Sunday, April 19, 2009
Velocity and Nominal Interest Rates
Macroeconomics predicts that people will hold less liquid money at higher interest rates because of the opportunity cost of interest they could have earned by investing. Does the data fit the prediction? In the graph above, it appears that it does. When velocity, $Y/M1, is high, people are holding on to their money. This infers that the interest rate is high. Some data is unavailable for 2004-2008. I also used the mean values of velocity and one-year treasury bills.)
You can algebraically obtain a relationship between velocity and nominal interest rate. I used the equation for money demand (M = $Y(Func*i), divided both sides by $Y. Since velocity is $Y/M, I took the inverse to obtain $Y/M = 1/Func(i)). This equation shows that the two variables are inversely related.