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After rising to 2.198 in Q3 1997, the ratio
of US Gross Domestic Product (GDP) to money supply M2 fell to 1.433 by Q3 2017.
Since then the ratio has bounced slightly to 1.457 in Q1 2019. Economists label
this ratio as the velocity of money. Some experts regard the steep decline in
the ratio as an ominous sign for the economy in the months ahead since it
raises the likelihood of a sharp decline in the growth rate of prices.
velocity.PNG (here there is a standard graphical representation.
This in turn raises the likelihood of price deflation and in turn of a severe
economic slump. It is also held that a fall in the ratio raises the likelihood
that monetary injections by the Fed are going to become ineffective in the
event that the US central bank will attempt to revive the economy once it falls
into an economic slump. What is the rationale behind this way of thinking?
The Popular View of Money Velocity:
According to popular thinking, the idea of velocity is straightforward. It is
held that over any interval of time, such as a year, a given amount of money
can be used repeatedly to finance people's purchases of goods and services. The
money one person spends for goods and services at any given moment can be used
later by the recipient of that money to purchase yet other goods and services.
For example, during a year a particular ten-dollar bill can be used as follows:
a baker John pays ten-dollars to a tomato farmer George. The tomato farmer uses
the ten-dollar bill to buy potatoes from Bob who uses the ten-dollar bill to
buy sugar from Tom. The ten-dollars here served in three transactions. This
means that the ten-dollar bill was used three times during the year, its
velocity is therefore three. A $10 bill, which is circulating with a velocity
of ‘3’ was used to finance $30 worth of transactions in that year.
Now, if there are $3000 billion worth of transactions in an economy during a
particular year and there is an average money stock of $500 billion during that
year, then each dollar of money is used on average six times during the year
(since 6*$500 billion=$3000).
Hence $500 billion by means of a velocity factor has effectively become $3000
billion. This implies that the velocity of money can boost the means of
finance. From this it is established that, Velocity=Value of transactions /
stock of money This expression can be also presented as, V=P*T/M Where V stands
for velocity, P stands for the average price, T stands for the volume of
transactions and M stands for the stock of money. This expression can be
further rearranged by multiplying both sides of the equation by M. This in turn
will give us the famous equation of exchange M*V=P*T This equation states that
money multiplied by velocity equals the value of transactions.
Many economists employ GDP instead of P*T thereby concluding that
M*V=GDP=P*(real GDP) The equation of exchange appears to offer a wealth of
information regarding the state of an economy. For instance, if one were to
assume a stable velocity, then for a given stock of money one can establish the
value of GDP. Furthermore, information regarding the average price or the price
level allows economists to establish the state of the real output and its
growth rate. Note that from the equation of exchange a fall in the velocity of
money (V) for a given money (M) results in a decline in economic activity as
depicted by GDP. In addition, for given money (M) and a given volume of
transactions (T) a fall in velocity results in a decline in the average price
(P).
For most economists the equation of exchange is regarded as a very useful
analytical tool. The debates that economists have are predominantly with
respect to the stability of velocity. If velocity is stable then money becomes
a very powerful tool in tracking the economy. The importance of money as an
economic indicator however diminishes once velocity becomes less stable and
hence less predictable. It is held that unstable velocity implies an unstable
demand for money, which makes it so much harder for the central bank to
navigate the economy towards the path of economic stability. Does the concept
of velocity of money make sense? From the equation of exchange, i.e. M*V=GDP it
would appear that for a given stock of money an increase in velocity helps to
finance a greater value of transactions than money could have done by itself.
As logical as it sounds, neither money nor velocity have anything to do with
financing transactions. Here is why. Consider the following: a baker John sold
ten loaves of bread to a tomato farmer George for ten dollars. Now, John
exchanges the ten dollars to buy five kg of potatoes from Bob the potato
farmer. How did John pay for potatoes? He paid with the bread he produced. Note
that John the baker had financed the purchase of potatoes not with money but
with bread. He paid for potatoes with his bread using money to facilitate the
exchange. Money fulfils here the role of the medium of exchange and not the
means of payment. (John has exchanged bread for money and then money is
exchanged for potatoes i.e. something is exchanged for something with the help
of money). The number of times money changed hands has no relevance whatsoever
on the bakers’ ability to fund the purchase of potatoes. What matters here
is that he possesses bread that serves as the means of payment for potatoes.
Imagine that money and velocity would have indeed been the means of funding or
the means of payments. If this would have been the case then poverty worldwide
could have been erased a long time ago. If rising velocity is supposed to boost
effective funding then it would have been to everyone’s benefit to make
sure that money circulates as fast as possible. This implies that anyone who
holds on to money should be classified as menace to the society for he slows
down the velocity of money and hence the creation of real wealth. In addition,
it does not make any sense to argue that money circulates as popular thinking
has it. It always belongs to somebody.
