Money is only a means to an end, and the end is the total volume of spending, which should be sufficient to give us high employment but not so great as to produce excessively rising prices.
When the Federal Reserve increases the money supply, the recipients of this additional liquidity probably spend some of it on domestically produced goods and services, increasing GDP. The funds thereby move from the original recipients to the sellers of the goods and services. Now the sellers have more money than before, and if they behave the same way as the others, they, too, are likely to spend some of it. GDP thus rises further, and the money moves on to yet another set of owners, who, in turn, may also spend part of it, thereby increasing GDP again. Over a period of time, say a year, a multiple increase in spending and GDP could thus flow from an initial increase in the stock of money.
This relationship between the increase in GDP over a period of time and the initial change in the money supply is important enough to have a name: the velocity of money. Technically speaking, velocity is found after the process has ended, by dividing the cumulative increase in GDP by the initial increase in the money supply.
Similarly, we can compute the velocity of the total amount of money in the country by dividing total GDP (not just the increase in it) by the total money supply. This gives us the average number of times each dollar turns over to buy goods and services during the year. In 1995, for example, with a GDP of $7,246 billion and an average money supply of $1,123 billion during the year, the velocity of money was 7,246 divided by 1,123, or 6.5 per annum. Each dollar, on the average, was spent 6.5 times in purchasing goods and services during 1995.
With this missing link-velocity-now in place, we can reformulate the problem of monetary policy more succinctly. The Federal Reserve controls the supply of money. Its main job is to regulate the flow of spending. The flow of spending, however, depends not only on the supply of money but also on that supply’s rate of turnover, or velocity and control of this the Federal Reserve does not have under its thumb.
A central problem of monetary theory is the exploration of exactly what determines the velocity of money-or looked at another way, what determines the volume of spending that flows from a change in the supply of money. As we shall see, disagreements over the determinants and behavior of velocity underlie part of the debate over economic stabilization policy.
But there’s more. The Federal Reserve has to worry not only about the relationship between money and spending but also about whether prices or production responds to increased spending. More GDP is good if it corresponds to more production but not so good if it means higher prices. Either outcome is possible. And that brings us to the subject of inflation.