Money, Credit and Velocity MACK Ofl Shakespeare: “Neither borrower, nor a lender he and to examine empirical evidence bearing on their (Hamlet, 1, iii, 75, Polonius to Laertes) purported policy consequences. The analysis pre- Goethe: “Let us live in as small acircle as we will,we are sented in this article does not support the critics’ either debtors or creditors before we have had time to look assertions. This conclusion rests on two arguments. around.” (Elective Affinities, Bk. II, Ch. 4) First, the relation between money and credit requires thatthe amount ofcreditgranted match the anticipated amount ofmoney thatwill be available to settle the debtwhen it comes due. Thus, regulating R.ECENTLY, many critics of monetary policy, the rate ofmonetary growth, which in turn regulates and some monetary policymakers as well, have as- the anticipated future quantity of money, deter- serted that the links between monetary aggregates minesthe amount ofcreditand theconditions under and national economic policy variables—that is, which it is granted. This constraining influence of GNP, inflation and real economic growth—have monetary growth on creditwould be undone only if been severed by a host offinancial andcredit market the relation between money and income growth innovations. If these critics are correct, then a departed from its historical pattern. monetary policy based on targetingthe growth of a monetary aggregate would become increasingly That it has not is the second argument: the em- ineffective and inappropriate, as credit arrange- pirical evidence on velocity, the relation between ments are substituted for monetary payments.1 money growth and income growth, reveals no sig- nificant change during the last two years from its The purpose of this article is to provide a theo- previous history. Consequently, despite recent retical framework in which to assess these claims claims to the contrary, the growth of the monetary aggregates is still reliably linked to the economic variables of interest to policymakers. The author, an associate professor ofeconomics at The Pennsyl- vania State University, isa visiting scholaratthe FederalReserve Bankof St. Louis. ‘For examples, see Neil C. Berkman, “Abandoning Monetary MONEY, CREDIT AND EXCHANGE Aggregates,” in Controlling Monetary Aggregates Jil, pro- ceedings ofaconference sponsored by the Federal Reserve Bank In contemporary societies, the exchange of goods of Boston (October 1980), pp. 76-100; Benjamin M. Friedman, is indirect The purchase or sale ofgoods, whether in “The Relative Stability of Money and Credit ‘Velocities’ in the United States: Evidence and SomeSpeculations,” NBER Work- organized markets or through informal arrange- ing PaperNo. 645 (March 1981);Anthony M. Solomon. “Finan- ments, is almost always in exchange for money or cial Innovation and Monetary Policy” (remarks before the Joint money-denominated promises. Direct bartering Luncheon of the American Economic and American Finance Associations, December28, 1981); James M. Tobin, “Inflation,” of one good for another is either nonexistent or in Encyclopedia of Economics, Douglas Creenwald, ed. unimportant (McGraw-Hill, 1982), pp. 510-23. Forthe contraryposition—i.e., that monetary policy should be undertaken through effective The reason for this is at once obvious, yet theo- control ofa monetary aggregate—see Milton Friedman, “Mone- retically challenging to elucidate. In the intro- tar~’Policy: Theoryand Practice ,“foun,al ofMoney, Credit and duction to his book, Theory of Money, Jurg Banking (February 1982), pp. 98-118; and Allan H. Meltzer, The Robert H. Rasche, Stephen H. Axilrod, and Peter Sternlight, Niehans observes: “Money, Credit, and Banking Debate: Is theFederal Reserve s Monetary Control Policy Misdirected?” Journal of Money, Economists (and laymen) have always felt that the Credit and Banking (February 1982), pp. 119-47. use ofa medium of exchange increases the efficiency 21 FEDERAL RESERVE BANK OF ST. LOUIS MAY 1982 ofan economy. The gain was usually considered tohe tam s what NI ilton Friecimain characterizes as large. it hats both qualitative and quantitive aspects. temporary abodes of purchasing power that are The qnaliative aspects appear when monetary ex- reatdilv convertible at low cost into an exchange change is compared with barter. Classical and nec)— medium .