Velocity Wanted: More Whimsical Than Money Stock

 

Money used to be “veil” in the discipline of economics. Somehow, money aka “liquidity” has become the “crown jewel” in the “empirical science” of macroeconomics ever since a particular book and a particular article in the second half of 1930s.

             The equation in the book is M= L(r) (1936 p.168), while that in the article is M= k∙I ≡ [k∙P∙Y] (1937). One of the first things we the lay people can hardly understand is the fact that the two theories based on the two equations are mutually contradictory: the interest rate is the cause defined from outside in the first “model,” so to speak, while the effect to be determined inside the second “model” (of the money market or the IS-LM). The two would not coexist if in economics as an abstract science.

             Therefore, macroeconomics is no economics. 

 

The “Cambridge Quantity equation.” According to this, we are supposed to hold money as a “constant” fraction of the annual income on one hand, while the annual income is “economically fluctuating” particularly “in the short run,” if not “in the long run” when “we are all dead.”

             First doubt: A constant "k” in “economic fluctuations,” how so?  

            Second doubt: Why is the income "I" particularly of the year out of “so many” periods?

            Well, your guess is as good as mine in both cases.

Cambridge Beauty Contest. Once upon a time in Scotland, there was conceived the “quantity equation” (a “quantity identity” to be precise): M∙V≡ P∙Y. Out of the four “variables” as it were, what would be the most whimsical?

             The last is the velocity of money, according to the “Cambridge Quantity equation,” where k= 1/ V is named as a “constant.” As a matter of semantics, whim and constancy are antonyms to one another.

             Let us hold on one second and call the monetary inventory equation of William Baumol from Princeton “into the equation.”

 

The Baumolite Equation. By now, we are familiar with this: M^d= (b∙T/ 2i)^1/2.

             Replacing “T” for all kinds of spending per annum with P∙Y for the gross domestic expenditures often called AD (aggregate demand), we get M^d = (b∙P∙Y/ 2i)^1/2≡ (b∙M∙V/ 2i)^1/2. Then, we have V =2i∙M/ b, and consequently ΔV/ V = ΔM/ M+ Δi/ i– Δb/ b.

             The velocity of money (V) varies first dependent upon incremental supply of money also called “monetary policy,” second a change in the interest rate and third a change in financial transaction costs, some combination of which, incidentally, take place without fail all through the year.

             Which shall we pick the more whimsical, the money stock (M) or the velocity (V)?

             The answer is up for grabs, but for “Just a Variable More, or the Cambridge equation!”

For a Few Dollars More • Ennio Morricone