The velocity of money refers to the rate at which money is transacted within the economy for goods and services. It simply measures the rate at which money is transferred from one entity to another. This is crucial to understand how strong the money supply circulation is within the country. An expanding economy would have a higher velocity of money.
The velocity of money is dependent on the business cycles, investment levels, propensity to save, inflation rates, GDP growth, and monetary policies of the economy. Therefore, the velocity of money can be a good indicator of the health of the economy. Higher inflation rates may lead to a higher velocity of money. Whereas, a recession will reduce the circulation of money and lead to lower velocity.
Recently, some questions regarding the effectiveness of the velocity of money in estimating the health of the nation have been put forth. The money velocity may be a better indicator, after all, of inflationary factors or money supply. Inflation leads to a higher circulation of money, and deflation leads to low circulation.
How does the Velocity of Money work?
The velocity of money measures the movement of currency in an economy. To simply put it, how many times does a unit of currency change hands in a single year? This takes into account two factors- the total production in an economy and the total money supply.
The velocity of money determines the proportion of the value of goods and services to the total money supply. If the value of the total production is higher than that of the total money supply, it indicates that the economy is growing faster than the rate at which money is being injected into it. That is a positive sign of growth.
Let us take the example of an economy consisting of a limited number of people to simplify our understanding of the velocity of money. There is a farmer A, an automobile manufacturer called B, and C who owns a food manufacturing company. A, B, and C have $50 each.
A purchases a combine harvester for his peas farm at $50. C purchases corn from A at $10 and leases a truck for delivery from B at $30. B purchases frozen peas for his consumption at $30. B also purchases milk from A at $25. C again purchases soy from A at $15 and sells soy milk to A and soy sauce to B at $10 and $15 respectively. B now hires A’s son to help in his factory at $40 per annum.
The total volume of transactions within this economy is worth $225, even though the total money supply was $150 at the beginning of the year. The velocity of money would be 1.5 for the year as $150 was expanded to 1.5 times in this economy without actually increasing the money supply.
Calculation of Velocity of Money
In the larger macroeconomic scale of a nation, the simple method of tracking every transaction is bulky work. Economists have instead come up with a formula to calculate the velocity of money.
The first component is GDP. The Gross Domestic Product of a nation is essentially the total value of all the goods and services produced in the economy on an annual basis. That primarily signifies the economic activity of the nation.
The second component is the money supply. Now, to measure the money supply, either or both M1 and M2 can be identified. M1 is the most liquid money in the economy. That includes cash, checkable demand deposits, and traveler’s checks held by the public. M2 includes M1 money and savings, time deposits, money market funds, and certificates of deposits. It is not nearly as liquid as the M1 money.
Money Velocity Formula
After learning about the components of the velocity of money, the following formula can be established-
Velocity of money= GDP/ Money Supply (M1 or M2)