Sunday, July 15, 2012

Velocity of Circulation

From Wiki:

The velocity of money (also called velocity of circulation) is the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply.

If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year

Farmer spends $50 on tractor repair from mechanic.
Mechanic buys $40 of corn from farmer.
Mechanic spends $10 on barn cats from farmer.

then $100 changed hands in the course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was . Note that if the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy's gross domestic product.

[ Some economic schools of thought believe velocity doesnt change.] This view has been discredited by the precipitous fall in velocity in the Japanese "Lost Decade" and the worldwide "Great Recession" and its aftermath of 2008-10. Monetary authorities undertook massive expansion of the money supplies, but instead of lifting nominal GDP as predicted by this theory, velocity fell as nominal GDP was relatively unchanged.

[Basil 1 Accords and Basil 2 Accords increased fractional reserve requirement which decreased both the overall money supply and velocity of circulation. Even with an expansion of the money supply via QE1-2, GDP has remained stagnant because of a slowdown of velocity. MPE fails to account for velocity. SSS does account for velocity]

Because "Velocity of Circulation" is difficult to control as it can depend greatly on human nature, there must be a mechanism to make adjustments to regulate the value of the currency. This is the purpose for the simple prime interest rate in SSS. Because of "Velocity" no economic system can be totally "Mathmatically Perfect." Therefore, there needs to be a corrective mechanism.

1 comment:

Ivan PFMPE™ said...

How is this velocity going to cause problems with our 1:1:1 relationship, maintained by an obligatory schedule of payment retiring principal at the rate of consumption or depreciation of the related property?

Don't just assert it does, explain how it does.