CHAPTER 21 The Demand for Money 555 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 1 F I G U R E 1- 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 Change in the Velocity of M2++ (gross), 1968 2008 Shaded areas indicate recessions Source : Statistics Canada CANSIM II series V41552801, V41707150, and V1997756 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