image:M3 Velocity in the US.png, 300px, Similar chart showing the logged velocity (green) of a broader measure of money M3 that covers M2 plus large institutional deposits. The US no longer publishes official M3 measures, so the chart only runs through 2005.
The velocity of money measures the number of times that the average unit of currency is used to purchase goods and services within a given time period.
The concept relates the size of economic activity to a given
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
, and the speed of money exchange is one of the variables that determine
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
. The measure of the velocity of money is usually the ratio of the
gross national product
The gross national income (GNI), previously known as gross national product (GNP), is the total domestic and foreign output claimed by residents of a country, consisting of gross domestic product (GDP), plus factor incomes earned by foreign ...
(GNP) to a country's money supply.
If the velocity of money is increasing, then transactions are occurring between individuals more frequently.
The velocity of money changes over time and is influenced by a variety of factors.
Illustration
If, for example, in a very small economy, a
farmer
A farmer is a person engaged in agriculture, raising living organisms for food or raw materials. The term usually applies to people who do some combination of raising field crops, orchards, vineyards, poultry, or other livestock. A farmer mig ...
and a
mechanic
A mechanic is an artisan, skilled tradesperson, or technician who uses tools to build, maintain, or repair machinery, especially cars.
Duties
Most mechanics specialize in a particular field, such as auto body mechanics, air conditioning an ...
, 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
A tractor is an engineering vehicle specifically designed to deliver a high tractive effort (or torque) at slow speeds, for the purposes of hauling a trailer or machinery such as that used in agriculture, mining or construction. Most common ...
repair from a mechanic.
*The mechanic buys $40 of
corn
Maize ( ; ''Zea mays'' subsp. ''mays'', from es, maíz after tnq, mahiz), also known as corn (North American and Australian English), is a cereal grain first domesticated by indigenous peoples in southern Mexico about 10,000 years ago. Th ...
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
. 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
Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
(GDP).
Relation to money demand
The velocity of money provides another perspective on
money demand
In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable ...
. Given the nominal flow of transactions using money, if the
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
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
In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
velocity is low and money demand is high. Both situations contribute to the time-varying nature of the money demand. In money market
equilibrium, some economic variables (interest rates, income, or the price level) have adjusted to equate money demand and money supply.
The quantitative relation between velocity and money demand is given by Velocity =
Nominal
Nominal may refer to:
Linguistics and grammar
* Nominal (linguistics), one of the parts of speech
* Nominal, the adjectival form of "noun", as in "nominal agreement" (= "noun agreement")
* Nominal sentence, a sentence without a finite verb
* Nou ...
Transactions (however defined) divided by Nominal Money Demand.
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
The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
;
:
is the aggregate
real value of transactions in a given time frame; and
:
is the total nominal amount of
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
in circulation on average in the economy (see “
Money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
” 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
real
Real may refer to:
Currencies
* Brazilian real (R$)
* Central American Republic real
* Mexican real
* Portuguese real
* Spanish real
* Spanish colonial real
Music Albums
* ''Real'' (L'Arc-en-Ciel album) (2000)
* ''Real'' (Bright album) (2010) ...
expenditures (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
schools of economic thought
In the history of economic thought, a school of economic thought is a group of economics, economic thinkers who share or shared a common perspective on the way economy, economies work. While economists do not always fit into particular schools, pa ...
. Those favoring a
quantity theory of money
In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directly ...
have tended to believe that, in the absence of
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
ary or
deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
ary 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.
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
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
Ludwig Heinrich Edler von Mises (; 29 September 1881 – 10 October 1973) was an Austrian School economist, historian, logician, and Sociology, sociologist. Mises wrote and lectured extensively on the societal contributions of classical liberali ...
in a 1968 letter to
Henry Hazlitt
Henry Stuart Hazlitt (; November 28, 1894 – July 9, 1993) was an American journalist who wrote about business and economics for such publications as ''The Wall Street Journal'', ''The Nation'', ''The American Mercury'', ''Newsweek'', and '' ...
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."
[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.]
References
Notes
{{reflist
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
Monetary economics
Freiwirtschaft
Demand for money