The term “velocity of money” refers to how fast money passes from one holder to the next. It can refer to the income velocity of money, which is the frequency at which the average same unit of currency is used to purchase newly domestically-produced goods and services within a given time period. In other words, it is the number of times one unit of money is spent to buy goods and services per unit of time. Alternatively and less frequently, it can refer to the transactions velocity of money, which is the frequency with which the average unit of currency is used in any kind of transaction in which it changes possession—not only the purchase of newly produced goods, but also the purchase of financial assets and other items.”
Velocity Of Money
What is the ‘Velocity Of Money’
The velocity of money is the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a given period of time. Velocity of money is usually measured as a ratio of GNP to a country’s total supply of money.
Explaining ‘Velocity Of Money’
Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle and should have a higher rate of inflation, all things held constant.
Velocity of Money & the Economy
There are differing views among economists as to whether velocity of money is a useful indicator of the health of an economy or, more specifically, inflationary pressures. The “monetarists” who subscribe to the quantity theory of money argue that money velocity ought to be stable absent changing expectations, but a change in money supply can alter expectations and therefore money velocity and inflation. For example, an increase in the money supply should theoretically lead to a commensurate increase in prices because there is more money chasing the same level of goods and services in the economy. The opposite should happen with a decrease in money supply. Critics, on the other hand, argue that in the short term, the velocity of money is highly variable, and prices are resistant to change, resulting in a weak and indirect link between money supply and inflation.
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