Department of Economics. University of Melbourne. Parkville Victoria
3052 Australia
ABSTRACT
The paper functionally describes the income velocity of money by including
the cost of a key substitute to money: exchange credit. Financial innovation
causes the cost of credit to fall, the quantity of money demanded to fall,
and the velocity to rise, all without shifting the money demand function.
The paper derives a general equilibrium money demand function, specifies
a parametric equation of the income velocity of money from the model, and
finds cointegration with consistent dynamics. It explains U.S. post-war
long run velocity through only the substitution effects from the relative
cost of exchange by money versus credit. It explains short run dynamics
with the same substitution effect. In addition, evidence suggests that
an income effects helps explain the dynamics as predicted by an application
of the permanent income hypothesis.
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