Introduction to Finance

velocity of money
measures the rate of circulation of the money supply. It is expressed as the average number of 
monetary base 
banking system 
reserves plus currency held by the 
public
money multiplier 
number of times 
the monetary base can be expanded 
to produce a given money supply 
level
velocity of money 
average number 
of times each dollar is spent on 
purchases of goods and services 
7
Federal Reserve Bank of St. Louis, Federal Reserve Economic Database (FRED), http://stlouisfed.org. As the 2007–08 
fi nancial crisis worsened, the money multiplier ratio dropped below 1.0 in late 2008 and has continued below 1.0 
through 2015. This very low multiplier refl ects the high liquidity in the banking system brought about by the Fed’s 
easy money and quantitative easing policies.
8
The reader interested in understanding how the money multiplier is derived will fi nd a discussion in most fi nancial 
institutions and markets textbooks.

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C H A PT E R 5 Policy Makers and the Money Supply
times each dollar is spent on purchases of goods and services, and is calculated as nominal GDP 
(GDP in current dollars) divided by M1. Changes in the growth rates for money supply (M1
g
) 
and money velocity (M1V
g
) aff ect the growth rate in real economic activity (RGDP
g
), and the 
rate of infl ation (I
g
) and can be expressed in equation form as follows:
M1
g
+ M1
V
g
= RGDP
g
+ I
g
(5.4)
For example, if the velocity of money remains relatively constant, then a link between 
money supply and the nominal GDP should be observable. Likewise, after nominal GDP 
is adjusted for infl ation, the resulting real GDP growth can be examined relative to M1 
growth rates. Changes in money supply have been found, in the past, to lead to changes in 
economic activity. However, a relationship between money supply and economic activity 
has been questioned during the recent perfect fi nancial storm. In an eff ort to thwart a pos-
sible collapse of the fi nancial system, recall that the Fed moved to force short-term interest 
rates to near zero and provided massive amounts of money liquidity. Furthermore, the Fed 
introduced the use of a nontraditional monetary tool called quantitative easing to further 
support the economic recovery eff orts after the 2007–08 fi nancial crisis and the 2008–09 
Great Recession. These eff orts have distorted the traditional money multiplier and velocity 
of money relationships. 
The Fed continues to emphasize easy money, although the target for the federal funds 
rate which was set in late 2008 at .00-.25 percent was increased to .25-.50 percent in Decem-
ber 2015. Of course, economic activity also is aff ected by government actions concerning 
government spending, taxation, and the management of our public debt. Thus, it is important 
that monetary and fi scal policy work together to achieve the United States’ national economic 
policy objectives.