What's Up With Velocity?

[Parts of this post are plagiarized from the Wikipedia entry for ‘Liquidity Preference”  for which I offer no apology. I vouch for the correctness of what I have plagiarized.]

In macroeconomic theory, liquidity preference refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity.

According to Keynes, demand for liquidity is determined by three motives:

1. The transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
2. The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
3. Speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases, people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate. The supply of money together with the liquidity-preference curve in theory interacts to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied.

Monetary velocity is a function of the liquidity preference. When investors and businesses expect bond prices  to fall, they maintain large cash holdings. When they expect bond prices to rise, they draw down their cash and invest in bonds. Today, velocity is low because of a high liquidity preference caused by the trauma of the Crash, and the perception that bond and stock prices are “too high”. In other words, a big part of M2 is not for transaction balances, but is rather a savings vehicle. This is exacerbated by the fact that the yield curve is low and flat. The opportunity cost of holding money is very low by historical standards. Going forward, market volatility should support low velocity, whereas a continued bull market should--at some point--begin to reduce the liquidity preference. Higher interest rates would also raise the opportunity cost of holding cash, and would increase velocity. Velocity will remain low until nominal growth returns to historical levels, which could be a long time.

Investment Conclusion

Economic growth has been retarded by the increase in the liquidity preference which has meant declining velocity in the face of growth in the monetary aggregates. The liquidity preference is a function of nominal interest rates, which are very low. The opportunity cost of holding cash versus bonds is minimal. The economy needs a much steeper yield curve, and it’s not going to happen.