The Problem With "Velocity Of Money"

Some commentators are of the view that when the velocity of money rises, all other things being equal, the buying power of money declines, (i.e., the prices of goods and services rise). The opposite occurs when velocity declines.

If, for example, it was found that the quantity of money had increased by 10% in a given year, while the price level as measured by the consumer price index has remained unchanged it would mean that there must have been a slowing down of about 10% in the velocity of circulation.

If the quantity of money had remained unchanged, but there has been a 10% increase in the price level in a given period, it would mean that there must have been an increase in the velocity of circulation of money of 10% in that period. It would appear therefore that velocity is an important determinant of the purchasing power of money.

Mainstream View of Velocity

According to popular thinking, the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used again and again to finance people's purchases of goods and services.

The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services. For example, during a year a particular ten-dollar bill might have been used as the following: a baker John pays the ten-dollars to a tomato farmer George. The tomato farmer uses the ten-dollar bill to buy potatoes from Bob who uses the ten dollar bill to buy sugar from Tom. The ten-dollar here served in three transactions. This means that the ten-dollar bill was used 3 times during the year, its velocity is therefore 3.

A $10 bill, which is circulating with a velocity of ‘3’ financed $30 worth of transactions in that year. Consequently, if there are $3000billion 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 6 times during the year (since 6*$500 billion =$3000).

A $500 billion of money by means of a velocity factor has effectively become $3000 billion. This implies that the velocity of money can boost the means of finance. From this, it is established that,

Velocity = Value of transactions/supply of money

This expression can be also presented as,

V = P*T/M

Where V stands for velocity, P stands for average prices, T stands for volume of transactions and M stands for the supply 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

M*V = P*T

This equation states that money times velocity equals the value of transactions. Many economists employ GDP instead of P*T thereby concluding that

M*V = GDP = P*(real GDP)

The equation of exchange appears to offer a wealth of information regarding the state of the economy. For instance, if one were to assume a stable velocity, then for a given stock of money one can establish the value of GDP. Furthermore, information regarding the average price or the price level allows economists to establish the state of real output and its rate of growth.

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