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Federal Reserve Bank of Cleveland
Table 1 Cycles in Velocity Growth
Aggregate

Period

Reces- Recovsions
eries Average

1948:IVQ 1979:IVQ

-0.3

3.9

3.2

1980:IQ 1982:IVQ

-0.4

2.3

0.5

OldM·2

1948:IVQ 1979:IVQ

-2.7

2.1

1.2

M·2

1960:IIQ 1982:IVQ

-2.2

0.2

-0.4

M·1

counts." In retrospect,

it also appears
that the new accounts may have permanently reduced the growth in M-1
velocity. This should be expected if we
accept the premise that the prohibition
against interest payments on demand
deposits was largely responsible for the
divergence between growth trends of
M-1 and M-2 velocity after World War II.

Velocity in 1983
As of April 1983,23 percent of M-1
consisted of interest-paying checkable
deposits. Even more relevant for future
velocity growth is that additions to M-1
are likely to be more heavily weighted in
the new accounts. Super-NOW accounts, introduced in January 1983, have
no regulatory ceiling on the interest rates
paid if the account meets the $2,500
minimum-balance requirement.
Since the introduction of nationwide
NOW accounts, there has been a
remarkable drop in M-1 velocity. This
decline in velocity has occurred over a
business cycle with an unusually short
recovery and an unusually long and deep
recession. Postwar velocity for each of
the monetary aggregates has typically
grown more slowly than average during
4. For further discussion of the effect of interestbearing transactions balances on the monetary
targets, see Theresa Gwazdauskas, "Interpreting
the Ms after the NOWs," Economic Commentary,
Federal Reserve Bank of Cleveland, May 4, 1981.

recessions and more quickly than average during recoveries (see table 1). The
most recent cycle included six quarters
of recession and four quarters of recovery. M-1 velocity growth was -2.0 percent in the recession and 2.3 percent in
the recovery-statistics
similar to those
for the old M-2 aggregate. If we adjust
the cycle average for the unusually long
recession and short recovery, we measure a "trend" of M-1 velocity growth in
the last cycle around 1.3 percent. 5
A rough estimation of the Federal
Reserve's expectations about velocity for
1983 can be derived from information
provided to Congress in the HumphreyHawkins report.P The GNP forecast (8.0
percent to 9.0 percent growth in 1983) is
the "central tendency" of the forecasts
by the Board of Governors and the individual Federal Reserve Bank presidents.
The GNP forecast takes into account the
targets chosen for 1983. The midpoint of
the M-1 target is 6.0 percent, implying a
"central tendency" forecast for M-1 velocity growth of 2.0 percent to 3.0 percent.
The expectations for M-1 velocity are
below the historical trend. Given the historical record of above-trend velocity
growth in the first year of recovery, this
forecast implies a downward shift in the
M-1 velocity trend. The midpoint of the
M-2 target is 8.5 percent, implying a "central tendency" forecast for M-2 velocity of
-0.5 percent to 0.5 percent. The historical
growth rate in recoveries was 0.2 percent, within this forecast range.

Conclusion
The rapid growth of the aggregates in
late 1982 and early 1983 reflects both the
flow of funds into new accounts and a
policy adjustment in response to a
downward shift in the velocity trends.
The Federal Reserve seems willing to
accept M-1 growth above the target
range in 1983 as velocity continues to
decline. If the decline persists, the target
might have to be raised. If the public
does not understand the relationship
between velocity trends and the monetary targets, then the Federal Reserve's
decision to raise the targets could be
misconstrued as being inflationary.
If economic growth continues to
accelerate, however, and velocity growth
returns to historical patterns, then the
Federal Reserve would have to lower
M-1 growth to preserve recent success in
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

reducing inflation. In this period of regulatory change and disinflation policy, the
Federal Reserve might not be able to use
M-1 targets to guide short-run, openmarket operations. However, empirical
evidence indicates that there has been a
lag between changes in monetary policy
and changes in economic activity. There
should be time to adjust the long-run
targets in response to large unexpected
developments in velocity before they
induce undesired changes in economic
activity and prices.
Economist William T. Gauin does research in the
areas of monetary theory and monetary policy for
the Federal Reserue Bank of Cleueland.
The uiews stated herein are those of the author
and not necessarily those of the Federal Reserue
Bank of Cleueland or of the Board of Gouernors of
the Federal Reserue System.
NOTE: No issues of the Economic Commentary
were published in May.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

5. The actual average M·1 velocity growth for the
last cycle is a weighted average of the growth in the
recession and the growth in the recovery:
-0.3 = 6/10 (-2.0) + 4/10 (2.3).
From 1948:IVQ through 1982:IVQ, there were 141
quarters with 33 quarters of recession and 108
. quarters of -ecovery. Using this experience as a
guide, we can adjust velocity growth over the last
cycle to see what it would have been if the cycle had
been more like those in the past:
1.3 = 33/141 (-2.0) + 108/141 (2.3).
6. See "Monetary Policy Objectives for 1983," the
report pursuant to the Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins).

