| | | | | | | Curiosity 9.2: What If Velocity Isn't Constant? | | | | | | | | | | Implicit in our derivation of the formula for inflation is an assumption that velocity is constant, but financial innovations are steadily increasing velocity. For example, the growing use of credit cards has made it possible for people to coordinate more closely their consumption payments and income receipts, reducing their need to hold money. The proliferation of automatic banking machines has allowed people to carry fewer dollars in their pocket. They are able to make a smaller amount of money holdings support the same amount of spending. This influence of financial innovations could be called a decrease in the demand for money, or, equivalently, an increase in velocity. | | | | | | | | | | Suppose, as was the case during the 1960s and 1970s, that financial innovations are decreasing the demand for money, and thus increasing velocity, at an annual rate of about 3 percent per year. If long-run growth is 2 percent, then there is a net decrease in money demand of 1 percent per year. If the supply of money is increasing at 8 percent per year a gap of 9 percent between money supply and money demand opens up, causing prices to rise by 9 percent. As a result, we must modify our equation for inflation: | | | | | | | | | | Long-run rate of price inflation = Money growth rate = Real income growth rate + Velocity growth rate | | | | | | | | | | From 1950 to 1980, M1 velocity climbed steadily from about 3 to about 7 but then fell dramatically (by about 7 percent) in the early 1980s and behaved irregularly thereafter. During this same period, M2 velocity held constant at about 1.7, but also fell markedly (by about 10 percent) in the early 1980s and has recently behaved irregularly. These velocity changes are illustrated in figure 9.4. A steadily growing velocity can be accommodated, as shown in our new equation for inflation, but an irregularly changing velocity implies that this equation is of less value as a summary of long-run economic behavior. | | | | | | | | | | For the mathematically minded, the modified inflation equation can be derived by using the quantity equation Mv = PQ to obtain the approximate result that | | | | | | | | | | | | | | | | This relationship is illustrated in figure 9.5 where the decrease in money demand due to annual banking innovations (i.e., corresponding to velocity increases) is represented by the top right-hand small rectangle. To keep the net money demand increase equal to the money supply increase, the inflation-caused increase in money demand becomes bigger. | | | | | |
| | | | | had money growth of 133 percent and inflation of 144 percent; and Argentina had money growth of 234 percent and inflation of 251 percent. | | | | | | | | | Two implications of the inflation equation are that (1) an economy does not experience inflation if its money supply increases at a rate equal to the real rate of growth of the economy, and (2) an economy will experience a low, steady inflation in the long run if its money supply grows at a low, steady rate. This is part of the rationale behind the monetarists' belief that | | | | |
