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

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

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

)ln()ln(_)ln(

111

t

t

t

tt

t

t

Y

Y

P

Pmonthvelocity

M

M

)ln()ln()ln(_111

t

t

t

t

t

tt M

M

Y

Y

P

Pmonthvelocity

Methodology, Data and Econometric estimates

1. The role of money velocity in the success of monetary policy program

(1) 9712_

__

__inf__inf_

,

,1,1

,,1,

it

itit

ititit

cdd

monthrateexwages

monthvelmonthdevmonthdev

Methodological issues –(1)

Variables of equation (1)Time series: 1996:01-2002:03

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1996 1997 1998 1999 2000 2001

INF_DEVIATION_MONTH

-.3

-.2

-.1

.0

.1

.2

.3

1996 1997 1998 1999 2000 2001

VELOCITY_MONTH

-.3

-.2

-.1

.0

.1

.2

.3

1996 1997 1998 1999 2000 2001

EX_RATE_MONTH

-.15

-.10

-.05

.00

.05

.10

.15

.20

1996 1997 1998 1999 2000 2001

WAGES

Unit-root test – (1)

intercept trend and intercept

Equation (1) estimates

Actual, Fitted and Residual Graph

-.15

-.10

-.05

.00

.05

.10

.15 -.4

-.2

.0

.2

.4

.6

1996 1997 1998 1999 2000 2001

Residual Actual Fitted

Residual tests – Normality test

0

2

4

6

8

10

-0.10 -0.05 0.00 0.05 0.10

Series: ResidualsSample 1996:02 2002:03Observations 74

Mean -7.13E-18Median -8.64E-05Maximum 0.136959Minimum -0.121607Std. Dev. 0.060502Skewness 0.018539Kurtosis 2.618304

Jarque-Bera 0.453455Probability 0.797138

Residual tests - Correlogram

Stability Tests

-.2

-.1

.0

.1

.2

1997 1998 1999 2000 2001

Recursive Residuals ± 2 S.E.

-30

-20

-10

0

10

20

30

1997 1998 1999 2000 2001

CUSUM 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

All variables are indices (base dec. 1995)

0.0

0.2

0.4

0.6

0.8

1.0

1996 1997 1998 1999 2000 2001

VEL_M1_BF

-.4

-.3

-.2

-.1

.0

.1

.2

.3

1996 1997 1998 1999 2000 2001

OUTPUT_BF

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1996 1997 1998 1999 2000 2001

EX_RATE_BF

.01

.02

.03

.04

.05

.06

.07

.08

.09

1996 1997 1998 1999 2000 2001

DEP_RATE

Velocity of M1, Ex.rate – Joint graphs

0.0

0.2

0.4

0.6

0.8

1.0

1996 1997 1998 1999 2000 2001

VEL_M1_BF

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1996 1997 1998 1999 2000 2001

EX_RATE_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

The variables are ordered in the following sequence: output, exchange rate , deposit rate and income velocity of M1.

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10 11 12

P e r c e n t

V E L _ M 1 _ B F

v a r i a n c e

d u e

t o

V E L _ M 1 _ B F

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10 11 12

P e r c e n t

V E L _ M 1 _ B F

v a r i a n c e

d u e

t o

O U T P U T _ B F

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10 11 12

P e r c e n t

V E L _ M 1 _ B F

v a r i a n c e

d u e

t o

E X _ R A T E _ B F

0

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10 11 12

P e r c e n t

V E L _ M 1 _ B F

v a r i a n c e

d u e

t o

D E P_

_R

RA

AT

TE

E

V a r i a n c e

D e c o m p o s i t i o n

9%

22%

57%

12%

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

-.2

-.1

.0

.1

.2

.3

.4

.5

1996 1997 1998 1999 2000 2001

VELOCITY_BF

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1996 1997 1998 1999 2000 2001

INF_DEVIATION_MONTH

-.2

-.1

.0

.1

.2

.3

1996 1997 1998 1999 2000 2001

OPORTUNITY_COST

.004

.006

.008

.010

.012

.014

.016

1996 1997 1998 1999 2000 2001

SPREAD

Unit-root test – (4)

Econometric estimates, equation (4)

Actual, Fitted and Residual Graph–(4)

-.2

-.1

.0

.1

.2

-.2

.0

.2

.4

.6

1996 1997 1998 1999 2000 2001

Residual Actual Fitted

Residual tests – Normality test

0

2

4

6

8

10

-0.10 -0.05 0.00 0.05 0.10 0.15

Series: ResidualsSample 1996:03 2002:03Observations 73

Mean 0.000744Median -0.006737Maximum 0.165607Minimum -0.113719Std. Dev. 0.053584Skewness 0.268633Kurtosis 3.149314

Jarque-Bera 0.945803Probability 0.623191

Residual tests - Correlogram

Stability Tests

-30

-20

-10

0

10

20

30

1997 1998 1999 2000 2001

CUSUM 5% Significance

-.15

-.10

-.05

.00

.05

.10

.15

.20

1997 1998 1999 2000 2001

Recursive Residuals ± 2 S.E.

Stability Tests

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1997 1998 1999 2000 2001

Recursive C(1) Estimates ± 2 S.E.

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1997 1998 1999 2000 2001

Recursive C(2) Estimates ± 2 S.E.

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1997 1998 1999 2000 2001

Recursive C(3) Estimates ± 2 S.E.

-4

0

4

8

12

16

1997 1998 1999 2000 2001

Recursive C(4) Estimates ± 2 S.E.

-.30

-.25

-.20

-.15

-.10

-.05

.00

1997 1998 1999 2000 2001

Recursive C(5) Estimates ± 2 S.E.

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.