Quantity Theory of Money
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Velocity of money
In economics, the velocity of money refers to a key term in the "quantity theory of money," which centers on the "equation of exchange":
- M*V = P*Q
where
- M is the total amount of money in circulation in an economy at any one time (say, on average during a month).
- V is the velocity of money, i.e., how often each unit of money is spent during the month. This reflects financial institutions and other economic conditions.
- P is the average price level for the economy during the month.
- Q is the total number of items purchased during the month. This is often measured by the "real" gross domestic product but would better be measured as total turnover of goods and services, including purchases of financial items.
The right-hand side of the equation above equals the total amount of money spent during the month. The left-hand side also equals that amount, so that the equation is an identity, i.e., an equation that is always true by definition.
Given this identity, the velocity of money can be measured as
- V = P*Q/M
In an early work espousing the quantity theory, velocity is defined as 'the ratio of net national product in current prices to the money stock.'1
Inflation
The equation of exchange can be used as a rudimentary theory of inflation. If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.
If V and Q are constant, then we can state the equation of exchange in terms of rates of growth:
- the rate of growth of the money supply = the inflation rate
See also
References
Note 1: Friedman, Milton and Schwartz, Anna J. (1965). The Great Contraction 1929–1933. Princeton: Princeton University Press. ISBN 0–691–00350–5.