Which measure of the money supply is associated with reduced fluctuations in the velocity of money?

• A. M2 reduces fluctuations in velocity
• B. Velocity does not depend on which money supply measurement we use
• C. M1 reduces fluctuations in velocity
• D. M2 increases fluctuations in velocity

Answer: (A)

The idea here is that how we measure the money stock affects how volatile the observed velocity is. Velocity is the ratio of nominal GDP to the money supply (V = PY/M). If we use a broader money measure, like M2, the denominator captures a wider set of liquid assets people use in transactions. These assets tend to move more slowly than the components of the narrow measure, so shifts in money demand that bounce around currency and checkable deposits (the components of a narrower measure) don’t translate into as large swings in the measured velocity. M2 includes savings deposits, small time deposits, and retail money market funds, which behave more like money in practice and therefore keep V smoother over time. So using M2 reduces fluctuations in the observed velocity of money.