An analysis of monetary velocity in an open economy

Abstract

In spite of widely accepted theoretical and empirical results regarding the relationship between the supply of money and other economic aggregates, the recent round of world-wide inflation has precipitated a growing interest in applying the quantity theory to monetary relationships among trading countries of the world. Though large gains have been made on theoretical grounds, empirical results remain scarce. In this study, effects of international forces on nominal income and the income velocity of money are investigated for twenty-two industrialized countries for the period, 1954-1973. Two general functional forms are considered. They are the income approach associated with Fisher and Marshall, et al, and the expenditure approach developed in this study. The latter is derived from extension of the quantity theory to monetary relationships among trading countries. It includes the ratios of world to domestic money and government expenditures to domestic money as arguments in the final reduced-form equation estimated. The two functional forms are then compared in terms of their predictive abilities. There are three areas of inquiry evolving from (1) the nature of the specified models, (2) properties of estimating equations, and (3) the relative performance of the two functional forms. A major emphasis is placed on evidence which supports the expenditure approach as the appropriate structure for analyzing open-economy effects. The estimates obtained question the stability hypothesis. Velocity will change in accordance with the growth rate in world money or government expenditures relative to domestic money. This is so whether or not steady money growth and a balanced budget are maintained. There is one instance in which velocity will be unchanged: when the growth rate of world money or government expenditures relative to domestic money remains unchanged. All external effects drop out in the income approach. There is an inherent crowding-out effect in this formulation. Following an increase in exports, for example, income and velocity will not change, assuming private expenditure and domestic money remain constant. Exports occur at the expense of private expenditures. Estimates are obtained after repairs for autocorrelation, using the least-squares method. Coefficients are unbiased and correspond to the test of the hypothesis that money demand is a constant proportion of income.