THE VELOCITY OF MONEY

M*V = P*Q

Velocity refers to the number of times that a dollar is spent in a period of time, usually one year.

EQUATION OF EXCHANGE

M * V = P * Q

M = MONEY SUPPLYV = VELOCITY OF MONEYP = PRICE LEVELQ = REAL GDP

M*V=P*Q

M= Money Supply – The stock of money, usually M1: Currency in circulation, traveler’s checks and checkable deposits

M*V=P*Q

V=Velocity of money - the speed at which money circulates through the economy.

It is also understood as the average number of times a dollar is spent on final goods and services per year.

M*V=P*Q

P= Price level – The average price level of the final goods and services in GDP

M*V=P*Q

Q = Real GDP – Real output equals the quantity of goods and services in GDP

Note that the velocity of moneydepends on the definition of money.

Source: Joseph Stiglitz, Economics, W.W. Norton & Co., 1993.

M1 is the money supply of currency in circulation (notes and coins, traveler’s checks [non-bank issuers], demand deposits, and checkable deposits).

M1 VELOCITY

M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals

M2 VELOCITY

MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand: notes and coins in circulation, traveler’s checks (non-bank issuers), demand deposits, other checkable deposits, savings deposits, and all money market funds

MZM VELOCITY

IF THE MONEY SUPPLY INCREASES

V MUST FALL . Q MUST INCREASE .

P MUST INCREASE .

SOME COMBINATIONChanges in the Money Supply Impacts Other

Economic Variables

The Monetarists’ View of Monetary Policy is as follows:

1. Changes in the money supply cause direct changes in AD and thereby changes in nominal GDP.

2. The key formula is MV = PQ

3. Velocity should be kept relatively stable.

4. Real GDP (Q) can increase 3 – 5% per year.

5. If Q increases 3 – 5% per year, any increase in M above 5% merely increases the price level.

6. Increases of less than 3% in M mean Q cannot increase by 3% or that the price level falls.

7. Therefore, strict monetarists would use the monetary rule to advocate that the money supply grow at the rate of growth in real GDP in order to maintain economic stability.

M

M

V

V

P

P

Q

Q

M

M

V

V

Q

Q

P

P

M

M

V

V

Q

Q

fe

fe

Example,

, ,

What is the rate of inflation ?

What is the economic explanation for these numbers?

4% 1% 0%

4% 1% 0% 5%

RELATIONSHIP AMONG THE GROWTH RATES OF MONEY, VELOCITY, PRICES,

AND REAL OUTPUT

                                      

Class Exercise

Year M V P Q $ GDP1980 $396 ---- .72 3761 $27081981 423 7.17 .79 3839 30331982 456 6.91 .84 3750 31501983 498 6.84 .87 3915 34061984 537 7.03 .91 4148 37751985 586 6.89 .94 4296 40381986 672 6.35 .97 4399 42671987 737 6.16 1.00 4540 45401988 769 6.37 ---- 4710 48981989 791 6.64 1.09 4819 52521990 811 6.81 1.13 ---- 5522

Fill in the blanks

Class Exercise

Year M V P Q $ GDP1980 $396 ---- .72 3761 $27081981 423 7.17 .79 3839 30331982 456 6.91 .84 3750 31501983 498 6.84 .87 3915 34061984 537 7.03 .91 4148 37751985 586 6.89 .94 4296 40381986 672 6.35 .97 4399 42671987 737 6.16 1.00 4540 45401988 769 6.37 ---- 4710 48981989 791 6.64 1.09 4819 52521990 811 6.81 1.13 ---- 5522

6.84

1.04

4886