Money velocity – you can’t have your cake and eat it

This post refers to Unit 4 of the CIE A2 Economics course. Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250
Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change
in the money supply causes an equal percentage change in the price level.

The speed at with which money goes around the circular flow is a significant indicator as to the economic activity of an economy. Money’s “velocity” is calculated by dividing a country’s quarterly GDP by its money stock that quarter – the bigger GDP is relative to the money supply, the higher the velocity.

Recessions – dampen the velocity by increasing the attractive of a store of value. People tend to save rather than spend. E.G. The Great Depression and the GFC. See graph for US velocity of money.

Covid-19 – with the closure of a lot of businesses and people worried about job security personal savings increased to 33.6% of disposable income. Also consumers didn’t have the money to spend.

The stimulus measures and the glut of dollars could cause problems once the consumer confidence starts to become prevalent. Inflation will inevitably rise again – which is not a bad thing considering the threat of deflation that we are currently experiencing. But the major concern is if the increase in spending spirals out of control with high inflation. It seems that central banks want the velocity of money to increase to kick-start the economy but they will need to consider how to control it if it gets above the ‘speed limit’. “You can’t have your cake and eat it”.

Source: Why money is changing hands much less frequently – The Economist 21-11-20

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