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

June 6,1983

~!:rlQnomicCommentary
Velocity and Monetary Targets

by William T. Gavin

To interpret the monetary targets in
1983, we have to know where we have
been and where we are going. The equation of exchange, MV = PQ, provides a
simple accounting framework for keeping
track of where we have been and for
suggesting where we may be going. Mis
the money supply, however defined; V is
the related velocity, or turnover of
money; P is the general price level; and
Q is real output.
The important variables are prices and
real output. However, the central bank
cannot determine how much of a given
change in the money supply will go into
prices and how much will go into output.
In the long run output will be determined
by real economic factors, such as population growth, capital accumulation,
technology, and the incentive structure
implied by tax laws and economic regulation. Even though changes in money
growth may not affect output in the long
run, changes in the money supply may
have substantial effects in the short run.
The uncertainty about how monetary
policy will affect prices and output over
periods as short as one year has led
economists to relate monetary targets to
nominal gross national product (GNP),
the product of P and Q. If the Federal

Reserve restrained money growth, it
would restrain nominal GNP. Initially, real
output may also be restrained (as we saw
in 1981-82). Over time, real economic
factors should dominate, and real growth
should return to its underlying trend. If
the reduced money-supply targets were
maintained over a period of years, nominal GNP would be restrained and inflation would be reduced. All of this, of
course, assumes a stable relationship
between GNP and the money supply.
Since 1981, the income velocity of M-1,
the primary money-supply target, has
declined dramatically. 1 The income
1. In this article the discussion of velocity is
generally restricted, except when noted, to M·1 and
M·2. M·1 consists of currency, demand deposits, travelers' checks, and other checkable deposits. M·2
includes M·1, small time and savings deposits, noninstitutional money market mutual funds, overnight
repurchase agreements, and Eurodollars. M·3
includes M·2, large-denomination time deposits,
term RPs, and institutions' money market mutual
fund balances. For more detailed definitions, see
"Domestic Financial Statistics," Federal Reserue
Bulletin, vol, 68, no. 12 (December 1982), p, A14.
Old M·2 refers to M·2 as defined before 1979, i.e.,
M·1 plus savings deposits, time deposits open
account, and time certificates of deposit (CDs)
other than negotiable CDs of $100,000 or more at
large weekly reporting banks. Old M·2 did not
include deposits at thrift institutions.

velocity of money is the ratio of nominal
GNP to the money supply. The monetary targets are based on expectations
for future velocity growth. If velocity
growth deviates from the expected trend
for an extended period, and if the Federal Reserve chooses to stay on a predetermined disinflation course, then the
monetary targets have to be changed.
This Economic Commentary examines
the monetary targets in light of recent
changes in the velocity of money.
Velocity of money is determined by
the aggregate behavior of individual people and firms. This behavior depends on
many factors, including the length of pay
periods, the uncertainty of future
income and expenditure flows, and the
opportunity costs of holding wealth in
the form of money.
Institutional factors also play an important role in determining velocity. The
. introduction of credit cards, for example,
reduced the need to hold money for
transactions purposes. Various cashmanagement techniques have greatly
reduced the demand for money by
firms.2 The development of socialwelfare programs, such as unemployment compensation, social security, and
health-care subsidies, has reduced the
need to hold precautionary balances.
Other special factors that influence
velocity are associated with the Federal
Reserve's policy to lower inflation. As
expected inflation falls, domestic
investors move out of real assets previously held as inflation hedges into
nominal assets included in the monetary
aggregates. 3 A lower expected inflation
rate in the United States may lead wealthy
2. For a discussion of these techniques, see John
B. Carlson, "Methods of Cash Management," Economic Commentary, Federal Reserve Bank of
Cleveland, April S, 1982_
3. See Michael W. Keran, "Velocity and Monetary
Policy in 1982," FRB SF Weekly Letter, Federal
Reserve Bank of San Francisco, March 18, 1983.
Keran argues that the fall in expected inflation
explains the large decrease in M-1 velocity in 1982.

individuals and multinational companies
to switch from other currencies into U.S.
dollars. If such dollars were held as
currency or as deposits in the United
States, they would tend to reduce the
income velocity of money.

The Velocity Assumption
Annual monetary targets are based on
the assumption that changes in velocity
are predictable within a narrow range.
Velocity is said to have a deterministic
trend if it has a predictable component
that depends on nothing else but time. If
velocity had a deterministic trend, then it
would be predictable over long time
periods; historical averages would be
good indicators of future velocity growth,
and the Federal Reserve could set targets
for the money supply well into the future.
Analysts who recommend pre-announced
multi-year targets for the money supply
implicitly assume a deterministic trend in
which all short-term velocity fluctuations
are temporary and offsetting.
Other analysts have argued that the
trend in velocity is not deterministic, but
that it is a function of many factors that
can change over time. Consequently, they
contend that it is not possible to predict
velocity very far into the future. The
Federal Reserve has implied agreement
with this latter view, setting monetary
targets for only one year at a time.The
Federal Reserve's targeting procedure
can be described as an "error learning"
process in which the monetary targets
are regularly reviewed and readjusted as
unpredictable developments in velocity
unfold. This strategy is consistent with
an undeterministic velocity trend in
which the short-term fluctuations include
both a transitory component associated
with the business cycle and a permanent
component that changes the trend.
Monetary targeting does not require
that velocity be a constant or even that it
have a deterministic trend. Monetary

targeting only requires that the central
bank have a procedure for adjusting the
targets when velocity deviates from what
is expected. There are currently several
methods for adjusting the targets. One
method is the stating of monetary targets
as ranges, usually 3 percentage points
wide. When the velocity prediction is
more uncertain than usual, the Federal
Reserve can widen the target range. A
range allows the Federal Reserve some
flexibility as it gathers more information
about velocity. A second mechanism for
adjusting targets is the mid-year review in
which the Federal Open Market Committee (FOMC) can change the target
range. A third mechanism is the practice
of basing the annual target on the actual
average level of the money supply rather
than the target level in the previous
year's fourth quarter (year-end base
drift). A fourth mechanism is the use of
multiple targets. Factors that affect
velocity of one of the monetary aggregates might not affect the others. The
Federal Reserve has generally employed
M-1 as the primary target. In periods
when M-1 velocity was exceptionally
uncertain, the Federal Reserve has
placed more emphasis on the M-2 target.
An example of each of these mechanisms at work can be seen in last year's
targeting experience. An unexpected
decline in M-1 velocity in 1982 led the
Federal Reserve to aim high in the range
at the beginning of the year, to announce
a desired growth rate at or above the
upper limit of the range at the mid-year
review, to place more emphasis on M-2
as of October 1982, and to accept a large
overshoot in the fourth quarter as part of
the base for the 1983 target.

