Determinants of the velocity of money, the case of Romanian economy
Dissertation Paper Student: Moinescu Bogdan Supervisor: Phd. Professor Moisă Altăr
Goals
To identify the real and monetary factors, which affect velocity of money
To measure the extent of each determinant’s influence on the variability of money velocity
using the Johansen’s cointegration procedure for the velocity of M1 (transactions velocity) using a dynamic equation for the velocity of M2 (velocity of circulation)
Determinants of money velocity – A review of literature
Irving Fisher (1911) – expected inflation
“When…depreciation is anticipated, there is a tendency among owners of money to spend it speedily…the result being to raise prices by increasing the transactions velocity”
Milton Friedman (1956)
Bordo and Jonung (1987, 1990) – institutional factor
Barnett and Xu (1998) - money demand perspective
Determinants of money velocity in Romania
Output Exchange Rate Deposit Rate Spread of commercial banking Confidence in national currency:
the opportunity of saving money through term deposits versus holding USD inflation deviation from its targeted level
Institutional factors
the abolition of the consumption rationalization system the development of banking system
the liberalization of the exchange market
the improvement of the institutional framework of monetary policy
The evolution of M1 and M2 velocity
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 1996 1997 1998 1999 2000 2001
VEL_M1_BF
VELOCITY_BF
The computation of M1 and M2 velocity index
velocity_bft,i = velocity_bft-1,i + velocity_montht,i
Mt Pt Yt ln( ) velocity _ montht ln( ) ln( ) M t 1 Pt 1 Yt 1
Pt Yt Mt velocity _ montht ln( ) ln( ) ln( ) Pt 1 Yt 1 M t 1
Methodology, Data and Econometric estimates
1. The role of money velocity in the success of monetary policy program
inf_ dev _ montht ,i inf_ dev _ montht 1,i vel _ montht ,i wagest 1,i ex _ rate _ montht 1,i d _ 12 d 97 c t ,i (1)
Methodological issues –(1)
Variables of equation (1)
Time series: 1996:01-2002:03
.5 .4
.2 .3
.3 .2 .1
.0 .1
.0 -.1 -.2
-.2 -.1
-.3 -.4 1996 1997 1998 1999 2000 2001
-.3 1996 1997 1998 1999 2000 2001
INF_DEVIATION_MONTH .3 .2 .1 .0
.00 .20 .15 .10 .05
VELOCITY_MONTH
-.1 -.2 -.3 1996 1997 1998 1999 2000 2001
-.05 -.10 -.15 1996 1997 1998 WAGES 1999 2000 2001
EX_RATE_MONTH
Unit-root test – (1)
intercept
trend and intercept
Equation (1) estimates
Actual, Fitted and Residual Graph
.6 .4 .2 .0 -.2 .15 .10 .05 .00 -.05 -.10 -.15 1996 1997 1998 1999 Actual 2000 2001 Fitted -.4
Residual
Residual tests – Normality test
10 Series: Residuals Sample 1996:02 2002:03 Observations 74 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.10 -0.05 0.00 0.05 0.10 -7.13E-18 -8.64E-05 0.136959 -0.121607 0.060502 0.018539 2.618304 0.453455 0.797138 8
6
4
2
0
Residual tests - Correlogram
Stability Tests
.2
30 20
.1
10
.0
0 -10
-.1
-20
-.2 1997 1998 1999 2000 2001 ± 2 S.E.
-30 1997 1998 CUSUM 1999 2000 2001
Recursive Residuals
5% Significance
Conclusion (1)
Wald test is performed in order to test whether changes of velocity are significant for the success of monetary policy
The econometric evidence points out the role of money velocity in driving inflation away from its targeted level.
Methodology, Data and Econometric estimates
2. Determinants of the velocity of M1
OBJ. - to separate the real from monetary causes and to estimate the importance of each from these factors on the transaction velocity variability
Data issues – (3)
Short data series Necessary data availability
industrial output index as a proxy for GDP dynamic the exchange rate (ROL/USD) was considered as proxy for the opportunity of holding foreign currencies average interest paid on deposits was considered as opportunity cost for transaction money
Unconvincing information provided by data
Variables of equation (3)
Time series: 1996:01-2002:03
1.0
.3 .2
0.8
.1
0.6
.0 -.1 -.2
0.4
0.2
-.3
0.0 1996 1997 1998 1999 2000 2001
-.4 1996 1997 1998 1999 2000 2001
VEL_M1_BF
3.0 2.5 2.0 1.5 1.0 0.5 0.0 1996 1997 1998 1999 2000 2001
OUTPUT_BF
.09 .08 .07 .06 .05 .04 .03 .02 .01 1996 1997 1998 1999 2000 2001
EX_RATE_BF
DEP_RATE
All variables are indices (base dec. 1995)
Velocity of M1, Ex.rate – Joint graphs
3.0 2.5 2.0
1.0
0.8
0.6
1.5
0.4
1.0 0.5 0.0
0.2
0.0 1996 1997 1998 1999 2000 2001
EX_RATE_BF
VEL_M1_BF
Unit-root test – (3)
intercept
trend and intercept
VAR Lag Order Selection Criteria
The number of lags used to perform the cointegration test and to estimate the error correction vector (VEC) is determined using the following criterion
Cointegration test – (3)
The cointegration test was performed using one centred seasonal dummy in order to avoid the seasonal increases of monetary aggregates in December.
