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posted on 18 July 2015

Money And Velocity During Financial Crisis: From The Great Depression To The Great Recession

by Dallas Fed

-- this post authored by Richard G. Anderson, Michael Bordo, and John V. Duca

The Great Depression and the Great Recession are acknowledged as the defining American financial crises of the past century. It has been well-understood, at least since Bagehot, that extraordinary monetary policies are necessary as a crisis develops and later must be unwound as the crisis wanes. Best-practice monetary policy is to initially accommodate the large shifts in liquidity demand engendered by financial crises, due to flights-to-quality and elevated risk prema.

Sharp increases in risk premia (tracked, for example, by the spread between yields on Baa corporate bonds and 10-year Treasury bonds, Figure 1) and decreases in M2's velocity (Figure 2) were signatures of the onset of the Great Depression and the Great Recession.

As the Great Depression abated, for example, risk premia decreased and velocity returned to more typical levels (Figure 1). Today, the Federal Reserve faces the challenge of returning monetary policy to a more normal stance following the Great Recession; a first step was taken this month (October 2014) by ending the Large Scale Asset Purchase program. Yet, uncertainty remains regarding the correct path for policy. As the macroeconomic effects of the most-recent crisis fade, for example, the Federal Reserve must unwind the aggregate demand stimulus of pushing the federal funds rate to zero and of asset purchases that have quadrupled its balance sheet. At the same time, policymakers must seek to prevent the money multiplier from increasing rapidly when risk premia and velocity revert to more traditional levels: the historical record shows that money demand will retreat in response to falling risk premia and increasing opportunity costs vis-à-vis bond yields. Resulting increases in velocity - not just broad money growth - along with understanding possible effects of financial reform will complicate interpreting movements in money, and hence challenge a successful exit. Our study suggests that the behavior of money demand before, during, and after the two largest financial crises of the past century - the Great Depression and the Great Recession - provides some guidance.

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