For monetary policy purposes it is important to understand what is happening to the velocity of circulation. An appreciation of the reasons why velocity might change makes it easier to predict how it might move in the future.

An understanding of what is happening to the velocity of circulation and how it will react to monetary policy actions such as a change in interest rates or the more direct approach of QE, is crucial when trying to analyse the factors underlying movements in the money supply data.

There are two major reasons why the velocity of money changes over the medium to long term.

The first reason why the velocity of money changes over the medium to long term concerns the costs associated with holding a particular form of money.

M0 (see 9.4 Measures of Money - Narrow money – M0), for instance, is non interest bearing, so for any individual the cost of holding notes and coin will simply be the rate of return which that individual would have earned had the cash been invested in a competing asset.

For M4 (see 9.4 Measures of Money - Broad money), on the other hand, the cost of holding a particular M4 asset will be the difference between the rate of interest payable on a competing asset and that paid on the M4 component.

The second main reason why the velocity of circulation moves over time is the change in the technology underpinning transactions.

The level of money balances held by individuals will be affected by such things as automated teller machines (ATMs) and plastic cards.

The ability to obtain cash easily from ATMs, for instance, means that less cash might be held in purses and wallets.

Similarly, the increased use of both debit and credit cards will tend to reduce the amount of cash that individuals will wish to hold.

But there is also a cyclical reason why the velocity of circulation might vary and that is the degree of confidence in an economy. An increase in confidence is likely to see economic agents spend money rather than save it, while a drop in optimism might encourage hoarding at the expense of spending.

This latter situation is what has faced the monetary authorities in the 2008-09 recession, hence the record low interest rates and the introduction of QE.