VEC estimates
The exclusion test provide evidence that exogenity cannot be rejected for these determinants.
Variance decomposition of transactions velocity
Variance Decom osition p
P rcent VEL_M _BF variance due to VEL_M _BF e 1 1
60 50
Percent VEL_M _BF variance due to EX_R TE_BF 1 A
60 50 40 30 20 10 0
9%
40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 12
57%
1 2 3 4 5 6 7 8 9 10 11 12
Percent V L_M _BF variance due to OU PU _BF E 1 T T
60 50
Percent VEL_M _BF variance due to D P R TE 1 E_ A _R TE A 60
50 40 30 20 10 0
22%
40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 12
12%
1 2 3 4 5 6 7 8 9 10 11 12
The variables are ordered in the following sequence: output, exchange rate , deposit rate and income velocity of M1.
Conclusions (3)
First, exchange rate is the most important determinant of income velocity of M1
Second, both real and monetary factors are important in explaining movements in transactions velocity.
Methodology, Data and Econometric estimates
3. Determinants of the velocity of M2
OBJ. - to measure and to test the stability of the sensitivity of income velocity of M2 to changes of confidence in national currency. Moreover, it will be analysed the role of commercial banking in explaining movements in velocity of circulation.
Data issues – (4)
There is no available data about the confidence in national currency, but its evolution could be expressed through:
changes of inflation deviation from its targeted level the opportunity of saving money through term deposits versus holding USD:
Variables of equation (4)
Time series: 1996:01-2002:03
.5 .4 .3 .2 .1 .0 -.1 -.2 1996 1997 1998 1999 2000 2001
INF_DEVIATION_MONTH .5 .4 .3 .2 .1 .0 -.1 -.2 -.3 -.4 1996 1997 1998 1999 2000 2001
VELOCITY_BF
.3
.016 .014
.2
.012
.1
.010
.0
.008 .006 .004
1996 1997 1998 1999 2000 2001
-.1
-.2
1996
1997
1998
1999 SPREAD
2000
2001
OPORTUNITY_COST
Unit-root test – (4)
Econometric estimates, equation (4)
Actual, Fitted and Residual Graph–(4)
.6 .4 .2 .0 -.2
.2 .1 .0 -.1 -.2 1996 1997 1998 1999 Actual 2000 2001 Fitted
Residual
Residual tests – Normality test
10 Series: Residuals Sample 1996:03 2002:03 Observations 73 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -0.10 -0.05 0.00 0.05 0.10 0.15 0.000744 -0.006737 0.165607 -0.113719 0.053584 0.268633 3.149314 0.945803 0.623191 8
6
4
2
0
Residual tests - Correlogram
Stability Tests
.20 .15 .10
30 20 10
.05
0
.00 -.05 -.10 -.15 1997 1998 1999 2000 2001
-10 -20 -30 1997 1998 CUSUM 1999 2000 2001
Recursive Residuals
± 2 S.E.
5% Significance
Stability Tests
1.2 1.0 0.8 0.6 0.6 0.4 0.4 0.2 0.0 -0.2 -0.4 1997 1998 1999 2000 2001 ± 2 S.E. 0.2 0.0 -0.2 1997 1998 1999 2000 2001 ± 2 S.E. 0.0 -0.2 -0.4 1997 1998 1999 2000 2001 ± 2 S.E. 0.2 1.2 1.0 0.8 1.0 0.8 0.6 0.4
Recursive C(1) Estimates
Recursive C(2) Estimates
Recursive C(3) Estimates
16
.00 -.05 -.10 -.15
12
8
4 -.20 0 -.25 -4 1997 1998 1999 2000 2001 ± 2 S.E. -.30 1997 1998 1999 2000 2001 ± 2 S.E.
Recursive C(4) Estimates
Recursive C(5) Estimates
Conclusions – (3)
Equation (4) does quite a reasonable job of explaining the dynamic of M2 velocity (R2= 0.77) The confidence in the national currency is an important determinant of income velocity of M2. The deregulation of exchange rate market in 1997 had a major impact on the function of the velocity of money. The sensitivity of velocity of circulation to the confidence in national currency is quite stable since 1997.
The improvement of Romanian’s banking system soundness reduced the contribution of banks to velocity instability.
Final remarks
The role of velocity variability in driving inflation away from its targeted level is confirmed by empirical results The main finding of the paper is that velocity fluctuations are less influenced by output variability and governed by the exchange rate, deposit rate and expectations about the outcome of monetary policy, in a sound banking environment.
Final remarks
This result represents the first step for a future analysis about the controllability of the velocity instability using monetary instruments.
Adding various structural factors in the way Bordo and Jonung (1987) suggest (e.g. including financial innovations and other deepening variables) would affect the variance decomposition of the velocity of M1 and the stability of the velocity of M2 function.