Asset Prices and Velocity Decline: An Empirical Investigation

Abstract

The quantity theory of money lost much of its significance in 1980s due to the phenomenon of velocity decline and consequent instability of the money demand function; missing financial transactions and asset prices were believed to be responsible (Borio, Kennedy and Prowse, 1994; and Werner, 2012). This study, therefore, uses asset prices for Pakistan to explain the velocity decline phenomenon in a regression model as well as in Vector Error Correction Model (VECM) using quarterly data for the time period 1981Q1-2018Q2. The study finds significant role of asset price index in explaining income velocity of money with a negative effect. Moreover, the sub-sample regressions show that asset prices are helpful in explaining velocity decline phenomenon for the time period 1981-1998 and 2008-2018 but not for 1998-2008. Moreover, there are brief periods in the sample when velocity actually increased despite an overall declining trend. To explain those short term reversals in velocity trend, the study uses indicator function. Results show that the increase in velocity for brief periods is also explained by asset prices