THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth

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Money & Banking MGT411

Lesson 38

THE FACTS ABOUT VELOCITY

Fisher's logic led Milton Friedman to conclude that central banks should simply set money

growth at a constant rate.

Policymakers should strive to ensure that the monetary aggregates grow at a rate equal to the

rate of real growth plus the desired level of inflation.

Knowing that the multiplier is a variable, Friedman suggested changes in regulations that would

Limit banks' discretion in creating money

Tighten the relationship between the monetary aggregates and the monetary base.

However, even with Friedman's recommendations, the central bank would stabilize inflation by

keeping money growth constant only if velocity were constant.

In the long run, the velocity of money is stable, though there can be significant short-run

variations.

From the point of view of policymakers, these fluctuations in velocity are enormous.

Assuming that central bank can accurately control the growth rate of M2 as well as accurately

forecast real growth.

Money Growth + Velocity Growth = Inflation + Real Growth

With an inflation objective of 2% and a real growth forecast of 3.5%, equation of exchange tells

us that policy makers should set money growth 5.5% minus the growth rate of velocity.

If velocity increases by 3% then money growth needs to be 2.5%

If it falls by 3% then money growth needs to be 8.5%

When inflation is low, short run velocity growth can be several times the policy makers'

inflation objectives.

So to use money growth targets to stabilize inflation, policy makers must understand how

velocity changes

Fluctuations in velocity are tied to changes in people's desire to hold money and so in order to

understand and predict changes in velocity; policymakers must understand the demand for

money.

Figure: Velocity of M1 and M2 (on the same vertical scale)

___M1 Velocity ____M2 Velocity

1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003

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Money & Banking MGT411

Figure: Velocity of M2 (on its own scale)

2.2

2.1

2.0

1.9

1.8

1.7

1.6

1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003

Years

Figure: Percentage change in the short-run velocity of M2, 1960-2004

-2

-4

-6

-8

1975

1980

1985

1990

1995

2000

Years

The Transactions Demand for Money

The quantity of money people hold for transactions purposes depends on

Their nominal income,

The cost of holding money,

The availability of substitutes

Nominal money demand rises with nominal income, as more income means more spending,

which requires more money

Holding money allows people to make payments, but has cost of interest foregone.

There may also be costs in switching between interest-bearing assets and money.

Example

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Money & Banking MGT411

If your monthly earning is Rs.30, 000 (deposited in bank each month) and assuming you spend

Rs.1, 000 each day, after 15 days your checking account balance will decline to Rs.15, 000 and

to zero on 30th day

Your bank offers you a choice of leaving the entire 30,000 in the account or shifting funds back

and forth between checking and a bond fund.

The bond fund pays interest but adds a service charge of Rs.20 for each withdrawal.

How would you manage your funds and what should be your frequency of shifting the funds

between the bond fund and checking account?

Consider the following alternatives.

Two alternatives for managing your cash balance

Strategy 1: Leave entire balance in checking account

Checking account balance

Bond fund

30,000

balance is zero

throughout the

month.

Day of the month

Strategy 2: Transfer half to bond fund, then transfer back at mid-month

Bond Fund Balance

Checking account

balance

15,000

Day of the Month

Day of the month

Your choice depends upon the interest rate you receive on the bond fund

If interest income is at least as much as the service charge then you will split your pay check at

the beginning of the month.

Otherwise you will not want to invest in bond fund.

If you shift half your funds once , at the middle of the month, you'll have Rs.15,000 in bond

fund during the first half of the month and Rs.0 during the second half, so your average balance

will be Rs.7,500.

Making shift will cost you Rs.20 so if the interest on Rs.7, 500 is greater than 20, you should

make the shift.

At monthly interest rate of 0.27%, Rs.7, 500 will produce an income of Rs.20

(20 / 7500= 0.0027)

So if bond fund offers a higher rate you should make the shift.

As the nominal interest rate rises, people reduce their checking account balances, which allow

us to predict that velocity will change with the interest rate.

Higher the nominal interest rate, the less money individuals will hold for a given level of

transactions, and higher the velocity of money

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Money & Banking MGT411

The transactions demand for money is also affected by technology, as financial innovation

allows people to limit the amount of money they hold.

The lower the cost of shifting money between accounts, the lower the money holdings and the

higher the velocity.

Suppose your bank offers free automatic transfer account. You sign up for it but continue using

your old check and debit account

Your take home pay is the same Rs.30, 000. Each time you make a purchase, your bank

automatically shifts the amount of purchase from your bond fund to your checking account

where it remains for one day before being paid to your creditor.

Spending your Rs.30,000 in 30 days, your average money holding will be Rs.1000 far below

Rs.1,500 you would hold if you simply left the 30,000 in your checking account and spent it at a

rate of Rs.1,000 per day

So lower the cost of shifting funds from your bond fund to your checking account, the lower

your money holdings at a given level of income and the higher the velocity of your money

An increase in the liquidity of stocks, bonds, or any other asset reduces the transactions demand

for money.

People also hold money to ensure against unexpected expenses; this is called the precautionary

demand for money and can be included with the transactions demand.

The higher the level of uncertainty about the future, the higher the demand for money and the

lower the velocity of money

The Portfolio Demand for Money

Money is just one of many financial instruments that we can hold in our investment portfolios.

Expectations that interest rates will change in the future are related to the expected return on a

bond and also affect the demand for money.

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