Monetarist Velocity of Money Theory
Milton Friedman has outlined his theory on the demand for money, and by association the velocity of money, as depending on many more variables than output and interest rates alone. His point is that these other variables are relatively slow to act, and play only a minor role in the short term.
The most important of these factors is:
Wealth – the idea here is that spending reacts less to changes in income if they are seen as temporary, and more to people’s idea of what their long-term income is likely to be. This is the permanent income hypothesis, and whilst it is difficult to estimate directly what level of income people will perceive themselves to have in future years, their wealth might serve as a proxy.
The data that has been collected here has not been overwhelmingly convincing, and you can read more about this via the PDF link below. Nevertheless, the theory does have a logic that is difficult to dismiss, and the data on wealth that has been collected is fraught with problems, so perhaps we shouldn’t place too much stock in the disappointing results here.
Regardless of the ability of the permanent income hypothesis in establishing a new basis for believing that velocity is stable, it does appear that the income velocity of money is capable of significant movement over the short-term, and for reasons that cannot be modeled.
It seems that there is a significant problem with building inflation forecasts based on empirical evidence alone, and just because the quantity theory of money has been successfully applied retrospectively to show that inflation spikes in the past have always been the result of excessive growth in the money supply, that doesn’t necessarily prove that inflation will always result from money supply growth.
This does not mean that I am siding with the Keynesians, it just means that the monetarist theory looks incomplete. The best approach to forming rational economic forecasts seems to be to adopt the Austrian approach, and try to think in a logical fashion given all available information about any specific problem.
Other variables that may affect velocity
At the current time, following the global pandemic, the west has experienced rapid growth in its money supply as governments have printed huge sums of money to fund fiscal stimulus packages.
Monetary policy has more or less been operating on a peddle-to-the-metal basis too, but ever since the 2008 financial crisis the US and UK have been in a liquidity trap – meaning that expansion of base money by the central banks has not led to a significant increase in lending via the high street banks. This in turn means that there is a serious lack of any money multiplier effect from the banking system, and therefore monetary policy boosts have been of limited effect.
Clearly, in a liquidity trap, money supply growth alone is unlikely to cause significant inflation, but it remains to be seen how long the trap will remain. If the trap exists because interest rates are so low that the banking sector is reluctant to make risky loans for little return, then what happens if the central banks start to raise interest rates - will we see a surge of new lending given the very large growth in base money already created by the central banks? If so then recent falls in velocity might be reversed, with huge pressure on prices to rise as predicted by quantity theory.
Velocity of money does seem to be affected by market sentiment, business confidence and consumer confidence. All of these factors have taken a hit because of the pandemic, not so much from younger people but certainly from older people and those most vulnerable.
The lockdown itself has obviously caused a direct reduction in velocity, because with people locked in their homes they are unable to get to shops, restaurants, bars, gyms and sporting facilities, none of which have been open for business anyway. Online spending has picked up, partly mitigating the lockdown, but overall velocity is down very sharply.
Then there is the long-term deflationary background that has been driving a gradual decline in velocity since the 1990s. Demographic changes such as an aging population and low birth rate have reduced the velocity of money.
There are of course many more factors to consider before forecasting higher inflation based on money supply growth. There have been serious supply chain issues that have affected prices, some of these issues will be resolved, others will remain. Then there is growing debt levels and the burden that they bring. There’s also the seemingly endless trade deficit, and budget deficit. Let’s not forget that the strength of our western currencies is also under the spotlight, with a strong possibility of depreciation that will impact prices.
The list goes on, and whilst the velocity of money and the quantity theory of money will continue to have relevance in normal times, should normal times ever return, we need to recognize that current times are far from normal, and old economic models built on historical evidence, whilst useful, are far from complete.