In a blog post about three years ago I explained that in the real world there is money supply and there is money demand; there is no such thing as money velocity. “Money velocity” only exists in academia and is not a useful economics concept. In this post I’ll try to make the additional point that in addition to being useless, it can be dangerous.
Before getting to why the money velocity concept can be dangerous, it’s worth quickly reviewing why it is useless. In this vein, here are the main points from the blog post linked above:
1) The price (purchasing power) of money is determined in the same way as the price of anything else: by the interplay of supply and demand. The difference is that money is on one side of almost every transaction, so at any given time there will be millions of different prices for money. This is why it makes no sense to come up with a single number (e.g. the CPI) to represent the purchasing power of money.
2) Money velocity, or “V”, comes from the Equation of Exchange. This equation is often expressed as M*V = P*Q, or, in more simple terms, as M*V = nominal GDP, where “M” is the money supply. In essence, “V” is a fudge factor that is whatever it needs to be to make one side of the ultra-simplistic and largely meaningless Equation of Exchange equal to the other side.
3) The Equation of Exchange can be written: V = GDP/M. Consequently, whenever you see a chart of “money velocity” what you are really seeing is a chart showing nominal GDP divided by some measure of money supply. During a long period of relatively fast monetary inflation the line on such a chart naturally will have a downward slope.
4) Over the past two decades the pace of US money-supply growth has been relatively fast. Hence the downward trend in the GDP/M ratio (a.k.a. money velocity) over this period. Refer to the following chart for details.
5) During the 2-decade period of declining “V” there were multiple economic booms and busts, not one of which was predicted by or reliably indicated by “V”.
That’s why “money velocity” is useless in describing/analysing how the world works. Unfortunately, there are many influential economists who believe that the simplistic Equation of Exchange can be put to good use when figuring out what’s happening in the world of human action and what should be done about it. These economists, some of whom are in senior positions at central banks, view “money velocity” not only as a valid real-world concept, but also as an important causal factor in the economy.
If you believe that changes in “V” cause changes in economic growth, with a higher “V” bringing about faster growth, then during periods of economic weakness you will be in favour of policies that are specifically designed to boost “V”. In particular, you will be in favour of policies that result in or promote faster spending for the sake of spending.
Of course, if the supply of money is constant then the calculated value of “V” will be high during periods of strong growth and low during periods of weak or no growth. However, the cause is the growth and the change in “V” is a calculated effect of the growth.
Thinking that growth can be boosted via policies designed to increase “V” is similar to the mistake made by Herbert Hoover during the first few years of the Great Depression. He knew that prices tended to rise during economic booms and fall during economic depressions, so he concluded that a depression could be avoided if prices were prevented from falling. That is, he confused cause and effect. This led to efforts to prop-up prices, especially the price of labour. Not surprisingly, these efforts were counter-productive.
Summing up, the belief that “money velocity” is a useful real-world concept is not only wrong, but also dangerous if it is held by people with the power to influence central-bank or government policy.
About Steven Saville
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