Historical Trends
1880-1960. The long-run trend in
velocity depends on the stage of development in the market economy and on
factors that determine the costs and

Chart 1 Velocity of Money:
1880-1960
Annual data
Percent
5
NNP

..

4

3

..
.... .

.'..-.
.
............
r v.,
.-

2

NNP
M-2

..

..

~.. ~.,.

••••••••••
:

1880

1900
1920
1940
1960
NOTE: Net national product (NNP) was used to
measure income.
SOURCE: Milton Friedman and Anna Jacobson
Schwartz, A Monetary History of the United
States, 1867-1960, Princeton: Princeton
University Press, 1963, table A-5, p. 774.

benefits of holding money. The long
decline in the old M-2 velocity shown in
chart 1 is attributed to economic progress. As the U.S. economy grew, the
size of markets grew and people
depended less on production for home
use, barter, and payment in kind. Coincident with and because of the growth of
the economy, the commercial banking
industry developed and provided the
notes and bank deposits that led to
"monetization" of the economy. This
process accounted for much of the
decline in velocity prior to World War I.
The decline in velocity between World
War I and World War II can be attributed to falling interest rates and to the
high level of economic instability associated with the Great Depression. During
World War II velocity rose and then
declined; the decline in velocity probably
resulted from the imposition of price
controls and rationing, as well as the
uncertainty created by the war. The
combined effect was a buildup of money
balances as the war continued.

After World War II the development of
close substitutes for money, credit cards,
and sophisticated cash-management
techniques tended to reduce the need to
hold assets in the form of money. The
post-World War II period was one of relative economic stability. Business cycles
fluctuated less than in previous periods,
and the federal government gradually
increased the coverage of social-welfare
programs, further reducing the need to
hold precautionary balances.
Beginning in January 1934, Regulation
Q prohibited the payment of interest on
demand deposits and restricted the
amount of interest that could be paid on
savings and time deposits. The prohibition of interest payments on demand
deposits and the interest-rate ceilings
imposed by Regulation Q meant that a
rise in interest rates would increase the
opportunity cost of holding money.
In the first years of Regulation Q,
interest rates were so low that the regulation probably had no effect on velocity.
After World War II, however, accelerating inflation led to rising interest rates.
The long-term Aaa corporate bond yield
approximately doubled over each
decade. As interest rates rose to new
highs with each succeeding business
cycle, the cost of holding money continued to rise.
1960-82. M-1 velocity continued to
grow about 3 percent per year from 1960
until 1982, whereas M-2 velocity growth
was approximately zero over the whole
period (see chart 2, panels A and B). The
divergence belween velocity growth
trends for M-1 and M-2 reflects binding
interest-rate ceilings on demand deposits
and innovations in the market that
enabled depositors to economize on M-1
balances. The growth rate of M-1 velocity accelerated from 1974; indeed, the
post-1974 decrease in M-1 demand was
the focus of extensive research by the
Federal Reserve. Although M-1 velocity
was variable, it was predictable within

Chart2 Velocity of Money: 1960-83
Quarterly data
Percent
7

(A)

tr

01'1 II II II II II I II " II " II
2.0r-----------__
(8)

0.0T! I
1960

II I I!

II II II II II! II I I IT

1968

1976

1984

SOURCE: Board of Governors of the Federal
Reserve System.

tolerances suggested by the monetary
target ranges. This stability appears all
the more remarkable in light of the many
institutional and economic factors that
were changing during this period.
In passing the Depository Institutions
Deregulation and Monetary Control Act
of 1980, Congress repealed many of the
interest-rate ceilings that had been in
effect since 1934. In January 1981 depository institutions nationwide were authorized to offer interest-bearing transactions
accounts. The introduction of these new
interest-bearing checkable accounts was
expected to reduce velocity growth as
the public went through the transition of
moving money out of accounts, both savings and checking, into the new ac-

velocity of money is the ratio of nominal
GNP to the money supply. The monetary targets are based on expectations
for future velocity growth. If velocity
growth deviates from the expected trend
for an extended period, and if the Federal Reserve chooses to stay on a predetermined disinflation course, then the
monetary targets have to be changed.
This Economic Commentary examines
the monetary targets in light of recent
changes in the velocity of money.
Velocity of money is determined by
the aggregate behavior of individual people and firms. This behavior depends on
many factors, including the length of pay
periods, the uncertainty of future
income and expenditure flows, and the
opportunity costs of holding wealth in
the form of money.
Institutional factors also play an important role in determining velocity. The
. introduction of credit cards, for example,
reduced the need to hold money for
transactions purposes. Various cashmanagement techniques have greatly
reduced the demand for money by
firms.2 The development of socialwelfare programs, such as unemployment compensation, social security, and
health-care subsidies, has reduced the
need to hold precautionary balances.
Other special factors that influence
velocity are associated with the Federal
Reserve's policy to lower inflation. As
expected inflation falls, domestic
investors move out of real assets previously held as inflation hedges into
nominal assets included in the monetary
aggregates. 3 A lower expected inflation
rate in the United States may lead wealthy
2. For a discussion of these techniques, see John
B. Carlson, "Methods of Cash Management," Economic Commentary, Federal Reserve Bank of
Cleveland, April S, 1982_
3. See Michael W. Keran, "Velocity and Monetary
Policy in 1982," FRB SF Weekly Letter, Federal
Reserve Bank of San Francisco, March 18, 1983.
Keran argues that the fall in expected inflation
explains the large decrease in M-1 velocity in 1982.

individuals and multinational companies
to switch from other currencies into U.S.
dollars. If such dollars were held as
currency or as deposits in the United
States, they would tend to reduce the
income velocity of money.

