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Nick,

Does the velocity of money, as taught to undergrads, include things like bonds/stocks/commodies/derivatives/etc. or anything else sold in the financial markets?

JoeMac: yes and no. There are two definitions of velocity of money:

1. Income velocity, as defined by MV=PY, where Y is income (expenditures on newly-produced final goods only.)

2. Transactions velocity, as defined by MV=PT, where T is all transactions (including bonds, stocks, used cars, intermediate goods, whatever).

(I expect I am talking about transactions velocities in this post.)

Isn't "If all other goods became less liquid, that would increase the demand for money" a tautology? Isn't saying that the demand for money had increased the same thing as saying that other goods have become more illiquid?

And where are expectations in all this?: "if the demand for money increases, but the central bank does not increase the supply of money in proportion, and if prices are sticky, the result will be a recession." If the demand for money increases because expectations about future real income are lower , and unless the central bank increasing the money supply are guaranteed to raise expectations about future real income (as differentiated from future nominal income) I'm not sure how increasing the money supply avoids a recession.

rob: I don't think it's a tautology. I can imagine a world in which everyone wants to keep $1000 in their wallets and bank accounts regardless of whether the other assets they held were very liquid or very illiquid. But it doesn't seem likely they would in fact behave that way.

Sure, other things will also affect the demand for money. But the liquidity of other assets should affect it too.

I agree with everything you just wrote. This is more or less exactly how I think about the matter. Very succinctly put!

Nick, I think you might want to consider the fungibility of the asset in question. That's probably more important than velocity in determining liquidity.

First: When Menger talks about "marketability" does he mean the same thing as hat you call "liquidity" here ?

I'm trying to think about this in terms of a barter economy where there is no single money commodity but some goods are more "liquid" than other. I think that the more liquid a good becomes then the more its value increases (assuming that demand for it for other reasons than its liquidity stays the same). Then if all other goods but one (say gold) becomes less liquid their value must fall and that one good (gold) must become relatively more valuable. Doesn't that make your statement a tautology ?

But if you bring expectation back in. If expectations about future sales (future income) are low then the demand (and the value) of relatively illiquid goods falls for reasons other than their liquidity.


Lee: thanks!

HJC: Yep, if all new and used cars were identical, and were perfect substitutes for each other, cars would be fungible, and much more liquid. But unless that degree of substitutibility changes over time, it wouldn't be very interesting to macroeconomists trying to explain why the economy changes over time.

Now, if an increase in risk makes some so-called "AAA" assets risky, and others remain safe, but we need to do some research to find out which is which (like having a mechanic inspect a used car before buying it) then that would make those assets less fungible and so reduce liquidity. That's what I was meaning to refer to at the end of my post.

rob: I think "marketability" and "liquidity" are, at least, closely related.

Talking about the liquidity of goods in a barter economy is a bit strange. Because you will get a whole matrix of liquidities, associated with the ease of trading good x for good y, which will depend on both x and y. Only in a monetary exchange, where all other goods trade for money, can you talk about the liquidity of good x.

"....Doesn't that make your statement a tautology ?"

Not a tautology, but I think I now see your point. It seems to follow fairly trivially from the premise that people value liquidity, so if other assets become less liquid relative to money, people must value money more relative to other assets. Let me think about that.

Nick, I get your point, fungible assets will remain fungible even in a crisis. Liquidity (i.e. the ability to sell an asset in a short time without loss of value) could possibly be a function of fungibility and velocity. Money being extreme in both; and CDOs an example of an unfungible asset that had high velocity pre-2007, but not during the crisis, hence their illiquidity (and price drop) at that time.

Nick

I agree with most of this post, but I'm not entirely comfortable with the casual shifts between the 'most liquid good' conceptualization and the 'most liquid asset' conceptualizations of money.

A financial asset is necessarily somebody's liability. Goods are not.

Can you think of a *widely used* transaction medium of impersonal exchange that is not somebody's liability? My means of payment has to be somebody else's (somebody *superior*) promise to pay, for an impersonal system to scale up.

From there, it's also easy to see why what you see as liquidity crises are actually liquidity + trust + net worth crises, and why winner does take all, but in a manner limited by the strategy space available to different actors who operate in different hierarchies of money. Different hierarchies have different winners. For the market of my neighbourhood off-license and most taxi drivers, currency has won. For most other transactions, bank deposits have won. For a very large class if transactions, the promise to pay bank deposits (credit card) has won. Between large financial institutions and high net worth individuals, shadow bank deposits have won.

