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Introduction

The quantity theory of money continues to be the most fundamental benchmark reference point for any monetarist analysis involving the causal relationship between monetary aggregates on the one hand and output and prices on the other. The theory, which is essentially an identity (i.e., MV=PT), has often been very simplistically interpreted to drive the message that “an increase in money supply causes proportional change in the price level”.

In this identity, M represents the stock of money; V is the transaction velocity of money, i.e. the number of times money may change hands in facilitating multiple transactions; P stands for the price level, relevant to the transactions financed by money; and T covers all transactions in a money-economy where each transaction may involve money as a “medium of exchange”. PT is the value of all transactions undertaken with money.

If V is time invariant or constant, and money is neutral in both long-run and short-run (i.e. no impact on output), then increase in money could lead to proportional increase in the price level. If money is non-neutral in the short-run (which is the mainstream belief that underpins the conduct of monetary policy), then increase in money supply could have dual effects, i.e. on output as well as inflation.

Assessment

An assessment of money velocity in relation to trends in nominal GDP suggests the following:

• The money velocity has persistently declined over last several decades, which could be ascribed to increasing monetization of the economy. Empirical literature suggests that countries may experience “U” shaped velocity pattern, as in the initial stages of development, due to increasing monetization of the economy, money demand increases (which gets reflected in money supply growth) and velocity drops. After a point, however, advances in financial system and results from financial innovations, technological innovations (like greater use of ATM/credit cards) and increasing...