The Money Velocity Myth
The Money Velocity Myth Author Frank Shostak – Acting-Man
Popular Imagery of Money on the Move
For most financial commentators an important factor that either reinforces or weakens the effect of changes in the money supply on economic activity and prices is the “velocity of money”.
An image from an article on the intertubes that “explains” the velocity of money (one of the articles we came across started out as follows: “The economy runs smoothly only when there is enough money in circulation. How much is enough?” The effect reading this has on us is not unlike that produced by the sound of fingernails scraping a chalkboard). We have found that many people find it extremely difficult to wrap their mind around the fact that the velocity concept actually doesn’t make sense, and that the matter has to be viewed from a different perspective. As an aside, we have noticed in discussions that even those who do eventually accept that a different conceptual approach is required, often insist on continuing to use the term because it “doesn’t matter what we call it”, or “to keep things simple” and similar excuses. It makes one feel like a priest trying to exorcise a particularly stubborn demon. [PT]
Illustration via supplychainbigairo.blogspot.com
It is alleged that when the velocity of money rises, all other thing 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 the velocity of circulation must have slowed by about 10%.
The Mainstream View of Money 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 follows: a baker by the name of 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 dollars in this example served in three transactions. This means that the ten-dollar bill was used 3 times during the year, its velocity is therefore 3.
The chart above depicts the quantity equation fudge factor… err, the velocity of the narrow money stock M1. As an aside, although the “V” charts of the official monetary aggregates essentially look very similar, in the broader aggregates (which include savings accounts, as well as a number of credit instruments), “V” began to decline much earlier already – namely around the time the first major global monetary policy-induced crisis of the post 1970s era started, i.e., the Asian crisis (note that previous post 1970s crises of this sort were not global in scope, such as e.g. Mexico’s peso crisis). The scale of the V graph of M2 is very different (because M2 is much larger), so we haven’t included it here, as it would be hard to compare visually. It wouldn’t contribute anything w.r.t. the principles under discussion anyway, as the theoretical points to be made about money velocity apply to all depictions of it. As we point out further below, these charts may be interesting from an economic history perspective though. [PT] – click to enlarge.
A $10 bill, which is circulating with a velocity of ‘3’ financed $30 worth of transactions in that year. Consequently, if there are $3000 billion 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).
The $500 billion of money is boosted by means of a velocity factor to become effectively $3000 billion. From this it is established that
Velocity = Value of transactions / supply of money
This expression can be summarized 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 the famous equation of exchange