[Submitted by CA. Vibhuti Gupta]
May 28, 2017
In a lay man language, Velocity of Money is a term used to denote a number of times a unit of money in an economy changes hands during a certain period.
It can be referred 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.
Calculation of Velocity of circulation = GDP / Money Supply
Money Supply: The total stock of money circulating in an economy is the money supply. The circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.
GDP (Gross Domestic Product) is the final value of the goods and services produced within the geographic boundaries of a country during a specified period of time, normally a year. GDP growth rate is an important indicator of the economic performance of a country.
Example : Assume a very small economy that has a money supply of INR 10,000 and only two people. A sells crayons and B sells paper. A start with INR 10,000 and buys INR 10,000 worth of paper from B. B turns around and buys INR 10,000 worth of crayons from A. A & B’s economy now has a "Gross Domestic Product" of INR 20,000 even though the money supply is only INR 10,000.If A & B do the same two transactions every month, their "GDP" will be INR 240,000 per year, though the money supply is only INR 10,000.
Hence, Velocity of Money = 240,000/10,000 = 24
This indicator is one of the best indicators of economic activity.
In a strong economy, the velocity of money is high and that same money gets transferred over and over (in a healthy economy, the same currency is collected as payment and subsequently spent many times over)
In a bad/weak economy the velocity of money slows down. So, in a down economy when people, companies and institutions have cash on hand they are less likely to take that money and spend it. The more money there is out there sitting idle in other people’s pockets – the slower the velocity becomes.
When the money is held — not spent or invested — then it does not contribute to the velocity of money. Money velocity increases only when the people spend or invest it. Therefore, any factors that cause people to hold money will decrease the velocity of money, while factors that increase spending or investment will increase the velocity of money.
a. Inflation increases demand for money because higher prices requires more money for a given amount of goods and services. Higher inflation also increases the holding costs of money. For instance, if the inflation rate is 10%, then the cost of holding money is -10%. So when inflation is high, people will either spend it or invest it before the money loses value. Hence, higher inflation rates increase the velocity of money, which increases inflation even more.
b. Interest rate: On holding money, our opportunity cost is that income which we get from bond or in other words, the interest rate. So, when interest rate increases, we want to hold more bond and less money and vice versa. Thus, money demand and interest rate has an inverse relationship. The opportunity cost of holding money is the interest rate a person could earn on assets they could hold instead of money. Higher interest rate (higher opportunity cost) causes lower money demand. Higher interest rates reduce the demand for money by increasing the opportunity cost of holding money, which is the interest that could be earned if the money was invested. So, if the interest rate is 5%, then the cost of holding money is the 5% that could have been earned in interest.
c. Technology that provides liquidity, such as credit cards or demand deposits that earn interest, such as interest-paying checking accounts, reduces the demand for money, since these payment substitutes provide a means of payment without the need to hold the money itself. Technology can also reduce the demand for money by reducing the cost or time to convert assets into a means of payment. For instance, if a bank provides an electronic method of transferring funds from your savings account into your checking account, then you will tend to hold less money in your checking account so that you can earn more interest.
Factors affecting Velocity of Money :
1. Value of Money: The velocity of money is high during inflation when value of money decreases because people will like to part with money as soon as possible. Similarly, during deflation, when the value of money rises, the velocity of money is low because people like to keep money with them.
2. Credit Facilities: The velocity of money increases with the expansion of lending and borrowing facilities in the country. Therefore, the growth of credit institutions has a favourable effect on the velocity of money.
3. Volume of Trade: As the volume of trade increases the number of transactions and the velocity of money increases and as the volume of trade decreases, the velocity of money decreases.
4. Frequency of Transactions: With the increase in the frequency of transactions, the number of payments and receipts increases and, as a result, velocity of money increases. Similarly, with the decrease in the frequency of transactions, the velocity of money decreases.
5. Business Conditions: The velocity of money increases during the period of hectic business conditions and decreases during slump conditions.
6. Business Integration: If business is vertically integrated, the velocity of money will be less and if business is vertically disintegrated, the velocity of money will increase.
7. Payment System: The velocity of money is also determined by the frequency with which the labour force is paid (i.e., weekly or monthly) and the speed with which the bills for goods are settled.
8. Regularity of Income: If people receive income at regular intervals, they will spend their income more freely and the velocity of money will increase. But, if people receive their income at irregular intervals, they will prefer to hold more cash balances to meet the uncertain conditions in future and the velocity of money will fall.
9. Propensity to Consume: Greater the tendency of the people to consume, other things remaining the same, higher will be the velocity of money. On the contrary, lower the propensity to consume, lesser will t3 the velocity of money. Saving, or not consuming, has an adverse effect on the velocity of money.
Money Supply and Nominal GDP in Trillions, of December. (Source: "M2 Money Stock," St. Louis Federal Reserve. "Nominal GDP," BEA.)
|1999||$4.61||$9.66||2.09||Tech stock bubble.|
|2002||$5.74||$10.98||1.91||Bush took office.|
|2006||$7.04||$13.86||1.97||Subprime Housing bubble.|
|2007||$7.44||$14.48||1.95||Banking liquidity crisis.|
|2008||$8.16||$14.72||1.80||Stock market crash. Bubble in oil prices.|
|2009||$8.47||$14.42||1.70||Obama took office. Recession ended.|
|2011||$9.63||$15.52||1.61||Debt crisis. Gold bubble.|
|2012||$10.42||$16.16||1.55||Treasuries yields hit 200-year low.|
|2013||$10.99||$16.69||1.52||Stock market bubble.|
|2015||$12.30||$18.04||1.47||value up 25%.|
|2016||$13.17||$18.57||1.41||Low business investment.|