Velocity of Circulation
The rate at which money exchanges hands in an economy
What Is the Velocity of Money?
The concept of currency and money dates far back to the Song Dynasty when the first coins were believed to be minted.
Across decades, the features and attributes of money have evolved. So although the question may arise as to why we are discussing money and its origin, it's equally important.
There is evidence that the concept of currency is old, and societies have had different types of units of exchange throughout the ages.
Before the creation of fiat currency, another form of the monetary system was in place. This system was known as the barter system, the most traditional form of the economic system.
Old traditional monetary systems like barter did not have challenges like the velocity of circulation but rather had an issue called the double coincidence of wants.
Double coincidence of wants means that a person needs to find another person who wants to exchange the goods required. For instance, if a trader were selling salt but wanted meat, they would have to look for someone in need of salt to trade against meat.
Salt, Ivory, Gold, and Silver were used as currency. The concept of the velocity of money finds its roots in the emergence of fiat currency. Fiat currency, also known as paper currency, is a form of a monetary system not backed by trust.
Therefore, the concept of the velocity of money gained great importance in monetary policies. Moreover, since the economy is a delicate mechanism, the idea of the velocity of circulation is important because it affects the economy in aspects of stability and growth.
It has a unique relationship with the monetary system, an important aspect of any economy.
Key Takeaways
- Fiat currency is the most common form of currency. Before this, another system called the barter system existed the most traditional form of the monetary system and possibly the oldest form of the economic system.
- The velocity of circulation is defined as the rate at which money exchanges hands in an economy. It is the number of times it moves from one person to another. This concept equally applies to all economies.
- The velocity of circulation is an important topic in Economics because it has a Unique connection with the Gross Domestic Product, economic growth, and inflation.
- To compute the same, in the numerator, we use the Gross Domestic Product; and in the Denominator, we use the money supply.
- The M1 money supply is defined as a macroeconomic concept that relates to the total currency held by the public, either cash or bank deposits. It relates to the most liquid assets held by the public and other assets called near-money assets. These " near money" assets include marketable securities and savings deposits.
- M2 is defined as the sum of savings deposits, money from market mutual funds, and time deposits.
- Keynesian economists believe that the velocity of money is an unstable concept that can change rapidly, causing changes in inflation. However, there is a difference in perceptions between the Monetarist and Keynesian ideologies on this topic.
What is Money?
Money is usually defined as the unit of exchange. However, throughout history, money has been described by its features and attributes.
It is a fact that every person receives money as a measure of exchange because they are confident that others will too. Therefore, based on this belief, society's currency theory is sustained.
It is not surprising that this theory only sometimes holds. This is because other factors, such as inflation, challenge the assumption that someone will be willing to receive that currency.
Regardless of what currency you use, the concept of the velocity of money still affects the economy.
There are several forms of money, and below are the common ones.
1. Representative Money
A sort of money called representative money is connected to a physical good, ideally gold.
For example, the standard Gold system of the United States and later the Brenton Woods system employed a similar mechanism, where you kept the gold in a bank vault, and a person or institution would exchange dollars for that gold.
People used this certificate to redeem the gold at the bank. A good illustration is the American Gold standard monetary system which was abandoned in 1933 by the Executive Order of President Roosevelt.
2. Fiat Money
Fiat, also known as paper money, is based solely on trust. Its value derives from being recognized as a legal tender in a specific economy.
Thus, we can summarize that fiat currency is accepted with the view that the government prints it, so everyone is likely to accept it. Fiat currency is solely based on trust.
Understanding the Velocity of Money
It is the rate at which money exchanges hands in an economy. It means the number of times it moves from one person to another.
The amount of currency that circulates in the economy during a specified period is another definition for this term, according to The Economic Times.
It also refers to the number of times any particular currency unit circulates in the economy.
This is an important topic in Economics because it uniquely connects to the Gross Domestic Product, economic growth, and inflation.
The velocity of circulation is to be calculated. There is a formula used to measure the velocity of circulation. The velocity of circulation is not a foreign concept; it happens around us daily.
Let's have a look at this illustration below.
- A Farmer borrows some money and uses $560 to pay a Mechanic to fix his Tractor.
- The Mechanic uses $45 to buy bread from a local store.
- The shop owner then uses that $45 to pay their workers.