I particularly liked this statement in your post. "If all other goods became less liquid, that would increase the demand for money". I almost entirely agree. I'd change it to "this would increase the demand for money relative to supply", because it's not clear whether it's the *money supply* which is reducing or the *money demand* which is increasing. A reduction in the number of economic actors whose IoUs are highly liquid can be construed as one or the other, depending on how strongly you want to compartmentalize 'money' and how much you believe in the winner-takes-all formulation. But we can all agree that Md > Ms results, necessarily.

It also follows that there are multiple strategies to fight this disequilibrium.

1) Reduce the real rate of return on money.
2) Increase the number of economic actors whose IoUs are highly liquid. This can be done by fiat, by making the market for these IoUs, or by increasing the net worth of these economic actors.
3) Create conditions such that when the list of current economic actors with highly liquid IoUs suffers a collapse, new ones can step in without much trouble. This also builds trust and keeps liquidity of non-money assets high.
4) Increase the net worth of those economic actors who never had liquid IoUs but who form the bulk of spending demand.

Liquidity is always forward looking and is therefore driven by expectations. That is why your points 1-3 look a bit superficial to me. You can state them as such but it looks to me that there is little connection between 1-3 and the rest.

Now your point 4 is very interesting. In the light of the previous discussions on bubbles I can hardly agree to the inverse correlation between liquidity and (expected) rate of return. For bubbles it is clearly positive, i.e. the higher expected rate of return is the higher the liquidity is. I do not remember now whether you agreed or not that money is a bubble but the positive correlation is really out there. Which breaks your theory apart :) or?

Great post, but for precision's, the claimed big negative correlation between liquidity/velocity and returns (or, for that matter, liquidity premium) is nowhere clear from the it. Yes, the two positive sloped curves in the chart show that, in equilibrium, liquidity and velocity are highly sensitive to shocks, but it still looks like as big of a jump to extend that to returns. As it seems, the latter remains as an empirical matter.

Ritwik: yes, I did sloppily slide back and forth between talking about "assets" and talking about "goods". I certainly want to include real assets like houses and other investment goods as part of the story. It's not just financial assets. But the liquidity of non-durable goods doesn't really matter, because they won't last long enough for people to want to sell them. I need to get clearer on this distinction.

"Can you think of a *widely used* transaction medium of impersonal exchange that is not somebody's liability?"

If we are talking about the past, then yes. Cowrie shells, salt, cigarettes, gold. But yes, not today.

" I'd change it to "this would increase the demand for money relative to supply", because it's not clear whether it's the *money supply* which is reducing or the *money demand* which is increasing."

If we define "money" as broad money (or use "money" as an adjective, meaning "moneyness") then I think you are right. That's a good other way of looking at it. The supply of moneyness falls, so the equilibrium price of moneyness rises. (I think this goes back to rob's point.)

Sergei: "Liquidity is always forward looking and is therefore driven by expectations. That is why your points 1-3 look a bit superficial to me."

Hmm. I think I should perhaps restate my 1 in terms of *planned* velocity depending on *expected* liquidity. (Which makes my blue curve even more like the planned expenditure curve in the Keynesian Cross!)

"For bubbles it is clearly positive, i.e. the higher expected rate of return is the higher the liquidity is."

Hmm. I will think about that.

Mauricio: thanks! Yep, even if the theory is right, but empirically the effects are just too small to matter much, the theory isn't very useful.

But at one extreme you have currency, which pays a negative expected (real) rate of return but is very liquid. Even safe government bonds, which are still very liquid, pay a rate of return that is usually a couple of percentage points above currency. For long-lived assets, a doubling of the rate of return would almost halve the price. For assets like stocks, where we expect the dividends to grow over time, the effect of a change in desired rate of return would have an even bigger effect on price, because P=annual dividends/(r-g).

Good comments all. Thanks.

Nick,

You will also need to consider redeemability when looking at financial assets.

Liquidity is a measure of how easily an asset is bought and sold within a market. Redeemability is a measure of how easily an asset is converted to liquid form by the issuing agent.

This is especially true of fixed duration securities like long term bonds. They may be traded freely within a market (high liquidity) but may haved limited redeemability because of term structure (low redeemability).

This will affect velocity if market liquidity dries up.

Agreed, it all starts and ends with Menger.

