Question

Changes to both the money supply and the velocity of money include changes in aggregate demand. However, the long-run impacts of changes in these variables are different. How are the effects of an increase in the velocity of money and the effects of an increase in the money supply different?

Answer 1

Velocity of money refers to the number of times currency changes hands in the economy. This is facilitated by easier payment/transaction infrastructure in the economy and demand for goods. Both change in money supply and velocity of money include changes in the aggregate demand.

The Fisher equation for money demand is instrumental in understanding this. The Fisher Equations states:

where M is moeny supply, V is velocity of money, P is price level and Y is the output.

From here we can see that an increase in M (money supply) and V (velocity) will lead to an increase in the right hand side i.e. PY. This increase however, varies with time period.

In short term, increase in M or V will lead to an increase in Y or we can say the aggregate demand increases. This is because with greater money supply, people have more money to create demand for goods in the short run. Greater velocity of money also means that money is changing hands fast, which occurs only when transactions are taking place vigorously. This denotes an increase in Aggragate Demand.

However, in the long term, the higher velocity is a sign that the same amount of money is being used for a number of transactions. A high velocity indicates a high degree of inflation which surfaces in the long run. Similarly, in the long run, the increased money supply will reveal that money increased for everyone and so did demand. This will bid up the prices of the goods and there will be inflation.

Both money supply and velocity act differently in the market. Money supply is the increase in money stock in the economy which gives a false essence of greater wealth to the money holder. This is called money illusion. And this is what is responsible for creating more demand and raising prices thereafter. Money velocity however, is not by an increase in money supply, rather increase in frequency of transactions in the economy with the same money.

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