Working paper No. 83
By Norbert Janssen
Until recently, narrow money velocity in the United Kingdom had followed an upward trend. Traditionally, this has been explained by the introduction of cash-saving innovations in the payments system. But velocity growth slowed in the early 1990s and has been negative in the past four years. The recent behaviour of M0 cannot be explained by an equation that merely proxies financial innovation with a cumulative interest rate term (Breedon and Fisher, 1996), perhaps because innovation has slowed down in the 1990s.
This paper analyses the demand for narrow money in a portfolio framework. It explains the decline in M0 velocity by the shift of the UK economy to a low inflation and interest rate environment. These effects are proxied by the inclusion of inflation and inflation variability as explanatory variables and by a logarithmic specification of interest rates, which captures the rise in interest semi-elasticity as inflation and interest rates fall. This model appears stable and explains the M0 velocity trend break relatively well.