China 's Currency Circulation Speed

Velocity of money plays an important role in the channel through which the change of money supply affects output and inflation rate. Is China’s velocity of money stable? If it is not stable, does it follow a specific pattern and what are the influencing factors? A thorough analysis of these issues has significant implications for the management of China’s monetary policy.The research of China’s velocity of money is closely related to another topic, which is the country’s exceptionally high M2/GDP ratio, or the inverse of velocity of broad money. Historically, China’s M2/GDP has been growing, which means the velocity of broad money has been actually decreasing. This phenomenon has sparked great concerns from both academics and practice over China’s excess liquidity. However, the constantly low inflation rate in China seemed to indicate the opposite, which has given rise to what some people call "The Mystery of China". How to explain and predict the tendency of M2/GDP of China is another important aspect of the research on velocity of money.Most researches in this field conducted by Chinese researchers so far are based on the traditional money demand function and the traditional definition of velocity of money. These researches performed empirical analyses to determine the impact of various variables such as GDP, interest rate, inflation rate, etc. on the velocity of money, which often led to contradictory conclusions. Regardless, by not considering what the velocity of money actually is, these researches only touched on the surface of the issue and thus had very limited values. While there exist a number of papers trying to analyze the problem from unique perspectives, remarkable achievements are still not seen.In the first part, this paper summarized the existing researches in this field and divided them into several categories according to their respective methods used and underlying logics. In each category, the strengths and weaknesses, results achieved and problems encountered are pointed out. In the meantime, a brief empirical analysis is performed in the traditional framework and shows that the velocity of narrow money and broad money are both positively affected by nominal GDP, while negatively affected by interest rate. This paper then digs into the essence of the problem by introducing an innovative theory of velocity of money from the fund flow standpoint. As the primary part of this article, this new theory defines "the velocity of incremental M2" based on the decomposition of the original sources of M2addition and analyses the velocity of M2under the new definition. The relationship between the M2velocity under traditional and newly-introduced definitions are then discussed, followed by an in-depth analysis of the changes of economic meanings and predictability of both variables in the process of China’s ongoing liberalization of financing channels. By applying the new theory put forward in this article, it is concluded that the increase of M2/GDP figure in itself is not of a great concern as it reflects the amount of new loans, current account surplus and capital account surplus and so on, as well as the significant portion of M2stock which is passively hoarded. China’s high M2/GDP in itself does not necessarily indicate excess money supply and should not be perceived as a reason to tighten monetary policy.