When John Lennon wrote his famous song about utopia, he should have also asked us to imagine a world where velocity was constant. Here are some characteristics of such a world:
1. No long and variable lags in monetary policy. Indeed no lags at all.
2. Money supply targeting would be identical to NGDP targeting.
Many people wrongly assume that “monetarists believe velocity is constant”. And yet we are also told that “monetarists believe in long and variable lags.” These people must think monetarists are pretty stupid, as a constant velocity implies no lags at all. So which is it? What do monetarists actually believe?
The answer is simple. Monetarists believe in long and variable lags and they don’t believe that velocity is constant. Rather monetarists believe that velocity would be relatively stable if monetary policy were stable. They believe that actual real world movements in velocity are mostly due to unstable monetary policy. More specifically, a highly expansionary monetary policy will often cause velocity to fall in the short run and rise in the medium to long run. It depends on the persistence of the monetary expansion—is it one time increase in M, or a permanent (inflationary) increase in the money supply growth rate?
It would be wonderful if velocity were constant, especially base velocity. All of Keynesian economics would immediately collapse. The entire ideology would become essentially useless. Fiscal policy would have no impact on NGDP. There would be no paradox of thrift. Animal spirits would not affect aggregate demand. The IS/LM model would become meaningless.
The reason I don’t favor monetary aggregate targeting is not because monetarism was tried and failed—it was never tried for an extended period of time—rather because my reading of the evidence is that velocity would not be stable enough to produce good results even were the Fed to stabilize growth in the monetary aggregates over a period of many decades. Thus I prefer using market forecasts as a guidepost.
Some monetarists disagree with me, but pointing to unstable real world velocity doesn’t really address this question.