Velocity Of Money

You’re spending the day by a river...but on what kind? A nice, trickle-of-a-stream, raging rapids, or something in-between? The main difference among the types of rivers? Velocity of water: how fast it’s going.

The velocity of money is the same, except with money. The velocity of money refers to the speed at which money is flowing in an economy. It’s the rate at which people spend money. The more people spend in a certain timeframe, the higher the velocity of money is. We can hear the increasing velocity of "ka-ching"s now.

In the aggregate, velocity of money for a country can be calculated by dividing nominal GDP (nominal meaning using current market prices, unlike real GDP, which calculates out inflation effects) by the average amount of money in circulation. That’s basically everything sold divided by the amount of actual dollar bills floating around in the system. When the velocity of money increases, then money is switching hands at a faster rate than before. Since it uses nominal GDP, it implies that prices change in proportion to the total money supply to get the same velocity of money.

When the velocity of money slows down, it means people are spending less, which will likely lead to lower GDP and potentially other negative macroeconomic factors, like increased unemployment. One man’s purchase is another man’s income, so fewer purchases means less income all around.

Yet the velocity of money has been criticized by some for its use in economics. Because it takes an aggregate look, rather than starting from the actions of individual actors, it’s argued that it can be misleading when not put into the proper context.

Another criticism of the velocity of money can be said to imply that prices change in proportion to changes in the total money supply, but that’s been shown to be untrue. Unlike in physics, velocity in economics is much more controversial.

Inflation makes everything more difficult. Since the value of a dollar changes over time, becoming worth less and less with inflation, the idea of what the velocity of money actually means also changes. Some economists find the velocity of money and the money supply essential for successful macroeconomic policy, while other economists would prefer to do away with it altogether.