term movements