The velocity of money becomes essential for determining the pace at which money in circulation is spent on goods and services. It is used to assist economists and investors in determining an economy's health and vitality. A healthy, growing economy is generally linked with a high velocity of money. Recessions and contractions are often linked with a low velocity of money.
Velocity of Money Meaning
Money velocity may be described as the rate at which money flows or is exchanged in an economy. In other words, it is the rate at which money is spent in an economy to purchase goods and services.
It is also known as money supply turnover. When a person earns more money, he becomes more confident in acquiring items, which increases money velocity.
The money velocity shows the status of an economy; for example, a high velocity of money suggests that money is flowing quickly through an economy toward the purchase of goods and services.
Velocity of Money Formula
The formula to calculate the money velocity is expressed as follows:
Velocity of Money= Total Expenditure (or Nominal GDP)/Money Supply
In this equation, the velocity of money is determined by dividing the total expenditure or nominal Gross Domestic Product (GDP) by the money supply. This ratio illustrates how efficiently money is being utilized within an economy.
Use of Velocity of Money
Below, we have provided some of the key uses of the money velocity:
Economic Indicator:
Money velocity gauges economic activity, indicating a thriving or sluggish economy based on money circulation speed.
Monetary Policy Guide:
Central banks use it to adjust interest rates and money supply, ensuring stable economic conditions.
Inflation Warning:
Rapid circulation may signal inflation, while slow movement can indicate deflationary risks.
Investment Signal:
Investors rely on it to assess economic health, making decisions based on active or stagnant money circulation.
Consumer Behavior Insight:
Helps understand consumer spending patterns; higher velocity signifies confidence and spending.
Policy Evaluation:
Assists policymakers in measuring policy effectiveness; adjustments can be made if desired outcomes aren't met.
International Trade:
Indicates economic strength, influencing international trade and investment decisions.
Trend Prediction:
Historically, it aids economists in predicting future economic conditions based on velocity changes.
Factors Affecting Velocity of Money
A variety of variables may influence the money velocity in an economy. These are some examples:
Money supply:
Money supply is inversely linked to money velocity. When the central bank expands the quantity of money, the velocity of economic transactions accelerates. This has the potential to cause inflation.
Consumer behavior:
The conduct of economic players has an impact on velocity. When individuals prioritize saving overspending, the rate of transactions slows and money velocity falls. Money moves faster when customers prioritize their spending.
Payment systems:
Monetary system elements such as credit availability or electronic banking influence the velocity of money. When there are minimal obstacles to transactions, money velocity rises; when it is difficult to spend money, it falls.
Velocity of Money Calculation Examples
Example 1: Efficient Transactions
In a bustling marketplace in Mumbai, Mr. Sharma buys vegetables worth ₹500 from Ms. Patel. Ms. Patel then uses that ₹500 to pay her electricity bill, and the electricity provider, Mr. Kumar, pays his employee, Mr. Singh, ₹500 for services rendered. In this scenario, the money velocity is calculated as follows:
Velocity of Money=Total Expenditure (₹1500)/Money Supply (₹500)=3
Here, the ₹500 circulated through three transactions, indicating a velocity of 3.
Example 2: Slow Circulation
In a rural village, Mrs. Reddy receives ₹1000 as her monthly salary. She keeps the money at home and uses it gradually over the course of a month for various expenses. During the entire month, the money doesn't change hands in any transaction. In this case, the velocity of money is:
Velocity of Money=Total Expenditure (₹0)/Money Supply (₹1000)=0
Here, the money remained idle, resulting in a velocity of 0, indicating very slow circulation.
Example 3: Rapid Transactions
In a commercial hub like Bangalore, a tech company pays its employees a total of ₹1,00,000 in salaries. These employees, in turn, spend their money on various goods and services within a week. The vendors, in receiving this money, pay their suppliers promptly. In this scenario, the velocity of money is:
Velocity of Money=Total Expenditure (₹1,00,000)/Money Supply (₹1,00,000)=1
Here, the entire ₹1,00,000 circulated within a week, resulting in a velocity of 1, indicating one full cycle of money circulation.
