Money and Velocity in the 1980s - Opportunity Cost and the Aggregates - Disinflation and Financial

Sep 21, 2026

Uploaded by Maeve

Discusses how money behavior and the velocities of monetary aggregates (M1 and M2) changed during the 1980s, linking these shifts to deregulation and disinflation. Explains increased sensitivity of money to interest rates, and how opportunity cost—foregone interest income from holding money—shapes money demand and velocity. Reviews why money-velocity relationships were more stable before 1980 and less predictable in the decade, affecting monetary policy planning and the ability to pre-specify money growth targets.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

AccessFree to download

Velocity Trends

Money and Velocity in the 1980s

Opportunity Cost and the Aggregates

Opportunity cost definition and measurement

Financial deregulation and deposit innovations

Disinflation and Financial

by John B.Carlson and # ■ Velocity Trends The behavior of money has changedgreatly in the 1980s.This article iden-tifies the newly emerging patterns inmoney and its relationship toeconomic activity.These new pat-terns,largely a consequence of bothderegulation and disinflation,revealan increased sensitivity of money tointerest rates.The implications forthe role of money in the monetarypolicy process are also discussed. differentIt had a systematic relation-ship to interest rates in the short runbefore 1980,but was,and continues tobe,relatively stable over long periods.² The substantial interest sensitivity ofthe monetary aggregates(M1,M2)andtheir velocities is being confirmed instudies of money demand.³In thesestudies,money demand is viewed as afunction of its opportunity cost—theforegone interest income of holdinglower-yielding money balances.Asthis cost of holding money rises,thedemand for money falls(and velocityincreases).The opportunity cost of agiven deposit typically is measured by # Money and Velocityin the 1980s John N.McElravey Prior to 1980.a shapsowdown inthe money supply was expected to beassociated with a downturn in eco-nomic activity.Indeed this concernwas still expressed by some analysts in1987 and 1988 as the growth rates ofmoney supply measures MI and M2slowed precipitously.'Nevertheless,the economy has remained strong,despite the problems caused by the1988 drought. Recent evidence suggests that moneygrowth is becoming more variablereflecting increasing sensitivity ofsome bank deposits to changes in inter-est rates.In turn,this interest-rate sen-sitivity has affected the behavior of thevelocity of money—the ratio of nom-inal income to money—and hence hasaffected the link between money andeconomic activity. This Economic Commentary discusseshow the newly emerging pattens in thevelocities of M1 and M2 ultimately re-flect the effects of financial deregula-tion and disinflation.Given the degreeof the interest-rate sensitivity ofmoney,and the uncertainty about howinterest rates may need to vary inresponse to shocks to the economy,ithas become difficult for policymakersto prespecify an appropriate growthrate for the nation's money supply over the short run.This problem is also dis-cussed. The relationship of money to nominalincome was once thought to be one ofthe most stable relationships in eco-nomics.This was evident in the behav-ior of MI velocity.From 1959 to 1980,M1 velocity grew smoothly along a 3-percent trend(see chart 1).While MIvelocity was systematically related tointerest rates,the impact of interest-rate changes appeared relatively small. In effect,a substantial slowdown inMI growth during this period wasusually associated with a slowdown inaggregate spending and,therefore,ineconomic activity.This tendency forchanges in M1 growth to mirrorchanges in economic activity made it auseful guidepost for monetary policy.Indeed,the Federal Reserve increasing-ly relied on Ml as a gauge for mone-tary policy during the 1970s. # ■ Opportunity Cost and theAggregates The apparent stability of the MI veloc-ity trend,however,was not inherent.During the current decade,MI velocityhas varied substantially with changesin interest rates(see chart 2).More-over,while MI velocity has declinedsince 1982,it is not evident that it isfollowing any identifiable trend path.The case of M2 velocity is somewhat the difference between the market inter-est rate on a relatively risk-free,short-term asset(such as the 3-monthTreasury bill)and the rate paid on thatdeposit(its own-rate). Prior to financial deregulation,begin-ning in the late 1970s,virtually allcheckable deposits were noninterestbearing.Thus,the opportunity cost ofMI balances-comprised of currencyand checkable deposits—was essential-ly equal to the Treasury-bill rate.Inter-est rates drifted upward over most ofthe postwar period.Rate levels at thetrough of each recession were higherthan at the previous trough (see chart 2).Money balances continual

FAQs

What changed about money behavior in the 1980s?

Money became more sensitive to interest rates, and this altered the relationship between money and economic activity through changes in the velocities of M1 and M2.

How does opportunity cost affect money demand and velocity?

Money demand depends on opportunity cost, meaning the foregone interest income from holding lower-yielding balances. As opportunity cost rises, money demand falls and velocity increases.

Why did money velocity look more stable before 1980?

Before 1980, money-velocity patterns—especially M1 velocity—followed smoother trends and interest-rate impacts appeared relatively small, making money growth a useful guidepost.

How do deregulation and disinflation complicate monetary policy?

Because money growth is becoming more variable and velocity responds more to interest rates, policymakers face uncertainty in prespecifying appropriate short-run growth rates for the nation’s money supply.

Sep 21, 2026

Uploaded by Maeve