Skip to main content

August/September 1983, 
Vol. 65, No. 7
Posted 1983-08-01

Was the 1982 Velocity Decline Unusual?

by John A. Tatom

John A. Tatom analyzes recent movements in velocity. Velocity, the ratio of the nation’s GNP to its money stock, fell sharply in 1982. Since velocity is an indicator of the public’s demand for money, many analysts have interpreted the decline as an unanticipated shift in the public’s desired holdings of transaction balances. According to this view, the shift worsened economic performance and raised serious doubts about the future prospects of controlling both inflation and spending by controlling the monetary aggregates. Tatom explains that velocity normally displays a cyclical pattern, rising faster than average during expansions and falling in recessions. He points to three reasons why velocity declines in recessions. First, money stock growth often accelerates after the economy enters a recession. Spending in the economy responds proportionately, but with a lag. As a result, velocity growth is temporarily depressed, then temporarily raised. The initial change, depressing velocity growth, tends to occur immediately; it is observed during the recession and reinforces the velocity decline associated with the slowing in money growth that preceded the recession. Second, real income falls during a recession. Because the public’s preference for money does not fall proportionately with its reduced demand for goods and services, M1 tends to rise relative to GNP. Finally, during recessions, businesses often develop excess inventory. The temporary production adjustments to eliminate this excess initially push production down sharply relative to sales. During such a period of inventory adjustment, measured velocity falls sharply. To assess whether recent velocity movements were unusually large, Tatom uses a model that describes velocity movements from 1948 to mid-1981 to compare velocity movements from mid-1981 through 1982 with actual developments. Tatom shows that the 1982 velocity decline was not unusual when compared with the estimates based on past velocity movements.