The Velocity Crowding-Out Impact: Why High Money Growth is Not Always Inflationary

Abstract

In the mainstream monetary policy consensus that prevailed prior to the global crisis, there was increasing de-emphasis on money and credit aggregates in the conduct of monetary policy, because of the overwhelming faith on the interest rate, both as an instrument of policy and as an indicator of overall monetary and liquidity conditions. In the aftermath of the global crisis, however, there seems to be a renewed emphasis on money and credit trends, though how the money growth indicator could be used in the actual conduct of monetary policy remains largely unclear. The Reserve Bank, despite abandoning explicit monetary targeting in 1998, still continues to announce indicative money and credit growth trajectories and also monitors their trends in order to identify any lead information that may be relevant for policy. In the analysis of the information content embodied in money growth, recognizing the possible sources of instability in money demand and resultant changes in money velocity becomes critical. In the context of the severe "velocity crowding out of quantitative easing" that was experienced in the US in the midst of the global crisis, it is important to recognise that external developments, particularly the risk of contagion from a crisis, could at times add significant instability to domestic money demand. Shocks to money demand from both anticipated and unanticipated factors could make the velocity unstable, adding thereby noise to the analysis of the money growth variable. This paper studies the money velocity trends for India, and using the standard determinants of velocity from the literature, it aims at exploring the possibility of generating forward looking assessment of velocity, so that money growth trends could be better explained relative to other economic variables, particularly output and prices. Every projected money growth trajectory, ideally, is linked to conditional predictability of velocity, which though is not always feasible.But in the absence of a reference to velocity trends, money growth alone at times may be misleading, even in the short-run. As per the empirical findings of this paper, conventional determinants of velocity appear to be statistically significant for Indian data, but the estimated parameters alone may not be sufficient for undertaking a forward looking assessment of velocity, particularly during periods of major uncertainty that could cause velocity to deviate significantly from its medium-term trend.