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Is the Velocity of Circulation Stable?

The short answer to this question is that it is not as stable as early monetarists had assumed. Part of the reason is that the way we use money has changed in the last 100 years; another reason is that when economic conditions change, so the velocity becomes less stable.

In times when there is a boom in economic activity, we might expect the velocity to rise, whereas in times of recession, it is likely to fall. In a slowdown, for example, we might expect the level of consumer spending to fall. When it does, the speed with which the stock of money circulates around the economy is likely to slow down as well. This in part is what is suggested by the truism of the equation of exchange.

The amount of spending in an economy might change according to the state of the economy. When the level of economic activity changes, the velocity of circulation can become less stable. Copyright: Garann Rose Means, from stock.xchng.

Friedman suggested that there was a link between the velocity of circulation and wealth and the interest rate. If velocity (V) was in part dependent on peoples' feelings about their wealth and of changes in the interest rate, then the original Fisher equation could be amended to explain changes in nominal income. This allows economists to look at what happens to output when the money supply changes as well as looking at what might be happening to prices.

In the 1980s, however, the velocity of circulation again looked unstable both in the United States and in the UK. Part of the reason was the deregulation of the financial industry, which meant that banks, building societies and other financial institutions had much more freedom in the products that they were able to offer and where 'money' could be held.

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