Explain how the velocity of money is likely to change when the following stabili

Question

Explain how the velocity of money is likely to change when the following stabilization policies are undertaken. How will this change in velocity affect the impact of the stabilization policy? (Hint: In each case, think about the effect of the policy upon interest rates, and the effect of interest rates upon velocity).

a)     The government increases its spending.

b)     The Fed engages in open market sales of government securities.

c)     The Fed lowers the required reserve ratio of commercial banks.

d)     The government raises the income tax rate.

Explanation / Answer

A) Initially the economy is in equilibrium. As the government increased its spending, there is greater demand of goods and services in the economy and result into higher demand level in the economy. Due to this the interest rate will rise.

As there is a direct relationship between rate of interest and velocity of money, the rise in interest rate will lead to rise in velocity of money. The reason behind this is that the interest rate is the opportunity cost of holding money; it’s intuitive that higher interest rates increase velocity of money.

B) In this case the central bank engages in open market operation if sales of government securities. It will result into less disposable cash in the hands of people and the money supply will fall. As the money supply falls, the interest rate rises and intuitively the velocity of money also rise. The reason being the same as given in part (a) that interest rate is the opportunity cost of holding money.

C) In this part, the central bank lowers the required reserve ratio of commercial bank. It means now banks has to keep less of money in vault and therefore they are able to give more loans. Result of this is people has more money in their hand implying the money supply has increased and the consequence of increased money supply is the decreased interest rate and intuitively the lower velocity of money. The reason being the same as given in part (a) that interest rate is the opportunity cost of holding money.

D) Now, the tool used by the government is tax rate. The government increases the income tax rate implying that people are left with fewer disposable income and consumers demand less even at the same price level. This will lead to lower demand in the economy and as a result the interest rate will fall. The reason being the same as given in part (a) that interest rate is the opportunity cost of holding money.

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