Velocity of money
The velocity of money measures the number of times that one unit of currency is used to purchase goods and services within a given time period.
If the velocity of money is increasing, then transactions are occurring between individuals more frequently.[3] The velocity of money changes over time and is influenced by a variety of factors.[4]
Because of the nature of financial transactions, the velocity of money cannot be determined empirically.
Illustration
If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year
- A farmer spends $50 on tractor repair from a mechanic.
- The mechanic buys $40 of corn from the farmer.
- The mechanic spends $10 on barn cats from the farmer.
then $100 changed hands in the course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was . If the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy's gross domestic product (GDP).
Relation to money demand
The velocity of money provides another perspective on
The quantitative relation between velocity and money demand is given by Velocity =
Indirect measurement
In practice, attempts to measure the velocity of money are usually indirect. The transactions velocity can be computed as
where
- is the velocity of money for all transactions in a given time frame;
- is the price level;
- is the amount of transactions occurring in a given time frame; and
- is the total nominal amount of money in circulation on average in the economy (see “Money supply” for details).
Thus is the total nominal amount of transactions per period.
Values of and permit calculation of .
Similarly, the income velocity of money may be written as
where
- is the velocity for transactions counting towards national or domestic product;
- is an index of realexpenditures (on newly produced goods and services); and
- is nominal national or domestic product.
Determination
The determinants and consequent stability of the velocity of money are a subject of controversy across and within
This determinant has come under scrutiny in 2020-2021 as the levels of M1 and M2 Money Supply grow at an increasingly volatile rate while Velocity of M1 and M2[3] flattens to stable new low of a 1.10 ratio. While interest rates have remained stable under the Fed Rate, the economy is saving more M1 and M2 rather than consuming, in the expectations that Fed benchmark interest rate increases from all-time lows of 0.50%. During this time, inflation has risen to new decade highs without the velocity of money.
Criticism
Ludwig von Mises in a 1968 letter to Henry Hazlitt said: "The main deficiency of the velocity of circulation concept is that it does not start from the actions of individuals but looks at the problem from the angle of the whole economic system. This concept in itself is a vicious mode of approaching the problem of prices and purchasing power. It is assumed that, other things being equal, prices must change in proportion to the changes occurring in the total supply of money available. This is not true."[6]
References
Notes
- ^ M2 Definition – Investopedia
- ^ M2 Money Stock – Federal Reserve Bank of St Louis
- ^ a b c "Money Velocity". Federal Reserve Bank of St. Louis. Retrieved October 28, 2013.
- ^ Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. Seventh Edition. Addison–Wesley. 2004. p. 520.
- .
- ^ Quoted in Hazlitt, Henry. 'Velocity of Circulation' in James Muir Waller (ed.). Money, the market, and the state: economic essays in honor of James Muir Waller. University of Georgia Press, 1968, p. 42.
Sources
- Cramer, J.S. “velocity of circulation”, The New Palgrave: A Dictionary of Economics(1987), v. 4, pp. 601–02.
- Friedman, Milton; “quantity theory of money”, in The New Palgrave: A Dictionary of Economics(1987), v. 4, pp. 3–20.
External links
- Velocity of money data – from the St. Louis Fed's FRED database