The Velocity Assumption
Annual monetary targets are based on
the assumption that changes in velocity
are predictable within a narrow range.
Velocity is said to have a deterministic
trend if it has a predictable component
that depends on nothing else but time. If
velocity had a deterministic trend, then it
would be predictable over long time
periods; historical averages would be
good indicators of future velocity growth,
and the Federal Reserve could set targets
for the money supply well into the future.
Analysts who recommend pre-announced
multi-year targets for the money supply
implicitly assume a deterministic trend in
which all short-term velocity fluctuations
are temporary and offsetting.
Other analysts have argued that the
trend in velocity is not deterministic, but
that it is a function of many factors that
can change over time. Consequently, they
contend that it is not possible to predict
velocity very far into the future. The
Federal Reserve has implied agreement
with this latter view, setting monetary
targets for only one year at a time.The
Federal Reserve's targeting procedure
can be described as an "error learning"
process in which the monetary targets
are regularly reviewed and readjusted as
unpredictable developments in velocity
unfold. This strategy is consistent with
an undeterministic velocity trend in
which the short-term fluctuations include
both a transitory component associated
with the business cycle and a permanent
component that changes the trend.
Monetary targeting does not require
that velocity be a constant or even that it
have a deterministic trend. Monetary

targeting only requires that the central
bank have a procedure for adjusting the
targets when velocity deviates from what
is expected. There are currently several
methods for adjusting the targets. One
method is the stating of monetary targets
as ranges, usually 3 percentage points
wide. When the velocity prediction is
more uncertain than usual, the Federal
Reserve can widen the target range. A
range allows the Federal Reserve some
flexibility as it gathers more information
about velocity. A second mechanism for
adjusting targets is the mid-year review in
which the Federal Open Market Committee (FOMC) can change the target
range. A third mechanism is the practice
of basing the annual target on the actual
average level of the money supply rather
than the target level in the previous
year's fourth quarter (year-end base
drift). A fourth mechanism is the use of
multiple targets. Factors that affect
velocity of one of the monetary aggregates might not affect the others. The
Federal Reserve has generally employed
M-1 as the primary target. In periods
when M-1 velocity was exceptionally
uncertain, the Federal Reserve has
placed more emphasis on the M-2 target.
An example of each of these mechanisms at work can be seen in last year's
targeting experience. An unexpected
decline in M-1 velocity in 1982 led the
Federal Reserve to aim high in the range
at the beginning of the year, to announce
a desired growth rate at or above the
upper limit of the range at the mid-year
review, to place more emphasis on M-2
as of October 1982, and to accept a large
overshoot in the fourth quarter as part of
the base for the 1983 target.

Historical Trends
1880-1960. The long-run trend in
velocity depends on the stage of development in the market economy and on
factors that determine the costs and

Chart 1 Velocity of Money:
1880-1960
Annual data
Percent
5
NNP

..

4

3

..
.... .

.'..-.
.
............
r v.,
.-

2

NNP
M-2

..

..

~.. ~.,.

••••••••••
:

1880

1900
1920
1940
1960
NOTE: Net national product (NNP) was used to
measure income.
SOURCE: Milton Friedman and Anna Jacobson
Schwartz, A Monetary History of the United
States, 1867-1960, Princeton: Princeton
University Press, 1963, table A-5, p. 774.

benefits of holding money. The long
decline in the old M-2 velocity shown in
chart 1 is attributed to economic progress. As the U.S. economy grew, the
size of markets grew and people
depended less on production for home
use, barter, and payment in kind. Coincident with and because of the growth of
the economy, the commercial banking
industry developed and provided the
notes and bank deposits that led to
"monetization" of the economy. This
process accounted for much of the
decline in velocity prior to World War I.
The decline in velocity between World
War I and World War II can be attributed to falling interest rates and to the
high level of economic instability associated with the Great Depression. During
World War II velocity rose and then
declined; the decline in velocity probably
resulted from the imposition of price
controls and rationing, as well as the
uncertainty created by the war. The
combined effect was a buildup of money
balances as the war continued.

After World War II the development of
close substitutes for money, credit cards,
and sophisticated cash-management
techniques tended to reduce the need to
hold assets in the form of money. The
post-World War II period was one of relative economic stability. Business cycles
fluctuated less than in previous periods,
and the federal government gradually
increased the coverage of social-welfare
programs, further reducing the need to
hold precautionary balances.
Beginning in January 1934, Regulation
Q prohibited the payment of interest on
demand deposits and restricted the
amount of interest that could be paid on
savings and time deposits. The prohibition of interest payments on demand
deposits and the interest-rate ceilings
imposed by Regulation Q meant that a
rise in interest rates would increase the
opportunity cost of holding money.
In the first years of Regulation Q,
interest rates were so low that the regulation probably had no effect on velocity.
After World War II, however, accelerating inflation led to rising interest rates.
The long-term Aaa corporate bond yield
approximately doubled over each
decade. As interest rates rose to new
highs with each succeeding business
cycle, the cost of holding money continued to rise.
1960-82. M-1 velocity continued to
grow about 3 percent per year from 1960
until 1982, whereas M-2 velocity growth
was approximately zero over the whole
period (see chart 2, panels A and B). The
divergence belween velocity growth
trends for M-1 and M-2 reflects binding
interest-rate ceilings on demand deposits
and innovations in the market that
enabled depositors to economize on M-1
balances. The growth rate of M-1 velocity accelerated from 1974; indeed, the
post-1974 decrease in M-1 demand was
the focus of extensive research by the
Federal Reserve. Although M-1 velocity
was variable, it was predictable within

Chart2 Velocity of Money: 1960-83
Quarterly data
Percent
7

(A)

tr

01'1 II II II II II I II " II " II
2.0r-----------__
(8)

0.0T! I
1960

II I I!