According to Ludwig von Mises in Human Action, money never circulates as
such, Money can be in the process of transportation, it can travel in trains,
ships, or planes from one place to another. But it is in this case, too, always
subject to somebody's control, is somebody's property. Why velocity has nothing
to do with the purchasing power of money Does velocity have anything to do with
the prices of goods? From the equation of exchange for a given M and the volume
of transactions (T) a fall in velocity V results in a decline in the average
prices (P) i.e. P=(M/T)*V. This is erroneous.
(In this he is using the establishment concept of what 'money' IS - they think
the token (coin, currency) IS money but it is NOT. So hie is correct but misses
the reason why. Then, in the following paragraphs he reverts to the 'myth' of
barter when describing the process by which goods and services are exchanged.
JS)
Prices are the outcome of individuals’ purposeful actions. Thus, John the
baker holds that he will raise his living standard by exchanging his ten loaves
of bread for ten dollars, which will enable him to purchase five kg of potatoes
from Bob the potato farmer. Likewise, Bob has concluded that by means of ten
dollars he will be able to secure the purchase of ten kg of sugar, which he
holds will raise his living standard. By entering an exchange, both John and
Bob are able to realize their goals and promote their respective well-being.
John had agreed that it is a good deal to exchange ten loaves of bread for ten
dollars for it will enable him to procure five kg of potatoes. Likewise, Bob
had concluded that ten dollars for his five kg of potatoes is a good price for
it will enable him to secure ten kg of sugar. Observe that price is the outcome
of different ends, and hence the different importance that both parties to a
trade assign to means. Individual’s purposeful actions determine the
prices of goods and not velocity. The fact that so-called velocity is
‘3’ or any other number has nothing to do with goods prices and the
purchasing power of money as such. According to Mises (again, in Human Action),
In analyzing the equation of exchange one assumes that one of its
elements--total supply of money, volume of trade, velocity of
circulation--changes, without asking how such changes occur. It is not
recognized that changes in these magnitudes do not emerge in the
Volkswirtschaft [political economy, or more loosely ‘economy’] as
such, but in the individual actors' conditions, and that it is the interplay of
the reactions of these actors that results in alterations of the price
structure. The mathematical economists refuse to start from the various
individuals' demand for and supply of money. They introduce instead the
spurious notion of velocity of circulation fashioned according to the patterns
of mechanics (Human Action p 399).
Velocity Does Not Have an Independent Existence:
(Actually it is not even the 'velocity' that people think it is.JS)
Contrary to popular way of thinking velocity is not an independent entity - it
is always the value of transactions P*T divided into money M i.e. P*T/M. On
this Rothbard wrote (Man Economy and State p 735), But it is absurd to
dignify any quantity with a place in an equation unless it can be defined
independently of the other terms in the equation. Given that V is P*T/M it
follows that the equation of exchange is reduced to M*(P*T)/M=P*T, which is
reduced to P*T=P*T, and this is not a very interesting truism. It is like
stating that $10=$10. This tautology conveys no new knowledge of economic
facts. Since velocity is not an independent entity, it as such causes nothing
and hence cannot offset the effects from money supply growth.
Velocity also cannot increase the means of funding as the equation of the
exchange implies. Moreover, the average purchasing power of money cannot be
even established. For instance, in a transaction the price of one dollar was
established as one loaf of bread. In another transaction, the price of one
dollar was established as half kg of potatoes, while in the third transaction
the price is one kg of sugar. Observe that since bread, potatoes and sugar are
not commensurable no average price of money can be established. Now, if the
average price of money cannot be established it follows that the average price
of goods (P) cannot be established either. Consequently, the entire equation of
exchange falls apart. Conceptually the whole thing is not a tenable proposition
and covering it in mathematical clothing cannot make it more tenable.
(Exactly right - but irrelevant since the whole concept of what 'money' is is
falacious, JS)
Additionally, does so-called unstable velocity imply an unstable demand for
money? The fact that people change their demand for money does not imply
instability. Because of changes in individual’s goals, they may decide
that at present it is to their benefit to hold less money. Sometime in the
future, they might decide that raising their demand for money would serve
better their goals. So what could possibly be wrong with this? It is the same
that goes for any other goods and services — demand for them changes all
the time. Conclusions A massive decline in the velocity of money M2 since Q3
1997 raises an alarm among some commentators that at some stage this could
result in a visible price deflation. This in turn runs the risk of plunging the
US economy into a severe economic slump. But, if this were to happen, the
reason would be not a fall in the velocity of money, but a decline in the
subsistence fund because of loose monetary policies. Contrary to popular
thinking, the velocity of money does not have a life of its own. It is not an
independent entity and hence it cannot cause anything, let alone price
deflation.
(But the velocity, and even more critical the acceleration, of the expansion or
contraction of CREDIT has a decided effect on the economy, JS)
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