Velocity of Money | Quantity theory of Money| CBCS

Keynesian Economics 

John Maynard Keynes’s General Theory of Employment, Interest, and Money, published in 1936, remains one of the most important works in economics. Keynes was the first to emphasize aggregate demand and links between the money market and the goods market. Keynes also emphasized the possible problem of sticky wages. In recent years, the term Keynesian has been used more narrowly. Keynes believed in an activist federal government. He believed that the government had a role to play in fighting inflation and unemployment, and he believed that monetary and fiscal policy should be used to manage the macroeconomy. This is why Keynesian is sometimes used to refer to economists who advocate active government intervention in the macroeconomy.

Monetarism 

The debate between monetarist and Keynesian economics is complicated because it means different things to different people. If we consider the main monetarist message to be that “money matters,” then almost all economists would agree. In the aggregate supply/aggregate demand (AS/AD) story, for example, an increase in the money supply shifts the AD curve to the right, which leads to an increase in both aggregate output (Y) and the price level (P). Monetary policy thus has an effect on output and the price level. Monetarism, however, is usually considered to go beyond the notion that money matters.

The Velocity of Money

The number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money.

Suppose on January 1 you buy a new ballpoint pen with a $5 bill. The owner of the stationery store does not spend your $5 right away. She may hold it until, say, May 1, when she uses it to buy a dozen doughnuts. The doughnut store owner does not spend the $5 he receives until July 1, when he uses it (along with other cash) to buy 100 gallons of oil. The oil distributor uses the bill to buy an engagement ring for his fiancée on September 1, but the $5 bill is not used again in the remaining 3 months of the year. Because this $5 bill has changed hands four times during the year, its velocity of circulation is 4. A velocity of 4 means that the $5 bill stays with each owner for an average of 3 months, or one quarter of a year.

In practice, we use gross domestic product (GDP), instead of the total value of all transactions in the economy, to measure velocity because GDP data are more readily available. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M):

If $12 trillion worth of final goods and services is produced in a year and if the money stock is $1 trillion, then the velocity of money is $12 trillion ÷ $1 trillion, or 12.0. 

We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P):

We defined V as the ratio of GDP to the money supply, M*V=P*Y. The final value of P*Y depends on what happens to V. If V falls when M increases, the product M*V could stay the same, in which case the change in M would have had no effect on nominal income. 

The Quantity Theory of Money

The theory based on the identity M*V= P*Y and the assumption that the velocity of money (V) is constant (or virtually constant). If we let denote the constant value of V, the equation for the quantity theory can be written as follows:

The equation is true if velocity is constant (and equal to V) but not otherwise. If the equation is true, it provides an easy way to explain nominal GDP. Given M, which can be considered a policy variable set by the Federal Reserve (Fed), nominal GDP is just In this case, the effects of monetary policy are clear. Changes in M cause equal percentage changes in nominal GDP. For example, if the money supply doubles, nominal GDP also doubles. If the money supply remains unchanged, nominal GDP remains unchanged.

When there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. That could mean that M in the quantity-theory equation equals both the quantity of money supplied and the quantity of money demanded.

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