II II II II II! II I I IT

1968

1976

1984

SOURCE: Board of Governors of the Federal
Reserve System.

tolerances suggested by the monetary
target ranges. This stability appears all
the more remarkable in light of the many
institutional and economic factors that
were changing during this period.
In passing the Depository Institutions
Deregulation and Monetary Control Act
of 1980, Congress repealed many of the
interest-rate ceilings that had been in
effect since 1934. In January 1981 depository institutions nationwide were authorized to offer interest-bearing transactions
accounts. The introduction of these new
interest-bearing checkable accounts was
expected to reduce velocity growth as
the public went through the transition of
moving money out of accounts, both savings and checking, into the new ac-

velocity of money is the ratio of nominal
GNP to the money supply. The monetary targets are based on expectations
for future velocity growth. If velocity
growth deviates from the expected trend
for an extended period, and if the Federal Reserve chooses to stay on a predetermined disinflation course, then the
monetary targets have to be changed.
This Economic Commentary examines
the monetary targets in light of recent
changes in the velocity of money.
Velocity of money is determined by
the aggregate behavior of individual people and firms. This behavior depends on
many factors, including the length of pay
periods, the uncertainty of future
income and expenditure flows, and the
opportunity costs of holding wealth in
the form of money.
Institutional factors also play an important role in determining velocity. The
. introduction of credit cards, for example,
reduced the need to hold money for
transactions purposes. Various cashmanagement techniques have greatly
reduced the demand for money by
firms.2 The development of socialwelfare programs, such as unemployment compensation, social security, and
health-care subsidies, has reduced the
need to hold precautionary balances.
Other special factors that influence
velocity are associated with the Federal
Reserve's policy to lower inflation. As
expected inflation falls, domestic
investors move out of real assets previously held as inflation hedges into
nominal assets included in the monetary
aggregates. 3 A lower expected inflation
rate in the United States may lead wealthy
2. For a discussion of these techniques, see John
B. Carlson, "Methods of Cash Management," Economic Commentary, Federal Reserve Bank of
Cleveland, April S, 1982_
3. See Michael W. Keran, "Velocity and Monetary
Policy in 1982," FRB SF Weekly Letter, Federal
Reserve Bank of San Francisco, March 18, 1983.
Keran argues that the fall in expected inflation
explains the large decrease in M-1 velocity in 1982.

individuals and multinational companies
to switch from other currencies into U.S.
dollars. If such dollars were held as
currency or as deposits in the United
States, they would tend to reduce the
income velocity of money.

The Velocity Assumption
Annual monetary targets are based on
the assumption that changes in velocity
are predictable within a narrow range.
Velocity is said to have a deterministic
trend if it has a predictable component
that depends on nothing else but time. If
velocity had a deterministic trend, then it
would be predictable over long time
periods; historical averages would be
good indicators of future velocity growth,
and the Federal Reserve could set targets
for the money supply well into the future.
Analysts who recommend pre-announced
multi-year targets for the money supply
implicitly assume a deterministic trend in
which all short-term velocity fluctuations
are temporary and offsetting.
Other analysts have argued that the
trend in velocity is not deterministic, but
that it is a function of many factors that
can change over time. Consequently, they
contend that it is not possible to predict
velocity very far into the future. The
Federal Reserve has implied agreement
with this latter view, setting monetary
targets for only one year at a time.The
Federal Reserve's targeting procedure
can be described as an "error learning"
process in which the monetary targets
are regularly reviewed and readjusted as
unpredictable developments in velocity
unfold. This strategy is consistent with
an undeterministic velocity trend in
which the short-term fluctuations include
both a transitory component associated
with the business cycle and a permanent
component that changes the trend.
Monetary targeting does not require
that velocity be a constant or even that it
have a deterministic trend. Monetary

targeting only requires that the central
bank have a procedure for adjusting the
targets when velocity deviates from what
is expected. There are currently several
methods for adjusting the targets. One
method is the stating of monetary targets
as ranges, usually 3 percentage points
wide. When the velocity prediction is
more uncertain than usual, the Federal
Reserve can widen the target range. A
range allows the Federal Reserve some
flexibility as it gathers more information
about velocity. A second mechanism for
adjusting targets is the mid-year review in
which the Federal Open Market Committee (FOMC) can change the target
range. A third mechanism is the practice
of basing the annual target on the actual
average level of the money supply rather
than the target level in the previous
year's fourth quarter (year-end base
drift). A fourth mechanism is the use of
multiple targets. Factors that affect
velocity of one of the monetary aggregates might not affect the others. The
Federal Reserve has generally employed
M-1 as the primary target. In periods
when M-1 velocity was exceptionally
uncertain, the Federal Reserve has
placed more emphasis on the M-2 target.
An example of each of these mechanisms at work can be seen in last year's
targeting experience. An unexpected
decline in M-1 velocity in 1982 led the
Federal Reserve to aim high in the range
at the beginning of the year, to announce
a desired growth rate at or above the
upper limit of the range at the mid-year
review, to place more emphasis on M-2
as of October 1982, and to accept a large
overshoot in the fourth quarter as part of
the base for the 1983 target.

Historical Trends
1880-1960. The long-run trend in
velocity depends on the stage of development in the market economy and on
factors that determine the costs and

Chart 1 Velocity of Money:
1880-1960
Annual data
Percent
5
NNP

..

4

3

..
.... .

.'..-.
.
............
r v.,
.-

2

NNP
M-2

..

..

~.. ~.,.

••••••••••
:

1880

1900
1920
1940
1960
NOTE: Net national product (NNP) was used to
measure income.
SOURCE: Milton Friedman and Anna Jacobson
Schwartz, A Monetary History of the United
States, 1867-1960, Princeton: Princeton
University Press, 1963, table A-5, p. 774.

benefits of holding money. The long
decline in the old M-2 velocity shown in
chart 1 is attributed to economic progress. As the U.S. economy grew, the
size of markets grew and people
depended less on production for home
use, barter, and payment in kind. Coincident with and because of the growth of
the economy, the commercial banking
industry developed and provided the
notes and bank deposits that led to
"monetization" of the economy. This
process accounted for much of the
decline in velocity prior to World War I.
The decline in velocity between World
War I and World War II can be attributed to falling interest rates and to the
high level of economic instability associated with the Great Depression. During
World War II velocity rose and then
declined; the decline in velocity probably
resulted from the imposition of price
controls and rationing, as well as the
uncertainty created by the war. The
combined effect was a buildup of money
balances as the war continued.

