Understanding the velocity of money is the measurement of evaluating and assessing the flow rate of capital and monetary tools. This involves the transference of currency from one entity to another, the issuance of currency notes, and the rate of economic conveyance. It is defined as the average movement of currency used to purchase domestically manufactured items, goods, or services in an allotted time.
What is the Velocity of Money?
The velocity of money represents the frequency at which one unit of currency (for example, $1) is used to purchase domestically produced goods and domestic services within a given period. Thus, the velocity of money is a measurement of the rate at which money is exchanged in an economy.
The frequency of consumed capital is determined per unit of time. This is considered a subcategory of economic activity. The commercial activity is controlled by the movement of money and the frequency or the speed at which the money was spent on the exchange of assets and variables. By identifying the velocity of money, the gross national product of a country can be discovered. If the momentum of money is snowballing, then the transactions and supply of money are frequently occurring. If the velocity of money increases, then it means that the rate of monetary transaction is also increasing, therefore assisting the economy. A variety of factors determines the frequency of money spent, and its fluctuations depend on certain variables.
Is the velocity of money constant?
No, the velocity of money is not constant because it increases when money is spent more frequently. When GDP, spending, and investment rise, then the velocity of money rises too.
The escalation and decay of a country‘s economy depend on the speed at which transactions are materializing. If more transactions are apparent throughout the country, then the economy and velocity tend to increase. Similarly, if the transactions are dropping, the velocity of money condenses therefore dwindling a country’s economy. On the other hand, a country with a fast velocity exhibits the need for more production, thus, enriching the local economy. This entire economic concept confirms the significance of each dollar note that travels from one individual to the next retailer to increase the productivity trade and industry. As per the Federal Reserve, it is the average rate of gross revenue noticed in the money supply.
The velocity of Money Formula
The velocity of money formula represents the nominal gross domestic product (GDP) ratio to the money supply (V=PQ/M). This velocity of money formula calculates the frequency at which one unit of currency is used to purchase goods and services within a given period.
The velocity of money can be identified as the total ratio of typical gross domestic product, which is the GDP to the money supply—using the following equation MV = PQ, where M is the monetary allowance. Thus, V is the velocity of money, or the rate people like to spend their money. P is their average price level, and Q relates to the total quantity of items and goods manufactured. In other words, it is calculated by dividing the total economic productivity or output by the money supply.
To calculate the velocity of money, the equation must include nominal GDP because the measure of money production does not entail inflation. Thus, there is a difference between the gross domestic product and the nominal GDP of the country. The only difference is that the latter identifies the country’s total economic output, whereas GDP is determined without being adjusted for inflation.
The velocity of money values per year
|Year||GDP||Velocity of money|
Factors affecting the velocity of money
Two main factors affect the rate of money transfer.
1. the change in the economy is GDP 2.
2. the transition and modification in the money supply.
Factors and variables that alter the shape of velocity are the total value of money, trade volume, the number of times transactions have taken place, and credit facilities that have been used.
Factors affecting velocity
- Money supply
The velocity of money and money supply are inversely proportional in the mathematical explanation. Therefore, they are not directly dependent on each other, and if the money supply increases, then there is a decrease in velocity or the circulation of money and vice versa.
- Frequency of monetary transactions
The velocity of money tends to increase with the rise of want to transactions. Therefore, it is clear that if that cash or liquid assets are exchanged faster, the velocity will increase dramatically.
- Income regularity
Suppose Individuals are paid through a stable system of income where there is a fixed input of money. In that case, that income is expected to be spent frequently and systematically, increasing the velocity of money.
- Payment system
Income is directly linked to the velocity of money. If individuals are based on a weekly, fortnightly, or monthly basis, the cash rate will fluctuate according to the income payment system. The bills and dues are matured through a standardized process of monetary input.
- Credit facilities
The velocity of money is expected to increase if there is an enlargement of loaning and borrowing services. If the credit institutions double, the velocity of money will also increase, therefore leaving a positive effect on the economy.
- Trade volume
The presence of trade and investment activities increases the circulation of money as well. Therefore, it is also favorable for the overall economy, and it helps strengthen the current and prospective state regulations.
- Business memberships
If the existing business regulations and establishments are on the rise, it is evident that the philosophy of money and every transaction will also increase. But, on the other hand, if the businesses are not operational, the transactions will be hard to track.
If items, goods, services, and businesses are purchased at a higher rate than the average great, then the velocity of money could be increased. But, on the other hand, if individuals are inclined to minimalistic consumption, people will start saving and harming the economy.
How do credit cards affect the velocity of money?
Using credit cards increases the velocity of money. Credit cards transactions reduce the need for cash and this increased velocity of money. Additionally, using credit cards increases tax collection and increases GDP which is the most important part of velocity of money formula.
The velocity of money for the US was 1.427, observed in the fourth quarter of 2019. This shows that a particular note of dollar was used 1.427 times in that year. This rate is the lowest turnover recorded for the velocity of money. It clearly shows that people and businesses in 2019 were more interested in holding cash than spending it on goods, services, and items for purchase and retail. As a result, a dollar was accumulated, saved, invested, or utilized to pay off debts at this rate.
It is being highlighted that the velocity city of money is gradually still is increasing. The introduction of the expansionary monetary policy in the 2008 financial crisis has given birth to a liquidity gap. People and small and large-scale businesses began accumulating liquid assets instead of spending them, disturbing cash flow. As a result, the economy becomes stagnant and financial productivity is just dropped. The expansionary monetary policy suggested lowering the federal funds rate to zero in 2008 and stagnated until 2015.
The velocity and circulation of cash are valuable in understanding and evaluating the inflation levels of a country. To assess the prospective economy, the frequency of money spent should be assessed by the economist to predict and foresee the overall aspect of a country’s economy.