No, Drops In Money Velocity Don't Offset Money Printing

velocity money

At the end of January, the yearly growth rate of our measure of US money supply (AMS) closed at 76.7 percent, against 4.8 percent in January 2020. It is tempting to suggest that this massive increase in the growth rate of money supply is likely to result in massive price inflation in the months ahead.

Based on the sharp decline in the velocity of money from 6.7 in June 2008 to 2.3 by December 2020, however, it can be argued that price inflation is not likely to accelerate in the months ahead. In this way of thinking, a decline in velocity offsets the effect of massive increases in money supply on price inflation. Here is why.

Over any interval of time, such as a year, a given amount of money can be used repeatedly in the purchase of goods and services. The money one person spends on goods and services is used by the recipient of that money to purchase goods and services from some other individual. For example, in a year a particular ten-dollar bill might be used as follows: a baker, John, pays ten dollars to a tomato farmer, George. The tomato farmer uses the ten-dollar bill to buy potatoes from Bob, who uses it to buy sugar from Tom. The ten dollars here was used in three transactions during the year; its velocity is therefore three.

The ten-dollar bill that circulated with a velocity of 3 generated $30 worth of transactions in that year. Now, if there are $3 trillion worth of transactions in an economy during a particular year and there is an average money stock of $500 billion during that year, then each dollar of money is used on average six times during the year (since 6*$500 billion = $3 trillion).

With a velocity of 6, $500 billion have generated $3 trillion worth of transactions. From this it is established that

velocity = value of transactions / stock of money

This can also be expressed as

V = PT/M

where V stands for velocity, P stands for the average price, T stands for the volume of transactions, and M stands for the stock of money. This expression can be further rearranged by multiplying both sides of the equation by M. This in turn will give us the famous equation of exchange

MV = PT

This equation states that money multiplied by velocity equals the value of transactions.

Many economists employ GDP instead of P*T, thereby concluding that

MV = GDP = P(real GDP)

The equation of exchange appears to offer a wealth of information regarding the state of an economy. According to it, a fall in the velocity of money (V) for a given money (M) results in a decline in economic activity as depicted by GDP. It also asserts that, for a given money stock (M) and a given volume of transactions (T), a fall in velocity results in a decline in the average price (P).

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