Velocity and Money Demand
Assume, based on income, a person spends $30 a day on goods and services.
The person has a savings account at a bank. This savings account is not money since the person cannot use it as a medium of exchange but it does pay a “market rate” of interest. A “market rate” of interest is the current interest rate in the market place and is higher than what a checking account may pay (often, checking accounts pay no interest). To be able to buy stuff, the person must visit the bank and transfer money from their savings account to checking or into currency. You can think that the person deposits a paycheck into the savings account every payday to replenish the savings balance.
1) Assume when the person goes to the bank, they withdrawal $600 from savings (putting the money into checking or keeping it as cash).
What is the person’s annual consumption? _$30 a day * 365 days a year = $10,950
How many days will their money last? _$600 / $30 a day = 20 days
How many times will the person visit the bank every year? _365 days / 20 days = 18.25
What is velocity? (hint: it’s the same as the number of trips to the bank per year) _18.25
2) The person changes their withdrawal to $300 each visit. $30 per day spending stays the same.
What is the person’s annual consumption? _$10,950
How many days will their money last? _10 days
Compared to case 1, how does this change the quantity of savings? _Increases. Though the person over the year will withdraw the same amount of money from savings, they will withdraw it slower. This means average savings balance will be higher.
How many times will the person visit the bank every year? _36.5
What is velocity? _36.5
What is the relationship between velocity and how much money people carry (demand):
If velocity goes up (from 18.25 to 36.5) people will end up holding less money (taking out $300 instead of $600)
3) The person wants to reduce velocity to 12. Daily spending stays the same.
What is the person’s annual consumption? _$10,950
How many times will the person visit the bank every year? _12 (= velocity)
How many days must their money withdrawal last? _365 / 12 = 30.417
How much money will the person need to withdrawal? _30.417 * 30 = 912.50
How does this change the quantity of savings? _It goes down since they’re withdrawing so much money
Why would someone want to make more frequent trips to the bank?
To keep more in savings and hold less money.
You would do this if the nominal interest rate is high
Why would someone want to make less frequent trips to the bank?
There is a high cost of banking – it costs a lot to go get more money. The bank is far away, or there are high fees for withdrawing money.
Money Equilibrium Review
1) Describe what happens in the market for money when there’s a money surplus:
2) Describe what happens in the market for money when there’s a money shortage: