[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

we need to hold. Money we do not need for transactions is better used to purchase
financial assets that earn interest. Increases in the dollar value of transactions
increase the demand for money; decreases in the dollar value of transactions decrease
the demand for money.
A useful simplifying assumption is that the amount of money individuals hold
is proportional to the dollar value, or nominal value, of their income. The same will
be true when we aggregate the economy; the overall demand for money will be proportional
to aggregate nominal income, which we measure by GDP. As we learned
in Chapter 22, we can express GDP as PY, the price level (P ) times the real GDP
(Y ). If nominal income in the economy rises, people hold, on average, more money.
Nominal income can rise because of an increase either in real incomes or in the
price level. If their real incomes rise, people will typically hold more money on average,
since they are likely to increase consumption and thus engage in more transactions.
Money demand also rises if the general level of prices rise, even if real
income remains constant, because each transaction will involve more dollars. When
every cup of coffee costs, say, $3 rather than $2.50, it takes $30 rather than $25 to
fill up a tank of gasoline, and the bill for a trip to the grocery store is $60 rather
than $50, individuals, on average, will need to hold more money to carry out their
transactions.
Velocity The relationship between the aggregate demand for money and aggregate
nominal income can be represented by the quantity equation of exchange,
which defines the amount of money that individuals wish to hold as proportional to
nominal GDP. We can write this equation as
MV = PY,
where M is the quantity of money demanded and PY is the nominal GDP. The final
term in the equation is the factor of proportionality or velocity, V. Suppose, for
example, that each individual in the economy held enough money to pay for one
month’s worth of spending. In this case, velocity for each individual would equal 12—
annual expenditures would be twelve times the average level of money held. If an
individual’s annual income was $60,000, on average he would want to hold $5,000.
If velocity were 26, so that on average individuals held an amount of money equal
to only two weeks’ worth of expenditures, someone with an annual income of $60,000
would hold $2,308. When we add up all the individuals in the economy, velocity
enables us to predict the aggregate demand for money when the aggregate income
is known. For example, suppose GDP is $11.2 trillion per year and velocity is 26. Then
the demand for money will be $11.2 trillion divided by 26, or $43 billion. Velocity,
therefore, is a measure of how many times a given dollar gets spent over the course
of a year. The higher the value of velocity, the more times a dollar is spent—the faster
it speeds from one transaction to another.
Velocity will depend on the methods available in the economy for carrying out
transactions. If many purchases are made with money, V is larger than if money is
rarely used in making transactions. If innovations in the financial industry reduce
the average amount of money that individuals need to hold, velocity rises.
608 ∂ CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVE