THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 587

CHAPTER 21

The Demand for Money

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IS VE LO CITY A CON STAN T ?
The classical economists conclusion that nominal income is determined by movements in the money supply rested on their belief that velocity PY/M could be
treated as reasonably constant.4 Is it reasonable to assume that velocity is constant?
To answer this, let s look at Figure 21-1, which shows four-quarter (short-run) percentage changes in velocity from 1968 to 2008 (nominal income is represented by
nominal GDP and the money supply by M2++ (gross)).
What we see in Figure 21-1 is that even in the short run, velocity fluctuates
too much to be viewed as a constant. Prior to 1980, velocity exhibited large
swings up and down. This may reflect the substantial instability of the economy
in this period. After 1980, velocity appears to have more moderate fluctuations,
yet there are large differences in the growth rate of velocity from year to year.
Velocity actually falls, or at least its rate of growth declines, in years when recessions are taking place.
Until the Great Depression, economists did not recognize that velocity
declines sharply during severe economic contractions. Why did the classical
economists not recognize this fact? Unfortunately, accurate data on GDP and the
money supply did not exist before World War II. (Only after the war did the government start to collect these data.) Economists had no way of knowing that their
view of velocity as a constant was demonstrably false. The decline in velocity
during the Great Depression years was so great, however, that even the crude
data available to economists at that time suggested that velocity was not constant. This explains why, after the Great Depression, economists began to search
for other factors influencing the demand for money that might help explain the
large fluctuations in velocity.

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F I G U R E 2 1- 1

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

8

Change in the Velocity of M2++ (gross), 1968 2008

Shaded areas indicate recessions.
Source : Statistics Canada CANSIM II series V41552801, V41707150, and V1997756.

4

Actually, the classical conclusion still holds if velocity grows at some uniform rate over time that
reflects changes in transaction technology. Hence the concept of a constant velocity should more accurately be thought of here as a lack of upward and downward fluctuations in velocity.