Money Demand and the Velocity of Money

The quantity theory of money, what the velocity of money means, and why the simple link between money growth and inflation broke down in recent decades.

Why do people hold money, and how is the amount of money in an economy related to prices? These questions are central to monetary economics.

Why people hold money

Economists identify reasons to hold money:

Transactions: to pay for everyday purchases.
Precaution: to handle unexpected needs.
Speculation: holding money when other assets seem risky, or when interest rates are expected to rise.

The quantity theory of money

An old idea in economics is summed up in an equation often written as MV = PY:

M is the quantity of money.
V is the velocity of money: how many times, on average, each unit of money is spent in a year.
P is the price level.
Y is real output.

If velocity is stable and output grows at its normal rate, then faster money growth mainly leads to higher prices. Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon”.

Evidence

Over long periods and in cases of very high inflation, money growth and inflation are closely linked. Hyperinflations, such as in Zimbabwe or Venezuela, involved enormous growth in money supply.

When the link broke down

In many rich countries after 2008, central banks created huge amounts of money through quantitative easing, yet inflation stayed low for years. The reason was that velocity fell: banks held large reserves, and people and firms held more money rather than spending it. The simple relationship between money and prices did not hold in the short run.

Many central banks therefore moved away from targeting money growth toward targeting interest rates and inflation directly.

The 2021 to 2022 inflation

When inflation surged after the pandemic, some economists pointed to the rapid growth in broad money in 2020 and 2021 as a warning sign, reviving interest in monetary aggregates, though most saw many causes behind the surge.

Money that doesn't move

A central bank creates money by buying bonds from banks. But if banks keep the new reserves instead of lending, and households save instead of spending, the money circulates slowly. Velocity falls, and prices do not rise much. The money exists, but it is not chasing goods.

Thinking more money always means proportionally higher prices

The effect of money on prices depends on how quickly money is spent and on the economy's output. In the short run, velocity can change a lot, weakening the link.

Key takeaways

People hold money for transactions, precaution and speculation.
The quantity theory, MV = PY, links money, velocity, prices and output.
Money growth and inflation are closely linked in the long run and in hyperinflations.
After 2008, falling velocity weakened the link, and central banks shifted to targeting rates and inflation.