WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity

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Money & Banking MGT411

Lesson 37

WHY DO WE CARE ABOUT MONETARY AGGREGATES?

Every country with high inflation has high money growth; thus to avoid sustained episodes of

high inflation, a central bank must be concerned with money growth.

It is impossible to have high, sustained inflation without monetary accommodation.

Monetary Aggregates

Figure: Inflation and Money Growth:

Moderate-Inflation Countries, 1981-2003

45° Line

··

Average Annual Money Growth (%)

Figure: Money, Growth and Inflation

45° Line

Inflation>Money Growth

Money Growth <Inflation

Average Annual Money Growth

When the currency that people are holding loses value much rapidly, they will work to spend

what they have as quickly as possible

This will have the same effect on inflation as an increase in money growth

It is impossible to have high, sustained inflation without monetary accommodation.

Something beyond just differences in money growth accounts for the differences in inflation

across countries.

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Money & Banking MGT411

Velocity and the Equation of Exchange

To understand the relationship between inflation and money growth we need to focus on money

as a means of payment.

Consider an example of four students

Ali has Rs. 100 in cash

Bilal has a Rs. 100 calculator

Chohan has 2 tickets worth Rs. 50 each for a cricket match

Dilawer has a set of 25 drawing pencils worth Rs. 4 each

Ali needs a calculator which he buys from Bilal.

Bilal wishes to see the match so he buys the tickets from Chohan

Chohan uses the proceeds to purchase the drawing pencils from Dilawer

Total Value of the transactions is

(Rs. 100 x 1 calculator) + (Rs. 50 x 2 tickets) + (Rs. 4 x 25 pencils) = Rs. 300

Generally

No. of Rupees x No. of time each Re is used = Rs. Value of Transactions

The number of times each rupee is used (per unit of time) in making payments is called the

velocity of money; the more frequently each rupee is used, the higher the velocity of money

Applying to economy wide transactions:

Quantity of Money x Velocity of Money = Nominal GDP

Using data on the quantity of money and nominal GDP we can compute the velocity of money;

each monetary aggregate has its own velocity

If we represent

Money with M

Velocity with V

Price level with P

Real GDP with Y

Nominal GDP = P x Y

Substituting, we get

MxV=PxY

The equation of exchange, MV=PY provides the link between money and prices if we rewrite it

in terms of percentage changes

The Quantity Theory and the Velocity of Money

MV = PY

% ΔM + % ΔV = % ΔP + % ΔY

Money Growth + Velocity Growth = Inflation + Output Growth

In the early 20th century, Irving Fisher wrote down the equation of exchange and derived the

implication that

Money growth + velocity growth = inflation + real growth

Assuming

No important changes occur in payment methods or the cost of holding money,

Real output is determined solely by economic resources and production technology,

Then changes in the aggregate price level are caused solely by changes in the quantity of

money.

In other words

Assume that %ΔV = 0 and %ΔY = 0.

Doubling the quantity of money doubles the price level.

Inflation is a monetary phenomenon (Milton Friedman).

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Money & Banking MGT411

In our example of four students, number of rupees needed equaled total rupee value of the

transaction divided by no. of times each rupee was used

Money demand = Total value of transaction

Velocity of Money

For the economy as a whole,

Money demand = Nominal GDP

Velocity

Md = 1/V x PY

Money Supply (Ms) is determined by central bank and the behavior of the banking system

Equilibrium means Md = Ms = M

Rearranging the Money demand function gives MV = PY

The quantity theory of money tells us why high inflation and high money growth go together,

and explains why countries can have money growth that is higher than inflation (because they

are experiencing real growth).

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.

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