Is Velocity A Constant

By Kitty Lee on July 13, 2010
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The classical economists' conclusion that nominal income is determined by movements in the money supply rested on their belief that velocity PY/ M could be treated as reasonably constant.l Is it reasonable to assume that velocity is constant? To answer this, let's look at Figure 1, which shows the year-to-year changes in velocity from 1915 to 1996 (nominal income is represented by nominal GDP and the money supply by M and Af2).

What we see in Figure 1 is that even in the short run, velocity fluctuates too much to be viewed as a constant. Prior to 1950, velocity exhibited large swings up and down. This may reflect the substantial instability of the economy in this period, which included two Audemar Piguet Replica Watches world wars and the Great Depression. (Velocity actually falls, or at least its rate of growth declines, in years when recessions are taking place.) After 1950,cartier love ring pink gold, velocity appears to have more moderate fluctuations, yet there are large differences in the growth rate of velocity from year to year.

The percentage change in Aft velocity (GDP/Mi) from 1981 to 1982, for example, was -2.5 percent, whereas from 1980 to 1981 velocity grew at a rate of 4. 2 percent. This difference of 6-7 percent means that nominal GDP was 6. 7 percent lower than it would have been if velocity had kept growing at the same rate as in 1980-1981.l The drop is enough to account for the severe recession that took place in 1981-1982. After 1982, Mi velocity appears to have become even more volatile, a fact that has puzzled researchers when they examine the empirical evidence on the demand for money. A/2 velocity remained more stable than M velocity after 1982, with the result that the Federal Reserve dropped its M targets in 1987 and began to focus more on A/2 targets. However,cartier love charity bracelet colors, instability of MHz velocity in the early 1990s resulted in the Fed's announcement in July 1993 that it no longer felt that any of the monetary aggregates, including A/2, was a reliable guide for monetary policy.

Until the Great Depression, economists did not recognize that velocity declines sharply Cartier Santos Replica during severe economic contractions. Why did the classical economists not recognize this fact when it is easy to see in the pro-depression period in Figure 1? Unfortunately, accurate data on GDP and the money supply did not exist before World War II. Only after the war did the government start to collect these data. Economists had no way of knowing that their view of velocity as a constant was demonstrably false. The decline in velocity during the Great Depression years was so great, however, that even the crude data available to economists at that time suggested that velocity was not constant. This explains why, after the Great Depression, economists began to search for other factors influencing the demand for money that might help explain the large fluctuations in velocity.

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