The velocity of money is the speed at which money moves through an economy, calculated by dividing the value of all transactions by the total amount of money available. A high velocity of money is considered good for a healthy economy, but it can also suggest inflation.
The velocity of money is the speed at which money moves through an economy. It is calculated by dividing the value of all transactions in the economy by the total amount of money available. The result is a number that describes how many times a chunk of money has been spent over a period of time – usually a year.
As an example, consider a small economy consisting of three authors who continually sell books to each other using wampum accounts as currency. If everyone starts with 20 wampum accounts, the total amount of money available in the economy is 60 accounts. This number is also called the money supply. If each of these prolific authors buys one book from the two for 10 accounts each, each individual still has 20 accounts, but 60 total accounts have been purchased. If they repeat this behavior every three months, the savings will have supported 240 book purchases over the course of a year. This number is equivalent to the gross domestic product (GDP) of a national economy.
The velocity of money in the exemplary economy is calculated by dividing the gross domestic product by the money supply. Divide 240 accounts per year by 60 accounts and you get ‘4 per year’. Note that the final result does not contain currency units; it could refer to individual bills, to strings of five or ten beads, or even to some observer’s estimate of the dollar value of bills. The only unit is the time frame in which transactions are taking place. This number means that an average piece of currency changes hands four times in the course of a year.
The same simple calculation can be performed to determine the velocity of money in 2008 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 therefore 10.17. That is, the average dollar in the economy has changed hands approximately ten times. Obviously, this final number is a very rough estimate, as in practice it is difficult to account for all transactions that occur. Only the black market represents a major source of rapid currency exchange, not represented in the official GDP.
Currency velocity 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 a healthy and productive economy. However, the high velocity of money can also suggest the existence of inflation, as money circulates faster when people need to use it more in any given transaction.
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