After World War II the development of
close substitutes for money, credit cards,
and sophisticated cash-management
techniques tended to reduce the need to
hold assets in the form of money. The
post-World War II period was one of relative economic stability. Business cycles
fluctuated less than in previous periods,
and the federal government gradually
increased the coverage of social-welfare
programs, further reducing the need to
hold precautionary balances.
Beginning in January 1934, Regulation
Q prohibited the payment of interest on
demand deposits and restricted the
amount of interest that could be paid on
savings and time deposits. The prohibition of interest payments on demand
deposits and the interest-rate ceilings
imposed by Regulation Q meant that a
rise in interest rates would increase the
opportunity cost of holding money.
In the first years of Regulation Q,
interest rates were so low that the regulation probably had no effect on velocity.
After World War II, however, accelerating inflation led to rising interest rates.
The long-term Aaa corporate bond yield
approximately doubled over each
decade. As interest rates rose to new
highs with each succeeding business
cycle, the cost of holding money continued to rise.
1960-82. M-1 velocity continued to
grow about 3 percent per year from 1960
until 1982, whereas M-2 velocity growth
was approximately zero over the whole
period (see chart 2, panels A and B). The
divergence belween velocity growth
trends for M-1 and M-2 reflects binding
interest-rate ceilings on demand deposits
and innovations in the market that
enabled depositors to economize on M-1
balances. The growth rate of M-1 velocity accelerated from 1974; indeed, the
post-1974 decrease in M-1 demand was
the focus of extensive research by the
Federal Reserve. Although M-1 velocity
was variable, it was predictable within

Chart2 Velocity of Money: 1960-83
Quarterly data
Percent
7

(A)

tr

01'1 II II II II II I II " II " II
2.0r-----------__
(8)

0.0T! I
1960

II I I!

II II II II II! II I I IT

1968

1976

1984

SOURCE: Board of Governors of the Federal
Reserve System.

tolerances suggested by the monetary
target ranges. This stability appears all
the more remarkable in light of the many
institutional and economic factors that
were changing during this period.
In passing the Depository Institutions
Deregulation and Monetary Control Act
of 1980, Congress repealed many of the
interest-rate ceilings that had been in
effect since 1934. In January 1981 depository institutions nationwide were authorized to offer interest-bearing transactions
accounts. The introduction of these new
interest-bearing checkable accounts was
expected to reduce velocity growth as
the public went through the transition of
moving money out of accounts, both savings and checking, into the new ac-

Federal Reserve Bank of Cleveland
Table 1 Cycles in Velocity Growth
Aggregate

Period

Reces- Recovsions
eries Average

1948:IVQ 1979:IVQ

-0.3

3.9

3.2

1980:IQ 1982:IVQ

-0.4

2.3

0.5

OldM·2

1948:IVQ 1979:IVQ

-2.7

2.1

1.2

M·2

1960:IIQ 1982:IVQ

-2.2

0.2

-0.4

M·1

counts." In retrospect,

it also appears
that the new accounts may have permanently reduced the growth in M-1
velocity. This should be expected if we
accept the premise that the prohibition
against interest payments on demand
deposits was largely responsible for the
divergence between growth trends of
M-1 and M-2 velocity after World War II.

Velocity in 1983
As of April 1983,23 percent of M-1
consisted of interest-paying checkable
deposits. Even more relevant for future
velocity growth is that additions to M-1
are likely to be more heavily weighted in
the new accounts. Super-NOW accounts, introduced in January 1983, have
no regulatory ceiling on the interest rates
paid if the account meets the $2,500
minimum-balance requirement.
Since the introduction of nationwide
NOW accounts, there has been a
remarkable drop in M-1 velocity. This
decline in velocity has occurred over a
business cycle with an unusually short
recovery and an unusually long and deep
recession. Postwar velocity for each of
the monetary aggregates has typically
grown more slowly than average during
4. For further discussion of the effect of interestbearing transactions balances on the monetary
targets, see Theresa Gwazdauskas, "Interpreting
the Ms after the NOWs," Economic Commentary,
Federal Reserve Bank of Cleveland, May 4, 1981.

recessions and more quickly than average during recoveries (see table 1). The
most recent cycle included six quarters
of recession and four quarters of recovery. M-1 velocity growth was -2.0 percent in the recession and 2.3 percent in
the recovery-statistics
similar to those
for the old M-2 aggregate. If we adjust
the cycle average for the unusually long
recession and short recovery, we measure a "trend" of M-1 velocity growth in
the last cycle around 1.3 percent. 5
A rough estimation of the Federal
Reserve's expectations about velocity for
1983 can be derived from information
provided to Congress in the HumphreyHawkins report.P The GNP forecast (8.0
percent to 9.0 percent growth in 1983) is
the "central tendency" of the forecasts
by the Board of Governors and the individual Federal Reserve Bank presidents.
The GNP forecast takes into account the
targets chosen for 1983. The midpoint of
the M-1 target is 6.0 percent, implying a
"central tendency" forecast for M-1 velocity growth of 2.0 percent to 3.0 percent.
The expectations for M-1 velocity are
below the historical trend. Given the historical record of above-trend velocity
growth in the first year of recovery, this
forecast implies a downward shift in the
M-1 velocity trend. The midpoint of the
M-2 target is 8.5 percent, implying a "central tendency" forecast for M-2 velocity of
-0.5 percent to 0.5 percent. The historical
growth rate in recoveries was 0.2 percent, within this forecast range.

