In the mid-nineteenth century, economists first began to study the relationship between money and economic activity. One of their earliest discoveries was that the velocity of money has an effect on inflation rates and production levels. While we still have much more to learn about this phenomenon, here are some interesting facts that can help you understand why it matters.
What is the velocity of money? – Definition
But what exactly is money velocity? It’s a measure of how many times, on average, a dollar is used to purchase final goods and services within a given period of time. For example, if you buy something with your dollar bill and then someone else buys something else from the same store with that same dollar bill later in the day, your currency has been used twice in one day. In this case, the velocity of your currency was 2.
Money supply measures how much money exists in an economy at any given time (the total amount of cash held by people). If you have $100 in your pocket today but no one else does yet because you haven’t spent it yet; this would count toward the money supply even though it hasn’t been put into circulation yet. So when economists talk about “velocity” or “circulation” they’re referring specifically to how much each unit of currency gets circulated (spent) during its lifetime — not just how many units exist at any given moment.
How to calculate the velocity of money
The velocity of money is a way to measure the rate at which money changes hands and circulates through the economy. This number is important because it gives you insight into how quickly your economy is growing and how much inflation there will likely be in the future, among other things. Let’s look at what exactly this term means and how it applies to your business and personal finances.
Let’s say that you have $100 to spend on groceries, clothing, entertainment, etc., during one week—but all these purchases take place over a period of 10 days: Monday through Thursday being spent on food; Friday through Sunday on clothes; then again Monday through Thursday for entertainment; etc., until all $100 has been spent. The velocity of money would be calculated by dividing your total expenditures ($500) by the amount of time (10) over which those purchases were made: 5/10 = 0.5 or 50%. This tells us that for every dollar out there in circulation among consumers, about half turns over every three days or so—a very high velocity indeed!
While there are several uses, one major application involves gauging the effect of monetary policy on inflation and production levels, as well as predicting trends in economic growth or recession.
For example, if a central bank increases its money supply and velocity remains constant, then more transactions will take place. This would result in higher prices. Conversely, if the central bank lowers its money supply while velocity remains unchanged, then fewer transactions would occur but each transaction would be larger since all prices (and therefore their values) remained constant.
The transaction velocity is the number of times on average that a dollar is used for a transaction.
Coronavirus economic relief efforts aided money supply growth, while fewer transactions were made throughout the economy due to consumer savings increasing from economic uncertainty, ultimately decreasing money velocity.
A higher velocity is a sign that the same amount of money is being used for a number of transactions. A high velocity indicates a high degree of inflation.