Velocity of Money and Productivity Growth: Explaining the 2% Inflation Target in the U.S. (1959–2007)

Christophe Faugere ()
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Christophe Faugere: Department of Economics and Finance, Kedge Business School, 680 Cours de la Libération, 33405 Talence, France

IJFS, 2024, vol. 12, issue 1, 1-34

Abstract: This article provides a macro-foundation for why the specific value of 2% is a valid inflation target. The approach postulates that innovations generate transactional cost savings by comparison to barter. The optimal velocity of money is derived as a function of productivity growth and of long-term and short-term interest rates, with coefficients reflecting the leverage ratio of depository institutions and the degree of bias in technical progress in the transaction technology. The model is tested for the U.S. (for aggregates M1, M1RS, and M1S) over the period 1959–2007. Setting the inflation target rate equal to the growth rate of velocity leads to an inflation rate near 2% and is akin to pursuing the Friedman k-% rule. This rule provides flexibility to prevent deflation. A long-term Taylor-type rule is derived. A robustness test is also conducted by extending the sample period up to 2023, covering sustained episodes of unconventional U.S. monetary policy.

Keywords: inflation target; velocity of narrow money; M1; M1RS; M1S; real GDP per capita growth; barter; financial leverage (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2024
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