Conclusion
The rapid growth of the aggregates in
late 1982 and early 1983 reflects both the
flow of funds into new accounts and a
policy adjustment in response to a
downward shift in the velocity trends.
The Federal Reserve seems willing to
accept M-1 growth above the target
range in 1983 as velocity continues to
decline. If the decline persists, the target
might have to be raised. If the public
does not understand the relationship
between velocity trends and the monetary targets, then the Federal Reserve's
decision to raise the targets could be
misconstrued as being inflationary.
If economic growth continues to
accelerate, however, and velocity growth
returns to historical patterns, then the
Federal Reserve would have to lower
M-1 growth to preserve recent success in
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

reducing inflation. In this period of regulatory change and disinflation policy, the
Federal Reserve might not be able to use
M-1 targets to guide short-run, openmarket operations. However, empirical
evidence indicates that there has been a
lag between changes in monetary policy
and changes in economic activity. There
should be time to adjust the long-run
targets in response to large unexpected
developments in velocity before they
induce undesired changes in economic
activity and prices.
Economist William T. Gauin does research in the
areas of monetary theory and monetary policy for
the Federal Reserue Bank of Cleueland.
The uiews stated herein are those of the author
and not necessarily those of the Federal Reserue
Bank of Cleueland or of the Board of Gouernors of
the Federal Reserue System.
NOTE: No issues of the Economic Commentary
were published in May.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

5. The actual average M·1 velocity growth for the
last cycle is a weighted average of the growth in the
recession and the growth in the recovery:
-0.3 = 6/10 (-2.0) + 4/10 (2.3).
From 1948:IVQ through 1982:IVQ, there were 141
quarters with 33 quarters of recession and 108
. quarters of -ecovery. Using this experience as a
guide, we can adjust velocity growth over the last
cycle to see what it would have been if the cycle had
been more like those in the past:
1.3 = 33/141 (-2.0) + 108/141 (2.3).
6. See "Monetary Policy Objectives for 1983," the
report pursuant to the Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins).

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

June 6,1983

~!:rlQnomicCommentary
Velocity and Monetary Targets

by William T. Gavin

To interpret the monetary targets in
1983, we have to know where we have
been and where we are going. The equation of exchange, MV = PQ, provides a
simple accounting framework for keeping
track of where we have been and for
suggesting where we may be going. Mis
the money supply, however defined; V is
the related velocity, or turnover of
money; P is the general price level; and
Q is real output.
The important variables are prices and
real output. However, the central bank
cannot determine how much of a given
change in the money supply will go into
prices and how much will go into output.
In the long run output will be determined
by real economic factors, such as population growth, capital accumulation,
technology, and the incentive structure
implied by tax laws and economic regulation. Even though changes in money
growth may not affect output in the long
run, changes in the money supply may
have substantial effects in the short run.
The uncertainty about how monetary
policy will affect prices and output over
periods as short as one year has led
economists to relate monetary targets to
nominal gross national product (GNP),
the product of P and Q. If the Federal

Reserve restrained money growth, it
would restrain nominal GNP. Initially, real
output may also be restrained (as we saw
in 1981-82). Over time, real economic
factors should dominate, and real growth
should return to its underlying trend. If
the reduced money-supply targets were
maintained over a period of years, nominal GNP would be restrained and inflation would be reduced. All of this, of
course, assumes a stable relationship
between GNP and the money supply.
Since 1981, the income velocity of M-1,
the primary money-supply target, has
declined dramatically. 1 The income
1. In this article the discussion of velocity is
generally restricted, except when noted, to M·1 and
M·2. M·1 consists of currency, demand deposits, travelers' checks, and other checkable deposits. M·2
includes M·1, small time and savings deposits, noninstitutional money market mutual funds, overnight
repurchase agreements, and Eurodollars. M·3
includes M·2, large-denomination time deposits,
term RPs, and institutions' money market mutual
fund balances. For more detailed definitions, see
"Domestic Financial Statistics," Federal Reserue
Bulletin, vol, 68, no. 12 (December 1982), p, A14.
Old M·2 refers to M·2 as defined before 1979, i.e.,
M·1 plus savings deposits, time deposits open
account, and time certificates of deposit (CDs)
other than negotiable CDs of $100,000 or more at
large weekly reporting banks. Old M·2 did not
include deposits at thrift institutions.

Federal Reserve Bank of Cleveland
Table 1 Cycles in Velocity Growth
Aggregate

Period

Reces- Recovsions
eries Average

1948:IVQ 1979:IVQ

-0.3

3.9

3.2

1980:IQ 1982:IVQ

-0.4

2.3

0.5

OldM·2

1948:IVQ 1979:IVQ

-2.7

2.1

1.2

M·2

1960:IIQ 1982:IVQ

-2.2

0.2

-0.4

M·1

counts." In retrospect,

it also appears
that the new accounts may have permanently reduced the growth in M-1
velocity. This should be expected if we
accept the premise that the prohibition
against interest payments on demand
deposits was largely responsible for the
divergence between growth trends of
M-1 and M-2 velocity after World War II.

