Is money velocity pro-cyclical? The case of India

Abstract

AbstractMonetary targeting served as a useful tool for conducting monetary policy until 1980s, but the instability in the relationship between money and nominal income led to its abandonment by most economies. One way of measuring this relationship is money velocity, defined as the ratio of nominal income to money. The purpose of the present study is to show that if short-run cyclical factors are accounted for, money velocity function becomes stable and thus any change in monetary aggregates will lead to predictable change in nominal income and therefore inflation. In such a scenario, monetary targeting can serve as a useful tool in the conduct of monetary policy. The study utilizes quarterly data from 1996:Q2 to 2020:Q1 and time series methodology to conduct empirical analysis. Findings show that money velocity and all its identified determinants exhibit pro-cyclical behaviour. After accounting for these determinants, money velocity has been found to be stable. The direction of causality runs from money velocity to rate of interest to investment to GDP. Thus, when formulating monetary and fiscal policies, policymakers can monitor the short-term cyclical patterns in money velocity as an indicator of forthcoming expansionary or contractionary conditions in the economy to design effective policies.