Velocity of Money: The Average Turnover Rate

 

To be fair, the velocity of money (V for velocity) is a non-issue in Cambridge Macroeconomics. Probably, that is the single greatest mistake ever made in Cambridge. As far as the real economy is concerned, “velocity of money” is far more relevant than “liquidity preference.” To be truthful, the latter is an oxymoron at best.

             According to Irving Fisher from New Haven, “Money is of no use to us until it is spent” (1930, p. 5). He is not alone: Paul Samuelson from Cambridge and William Nordhaus from New Haven second, “Money is useless until we get rid of it” (2010, p.458). Worse, money when preferred is in solid legal tender or thin-airy demand deposits, far from liquid, fluid or current.

             At any rate, the rest of us as non-macroeconomist couldn’t agree more with the three great names. In the first place, we are legally forbidden to eat, wear or burn money however hungry, cold or sick we may be. It when with us no Scrooges is of no economic use whatsoever.

             Down to business, what is the value of money? Macroeconomists will unanimously say that the value is in being legal tender or the legitimate vehicle of tendering our liabilities, if not theirs. In other words, money is useful only for the purpose of repaying our liabilities of indefinite kinds. Why would the rest of us in the right mind prefer money aka “liquidity” to anything else as company and keep it on purpose?

             Oh, that’s not the end of story. Money is not only annoying in “hoarding,” but also dangerous. This is particularly because robbers are very good at smelling money. Watch out, or you will hear the shout, “The money or your life!”

             Why, then, do we in the right mind prefer, if ever, liquidity to something else? That’s a great question: The answer as for now is for the sake of saving financial transaction costs of various kinds (back to this point later). At any rate, the real value of money is in spending, never in preferably hoarding. On the flipside, “spending” is never for “benevolence” Adam Smith talked about: That’s always and everywhere for the marginal benefit of our own.

             The second question in the line: Consuming money being illegal, what on Earth are our parties in the right mind going to do with the money they get? Asking that question, you must be a genius more prodigious than most macroeconomists: They intend to spend it as soon as possible because of the uselessness. If they hoard the money for a while, it is not because they prefer liquidity but because the “keeping” helps save financial transaction costs. 

             Combining those two answers, we come to conclusion that money keeps turning around all across the nation: I hoard money for the only purpose of spending while you do as well. As such money keeps on running, “Rolling, rolling, rolling, on the river!”

             Somehow on the sidewalk of the national economy, the great British philosopher David Hume among others comes up with the idea of “quantity equation”: How many turns in average would the aggregate money stock change hands before producing the gross national products (GDP) in nominal? The equation is often illustrated in this form, M∙V= P∙Y, where V for velocity of money.  

             We check out some points of the “equation.”

1)     The stock of money (M) is assumed to be “constant” all through the year. Around that time of David Hume, the money all across the nation was more or less easily countable owing to its nature of glittering.

2)     The price level must by conception be a single index representing all different prices, each varying every once in a while; some per week, others per fortnight, still others per month, and the like. On the flipside, there is no such thing as the aggregate cycle of price variations.

       Thus, the price level is more symbolic than practical. No wonder that nobody can make a call what in reality the price level is at. Only way out: Let us assume the price level to be “constant” so as to give a birth to the IS-LM model.

3)     The velocity of money, representing the annual average turnover of money, is not really a “variable,” much less a “constant.” It’s an imaginary concept and that ex post only.

4)     Alas, the name “velocity” must have been the “average turnover rate” per annum, while the name equation been the “identity.” Those particular misnomers have misled macroeconomists many occasions over.