Velocity in 1983
As of April 1983,23 percent of M-1
consisted of interest-paying checkable
deposits. Even more relevant for future
velocity growth is that additions to M-1
are likely to be more heavily weighted in
the new accounts. Super-NOW accounts, introduced in January 1983, have
no regulatory ceiling on the interest rates
paid if the account meets the $2,500
minimum-balance requirement.
Since the introduction of nationwide
NOW accounts, there has been a
remarkable drop in M-1 velocity. This
decline in velocity has occurred over a
business cycle with an unusually short
recovery and an unusually long and deep
recession. Postwar velocity for each of
the monetary aggregates has typically
grown more slowly than average during
4. For further discussion of the effect of interestbearing transactions balances on the monetary
targets, see Theresa Gwazdauskas, "Interpreting
the Ms after the NOWs," Economic Commentary,
Federal Reserve Bank of Cleveland, May 4, 1981.

recessions and more quickly than average during recoveries (see table 1). The
most recent cycle included six quarters
of recession and four quarters of recovery. M-1 velocity growth was -2.0 percent in the recession and 2.3 percent in
the recovery-statistics
similar to those
for the old M-2 aggregate. If we adjust
the cycle average for the unusually long
recession and short recovery, we measure a "trend" of M-1 velocity growth in
the last cycle around 1.3 percent. 5
A rough estimation of the Federal
Reserve's expectations about velocity for
1983 can be derived from information
provided to Congress in the HumphreyHawkins report.P The GNP forecast (8.0
percent to 9.0 percent growth in 1983) is
the "central tendency" of the forecasts
by the Board of Governors and the individual Federal Reserve Bank presidents.
The GNP forecast takes into account the
targets chosen for 1983. The midpoint of
the M-1 target is 6.0 percent, implying a
"central tendency" forecast for M-1 velocity growth of 2.0 percent to 3.0 percent.
The expectations for M-1 velocity are
below the historical trend. Given the historical record of above-trend velocity
growth in the first year of recovery, this
forecast implies a downward shift in the
M-1 velocity trend. The midpoint of the
M-2 target is 8.5 percent, implying a "central tendency" forecast for M-2 velocity of
-0.5 percent to 0.5 percent. The historical
growth rate in recoveries was 0.2 percent, within this forecast range.

Conclusion
The rapid growth of the aggregates in
late 1982 and early 1983 reflects both the
flow of funds into new accounts and a
policy adjustment in response to a
downward shift in the velocity trends.
The Federal Reserve seems willing to
accept M-1 growth above the target
range in 1983 as velocity continues to
decline. If the decline persists, the target
might have to be raised. If the public
does not understand the relationship
between velocity trends and the monetary targets, then the Federal Reserve's
decision to raise the targets could be
misconstrued as being inflationary.
If economic growth continues to
accelerate, however, and velocity growth
returns to historical patterns, then the
Federal Reserve would have to lower
M-1 growth to preserve recent success in
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

reducing inflation. In this period of regulatory change and disinflation policy, the
Federal Reserve might not be able to use
M-1 targets to guide short-run, openmarket operations. However, empirical
evidence indicates that there has been a
lag between changes in monetary policy
and changes in economic activity. There
should be time to adjust the long-run
targets in response to large unexpected
developments in velocity before they
induce undesired changes in economic
activity and prices.
Economist William T. Gauin does research in the
areas of monetary theory and monetary policy for
the Federal Reserue Bank of Cleueland.
The uiews stated herein are those of the author
and not necessarily those of the Federal Reserue
Bank of Cleueland or of the Board of Gouernors of
the Federal Reserue System.
NOTE: No issues of the Economic Commentary
were published in May.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

5. The actual average M·1 velocity growth for the
last cycle is a weighted average of the growth in the
recession and the growth in the recovery:
-0.3 = 6/10 (-2.0) + 4/10 (2.3).
From 1948:IVQ through 1982:IVQ, there were 141
quarters with 33 quarters of recession and 108
. quarters of -ecovery. Using this experience as a
guide, we can adjust velocity growth over the last
cycle to see what it would have been if the cycle had
been more like those in the past:
1.3 = 33/141 (-2.0) + 108/141 (2.3).
6. See "Monetary Policy Objectives for 1983," the
report pursuant to the Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins).

Address Correction
Requested:
Please send corrected mailing label to the Federal
Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101.

June 6,1983

~!:rlQnomicCommentary
Velocity and Monetary Targets

by William T. Gavin

To interpret the monetary targets in
1983, we have to know where we have
been and where we are going. The equation of exchange, MV = PQ, provides a
simple accounting framework for keeping
track of where we have been and for
suggesting where we may be going. Mis
the money supply, however defined; V is
the related velocity, or turnover of
money; P is the general price level; and
Q is real output.
The important variables are prices and
real output. However, the central bank
cannot determine how much of a given
change in the money supply will go into
prices and how much will go into output.
In the long run output will be determined
by real economic factors, such as population growth, capital accumulation,
technology, and the incentive structure
implied by tax laws and economic regulation. Even though changes in money
growth may not affect output in the long
run, changes in the money supply may
have substantial effects in the short run.
The uncertainty about how monetary
policy will affect prices and output over
periods as short as one year has led
economists to relate monetary targets to
nominal gross national product (GNP),
the product of P and Q. If the Federal

Reserve restrained money growth, it
would restrain nominal GNP. Initially, real
output may also be restrained (as we saw
in 1981-82). Over time, real economic
factors should dominate, and real growth
should return to its underlying trend. If
the reduced money-supply targets were
maintained over a period of years, nominal GNP would be restrained and inflation would be reduced. All of this, of
course, assumes a stable relationship
between GNP and the money supply.
Since 1981, the income velocity of M-1,
the primary money-supply target, has
declined dramatically. 1 The income
1. In this article the discussion of velocity is
generally restricted, except when noted, to M·1 and
M·2. M·1 consists of currency, demand deposits, travelers' checks, and other checkable deposits. M·2
includes M·1, small time and savings deposits, noninstitutional money market mutual funds, overnight
repurchase agreements, and Eurodollars. M·3
includes M·2, large-denomination time deposits,
term RPs, and institutions' money market mutual
fund balances. For more detailed definitions, see
"Domestic Financial Statistics," Federal Reserue
Bulletin, vol, 68, no. 12 (December 1982), p, A14.
Old M·2 refers to M·2 as defined before 1979, i.e.,
M·1 plus savings deposits, time deposits open
account, and time certificates of deposit (CDs)
other than negotiable CDs of $100,000 or more at
large weekly reporting banks. Old M·2 did not
include deposits at thrift institutions.