Model Answer
0 min readIntroduction
The velocity of money, a crucial concept in monetary economics, measures the rate at which money is exchanged from one transaction to another. It is fundamental to understanding how changes in the money supply impact economic variables like prices and output. Two prominent schools of thought, the Fisherian (Transactions Approach) and the Cambridge (Cash Balance Approach), offer differing perspectives on the determinants and nature of this velocity, influencing their respective Quantity Theories of Money.
Determinants of Velocity of Money in Fisher's Equation
Irving Fisher's equation of exchange, expressed as MV = PT (where M = Money Supply, V = Velocity of Money, P = Price Level, and T = Volume of Transactions), treats velocity (V) as the average number of times a unit of money is spent on final goods and services within a given period. Fisher considered V to be relatively stable in the short run, determined largely by institutional and technological factors rather than being directly influenced by the quantity of money itself. The key determinants influencing the velocity of money in Fisher's framework include:- Frequency of Income Payments: More frequent payments (e.g., weekly vs. monthly) tend to increase velocity as individuals hold cash for shorter periods.
- Development of Banking and Financial Instruments: Advanced financial systems with efficient clearing mechanisms reduce the need to hold large cash balances, thus increasing velocity.
- Efficiency of Transportation and Communication: Better infrastructure facilitates quicker transactions, increasing the speed at which money circulates.
- Community Habits and Customs: Societal preferences for using cash versus credit, or saving versus spending, influence how quickly money changes hands.
- Economic Stability: In periods of economic stability, people spend money predictably. During hyperinflation, people spend money quickly to avoid devaluation, increasing velocity.
Difference from the Cambridge Version of Velocity of Money
The Cambridge version, primarily associated with economists like Alfred Marshall, A.C. Pigou, and John Maynard Keynes, presented an alternative approach. While Fisher focused on money as a medium of exchange, the Cambridge economists emphasized its role as a store of value. Their equation, often expressed as M = kPY (where M = Money Supply, k = proportion of nominal income held as cash balances, P = Price Level, and Y = Real Income), implies velocity as the inverse of 'k' (V = 1/k). The key differences between Fisher's and Cambridge's interpretations of velocity are summarized below:| Feature | Fisher's Equation (Transactions Approach) | Cambridge Version (Cash Balance Approach) |
|---|---|---|
| Concept of Velocity | Transactions Velocity (V): Average number of times a unit of money changes hands for all transactions (including intermediate ones). Focus on money as a medium of exchange. | Income Velocity (implied as 1/k): Reflects how much money people desire to hold as a proportion of their nominal income. Focus on money as a store of value. |
| Determinants of Velocity | Primarily institutional and technological factors (payment frequency, banking development, transport efficiency), assumed stable in the short run. | Behavioral factors: individual decisions to hold cash balances (k), influenced by interest rates (opportunity cost), wealth, expectations about future prices, and convenience/security of holding cash. |
| Nature of Money | Flow concept; money is primarily viewed in terms of its flow of expenditure over a period. | Stock concept; money is viewed as a stock held by individuals at a point in time. |
| Emphasis | Supply side of money, focusing on the mechanical circulation of money. | Demand side of money, focusing on individual's desire to hold cash balances. |
| Short-run vs. Long-run | Assumed constant in the short run for predicting price level changes. | 'k' (and thus velocity) is less stable and can fluctuate even in the short run due to changes in individual preferences and expectations. |
Conclusion
In essence, while both Fisher's and the Cambridge versions contribute to understanding the relationship between money and prices, their conceptualization of velocity diverges significantly. Fisher's mechanistic view emphasized institutional factors governing transaction speed, treating velocity as stable. In contrast, the Cambridge approach, by introducing 'k' as a behavioral variable reflecting money demand for holding cash balances, provided a more nuanced understanding of velocity, incorporating individual preferences and expectations. This latter perspective laid the groundwork for Keynes's liquidity preference theory and enriched modern monetary theory by highlighting the endogenous nature of money velocity.
Answer Length
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