Question: 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?