Some commentators are of the view that what matters for price inflation ahead is not just increases in money supply but also the velocity of money –or how fast money circulates. Some hold that a decline in velocity will offset the strong increase in money supply such that its effect on price inflation will not be very dramatic, if at all. What is the rationale behind this thinking?
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 on goods and services at any given moment can later be used by the recipient to purchase yet other goods and services. For example, during a year a particular ten-dollar bill may 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 then uses it to buy sugar from Tom. The ten dollars here served in three transactions, meaning that the ten-dollar bill was used three times during the year. Its velocity is therefore three.
Most economists regard money velocity as a very useful analytical tool. The debates that economists do 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 much harder for the central bank to navigate the economy toward the path of economic stability.
Value versus Velocity
It would appear that an increase in velocity helps a given stock of money finance a greater value of transactions than it could have done by itself. But as logical as it sounds, neither money nor velocity have anything to do with financing transactions. Consider the following: John the baker sold ten loaves of bread to a tomato farmer George for ten dollars. Now John exchanges the ten dollars to buy five kilograms of potatoes from Bob the potato farmer. How did John pay for the potatoes? He paid with the bread he produced. John the baker financed the purchase of potatoes not with money, but with bread. He used money to facilitate the exchange. Here money fulfils the role of medium of exchange, but it is not the means of payment. (John exchanged bread for money and then exchanged the money for potatoes, i.e., something was exchanged for something with the help of money).
The number of times the money changed hands has no relevance whatsoever on the baker’s ability to fund the purchase of potatoes. What matters is that he possesses bread, which serves as the means of payment for potatoes. Neither money nor velocity have anything to do with financing transactions.
Imagine if money and velocity were indeed the means of payment or funding. If this were the case, then poverty worldwide could have been erased a long time ago. If rising velocity boosts effective funding, then it would benefit everyone to make sure that money circulates as quickly as possible. This implies that anyone who holds on to money should be classified as a menace to society, for they slow the velocity of money and hence the creation of real wealth. It does not even make any sense to argue that money circulates at all, as the popular thinking has it. It always belongs to somebody.
According to Ludwig von Mises (Human Action, 1949), 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.”
People want to hold money for many unpredictable and different reasons. Moreover, velocity is not independent of prices and a person’s subjective valuations. Thus, it doesn’t really tell us much about prices. Valuations change constantly. Because of changes in an individual’s goals, he/she may decide that at present it is to his/her benefit to hold less money. Sometime in the future, he/she might decide that raising his/her demand for money would better serve his/her goals. What could possibly be wrong with this? The same thing goes for any other goods and services: demand for them changes all the time.
Prices are based on individual human action
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 kilograms of potatoes from Bob the potato farmer. Likewise, Bob has concluded that by means of the ten dollars he will be able to secure ten kilograms of sugar, which he holds will raise his living standard. By entering into an exchange both John and Bob are able to realize their goals and promote their respective well-being. John agreed that it was a good deal to exchange ten loaves of bread for ten dollars, since it would enable him to procure five kilograms of potatoes. Likewise, Bob concluded that ten dollars for his five kilograms of potatoes was a good price, since it would enable him to secure ten kilograms of sugar.
Price is the outcome of different ends, and hence the different importance that both parties to a trade assign to means. Individuals’ purposeful actions determine the prices of goods, not velocity. The fact that so-called velocity is any number has nothing to do with goods prices or the purchasing power of money.
By Frank Shostak
Frank Shostak’s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Culled from https://mises.org.