Trends in velocity and policy expectations

Abstract

U.S. velocity of base money exhibits three distinct trends since 1960. After rising steadily for 20 years, it flattens out in the 1980s and falls substantially in the 1990s. This paper explores whether the observed secular movements in velocity can be accounted for exclusively by endogenous responses to changing expectations about monetary and fiscal policy. We use a model that includes money, nominal bonds, and capital. The model maps policy expectations into portfolio decisions, making equilibrium velocity a function of expected future money-growth, tax rates, and government spending. When expectations are estimated using Bayesian updating, simulated velocity matches the trends in actual velocity surprisingly well.