Relationship between velocity of money and interest rate

Velocity of money - Wikipedia

relationship between velocity of money and interest rate

For instance, over the last years the velocity of money has had a sort of imply a linear relationship between velocity and the interest rate. June This thesis considers the long run relationship between velocity of money and nominal interest rate with the proposed Cash in Advance model. In the. The term "velocity of money refers to how fast money passes from one holder to the next. 1 Illustration; 2 Relation to money demand; 3 Indirect measurement in a very small economy, a farmer and a mechanic, with just $50 between them, buy Given the nominal flow of transactions using money, if the interest rate on.

To understand how the velocity of money changes, one must understand what changes the demand for money. Under most economic models, over the long-term, inflation depends on how much the growth of the money stock exceeds real GDP.

The velocity of money is a function of interest rates

The supply of money is the only factor that politicians can control, at least directly. Real GDP and the velocity of money cannot be controlled legally or politically. So to control inflation by targeting the money growth rate, a central bank must know what influences the demand for money and how changes in monetary policy rules will influence that demand.

The Effect of Lower Interest Rates Will Depend on Debt Load and Economic Conditions The increase in aggregate demand with lower interest rates will depend on the debt load of consumers and firms and on economic conditions. While, it is true that lower interest rates stimulate aggregate demand, with all else being equal, the magnitude of this effect will depend on debt loads and economic conditions.

High debt loads will decrease the stimulatory effect of lower interest rates, because debtors will be reluctant or unable to increase their debt load.

Furthermore, they must decrease spending and investments to pay their debt.

relationship between velocity of money and interest rate

Likewise, when economic conditions are poor, consumers and firms will be reluctant to increase spending or to increase investments, because of the increased risk. This is best illustrated by the prolonged period for the economy to emerge from the Great Recession of todespite record low interest rates. Consumers and firms were deeply in debt, so their creditworthiness had declined dramatically. Additionally, because banks wanted to avoid more losses, their lending requirements became stricter.

Thus, few people could take out loans, even if they wanted to.

relationship between velocity of money and interest rate

Furthermore, because people didn't have money to spend, firms were also unwilling to borrow, since they already had excess capacity due to their depressed economy. So, at the start of the Great Recession, lower interest rates had a much lesser effect in stimulating the economy, which is why the after effects of the recession lasted so long.

Velocity of Money

Determinants of the Demand for Money The primary factors affecting the demand for money are the: To calculate the velocity of money, I used the historical data of personal consumption, frankly, to keep the model simple. M1 was used to calculate the average holding of money. All of the numbers were converted to the real terms and were tied to the dollars.

relationship between velocity of money and interest rate

The annual federal funds rate was used to analyze the relationship between the interest rate and the velocity of money. The annual federal funds rates were obtained online and no changes were made to them. Even though the correlation coefficient is not strong, it justifies the claim that the interest rate and money holding are inversely related. Moreover, the correlation coefficient of personal consumption and velocity of money from is approximately 0.

From the calculated coefficient, it is obvious that the velocity of money and personal consumption are very strongly related. Section 2 Applied Analyzing the Graphs There are some interesting conclusions which can be drawn out from the graphs. As one can see, even though there have been minor fluctuations here and there, the overall graph of the velocity of money seems to have an upward trend.

By consulting the simple model of the velocity of money which was discussed in the theoretical section of the paper, one can see that for the velocity of money to have an upward trend either personal consumption should increase or money holding should decrease. Time line is listed on the horizontal axis and velocity is on the vertical axis. This is the graph of the annual nominal federal funds rate.

What is the relationship between velocity of money and interest rate?

This is the graph of the real federal funds rate. This graph is of real personal consumption tied to dollars in billions. Real Personal Consumption tied to dollars is on the vertical axis and Time frame is on the horizontal axis. This can be majorly related to one very important fact-the rise in interest rate.

The nominal federal funds rate started rising from to The condition with the real federal funds rate was more dramatic because it hit the negative values two times beforebut still the overall trend was increasing. As one can see, the velocity of money reached its peak in the early s, and the curve more or less had a uniform motion from The nominal and the real federal funds rate peaked in the yearand had the values The interest rate seems to have a declining trend after the early 80s.

relationship between velocity of money and interest rate

Hence, during the early 80s, increment in federal fund rate caused people to lower their average money holding M1. This resulted in high velocity of money. But as the federal funds rate started to decline after the early 80s, the velocity of money started to fall.

Moreover, over the yearsthe correlation coefficient of the velocity of money and the real federal funds rate takes the value 0.

relationship between velocity of money and interest rate

Also, one needs to take into account the fact that the velocity of money not only depends on the interest rate, but is also very much influenced by personal consumption. In other words, it holds true that the velocity of money could decline even during a period when the interest rate is rising. Basically, if the rise in interest rate reduces the real money balance relative to the volume of personal consumption spendingthen the velocity increases Barro, Lastly, the Wikipedia section of Relation to money demand is flawed.

  • Velocity of money
  • Relation between Velocity of Money and Demand for Money?
  • Money Demand and Money Velocity

It states in relevant part: Given the nominal flow of transactions using money, if the interest rate on alternative financial assets is high, people will not want to hold much money relative to the quantity of their transactions—they try to exchange it fast for goods or other financial assets, and money is said to "burn a hole in their pocket" and velocity is high.

That argument is flawed because it implicitly assumes that a low interest rate associated to money supply can coexist with a high interest rate on alternative financial assets: That creates arbitrage opportunities. In reality, both rates have a positive correlation. When alternative rates are high, people could not hold much money anyway because the interest rate associated to money supply is also high.