In summary, you can say that the notes the farmer used to pay the Mechanic later exchanged several hands.
Therefore, this illustration above shows how the velocity of money is tied to the economy as a whole. It is this connection that also plays a significant role in determining inflation.
The Velocity of Money Formula
You can calculate the velocity by dividing the Gross Domestic Product by the total value of money in supply.
The velocity of money is sometimes used to gauge how rigorous the economy is and how the overall economy is performing.
The velocity of money alone is not an economic indicator; however, it is usually used with other key indicators that help determine financial health, such as inflation, GDP, or unemployment.
The following is how the velocity of money is calculated.:
The velocity of money = The Gross Domestic Product ÷ Money Supply.
In the numerator, we use the Gross Domestic Product; in the Denominator, we use the money supply, sometimes referred to as M1 and M2, respectively.
It is important to understand what M1 and M2 money supplies mean concerning the subject of the velocity of money.
M1 is a macroeconomic concept that refers to the total currency held by the public, either cash or bank deposits held by commercial banks. Therefore, M1 is simply money held by the public, including cash at hand or held at a commercial bank.
M2, on the other hand, includes M1 and other near-money assets. These " near money" assets include marketable securities and savings deposits.
The Gross Domestic Product, also abbreviated as GDP, is used to calculate the velocity of money. The velocity of money is easy to calculate, as demonstrated by the formula below.
The GDP is the monetary value of all goods and services produced in a given economy. Therefore, we need to use the formula to calculate the Gross Domestic Product.
GDP = Gross private consumption + Gross private investment + Government spending.
On the other hand, the velocity of money is defined as the average money supply currently in circulation in the economy. Therefore, the Gross Domestic Product and the average money supply form the variables used to compute the velocity of currency.
Importance of Velocity of Money
The concept of velocity of money plays a significant role in an economy. Therefore, it is a subject of macroeconomics that relates to the circulation of money in an economy.
According to several experts, the velocity of money can be used to assess and measure the economy. In addition, this analytical tool is used with other tools, including the GDP, unemployment, and the CPI (Consumer Price Index).
It's important to note that there are two standards. Economists can either measure the velocity of money using M1 or M2.
The Federal Reserve Bank defines and describes M1 and M2, respectively. According to the Feds, M1 is the total amount of currency in the economy. In comparison, M2 includes the sum of savings deposits, money from market mutual funds, and time deposits.
For instance, Experts argued in 2020 that the Federal Reserve bank's Quantitative Easing was a time bomb waiting to explode.
After the reopening of the US economy, the steady rise of inflation manifested itself. In addition, inflation started to rise as the government began removing restrictions and easing regulations.
American people began to spend more money as the uncertainty in the economy reduced, consequently leading to a high velocity of circulation.
In a news article, the author noted that the quantity of money tends to increase by about 5% in an economy during recessions.
Velocity of Money and the Economy
It is a well-established fact that when there is an increased supply of money in the economy, people tend to spend more, which leads to higher demand for goods and services.
The underlying assumption is that the rate at which money changes hands and other factors puts pressure on a few goods in an economy.
There is a long-standing relationship between the economy, money supply, and its velocity. These components are intertwined and consequently have a bearing on economic growth.
For instance, in the Reserve Bank of Australia, several experts emphasized a theory by Milton Friedman wherein the inflation levels are linked to the money supply's growth rate.
According to that theory, the assumption that money circulates in the economy at a constant rate is cast aside.
According to the article written by Gareth Hutchen on ABC news, inflation rose in Australia because of the circulation velocity.
In that article, Gareth alleged that the circulation velocity declined for decades in Australia. Consequently, when the recession hit during the pandemic, everyone stayed home, and there were fewer opportunities for money to circulate in the economy. Therefore inflation levels were stagnant.
In a nutshell, the relationship between inflation and economic growth is heavily influenced by the velocity of money. The velocity of circulation can be healthy and toxic to the economy at the same time. Inflation in an economy can be exacerbated when the velocity of circulation is.
Therefore, it is important to know that Keynesian economists believe that the velocity of money is an unstable concept that can change rapidly, causing changes in inflation. However, there is a difference in perception between Monetarists and Keynesians about the concept at hand.
Nevertheless, inflation rises rapidly when money begins to exchange hands quickly, and as a result, the economy experiences a huge money supply.
or Want to Sign up with your social account?