02 April 2014

The velocity of money is a function of interest rates

The velocity of money has a way of frustrating the best-laid plans of central banks. For instance, when the Fed wants to squeeze the growth of money it often finds that velocity increases sharply, so that the same amount of money does much more work than before, thus rendering the constriction of money ineffective. Similarly, when the Fed wants to expand the amount of money, it often finds that the velocity of money falls sharply.

The unpredictability of money velocity was a key factor in hastening the demise of monetarism in the eighties. Economics, the textbook by Paul Samuelson and William Nordhaus, said in the 2005 edition: "As the velocity of money became increasingly unstable, the Federal Reserve gradually stopped using it as a guide for monetary policy... Indeed, in 1999, the minutes of the Federal Open Market Committee contain not a single mention of the term 'velocity' to describe the state of the economy or to explain the reasons for the committee's short-run policy actions."

Economists since Milton Friedman have sought to relate velocity to a number of factors and have been unsuccessful. The graph below will therefore come as an utter surprise to many. It plots the velocity of money against Moody's Seasoned AAA Corporate Bond Yield. For the entire period of five decades, 1960 to 2011 it shows that velocity runs a course exactly parallel to corporate bond yield. No one can be more surprised than I am. The velocity of money graph occurs in my book "The General Theory of Money" published in May 2012 but until now I had never thought of connecting it with interest rates if only because all the papers I had read never spoke of any relation between the two.

The monetary aggregate used in the graph is what I have called Corrected Money Supply in my book. A brief explanation is in order. Assume that you receive a salary of $1000 at the start of every month into your demand deposit. During the course of the month you spend 95% of this and save 5%. So the demand deposit would start at $1000 and run down to $50. However, you choose to keep a little extra in your demand deposit to allow for exigencies, say $500, roughly the value of your demand deposit at the middle of the month. If you add all the funds in all demand deposits in the economy there would thus be a certain amount of money that is never spent. Corrected Money Supply is M1 reduced by this money that is not a medium of exchange but is held purely with a precautionary motive.

One economist who came close to identifying the relation between money velocity and interest rates was John Tatom. In a 1983 paper called "Was the 1982 velocity decline unusual?" published by the Federal Reserve Bank of St Louis he observed that during numerous recessions after 1947 the velocity of money fell. He was, however, puzzled by the fact that in the 1970 and 1973-75 recessions the velocity rose. After some analysis he concluded: "Explanations that focus on declining interest rates also do not match up well with the recent pattern of velocity declines. In the first quarter of 1982, corporate Aaa bond yields averaged 15.01 percent and had risen from 14,62 percent one quarter earlier or 14.92 percent two quarters earlier. During the remaining quarters of 1982, the bond yield declined to 14.51 percent, 13.75 percent and 11.88 percent.9 The pattern in the second half of 1982 is consistent with a decline in velocity. What remains unexplained, however, is the largest decline in velocity, which occurred in the first quarter."

If Tatom had had the right monetary aggregate he would have reached different conclusions. He would also have realised that if money velocity falls during most recessions it is because usually interest rates fall during recessions.

The mechanism relating a rise in interest rate to a rise in velocity (or as it has been sometimes called, the case of the missing money), is quite simple. But for economists who have been brought up to view money in a particular way it is very difficult to grasp.

P.S. My book Macroeconomics Redefined published in June 2015 devotes two entire chapters to the velocity of money and shows why it has nothing to do with speed.

Category: Economics

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