Velocity of Money, Productivity Growth and the 2 Percent Inflation Target

Abstract

In line with the transaction motive literature (Baumol, 1952 and Tobin, 1956), I postulate that financial innovations generate transactional cost savings by comparison to barter. Hence, the optimal velocity of narrow money is a function of labor productivity growth and of the differential between long-term and short term rates. A key parameter in that relation is the mean leverage ratio for depository institutions. I use a VECM for the U.S. (using M1, M1RS and M1S) from 1959-2007 and find good support for the model. The velocity of money tracks productivity growth at about 2% over the period. Setting the inflation target rate equal to the growth rate of velocity leads to an inflation rate near 2% and is akin to pursing a Friedman (1960) k% rule that takes into account a trending money velocity. While this rule is not shown to be optimal here, it provides flexibility to prevent deflations. A long-term Taylor (1993) type rule is also derived.