Velocity is a pretty easy concept to understand. It's measurable... just put a computer chip on some item and monitor how often it changes hands. But you never really go into defining liquidity. What does it look like? How does one measure it? Are we talking bid-ask spreads? It's tough to figure out the empirical "oomph" of your post without a bit more colour on liquidity. Which is tough... remember your old L-data post?

JP Koning

Mitchell-Innes, not just Menger. :)

JP: Yep. "Liquidity" is a concept I've been struggling to define for some time. Some previous attempts: here, here, here, but I don't really feel satisfied with any of my answers.

Frank: Yep. I think that is especially important if there's a chance that everyone might want to sell at once ("rush for the exits"). The last of the three links above was my attempt to get my head around something similar.

JP,

I am not sure that bid-ask spreads fully capture the liquidity of an asset. Bid-ask spreads capture price volatility of the underlying asset, but they do not capture volume volatility. A person can choose not to sell his asset holdings at any price (hoarding) or can be forced to sell his asset holdings at below market price (bankruptcy / liquidation). With hoarding, volume decreases irrespective of price (reduced liquidity), with bankruptcy volume increases irrespective of price (increased liquidity).

Frank: for non-fungible assets, like used cars, bid-ask spreads are an even worse measure of liquidity. It's hard to say what they even mean. If I am buying a used car (or house), I face a trade-off. I can buy whatever is for sale quickly, or I can wait for a better price and for a car that is a lot closer to what I want.

Nick

Some combination of bid-ask spread and price-impact-of-marginal-sale is probably close enough to capturing the liquidity of pure commodities, whether financial or real.

However, as Perry Mehrling notes, the bid-ask spread that is relevant is NOT necessarily the current bid-ask spread in the market. The bid ask spread that is relevant to the measurement of liquidity is the spread of the *ultimate* seller and buyer, the ultimate value trader.

A lot of Mehrling's recent work is about precisely this - looking at money and central banking from the perspective of a cental bank being the ultimate dealer, not just of reserves but also of other money-like markets. He frequently quotes Jack Treynor's "Economics of the dealer function : the only game in town" as an inspiration for his views.

Rowe: “7….Assets markets might dry up and asset prices drop for no reason at all.”

Not so fast! #7 has #5 for its premise: “5…. A small exogenous change in liquidity or velocity will cause a large change in equilibrium liquidity and velocity.”
An exogenous change in liquidity or velocity is not the same thing as “no reason at all.” We know that such changes in liquidity or velocity don’t strike light lightening out of the blue. If we assume minimal rationality for people, they just don’t act that way. V&L change because of changes in people’s expectations about the future, which is usually caused by uncertainty about the present where certainty used to reign.

Uncertainty arises when investments go wrong, or as Menger would say, malinvestments occur due to manipulation of interest rates by banks.

I looked up "liquidity" and got three definitions. One was as a two dimensional vector, with velocity as one of the dimensions. ;) The other two were denominated in terms of money, but differently. None were precise. {shrug}

Ritwik: "However, as Perry Mehrling notes, the bid-ask spread that is relevant is NOT necessarily the current bid-ask spread in the market. The bid ask spread that is relevant to the measurement of liquidity is the spread of the *ultimate* seller and buyer, the ultimate value trader."

Interesting. I suppose that that implies fuzzy supply and demand curves. :)

Roger: suppose my blue or red lines were curved, so they intersected 3 times. That means (usually) there would be two locally stable equilibria, and the one in between would be an unstable equilibrium. If everybody woke up one morning and expected the economy to switch from the high liquidity-velocity equilibrium to the low equilibrium, it would switch.

My experience is that in the stock market, if you want to know how easily a stock can be bought or sold you look at the bid-ask spread, how narrow the order book is, and how packed in it the various quotes are, and the historical persistence of a bid-ask spread. This is liquidity information.

You can also look at how often it trades and the size of trades. You can compare this to the total amount of stock outstanding. This is velocity information.

Part of me thinks that liquidity and velocity could just be different sides of the same coin. When you look at the velocity of a stock, you're measuring it in a state of motion. When you look at its liquidity (and say the bid-ask spread is your data) then you're observing a stock during an interval of rest. It's like conceptualizing the equation of exchange as MV=PT, or as M(1/k)=PT where k=1/V. They're reciprocals of each other.

Nick, but why would they have such expectations?

