The velocity of circulation of money has fallen dramatically since 2008. The diagram above demonstrates that velocity has fallen to half of its peak in 2008, back to levels last experienced in the 1970s. In previous posts I claimed that this is an indication of lower demand for money for transactions purposes – that is, economic agents eschew paper money in favour of credit cards or internet banking which leaves cash balances idle. What I omitted to say is that, in the Keynesian world, lower velocity implies a higher demand for money as an asset – the so-called “speculative demand for money”.
While the fact is that velocity has fallen, this is either due to lower transactions demand for money OR an higher speculative demand. Is there a way to resolve this dichotomy?
The Keynesian speculative demand is, literally, mattress stuffing. People withdraw banknotes and leave them under the mattress or in a vault. Were this the reason for the decline in velocity then banks would have been dispensing an enormous quantity of banknotes. Banks, however, have not experienced shortages at the ATM. Instead, rather than being short of cash, Banks have built up significant excess reserves on deposit with the central bank. Firms and households simply don’t need the money that has been made available to them. This suggests that the demand for money for transactions purposes has declined and this is the culprit driving the decline in velocity.
Why is it important to know whether velocity has fallen due to the transactions demand or the speculative demand for money? From a policy perspective, the monetary authorities need to rely upon some stable relation between money demand and interest rates. If the demand for money is speculatively high then lowering interest rates below zero should be able to coax economic agents to spend or invest their cash hoards. On the other hand, if money is no longer needed for transactions purposes then there is no link between interest rates and money demand, and there is nothing the monetary authority can do to systematically influence output or the price level. The logic above suggests the latter.