Big errors start from smaller ones. In economics, the plausible concepts of money neutrality and the velocity of money have led to many problems. This essay defines these concepts; I discuss the difficulties with them in later sections.
The idea of money neutrality is simple: monetary values are a unit of measurement for market transactions, and that if we change the units of measurement, it does not affect the real value of transactions.
There is a simple real-world experiment that appears to validate this idea: currency redenomination. For example, General Charles de Gaulle of France created the nouveau franc on January 1, 1960, by striking the last two digits off calculations of existing French francs in circulation.* In other words, a nouveau franc is just 100 old francs, and contracts were adjusted to compensate. The objective was to return nominal prices back to what feel like “normal” levels after inflation.
It is clear that just multiplying all monetary values by some constant is not going to make people better off – other than the convenience value of returning prices to levels that people consider to be “normal.” Within an economic model, the implication is that if we scale monetary values by some constant, the model dynamics for real variables should not be changed. That is, the model output is neutral with respect to the monetary unit.
Formally defining money neutrality is difficult (outside of a currency redenomination). This is discussed further in “The Incoherence of Money Neutrality” (Section 11). For the present, I will stick with a hand-waving definition: changing the stock of money (in a real-world economy, or in an economic model) will not affect real variables. (Although this is close to the definitions normally used, the previously referenced essay explains why this definition is problematic.)
The concept is quite often broken down into long-run and short-run neutrality. Models such as Real Business Cycle models have the property that changes in money have no effect on real variables at any time, which is the definition of short-run neutrality (money is neutral, even in the short run). However, it is unclear whether Real Business Cycles are anything other than an elaborate practical joke.
Long-run money neutrality is more commonly encountered. The argument is that operations that change the money stock may have a short-term effect on real economic variables, but in the long term, the only effect on changes in monetary aggregates is via changes in the price level.
Velocity of MoneyMoney velocity is a concept that has caused considerable grief. Although we can always calculate the “velocity of money,” it is unclear whether it is useful in practice. If velocity were constant, the classical Quantity Theory of Money would result.
Within the history of monetary economics, the equation
M∙V = P∙Qis of utmost importance. Within the equation, M stands for the money supply, V for the velocity of money, P for the price level, and Q for the quantity of output. The quantity P∙Q is the dollar value of output (price times quantity), or nominal GDP. The intuition is that the velocity is the number of times the money supply circulates in a year.
If velocity were constant, we could use this equation to develop strong conclusions about the relationship between the money supply and nominal GDP (and the price level). Doubling the money supply would double nominal GDP.
Furthermore, if we accept that money neutrality is at least roughly correct, we would expect real output (Q) to be largely unaffected by the doubling of the money supply. In which case, the implication of a constant velocity is that the price level (P) would (at least roughly) double. This matches the simpler definitions of the Quantity Theory of Money.
Of course, if we note the difficulties associated with exogenous money previously noted, the value of this insight is limited – how exactly is the money supply going to double?
In any event, empirical analysis shows us that velocity is nowhere near constant. This empirical analysis is pursued at greater length in “Instability of Money Velocity.” [Which appears as another section of the book. This online article looks at some money data, and the instability of the velocity of money.]
Concluding RemarksMoney neutrality and the velocity of money appear to be reasonable concepts. The difficulty is attempting to apply them to the real world.
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* Milton Friedman, on page 21 of Money Mischief: Episodes in Monetary History. Published by Harcourt Brace Jovanovich, 1992.
(c) Brian Romanchuk 2017