Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks

The explanation of velocity has been based in substitution and income effects, since Keynes’s (1923) interest rate explanation and Friedman’s (1956) application of the permanent income hypothesis to money demand. Modern real business cycle theory relies on a goods productivity shocks to mimic the data’s procyclic velocity feature, as in Friedman’s explanation, while finding money shocks unimportant and not integrating financial innovation explanations. This paper sets the model within endogenous growth and adds credit shocks. It models velocity more closely, with significant roles for money shocks and credit shocks, along with the goods productivity shocks. Endogenous growth is key to the construction of the money and credit shocks since they have similar effects on velocity, through substitution effects from changes in the nominal interest rate and in the cost of financial intermediation, but opposite effects upon growth, through permanent income effects that are absent with exogenous growth.