Tax Rate Changes, Interest Rate Volatility, And The Decline In Velocity, 1981-1983

Abstract

One of the most puzzling economic events in the U.S. during this decade has been the dramatic decline in the growth rate of the income velocity of money. From the fourth quarter of 1981 to the second quarter of 1983, the velocity growth rate fell by nearly 4% as opposed to its 3% trend growth rate. Traditional models have been unable to fully capture this unusual behavior of velocity, over predicting its rate of growth. The present study is concerned with this over prediction problem and attempts to more accurately explain the decline in the velocity growth rate in the 1981-1983 period. It examines the extent to which increased interest rate volatility in the early 1980’s and the Reagan tax cuts may be contributed to the decline of the velocity growth rate from 1981 to 1983.