Milton Friedman and Anna Schwartz argued in the last chapter of their Monetary History of the United States that a shift in money growth will usually cause velocity to shift in the same direction: So higher money growth causes optimism, and slower growth causes pessimism. They believed that velocity had its own shocks, as well.
a. Let€™s run through some examples of how this might work, in a setting where the Fed wants to keep AD growth stable at 10%. To keep things simple, we€™ll just assume that the Fed can control money growth perfectly, and we€™ll assume that a 1% change in money growth causes a 0.5% shock to velocity growth in the same direction. Fill in the table.
In each case, AD = Initial velocity shock + Money growth + Velocity shock caused by money growth.

b. If velocity does tend to move in the direction of money growth, how does this change the Fed€™s response to economic shocks: Should it take bigger moves or smaller moves in money growth when a shock comes along?

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Velocity Shock Caused by Initial Velocity Money Shock 4% 3% 16% 8% 4% 0% Year Growth Money Growth 4% 496 0.5 2%