Michael D. Bordo
Rutgers University

Lars P. Jonung
Stockholm School of Economics

Pierre L. Siklos
Wilfrid Laurier University

[Preliminary: September 1992]

*Bernard Eschweiler provided able research assistance. Siklos thanks Wilfrid Laurier University for financial assistance in the form of a short-term research grant and Pierre Perron who provided a copy of his program which tests for unit roots.

Prepared for presentation at the Quantitative Economic History (October 1992) and the Cliometrics Society Conferences (January 1993).


Previous evidence, most recently by Bordo and Jonung (1990) and Siklos (1989a, 1991), has shown on a country-by-country basis that proxies for institutional change significantly improve our understanding of the long-run behaviour of velocity and, consequently, of the demand for money. The principal problems with these studies are with the proxies for institutional change. In particular, these may be too closely correlated with velocity because they are not necessarily independently measured from velocity.

However, if institutional change is a common development across industrialized countries it should have a common influence on velocity whereas the same need not be true for the other principal determinants of velocity such as income and interest rates. In statistical terms, this implies that the institutional change process should be cointegrated across countries but the conventional velocity determinants need not be.

The purpose of this study is to extend the existing evidence to study common features in velocity, income, and interest rates, across countries. The countries considered are Canada, the U.S., the U.K., Norway, and Sweden. We are relying on a sample of annual observations from 1870. The recently developed and refined techniques of testing for cointegration are used to study the common features in the series of interest.

Briefly, the evidence suggests support for the view that there exists a unique long-run relationship in velocity but not in income and interest rates and that the common feature in velocity is more apparent after rather than before World War II. However, before World War II, common features in velocity are more apparent for the U.S. and Canada, and separately, for Norway and Sweden. We argue that the evidence can only be understood in the context of common historical developments in the respective countries' financial systems.


Bordo and Jonung (1981, 1987) propose an institutional change explanation for the long-run behaviour of velocity, while Siklos (1989a, 1991) suggests that to generate a long-run statistical model of velocity a conventional model needs to be augmented with institutional change proxies. Conventional means that velocity depends upon real income and interest rates. The previous literature in this area (e.g., Rasche 1987) has tended to underemphasize the role of institutional change factors although economists now agree that it represents an important feature in understanding the behaviour of velocity or the demand for money (e.g., Poole 1988, Darby et. al. 1987, Laidler 1982, 1985, 1990). Recently developed econometric methods are now better able to address the nature of long-run relationships between time series. In particular, testing for cointegration means that the statistical evaluation of long-run relationships between time series is no longer subject to the problem of spuriousness which may have plagued earlier studies. Many authors have applied tests of cointegration to determine whether the traditional determinants of the demand for money, namely income and interest rates, are cointegrated with some measure of the money stock (Miller 1991, Hafer and Jansen 1991, and Hoffman and Rasche 1991, represent only a partial list of recent contributions in this area). Existing empirical evidence suggests that usually a broad monetary aggregate, such as M2, income and interest rates are cointegrated over a variety of samples, at least for US data. By contrast, the evidence is decidedly mixed for models which use an M1 definition of money. Hoffman and Rasche (1991) find that previous studies of M1 behaviour were misspecified and that an equilibrium relationship within a conventional money demand model can be found. Baba, Hendry and Starr (1992) conclude otherwise since their long-run model is complex incorporating yield spreads and other features of interest rate behaviour. Mehra (1992) and Miller (1991) also find that M1 is an unreliable variable for understanding short-run money demand behaviour. An important drawback with existing studies is that samples are short in duration. Since an equilibrium relationship may take a considerable amount of time to reveal itself it is important, whenever possible, to consider using data over a long period of time as opposed to simply increasing the sampling frequency of the data. In this connection it is worth noting that Hafer and Jansen (1991) also prefer M2 over M1 for US annual data since 1985 in the sense of a finding of cointegration in a conventional money demand relation. Because the definition incorporates over time the influence of financial innovations (Hester 1981), perhaps this explains a potential source of money demand instability in M1 based models (see also Baba, Hendry, and Starr 1992). In a related development Ramey (1991) has formulated a real business cycle model in which the financial sector plays an important role and she presents empirical evidence to support the view that "technological innovations", which could be interpreted as a proxy for institutional change, are significant in US data.

Cointegration implies that a set of time series act as "attractors" to each other (Granger 1990), that is, the series form an equilibrium relationship in the statistical sense. This does not preclude the possibility that any such relationship can be disturbed, even if only temporarily, over time. On this basis Gregory and Nason (1991) develop tests of structural stability in cointegrating relationships stemming from the work of Hansen (1991). Gregory and Nason find that, for the same annual US data which Lucas (1988) used to demonstrate the empirical stability of long-run money demand, it is comparatively difficult to conclude that there are structural breaks in a US demand for money function of the traditional variety.

Since the long-run in economics need not be the same for all problems an important issue is the selection of the sampling frequency of the data (Hendry 1986, Perron 1989). Since the effects of technological or institutional changes in the financial sector may occur slowly or have long-lasting effects, it would seem preferable in empirical work to rely on as long a sample as possible.

Previous evidence, most recently by Bordo and Jonung (1990) and Siklos (1989a, 1991), has shown on a country-by-country basis that proxies for institutional change significantly improve our understanding of the long-run behaviour of velocity. Given the previous finding that institutional change is common to each country it would seem natural to ask whether there are common features in financial changes across countries. Bordo and Jonung (1987, ch. 4, p. 48) pool their data to show that the influence of institutional change variables on velocity is similar in all the countries examined, suggesting that common forces underlying the institutionalist proxies explain the common behaviour of velocity. To investigate such a possibility we perform a variety of tests to determine if velocity and each of its individual determinants are, separately, cointegrated across countries. We also examine the short-run dynamics of any such relationships as well as the stability of any cointegrating relationship.

In performing these tests our objectives are three-fold. First, to explore whether the common features of financial systems across countries are as significant as Friedman and Schwartz (1982, ch. 7) found was true of the US and the UK based on sophisticated measures of correlation. However, we expand the selection of countries to include Canada and Sweden,1 in addition to using data from the US and the UK. Second, an analysis of the commonality of institutional change across countries could shed some light on the speed with which technological changes are transmitted across countries, that is, whether countries at similar stages of development in effect import payment technologies from other countries. A third objective of the paper is to ascertain whether certain historical features, which would presumably have had an impact on financial development, can be detected in the data. It is here that structural stability tests will have useful implications. In a sense, then, we attempt to combine the narrative and statistical approaches to the issues of interest in this paper.

Briefly, the results suggest support for the view that there exists a single cross-country long-run relationship in velocity but not in income and interest rates. Moreover, common features in velocity across countries are more apparent after World War II rather than before the war. In general, we argue that the statistical evidence can only be understood in the context of common historical developments in the respective countries' financial systems.

After a brief review of the institutional hypothesis of the long-run behaviour of velocity (section 2), and a description of econometric issues (section 3), empirical evidence confirming the above conclusions are presented (section 4). The paper concludes with a summary in section 5.