"And if the demand for money increases, but the central bank does not increase the supply of money in proportion"

*****

And, "1. Income velocity, as defined by MV=PY, where Y is income (expenditures on newly-produced final goods only.)

2. Transactions velocity, as defined by MV=PT, where T is all transactions (including bonds, stocks, used cars, intermediate goods, whatever).

(I expect I am talking about transactions velocities in this post.)"

I assume you mean money and M are both monetary base?

By George he's got it! Liquidity requires low information cost.

However people also want return, so there needs to be a class of assets that also have low information cost, but have yield. The result is the repo market, which has very low transaction costs, so exchanging safe assets for money is inexpensive enough to do frequently.

Money in this market has a high velocity (your liquidity effect). It becomes large, since it gives a better risk weighted return than bank deposits. Now just suppose that there is a revulsion for a large percentage of the formerly low information assets used for repos with a corresponding fall in market volume. Your logic predicts a financial crisis, which there was.

With me you're preaching to the choir.

Nick,

"Part of me thinks that liquidity and velocity could just be different sides of the same coin."

I like to think of it more like potential energy (liquidity) and kinetic energy (velocity). Potential energy is a static property of an item, where as kinetic energy is the energy of that item in motion. When the asset is in the seller's hands it can be quite liquid. As it leaves the seller's hands and goes to the buyer's hands it loses liquidity and gains velocity. Once it reaches the buyer's hands it loses velocity and gains liquidity.

Liquidity comes from low information cost. This low information cost allows the asset to be exploited more easily and more rapidly - thus velocity. Imagine if you had to log onto a web site and type in the serial number to know whether a $20 bill was good and what, if anything, the applicable discount was.

Peter N: "Liquidity comes from low information cost."

I think that is one important thing that affects liquidity. But it's not the only one. I wanted to buy an MX6. I had to wait a couple of weeks, then drive 400kms to Toronto, to get the one I wanted. If I had wanted to buy a Honda Civic, a much more common car, with a thicker market, I wouldn't have had to wait so long or go as far as Toronto. My transactions costs would have been halved, or more. But I would have faced exactly the same risk of buying a lemon in both cases.

Roger: "Nick, but why would they have such expectations? "

Because of a sunspot, comet, or because somebody did the goat sacrifice wrong. Now nobody believes such nonsense, but some people believe that maybe other people believe...that maybe other people believe such nonsense.

Peter N: On second thoughts, there are probably interactions between the velocity and low-information effects on liquidity.

This is not as clear as it should be:

If velocity is high, so everybody trades their car every year, there are very few lemons traded, so nobody bothers to get a mechanic's inspection, so used cars are doubly liquid.

If velocity is low, the cars traded have a high proportion of lemons, so everybody gets a mechanic's inspection, and used cars are doubly illiquid.

"Because of a sunspot, comet, or because somebody did the goat sacrifice wrong."

But we know that people don't act like that. Without accepting mainstream econ's perfect rationality, we know that in today's world people have at least a minimal amount of rationality. For the most part, most people do liner forecasting: the world tomorrow will look pretty much like the world yesterday. Some dramatic news or experience has to happen in order for them to deviate from linear forecasting. I just think your model needs an unrealistic view of people.

Ritwik,

"A financial asset is necessarily somebody's liability. Goods are not."

A financial asset is somebody's contractual liability. Meaning that both the buyer and seller have agreed to the legal terms under which the contract is fulfilled.

But contractual liabilities are not the only type. For instance the goods that you buy at the market eventually become waste that must be disposed of. And so you pay a merchant to receive goods and then you pay a municipality to dispose of the waste. Those goods are at first your asset but then become your liability as you pay someone to take the refuse away.

In between, the value of the asset is realized, energy from food for instance. The difference between an asset and a liability to an owner is ultimately the difference between maintenance costs and realizable value.

And it is often the case that what the owner sees as an asset may be seen by someone else as a liability. The reason is that value has a subjective element.

Frank Restly: "And it is often the case that what the owner sees as an asset may be seen by someone else as a liability. The reason is that value has a subjective element."
A thing may even be an asset or a liability depending on how the pwner sees it. A frequent flyer mile can be a liability ( I have to redeem them) or an asset (they attract customers). That's why Air Canada could sell Aeroplan. They were an asset. And insteas of merely using wasted seats to redeem miles, they now sell them to Aeroplan.
I've heard accountants talk about the "Milton manoeuvre"...when you switch something from the liability to the asset column. A double boost to equity.

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