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Velocity of Money and Optimal Monetary Policy for the Korean and US Economies

Economic Research Institute (82-2-759-5415) 2006.02.09 4805

Velocity of Money and Optimal Monetary Policy for the Korean and US Economies

Author : Hwagyun Kim(Professor, SUNY at Buffalo)
          Chetan Subramanian(Professor, SUNY at Buffalo)

  There have been large changes in the velocity of money around the world over the post war period and they could be a potential source of output and inflation variability affecting stabilization policy. In this paper, we extend a Calvo style sticky price model to examine the role of the velocity of money in inflation and output gap dynamics and thereby optimal monetary policy, both from a theoretical and empirical perspective.
   Money in our model is introduced though a transaction cost technology with an exogenous shock process. The shock captures stochastic change in the transaction technology and could be interpreted as velocity shock. The technology acts like a stochastic distortionary consumption tax which fluctuates endogenously with velocity of money. This approach could generate a long run money demand relationship consistent with data, while it also emphasizes distortion effect of money holding.
   The resultant Phillips curve becomes a function of velocity as well as an output gap and a forward looking inflation terms, a feature for which we provide empirical support. More specifically, we adopt the GMM methodology to estimate the velocity augmented Phillips curve using the Korean data between 1970 and 2004, and US data between 1951 and 2005. We observe that historical inflation dynamics in both countries are consistent with the velocity-augmented forward looking Phillips curve.
   In addition, we find that the problem of the optimizing policymaker is non-trivially modified in the presence of velocity shocks. The loss function now includes a velocity shock component as well as the standard output gap and inflation terms. This then implies that it is optimal for the policymaker to allow for some variability in inflation and the output gap as long as there are shocks to velocity of money. Numerical exercises report that the extent of the variability under optimal policy is critically dependent upon the parameters of the money demand function in both countries.