Question

Describe the relevance of velocity’s stability on monetary policy

Answer 1

The weak link in monetary policy is the connection between money as stock and money in circulation, the so-called velocity of money. The velocity of the circulation of money refers to the frequency of the monetary transactions in an economy. One unit of money serves for several transactions over time.

Because “money” is not a definite term, the dimension of the stock of money depends on the definition of the aggregate. To determine the velocity of money, the monetary authorities use various aggregates such as the monetary base or the monetary stock M1 (cash and deposits) or the wider aggregates M2 or M3 as references.

In the first case, the definition answers the question by what factor the amount of base money transforms into the nominal gross domestic product. When M1 is used, the question is by which factor circulating cash and deposits multiply into nominal national income.

Whatever the aggregate used, the velocity of money can strengthen or weaken the effects of a change of the amount of money. The countermovement of the velocity can change an increase of the stock of money into a contraction or turn a monetary contraction of the stock into an expansion. Inflationary expectations lead to a higher ratio of the velocity of money while deflationary and dis-inflationary expectations lead to a lower ratio of the velocity.

The frequency of the monetary transactions depends on the decisions of the individual users of money in the economy. When people decide to use money more rapidly, the velocity rises, and this would accelerate the effect of the expansion of the monetary stock. When, in contrast, the public uses available money more slowly, the velocity falls. Such actions would offset the effect of the expansion of the stock of money, or, in the case of a reduction of the stock of money, accelerate the contraction.

The velocity of the circulation of money is subject to strong swings. Because the ratio is not stable, the effects of changes in the money supply are not certain. There are no tools to control velocity. The monetary authorities are not able to foresee how the velocity of money will change. The trends may be long or short, and when they are long and seem to be stable, they may change abruptly. A reliable calculation of the future trend is not possible even if many data points are available. Although the weakest link in the chain, the velocity of the circulation is not the only weak link in the chain of the monetary transmission mechanism. The problems of monetary policy begin with finding an adequate definition of money.

Doubts continue with the effects of the central bank balances on the balances of the commercial banks. Theoretically, the link between the money stock of M1 multiplied by its velocity and the nominal gross domestic product is a definitional identity. Yet the real issue remains opaque because no-one knows exactly how much the monetary impulses will stimulate the real economy or affect mainly nominal values through the price level.

The promise of the central bankers to act as the caretaker of the nation’s money is a great illusion. Even more preposterous is the claim of the central bankers that they could keep the economy on the path of a low-inflation economic growth path.

Rather, the opposite is true. Central banks have become the source of ubiquitous moral hazard in the financial system. This way, central banking itself creates the instability it promises to prevent and to cure. There is the tragic twist to this situation that when the crises occur, the public is made to believe that the culprit is the free market economy when in fact it is government and central bank interventionism that produced the mess.