Working Paper 579

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Shrinking Money and Monetary Business Cycles

Harold L. Cole - Consultant
Lee E. Ohanian - Consultant

Published March 1, 1997

In the postwar period velocity has risen so sharply in the U.S. that the ratio of money to nominal output has fallen by a factor of three. We analyze the implications of shrinking money for the real effects of a monetary shock in two classes of equilibrium monetary business cycle models: limited participation (liquidity) models and predetermined (sticky) price models. We show that the liquidity model predicts that a rise in velocity leads to a substantial reduction in the real effects of a monetary shock. In sharp contrast, we show that the real effects of a monetary shock in the sticky price model are largely invariant to changes in velocity. We provide evidence that suggests that the real effects of monetary shocks have fallen over the postwar period.

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