David B. Gordon, Eric M. Leeper, and Tao Zha
Federal Reserve Bank of Atlanta
Working Paper 97-7
November 1997

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U.S. velocity of base money exhibits three distinct trends since 1950. After rising steadily for thirty years, it flattens out in the 1980s and falls substantially in the 1990s. This paper explores whether the observed secular movements in velocity can be accounted for exclusively by endogenous responses to changing expectations about monetary and fiscal policy. We use a model with two key features: a substitute for money in transactions and an array of assets that includes money, nominal bonds, and physical capital. The model maps policy expectations into portfolio decisions, making equilibrium velocity a function of expected future money growth, tax rates, and government spending. When expectations are estimated using Bayesian updating, simulated velocity matches the trends in actual velocity surprisingly well.

JEL classification: E50, E63

Key words: velocity, policy expectations, portfolio decisions, transactions services, Bayesian updating

This paper was prepared for the Carnegie-Rochester Conference Series. The authors benefited from conversations with Ed Buffie, Jerry Dwyer, Marty Eichenbaum, Donald Gordon, Peter Pedroni, and Will Roberds. Clark Burdick and Dan Waggoner helped with computational issues, and Bryan Acree assisted with data collection. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to David B. Gordon, Department of Economics, Clemson University, Sirrine Hall, Box 341309, Clemson, South Carolina 29634-1309, 803/656-3956, gd@clemson.edu; Eric M. Leeper, Department of Economics, 919 Ballantine Hall, Indiana University, Bloomington, Indiana 47405, 812/339-4262, eleeper@indiana.edu; and Tao A. Zha, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713, 404/498-8353, tzha@mindspring.com.