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Velocity Of Money

Updated on February 1, 2024
Article byAswathi Jayachandran
Edited by
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Velocity Of Money?

The Velocity of Money estimates the units of currency/money regularly circulated in the economy to facilitate the exchange of goods and services. The ratio between a country’s Gross Domestic Product (GDP) and its total money supply represents the velocity of money; that is GDP is divided by the total money supply.

For eg:
Source: Velocity Of Money (wallstreetmojo.com)

The velocity of money refers to the money circulated in an economy in a given period, which shows the speed at which money is exchanged as purchase consideration. It indicates the power of a country’s economy. When money movement is categorized as High-velocity Circulation, it indicates high inflation. The concept reveals the health of an economy and predicts if prices will remain stable or begin to rise in a given period.

Key Takeaways

• The velocity of money estimates units regularly circulated in an economy. The computation requires dividing the country’s Gross Domestic Product (GDP) by the nation’s total money supply.
• The velocity of money computes the units regularly circulated in an economy to purchase goods and services.
• The frequency with which the exchange of units of money occurs explains how businesses, consumers, and individuals use the money they have.
• Money supply, transactions and their frequency, consumer actions, and credit facilities are some factors affecting the velocity of money circulation in an economy.

Velocity Of Money Circulation Explained

The velocity of money is the speed at which units of money are exchanged in an economy during a specific period to enable people to conclude transactions. The higher the number of times a unit of money travels, the higher its contribution to the nation’s money supply and the more it raises the overall price levels in the country.

It is a useful economic indicator as it shows the amount of money that must be in circulation in an economy to ensure smooth transactions. The emphasis here is on money that is exchanged. Hence, idle money, which is not in circulation, is not considered while computing the velocity of money. Idle funds do not affect the money circulation speed in an economy.

The speed and frequency with which money gets exchanged offer insight into how businesses and individuals use money in an economy. It shows whether money is being saved or spent. A low velocity of money circulation often implies that households hold more money than they normally spend.

The components of money supply, M1, M2, M3, and MZM, help us understand the concept better. Each component is important, as M1’s decreasing velocity shows there may be fewer short-term (every day) transactions. M1 considers all money (notes and coins) in an economy.

M2 is an extension of M1 since it considers M1 plus short-term time deposits and money market funds. The velocity of Money Zero Maturity (MZM), which indicates the liquidity levels of an economy, determines the rate at which financial assets are exchanged within the economy.

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Factors

Some factors affecting the velocity of money circulation are listed below:

• Money supply: Money supply is nothing but money in circulation in an economy. A reduced money supply increases its velocity.
• Transactions and their frequency: A higher number of transactions increases the velocity of money circulation. If the trade volume increases and more products and services are purchased and sold, the frequency of transactions increases. This will increase the velocity of the circulation of money.
• Consumer actions: The volume depends on consumers’ actions. In an economy, if people are paid well at regular intervals, they tend to spend freely and frequently. As financial uncertainty reduces, it curbs their tendency to save and the need to hold cash. The higher the spending, the higher the velocity.
• Credit facilities: A country’s monetary and fiscal policies regulate the money flow in an economy. These policies control the cash available to the public for spending. Therefore, velocity increases when adequate lending and borrowing facilities are available.
• Other factors: Certain factors, such as the ease of payment, affect the velocity of money. The more people find spending convenient, the more likely they are to do so. For example, people will spend more with electronic payment methods, such as UPI (Unified Payment Interface), debit cards, etc., instead of withdrawing money from the bank every time.

The value of money is another factor that boosts the velocity of its circulation. Inflation reduces the value of money. Hence, people spend more money at a higher frequency to buy the same goods as earlier, leading to increased transactions. Other factors, such as business conditions, economic cycles, interest rates, demand-supply dynamics, etc., affect money value.

Examples

Check out these examples to get a better idea:

Example #1: How Velocity Changes

Let us consider hypothetical examples of individuals A and B. A wants to buy some goods, and since he has cash, he buys them. This is a transaction, and an exchange of money occurs.

The entity from whom A purchased the goods receives money, and the dealers who sold to A’s seller also receive income from the sale. On the other hand, B wants to buy a car and has cash, but he postpones the purchase since he is in no hurry. This can affect the income of the car dealer and the income of the dealer’s agent. When B does not make the purchase despite holding money, the money sits idle for a long time, reducing the velocity of money circulation. Since person A purchased goods, transactions were made, and money entered circulation, increasing its velocity.

Example #2: How To Use The Velocity Of Money Formula

Let us consider another hypothetical example. In an economy, there are three big players: X, Y, and Z. At the beginning of the year, X decided to buy goods from Y, and Y bought goods from Z. The transaction resulted in \$10000 exchanging hands at various stages. This resulted in the nominal GDP for the year being \$10000. The money supply is \$500.

The formula for the velocity of money = GDP / Money supply.

10000/500 = 20; therefore, the velocity of money is 20.

Effects On Inflation

Inflation mainly occurs due to the excess availability of money in an economy in proportion to the goods and services produced in a country. The following equation can represent it, also called the velocity of money equation.

The velocity of money equation can be given by,

MV=PQ

where,

• M = Money
• V = Velocity
• P = General Price Level
• Q = Quality of goods and services produced in the economy.

If more transactions are executed in an economy, the velocity increases, and the economy tends to expand. Due to economic growth, if demand grows faster than supply, an increase in inflation is expected. If velocity decreases due to fewer transactions, the economy tends to shrink.

1. How stable is the velocity of money?

The scenario differs in each country. It depends on certain factors. The velocity is hardly constant, at least in the US economy. If the velocity decreases due to an expansionary monetary policy, it could neutralize the anticipated effects of increased money supply and result in deflation instead of inflation in an economy.

2. How does the velocity of money affect interest rates?

The velocity of money rises with rising interest rates because it is directly related to the frequency with which money exchanges hands. Rising interest rates prompt people to deploy money for gain instead of holding it idle.

3. Is the velocity of money constant?

The quantity theory of money works on the assumption that the velocity of money is constant. If the velocity is constant, the growth rate will be zero. Hence, a nation’s money supply growth rate will be equal to the inflation rate and the real GDP growth rate.

3. How do credit cards affect the velocity of money?

While credit cards are convenient payment methods, they may increase the number of transactions being executed in an economy. A higher number of transactions increases the velocity.

This has been a guide to What is Velocity Of Money Circulation. Here, we explain the topic with its factors, examples, effects on inflation. You can learn more about it from the following articles –