The velocity of money measures the speed at which money moves through an economy. It is calculated by dividing the value of all economic transactions by the total amount of money available and is important for predicting economic outcomes.
The velocity of money is the speed at which money moves through an economy. It is calculated by dividing the value of all economic transactions by the total amount of money available. The result is a number that describes how many times a given piece of money has been spent over a period of time, usually a year.
For example, consider a small economy consisting of three authors who continually sell to each other using Wampum pearls as currency. If everyone starts with 20 wampum pearls, the total amount of money available in the economy is 60 pearls. This number is also called the money supply. If each of these prolific authors purchases a book from both others for 10 beads each, each individual still has 20 beads, but 60 books have been purchased in total. If they repeat this behavior every three months, the economy will have supported 240 beads of book purchases over the course of a year. This number equals the gross domestic product (GDP) of a national economy.
The velocity of money in the example economy is calculated by dividing gross domestic product by the money supply. Divide 240 beads per year by 60 beads and you get a result of “4 per year”. Note that the final result contains no units of currency; it could refer to individual pearls, strings of five or ten pearls, or even some observers’ estimate of the value of pearls in dollars. The only unit is the space of time in which the transactions take place. This number indicates that an average piece of currency changes hands four times over the course of a year.
The same simple calculation can be performed to determine the 2008 money velocity in the United States. According to the CIA Factbook, the United States had a GDP of $14.61 trillion US dollars (USD) and a money supply of $1.436 trillion. The velocity of money was then 10.17. That is, the average dollar within the economy has changed hands about ten times. Of course, this final number is a very rough estimate, as in practice it is difficult to account for every transaction that occurs. The black market alone represents a large source of rapid currency turnover not represented in official GDP.
The velocity of money is still considered an important calculation by economists because it can help predict economic outcomes. All else being equal, a high velocity of money is considered good because it suggests the existence of a healthy and productive economy. However, the high velocity of money can also suggest the existence of inflation, as money moves faster when people have to use more of it in a given transaction.
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