Impact of Velocity of Money for Malaysia

The quantity theory of money (QTM) asserts that aggregate prices (P) and total money supply (M) are related according to equation:

P = VM / Y

where Y is real output and V is velocity of money.  A central implication of QTM is that a given change of money growth induces an equal change in inflation rate. Milton Friedman thus claimed that “inflation is always and everywhere a monetary phenomenon”.

A crucial assumption behind this claim is that the velocity of money or its growth rate is constant and money growth has no effect on real GDP growth. For Malaysia, we could use the same equation for velocity, V=PY / M. In which case for a 5-year period, the velocity ratio of nominal GDP to quantity of money (M2) was as follows:

	2013	2014	2015	2016	2017	Jun-18
Nominal GDP (RM trillion)	1.02	1.10	1.16	1.23	1.35	1.45
M2 (RM trillion)	1.44	1.54	1.59	1.60	1.72	1.77
V = PY/M	0.71	0.71	0.73	0.77	0.78	0.82

It may be observed that the velocity of money remains rather constant with some marginal increase from 2016.

According to St Louis Federal Reserve (Yi Wen, on “The Quantity Theory of Money”, Paper No. 25) the post-war U.S. data suggests that velocity of money is far from constant. So instead of assuming the velocity of money or its growth as a constant, we can use the QTM equation (in lower case and percentage change in growth rate)

v = p + y – m

to accommodate the changes in velocity to be dictated directly by three sources: inflation, output growth and money growth. For the U.S., in the long run Friedman is probably right – changes in inflation and changes in money growth are closely related (St Louis Federal Reserve, 2006, Number 25).

In Malaysia, money growth (M2) was observed as follows:

	2013	2014	2015	2016	2017	Jun-18
Change in M2 (%)	7.94	7.53	2.88	3.05	4.82	5.71

And inflation over the same period was:

	2013	2014	2015	2016	2017	Jun-18
Change in CPI (%)	2.10	3.20	2.10	2.10	3.50	0.80

Nominal GDP growth declined from 6% in 2014 to 4.5% by June 2018, as depicted below:

	2013	2014	2015	2016	2017	Jun-18
Change in GDP (%)	4.70	6.00	5.00	4.20	5.40	4.50

What does this mean? How fast money changes hands per unit of time is the velocity of money. This is a gauge of economy’s strength or people’s willingness to spend. Since December 2017, the tempo in the Malaysian economy has dropped. Velocity of money, as expressed earlier, v=p+y-m and shown below (from 2013 up to June 2018):

	2013	2014	2015	2016	2017	Jun-18
Velocity of Money (%)	(1.14)	1.67	4.22	3.25	4.08	(0.41)

In a sense higher velocity may suggest greater vibrancy in the economy and that it is likely to expand. Over last five years, this has been upward from 2013 with a general decline thereafter (save for a rise in 2017).

Stable money growth assists in keeping inflation in check. That’s helpful to savers but does not encourage consumption or business uptick. (We are far from hyperinflation for now and that’s 50% increase per month – a’la Venezuela or Zimbabwe).

So what can we do? The Central Bank has an array of tools (interest rate, reserve changes and open market operations) but policy constraints or conundrum may veer towards “tweaking” than a radical shift. A low interest rate environment may assist in business sentiment or provide conditions for growth. But that impacts exchange rate in a rising interest rate regime of the U.S. So should we do quantitative easing (“QE”) to stimulate growth and income? But that may impact inflation.

The U.S. did its QEs for six years without inflationary pressure because the economy was already deflationary when it began. In addition, banks and financial institutions hoarded the money in order to shore up their own balance sheets and regain profitability. Banks had toxic loans and were unusually cautious. Meanwhile, the real economy remained productive and growing. M2 money supply remained fairly stable.

For Malaysia, we need stimulants of the right type – perhaps measured quantitative easing - and appropriate fiscal measures to improve the general economic tempo. And that we hope the Minister of Finance could do in Budget 2019.

References:

1. The Quantity Theory of Money, Economic Synopses, 2006 (Number 25)

2. Money Growth, Money Velocity, and Inflation (www.thismatter.com)

3. What is the correlation between money supply and GDP? By Sean Ross (www.investopedia.com)

4. How does the velocity of money affect a national economy? (www.quora.com)

5. Department of Statistics and Ministry of Finance, Malaysia

6. www.tradingeconomics.com