Velocity of money

Chart showing the log of US M2[1][2] money velocity (green), calculated by dividing nominal GDP by M2 stock, M1 plus time deposits 1959–2010. Employment-to-population ratio is displayed in blue, and periods of recession are represented with gray bars).
Similar chart showing the velocity of a slightly narrower measure of money consisting of currency and liquid deposits M1 1959–2010.
Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005.

The velocity of money (also called the velocity of circulation of money) refers to how fast money passes from one holder to the next. It can refer to the income velocity of money, which is the frequency at which the average unit of currency is used to purchase newly domestically-produced goods and services within a given time period.[3] In other words, it is the number of times one dollar is spent to buy goods and services per unit of time.[3] Alternatively and less frequently, it can refer to the transactions velocity of money, which is the frequency with which the average unit of currency is used in any kind of transaction in which it changes possession—not only the purchase of newly produced goods, but also the purchase of financial assets and other items.

If the velocity of money is increasing, then transactions are occurring between individuals more frequently.[3] Although once thought to be constant, it is now understood that the velocity of money changes over time and is influenced by a variety of factors.[4]

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

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 2/\text{year}. Note that 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 money demand. Given the nominal flow of transactions using money, if the interest rate on alternative financial assets is high, people will not want to hold much money relative to the quantity of their transactions—they try to exchange it fast for goods or other financial assets, and money is said to "burn a hole in their pocket" and velocity is high. This situation is precisely one of money demand being low. Conversely, with a low opportunity cost velocity is low and money demand is high. In money market equilibrium, some economic variables (interest rates, income, or the price level) have adjusted to equate money demand and money supply.

Indirect measurement

In practice, attempts to measure the velocity of money are usually indirect. The transactions velocity can be computed as

V_T =\frac{PT}{M}

where

V_T\, is the velocity of money for all transactions in a given time frame;
T\, is the aggregate real value of transactions in a given time frame;
P\, is the price level; and
M\, is the total nominal amount of money in circulation on average in the economy (see “Money supply” for details).

Thus PT is the total nominal amount of transactions per period.

Values of PT and M permit calculation of V_T.

Similarly, the income velocity of money may be written as

V =\frac{PQ}{M}

where

V\, is the velocity for transactions counting towards national or domestic product; and
PQ\, 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 schools of economic thought. Those favoring a quantity theory of money have tended to believe that, in the absence of inflationary or deflationary expectations, velocity will be technologically determined and stable, and that such expectations will not generally arise without a signal that overall prices have changed or will change.

Some people have incorrectly interpreted velocity to mean the time between receipt of income and when it is spent. Note that how much income is spent helps determine GDP, but the time during a pay period at which it is spent is immaterial. There could be a large volume of spending by people who waited a long time between receiving income and spending it. They could store their income in non-money forms, such as stocks and bonds, between receiving income and spending it. So the notion that velocity of money equates to "how fast income is spent" is a fallacy.

The view that velocity of money is constant is criticized by Samuelson thus:

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.[5]

Criticism

Austrian school of economics

Henry Hazlitt criticized the concept of the velocity of money, citing that the equation used to calculate it ignored the psychological effects that also have a significant role in determining the value of a currency. As an example, he shows that in a period of inflation, that when the money is newly introduced, the price level increases by a smaller proportion than the increase in the supply of money, but that when the money has been in circulation for a while, that the price level has increased by a greater proportion than the supply of money. He states that this is not due to a change in the velocity of money, but rather the discrepancy is due to "fears . . . that the inflation will continue into the future, and that the value of the monetary unit will fall further." Hazlitt offers an alternative to the quantity theory of money and the velocity of money concept that is a necessary consequence. He explains that what changes the value of money is the value that people place on the currency, and that it is not the velocity of money that determines the value of a currency, but rather the sum of individuals' value of the currency that determines the velocity of money.[6]

Ludwig von Mises offered a more philosophical criticism, "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." [7]

References

Notes

  1. ↑ M2 Definition – Investopedia
  2. ↑ M2 Money Stock – Federal Reserve Bank of St Louis
  3. 1 2 3 "Money Velocity". Federal Reserve Bank of St. Louis. Retrieved October 28, 2013.
  4. ↑ Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. Seventh Edition. Addison–Wesley. 2004. p. 520.
  5. ↑ Samuelson, Paul Anthony; Economics (1948), p 354.
  6. ↑ http://mises.org/daily/2916
  7. ↑ Ludwig von Mises, Human Action (New Haven: Yale University Press, 1949), and The Theory of Money and Credit (London: Jonathan Cape, Limited, 1934, and New Haven: Yale University Press, 1953).

Sources

External links

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