2.4 VELOCITY OF MONEY At the heart of the relationship between money, output and prices is the velocity of moncy, i.c. the ratio of nominal income to the stock of money. Monetary authorities all over the world strive to control money supply not for its own sake, but for regulating the flow of spending in the economy with a view. to containing inflationary pressures. The flow of spending, however, depends not only on the stock of mofley but also on its rate of turnover, or the velocity of moncy,.which is not under the direct control of the authorities. Any given stock of money might be: spent faster or more slowly, i.e. velocity of money might rise or fall. Accordingly, a wide range of potential spending levels could conceivably flow from the same stock of money. In other words, monetary expansion may be a necessary condition for the continuation of inflation, but it is not a sufficient condition. Monetary acceleration will-not raise prices if the underlying expansionary impulse is neutralised by a contemporaneous fall in the velocity of money. Monetary history of different-countries is replete with such examples where velocity of money has played an important role. The classic example in this regard is the US economy around the Great Depression. During the 1930s, the narrow stock money in the US expanded by about 35 per cent and yet consumer prices actually fell by as much as 20 per cent, The Monetarist-Neo-Keynesian debate on monetary policy hinges, at least in part, on the behaviour of velocity of money. Monetarists believe that velocity is relatively stable and changes therein are highly predictable. Neo-Keynesians are less sanguine and argue that either contention is an exaggeration. The empirical studies in the context of advanced economies have demonstrated that velocity of money is neither perfectly stable nor fully predietable. On the other hand, its movements also do not appear to be random or perverse. If the monetary authorities could discover the underlying factors responsible for fluctuations in velocity of money, a meaningful monetary policy is possible even with a moving target. It is on these premises that most empirical studies appear to have concentrated on locating the ‘proximate determinants’ of velocity of money. - The proximate determinants could be analysed in two ways: static and dynamic, The velocity of money, at any point in time, depends in some sense or the other on the opportunity cost of holding money. Illustratively, in the inventory-theomaie approach of Baumol (1952), Tobin (1956) and Romer (1986) kind of models, the velocity of money is, by and large, determined by the interest rate, which is the cost of holding cash rather than money. A relatéd set-of cash-in-advance model algo emphasise the cost of visiting the bank (Lucas and Stokey, 1987). Yet another second set of model emphasise the time costs of visiting the bank (Guidotti and Vegh, 1993; Feenestra, 1986). A third set of model determine stock of money in terms of portfolio allocation between money, and other financial assets (Rotemberg, 1984; Grossman and Weiss, 1983; Alvarez and Atkenson, 1997; Alvarez et al., 2002). A recent cross-country-study establishes a reasonably stable relations hip between transaction costs and the velocity of money (Mendizabal, 2003). An associated result is that there is a positive relationship between the rate of inflation and the velocity of money, which suggests that uncertainties in the value of money could lead to a48 Monetary Policy, F i ili ry Policy, Financial Stability and Central Banking in Indio shift to other assets. This is especi: Chowdhury (199. ally so in the case of developing countries. ty (1994), for example, established that inflationary expecta affect the velocity of money it ! study of 30 devels ia eon ia developing countries studied over 1955-88. A 1961-90 were Granger caused b hows that changes in the velocity of money during in 21 countries and by real by money growth in at least 20 countries, by inflation dosomeosition analysts sont income 18 countries (Owoye, 1997). Variance cause of changes in the velo a rales that inflation tums out to be the more dominant facomel inline: counties ty of money as compared with money growth or real Pa synemite sense, across time, the velocity of money would, by and large, depend | yn of the institutional factors. When Friedman ‘and Schwartz, examined the behaviour of velocity of money in the US in their celebrated work ‘Monetary History of the United States, 1867-1960’, they observed a steady declining trend until | the late 1940s, which they attributed to the fact that income elasticity of money demand was significantly