Demand for Money vs. Velocity of Circulation

Economics Economics Questions
,
1

What’s the difference and connection between the two? First, demand for money can be measured at any instant, whereas velocity of circulation can be computed only over a period of time, where it can mean the average amount of money that changes hands.

Second, suppose that demand for money has increased. This causes surpluses of unsold goods. Hence the velocity of circulation of money will go down. But when prices have adjusted downward and the PPM has consequently risen, velocity will go back to its previous level. Thus, velocity remains the same yet with a higher demand for money.

Third, suppose that demand for money has decreased. Temporary shortages will result. But velocity of money will be unchanged, since, like before, every good is sold, despite the fact that some buyers remained unsatisfied and would have paid the present price, had there been greater quantity supplied. But even when prices increase in response to smaller demand for money, velocity will be unchanged.

Now let’s consider the situation in which the velocity of money at Δt1 is less than at Δt2. It seems that people are more willing to get rid of their cash balances during Δt2, and so the demand for money must decrease (either as a cause or effect of the increase in velocity – which?) and PPM, increase. Similar reasoning applies when the velocity of money decreases.

Is this analysis correct? Thanks.

2

Here’s a Daily Article from a week or so ago about the Velocity of Circulation that might help you out.

----edit----

And another I just found and started reading.

3

The next-to-last paragraph should, of course, read: “so the demand for money must decrease (either as a cause or effect of the increase in velocity – which?) and PPM, decrease, as well” Coward, thank you for the articles.

4

In the first two cases I consider demand for money (DFM) changes which result in opposite price adjustments. By saying that “In fact (though this happens less often), an increase in the velocity of circulation of money may be accompanied by an increase in the purchasing power of money, i.e., by a fall in prices” Hazlitt seems to think of a reverse case:

1’) Prices go down yet without a corresponding increase in the DFM, so PPM increases and there is more economic activity and greater V. This is said to be possible “in a speculative collapse, as, say, in late 1929.”

2’) Prices go up yet without a corresponding decrease in the DFM, so PPM decreases and there is less economic activity and lesser V.

My final case, where I assume that V has increased, must be interpreted as caused by the smaller demand for money: “When people value money less and goods more, they will offer more money for goods, and may increase ‘velocity of circulation.’” This corresponds to (2) or “third,” in the original post. What can happen, I suppose, is that inventories will be cleared out faster, so even though I say V does not change, in the real world it may increase.

In addition, Mises is quoted that “In a changing world everybody is under the necessity of keeping an amount of ready cash on hand,” where I assume that by “changing” he means uncertain and un-ERE-like. I make the same point in Saving, Investing, and Hoarding: Cash balances provide “[g]reater security for the hoarder, since one of the functions of money is a ‘store of value.’ In other words, it is a shield against the uncertainty of the future and against unforeseen future expenses.”

Changes in the DFM are due to particular monetary-type events (such as inflationary expectations or changes in frequency of payments to workers; see The Mystery of Banking for an extended list of causes). Do these events therefore change perceived uncertainty, if that’s the only reason for keeping cash? Because aside from those, all that change are relative prices of goods and services.

5

That article is fricking brilliant! Good old Hazlitt eh?

6

I think this is slightly mistaken.

On the money side, consider MV=PT. Suppose (as you do) that the change has no long-term real effect, so T is constant in the long run. Also suppose M is constant. Suppose demand for money doubles. Because M is constant, the only way people can actually double their purchasing power is for the PPM to double–i.e., prices to fall in half (on “average”). As you say, in the short run, before markets have cleared–before prices have fallen, there may be a temporary surplus of goods. Thus in the short run, V has fallen, M is constant, and P has not fallen enough yet, thus T has to be lower in the short run, which indicates the surplus of unsold goods. Then as markets clear, P falls and T increases until T resumes its original value, P is half of its original value, and V is half its original value. V does not go back up to its original value.

So, a permanent change in the demand for money will permanantly change V, given a constant T.

I think it’s not correct to say that V is just another way of representing the demand for money. We might rearrange the equation as (M/P)*V=T, and say that M/P is the “real” money supply. If you add up everyone’s desired cash holdings it would add up to a total desired supply of purchasing power M/P. Thus I might claim that M/P, not V, represents the demand for money. In that case, we might say that V is the mechanism by which people achieve their desired level of cash holdings. Although, people don’t actually think in those terms either. The means that one uses to increase one’s cash holding is to increase sales and decrease purchases. The real mechanism is the market-clearing process.

Of course in the real world T and P aren’t usefully defined or measurable or constant. Changes in the money relation have a real effect because not all prices are affected to the same extent. And an increase in speculative trading increases T without necessarily increasing the real productive output of goods, so you don’t want to fall into the trap of thinking T is real output. And because the concepts of demand for money and market-clearing are much clearer and accurate and contain so much more information, it’s better to use them and drop the whole MV=PT equation.

7

Velocity is a part of demand. If velocity is low, it means that people have high demand for money, which is why they’re holding onto their money. If velocity is high, it means that people have low demand for money, which is why they get rid of it quickly.

8

Joel, you are absolutely right. Thank you for the correction. It is T that goes up while P is going down. I was thinking about the total amount of goods that will change hands. The “velocity of goods” will come back up to what it was. But each monetary unit will circulate half as frequently.

I also agree that the production structure may be rearranged by a change in the demand for money.