Definition of Velocity of Money

Velocity of Money

Let M be the nominal stock of money, let P be the nominal price level, and let Y be the flow of real transactions (often proxied by real GDP). The equation of exchange

MV = PY,

where V is the velocity of money, always holds because the velocity of money is not directly observable. In other words, the equation can be rearranged to make it clear that it is simply the definition of velocity:

V = PY / M.

This math can be turned into a theory of the demand for money if the velocity is taken to be a behavioral outcome determined as a function of certain variables such as real transactions and the interest rate.

The former interpretation as an accounting identity is found in the Classical Model. The latter interpretation is found in the Keynesian IS/LM Model.

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