higher than unity. While reviewing Friedman-Schwartz (1963), Tobin (1965) attributed even the secular decline of velocity in the earlier period to ‘institutional factors’ such as the spread of commercial. banking, which was in fact, accepted by Friedman (1982). . The shift towards ‘institutional factors’ in explaining the secular behaviour of velocity. of money appears to have culminated in the Bordo and Jonung (1987) study, which indeed is a land mark in this area of research. According to the study, the long-run or secular behaviour of velocity generally follows a U-shaped pattern, with an initial declining segment, an intermediate flat segment, followed eventually by a rising segment (Figure 2.1). This pattem is evident not only, in advanced economies (for data covering over 100 years), but is also confirmed by cross-section data for about 80 countries since 1950 with falling velocity in the low-income countries, rising velocity in the high-income countries and relatively constant velocity inthe middle- Income countries. The secular fall in velocity is explained by grawing monetisation of the economy and the spread of commercial banking, whereas-the secular rise in velocity is a reflection of financial innovations and ei financial sophistication. The narrow money velocity (V), in fact ri up much faster than the broad money velocity (V2), because households tend to be conservative in withdrawing their savings from bank deposits. Level of velocity \y Phase ff Phase Phase til > Stage of economic development Figure 2.1 Stalyised Pattern of Velocity Behaviou IC2.4.1 Stupies IN THE VeLocity of Money The velocity of money in the Indian economy has tended to trend downwards since the 1970s in response to the process of financial deepening. While the decline in the M, velocity appears to be, more or less, arrested in the 1990s, the Mj velocity has continued to trend downwards. This places India in the middle-income group in terms of the classification suggested by the Bordo-Jonung study (Jadhav, 1994). The M, velocity is relatively more volatile because of a number of factors. First, the re-classification of the withdrawable portion of savings deposits from time deposits to demand deposits in 1978 created a break in the series. Secondly, the periodic rallies in the capital market tend to impact narrow ‘money as: household savings switch from fixed deposits to current accounts of brokers or mutual funds. This is buttressed by similar flows to vostro accounts maintained by foreign institutional investors who made major investments in the Indian stock markets in the mid-1990s, when emerging market economy stock was in fashion, towards the end of the 1990s, when Indian information technology stocks rode the boom in‘technology scrips all over the world and in 2002-03, when Indian stock offered attractive returns relative to what was available elsewhere. Thirdly, the flight-to-safety of household savings to fixed deposits and social security from capital market instruments and public deposits with non-banking financial companies (NBFC) has very different implications for narrow money. While a switch to bank fixed deposits or small savings from the capital market or NBFC public deposits entails a corresponding reduction in narrow money, a shift to insurance is usually neutral to narrow money, because the ultimate recipients, be they brokers, NBFCs or insurance companies tend to transact their business essentially through current accounts. Finally, the gradual shortening of the minimum maturity of time deposits to a week is also blurring the distinction between narrow money and broad money. a The M, velocity of money has, in fact, continued to trend downwards, in line with the long-term trends, suggesting that the process of monetary deepening is still not complete (Figure 2.2). Financial innovations, once they are sufficiently deep, should enable a smaller money stock to support a larger nominal demand and induec an increase in the income velocity of money — which was actually the case for a brief period in the mid-1990s. 8 74. zie - ee, & 5 4 _ Spread of banking habits Large capital - 4 7 Phase of financial liberalisation 14 — a Bo Be) 8 8s soe eS g& £@ #©£ € gs 86 & 2 F F&F & S 8 8.8 8 £€ 8B F F E Sect oS = = E Ss a 3 : end-March = GDP/Mg .. - GDP/M, Figure 2.2 Income Velocity of Money50 Monetary Policy, Financial Stability and Central Banking in India A critical reason for the sustained downtrend is that most of the financial innovations in the 1990s, in the form of certificates of deposits (with banks as primary issuers) ‘or commercial paper (with banks as primary holders), have taken place within