bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

a deterministic trend) and define P-Star as money per unit of real potential
output. In other words, the Quantity Theory equation becomes:
P* = (M/y*)V*
with y* and V* representing long-run equilibrium levels of output and
velocity. The models are then used to indicate the existence of inflationary
pressures in the economy by comparing current levels of income and velocity
with their long-run equilibrium levels. If current income is above longrun
equilibrium income, (y > y*), then, ceteris paribus, current income must
fall in the long-run, with the existing monetary pressures in the economy
being transferred to the price level. Equally, if current velocity is below its
long-run level, it must rise in the long-run generating increased expansionary
pressure that must fall on y or P. Plainly, if y = Y*, all additional monetary
pressure will fall upon P. Thus, short-run movements in the price
level are modelled as the product of an output gap, (Y - Y*), and a velocity
gap, (V − V*). However, the P-Star approach suffers from the same problems
as other cointegrating studies in that, to obtain definite answers, one
must impose on the models assumptions drawn from economic theory,
notably here the assumption of a long-run equilibrium velocity of money.
We are also left to explain the short-term deviations of V from V*.
In general, while cointegration studies have been judged useful, they
have not yet been able to establish a stable demand for money function with
a specific form and invariant coefficients for out-of-sample data. We need,
therefore, to consider the principal explanations of the continuing problems
with the function.
Shocks to the demand for money function
TESTING THE DEMAND FOR MONEY 151
...6.7
Economists have proposed a number of possible causes of sudden shifts in the
demand for money function in the 1970s and 1980s. These have included:
(i) financial innovations associated with institutional change in the
financial sector;
(ii) uncertainty about the rate of inflation as a result of the large swings
in inflation rates in the 1970s and 1980s;
(iii) currency substitution, especially following the movement away
from fixed exchange rates in the early 1970s.
Although we shall say a little about the second and third of these, we
concentrate here on the impact of financial innovations since this has produced
by far the greatest amount of lucubration.