Robert C. Vogel, Robert P. Trost, The Response of State Government Receipts to Economic Fluctuations and the Allocation of Counter-Cyclical Revenue Sharing Grants, The Review of Economics and Statistics, Vol. 61, No. 3 (Aug., 1979), pp. 389-400

CONTROVERSIES involving inflation, particularly inflation in developing countries, have usually focused on Latin America.1 One major point which emerges from these controversies is the distinction between a fully anticipated, fully adjusted inflation and an inflation which proceeds with such irregularity that economic agents are able neither to anticipate nor to adjust completely. To the extent that individuals can anticipate and adjust to inflation, a higher rate of inflation will cause the income velocity of money to rise, as attempts are made to exchange money for hedges against inflation.' The influence of inflation on monetary velocity is less clear, however, under the conditions of imperfect anticipation and adjustment which prevail in Latin America. Not only are the rates of inflation in most Latin American countries high, but they also tend to be highly variable. In addition, most Latin American countries have less than perfect markets for hedging against inflation, and these are further restricted by the regulations often imposed on interest rates, prices and international trade in the wake of inflationary conditions.' The present paper examines the impact of inflation on the income velocity of money for sixteen Latin American countries over the period 1950-1969. Such an examination not only indicates the sensitivity of demand for real cash balances to changes in the price level, but also reflects the extent to which economic agents under conditions prevailing in Latin America can anticipate inflation and adjust by hedging. Aside from Cagan's well-known work on hyperinflation (Friedman, 1956, pp. 25117), most empirical studies of the demand for money in individual countries conclude that inflation does not have a significant impact on velocity.4 These studies generally argue that the small changes in the price level usually observed cannot be adequately anticipated or are not large enough to cover the costs of adjustment. A recent article by Melitz and Correa (1970) on international differences in income velocity, like most studies of individual countries (but contrary to theoretical expectations), also concludes that inflation does not influence velocity. This article, like the present study, uses international comparisons, but the findings differ substantially. Melitz and Correa find that the coefficient for the impact of inflation on velocity does not have the expected sign and therefore omit the inflation variable from further consideration. They argue that price changes are important only in cases of hyperinflation and that adjusting to mild inflation is too costly and difficult to be worthwhile. Having excluded inflation as an explanatory variable, Melitz and Received for publication May 24, 1972. Revision accepted for publication January 30, 1973. * The authors wish to thank Michael C. Lovell for many helpful comments and suggestions, Francisco Chaves for assistance with data collection and computational work, and the Wesleyan Computer Center for generous use of its facilities. ' Best known is the monetarist-structuralist controversy over the causes of inflation and the impact of inflation on economic development. See, for example, Baer and Kerstenetzky (1964), Johnson (1967, pp. 281-291) and Baer (1967). 2-Johnson (1967, pp. 104-142) identifies the tax on real cash balances as the essence of the quantity theory approach to inflation, and it is the efforts to escape this tax which cause monetary velocity to rise with inflation. 'In discussions of inflation and economic growth, more costs and benefits of inflation are attributed to structural imperfections rather than to the tax on real cash balances. Structuralists emphasize the benefits of inflation in circumventing market imperfections, while monetarists focus on the costs of inflation in conjunction with inappropriate government regulations. See Johnson (1967, pp. 281-291) and Baer (1967). 4 However, some studies in a collection edited by Meiselman (1970) provide limited support for a positive influence of inflation on velocity in several less-developed countries. Deaver (Meiselman, 1970, pp. 7-67), finds the rate of inflation to be a significant variable in explaining velocity changes in Chile during the period 1932-1955, while Campbell (Meiselman, 1970, pp. 339-386) finds a positive correlation between velocity and changes in the rate of inflation in a comparative study of South Korea and Brazil. In a cross-country study Perlman (Meiselman, 1970, pp. 297337) finds nominal interest rates or inflation rates (as proxies for the opportunity cost of holding money) to be significant in explaining international differences in liquid asset portfolios.

HE most important motivation for T current study investigating lagged relationships in corporate demand for liquid assets is current controversy over lags in monetary policy. The literature is so wellknown that it need not be recapitulated here. The evidence that has been presented is of two kinds: analysis based on turning points in different series, i.e., that by Friedman; and an analysis based on estimation of distributed lag relationships, i.e., by Karaken and Solow. The latter authors estimate distributed lag relationships in different sectors and simply add these up. However, as Tucker [12] has pointed out, in a general equilibrium context summing lags in various sectors to measure lag in monetary policy is not a valid procedure. This implies that estimation of distributed lags should be done in a simultaneous equations context. But we feel that there are still several unresolved problems connected with estimation of single equations. The present study, therefore, concentrates on estimating distributed lags in a single equation context, with a specific view of analyzing merits and demerits of various alternative estimation techniques proposed till now for estimation of distributed lag models. We recognize that controversy over lags in monetary policy must be resolved in a general equilibrium context, with additional evidence on interactions among all variables, and especially on lags in each component function. For manufacturing corporations there is little evidence on lags in liquid asset demand, since most studies do not focus explicitly on this problem. Only Heston [7] and Anderson [2] enter lagged dependent variables in their regressions to examine adjustment. However, neither study discusses various problems of statistical estimation and interpretation. Anderson finds that approximately one-third of adjustment to equilibrium occurs in one quarter for cash while figure is about onefourth for government securities.' On other hand, Heston discovers that cash adjusts less than two-thirds of way to equilibrium in one year, and government securities less than one-half.2 The number of aggregate time-series studies of money demand dealing explicitly with lags is also not large, nor are statistical procedures particularly sophisticated. In one of earliest studies using a lagged model, Bronfenbrenner and Mayer [3] find that implied speed of adjustment toward equilibrium is onefourth to one-half per year. Treating money supply as an endogenous variable and using technique of two-stage least squares, Teigen [11] observes that during postwar period, one-third of adjustment to equilibrium occurs in a quarter, while for interwar period about one-half of adjustment takes place in a year.3 A study of money demand by Chow [4] also considers question of lagged adjustment at length, both by contrasting permanent income and wealth with current income and by including lagged dependent variables.4 Chow finds that speed of adjustment is less than one-half in first year. In a Federal Reserve study, De Leeuw [5] employs alternative estimation techniques in an attempt to deal with problems of serial correlation and lagged adjustment. He concludes his analysis saying the long lag hypothesis emerges from tests against post-war data