~ classical economists were graphic in describing the double coincidence of wants of the hungry tailor and the shivering baker which would he necessary for Second, if the purchase of tlte good to be financed an e xchalt go ill a I~arte r eco nout van cI the narrow by the proceeds front the sale of another good pre- limitations it imposes on the division of lahor. The cedes the sale of that other good, then the anticipated use of’ us oncy wool cI increase cc-el hue by freeing future sale proceeds may he used to ntediate the exchange from the shackles of the double coinci’- 2 earlier purchase. Of cotuse, an exchange arrange- dence of wants. ment like this is a fitmiliar part of modern economies; such purchases are said to he macic “on credit.’’ Robert Clower succinctly summarized the results Credit is granted b sellers or other third party of these advantages as imposing a constraint on ‘the lenders to buyers precisely on the basis of the exchange process: ‘ Money buys goods and goods buyers anticipattecl future receipts (with the lender buy money; but goods do not bny goods.’’~In other concurring) and, of course, is measured in utonetary words, it is the nature of a system of monetary ex- units. As a consequence. credit is as much of a change to replace the cumbersome barter exchange medium of exchange as is money-.8 of goods with two non—synchronized monetized exchanges: at sale of goods for money and a later While both credit and money atre used to mediate purchase of goods by money. This exchange attrib- exchainge, they are obviously different entities. The ute in turn has implications for both the appropriate qttautity of money circulating in ant economy is at definition of money and for the monetary- arrange- stock; its units are used repeatedly itt at sequeitce of ments used in exchange.4 exchamges. Credit, on the other hand, is a flow and is transaction—specific; it can only mediate the trains— First, the period between the sale of one good fbr action fkr which it was created.~ money and the subsequent purchase of another good may be long ettonglt or predictable enough to allow t the interim holding of funds in a non—transaction Two good s tISalt are Pc ii ec-t sobs tito tes atre ectsn Ontical Iv tltt’ saltic’ account. This implies that the appropriate monetary good. If two dluraslsle goods are cssstlessly translorosalsle. sloe intts he cstls c-’ r, tlteis tlsc v are pe rfec:t oils sti totes i It ails Ityento i-v - On aggregate may not be narrowly defined money (i.e., tlsis criterion, if the cost of trasnsferrisg funds froloasaviogs Ml), bitt a broader aggregate (e.g., M2) which con- ascc 000 t to a’ dIe itt all id ascd ow) t1 (Sr tts cat rid’ nc-v cv crc’ xc’to. t Iteli, cleat rI v, sasvhtgs scudssiitts wot tIc be eco ‘soiss i call v in cli itin gu is1 able flsno dci I and aicco outs tsr dill-re!)c-v at nd cviso Ici hc’ cxc I saili gr- istccl iat - Cooce rse lv, if th cc cit sts of trat)) STi~cv crc’ proIs il si ti ye1 ~ lasrgc’. sasc-iogs ascconitts would not Its’ at closc’ sohstitote for burg Niebasits, the ?heor o/i/oslc-lf (jtslsits Hopkins University t deinaotcl deposits. llencc’, ass Fniedloaso and Schwasrtz aarglls’, tlsc’ l rcss. 1978), is 2. qnes tict is of cc-I tact in~n c-v is caoti sot be sc ttli’d on an at pri sri I sat s’s. an sert \V. Clow Cr, ‘‘A Recoit siderastisSn of tlt e NI i e rolou it clation 0 ]s sit is as,) c’inparic:as I it’ stion xv it i cIt, iii pairt, dlepc’Id 5 015 liow of Nitti,ctarv The it rv,’’ Ue.s te,l butt it it Jo 01(1? (NI arc’lt 1967). c:o stlv ill te r—dlepOsit trasi n ft. rs a,rd - ~t6. Also, see Karl Brunner and Allan H, Meluer, ‘‘The Uses of °‘l’lsis olsservastion li its I ccl Clocvc’ r ails cI oth cr5 tss as rgtt t’ tIlast sIllnd NI toca N lo isti V iit Ut c Titeon of Ai Exchange Econctits y,’’ A; car— 1 1 IIseal Snrc’ of c-s-cdit tic ~ii/c?~ /ftp or ist c’ of c-red it be’ in c-lu c ccl an t ltd a(~ossEcas ;iis;;i ic Rei - ic Ic (Decent her 1971), pp - 784—805. p0 lit-v ri-I c’vasnt conc:ept of 111011ev: ‘‘for mdlsat pratcticasl l~ NI iI ton Fric’di 0 am and A itI las 5(11w asrtz cI C Sc ri hecl tlt is attn ho te ass poses, ‘ntis rs c’ v’ shcsul cI ht-’ tint sit lc’recI tcs md sidle Iraid e c-ri-cl it ass tlte Se itarati rut of the act of ~torchase f rot it tlte act of sale,’’ hi It well as c-u nt’s d’V a, Ic1 dIe It) sn dl dcc piss its. litsI sc- rt IV. Clocvc’ critic-ired the itt c-cl ~II lit of cxcit ange attproach as Ite fog titi I narrow Tlsecsrc’ticasl F; son dlast sins of Nit ltd tasr>- Pol ic:v,’’ in hissIt’ tc; 5-if 5 to calptsire the essential nature of lnonc’v: T/~c’oojcis~c?Mossetos-sj Pcs?it-sy iii t?sc’ 1970.s, (;ecsrgi- Clasytisu, jcslsn C. Gilbert audI Rohert Seclgccic:k, ecls - (Oxford University Press.