the banking system, which continues to remain special. Credit card transactions also continue to remain small and are in any case settled through the banking system. A second reason is that since Indian monetary aggregates are not compiled on a residency basis, the large-scale non-resident deposit flows of the 1990s ended up bloating broad money, as they were counted as deposits instead of being set off against banks’ foreign assets. The few studies of velocity that are available in the Indian context may be classified into three broad groups: those which are descriptive in character, thése which are explanatory and those which attempt to investigate the stochastic properties of velocity behaviour. One of the earliest attempts in the descriptive category was by Iyer (1970), which observed a declining trend in velocity of both narrow as well as broad money during the period 1955 through 1969. Saravane (1971) followed a sectoral approach in analysing money demand as well as velocity of money and pointed out that the velocity - of money for the household sector ranged between 5.44 and 6.91 during 1950-51 to 1962-63 with marginal year-to-year fluctuations. Vasudevan (1975) found that velocity of money displayed characteristics of instability during 1951-52 to 1973-74. ‘The search for a suitable econometric function for velocity of money in India began, probably, with Venkatachalam and Anjaneyulu (1970). Subsequently, Singh, Shetty and Venkatachalam (1982) study pointed out that velocity of narrow money displayed a sharper decline after 1975-76 than that warranted by the secular increase in monetisation of the economy due to the suddenness in the emergence of inward remittances (during the second half of 1970s) leading to large accumulation of money balances on account of the decision delays by wealth holders. Chakrabarty and ~ Varghese (1989) demonstrated that faster financial deepening of the economy (in the latter part of the period 1950-51 to: 1984-85) has caused the decline in velocity for broad money. ‘As mentioned earlier, besides these econometric studies of velocity behaviour, there are few other studies of velocity dealing with its stochastic properties using time- series methods. In the Indian context, Kamaiah and Paul (1979) attempted to fit a velocity function for India using annual data up to 1974-75 based on the conventional variables, such as, real income, interest rates and prices expectations. Subsequentl; Kamaiah, Paul, et al. (1987) used autoregressive integrated moving average (ARIM. ne methods on quarterly data for the period 1970-71 to 1981-82 to conclude that veloci : behaviour of narrow money does not appear to follow the random walk feminaie etd in the stock of money could lead to predictable changes in the nominal -This was confirmed in a study using quarterly seri ee well as broad money-constructed for the period ‘9s Ml iaiiseai cena. ~- =A serviceable velocity function was set up with a set of explanator Sere is rea incase nlereat ate le epecailfolicotmmmercialiie earcic neta by population per bank-office), the degree of financial sophisticati es (as measured by the share of assets other than bank deposits in the gross financial Seite houschold sector) and monetary expansions in the past. The results fees diateMoney Matters 51 (Velocity of broad money in India turns out to be highly predictable, which __ conforms with the monetarist paradigm. Gi) Inclusion of the ‘institutional’ variables improves the statistical properties of the fit and more importantly, brings about a sharp fall in the magnitude of the long-run real income elasticity of velocity. (iii) The implied long-run (nominal) interest semi-clasticity of velocity is of the order of 0.6 and it docs not seem to be sensitive to the presence of ‘institutional’ factors as additional explanatory variables. (iv) Monetary accelerations tend to exert negative influence on velocity of money with a lag in line with the monetarist hypothesis. ‘A crucial issue is the stability of the velocity of money-in the Indian economy in the context of the financial innovations taking place in the Indian economy. The downward drift in the M, velocity has.been accompanied by a diminution in the Volatility perhaps because the countervailing forces of monetisation and financial innovations in the- 1990s have imparted a degree of stability (Table 2.4). ‘Table 2.4 Velocity of Money — Summary Statistics Statistics 1971-2004 1971-1990 1985-2004~ 1 2 3 , Mean 27 at its Volatility ; 03 na e ‘Augmented Dickey-Fuller Unit Root Test Statistic -1.30)) ~09112)] “aang MacKinnon critical value for rejection of hypothesis at 1 per cent level ~3.6 39 “a