Financial Sector Weakness and the M2 Velocity Puzzle

Deterioration in the link between M2 and GDP, along with large prediction errors, led the Federal Reserve to downgrade M2 as a reliable indicator in 1993. We argue that the financial condition of depository institutions was a major factor behind this unusual pattern of M2 growth. When constructing measures of M2 based on banks' and thrifts' capital positions, we obtain superior M2 forecasting results and a more stable relationship between M2 and the ultimate goals of policy. M2 may contain useful information when there are no major disturbances to depository institutions