The velocity of money is frequently cited to pooh-pooh those of us warning about price inflation. They post this chart from the Federal Reserve.
This goes back to Irving Fisher’s formula MV=PT, where M is representative of the amount of money, V is the velocity, P is price and T is transactions.
First off, the idea that money “circulates” is a misnomer. Money is exchanged. It changes ownership just like any other good or service.
Whenever you look at a statistic or a fact you must use logic. Facts are meaningless without logic or a philosophy to interpret what you are looking at. So we look to the Federal Reserve website to see the explanation for this number and what it means. This is how they actual calculate the number.
Calculated as the ratio of quarterly nominal GDP to the quarterly average of M2 money stock.
So they take GDP and divided it by the money supply. Both the GDP and the money supply are measured in dollars. Therefore what we get is a ratio, which has no units. They than give an explanation about what this ratio means, which directly contradicts how they calculate the published number.
The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.
So how they actually calculate the velocity of money is a ratio (GDP/Money Supply) with no units . The worded definition they give is “the number of times one dollar is spent to buy goods and service per unit time”. The worded definition they give is in no way related to how they calculate it. One is unit less and the other is dollar spent per unit time. When any analysis comments on the velocity of money they always speak of it as “the number of times one dollar is spent to buy goods and service per unit time”.
Taking the GDP and dividing it by the money stock is meaningless. It tells you absolutely nothing. When people talk about the velocity of money, I suspect what they really mean is the demand to hold cash balances. If a person knew his cash was going to depreciate very fast, he would not want to hold it in his checking account for very long for fear that tomorrow it could buy significantly less goods. We see this behavior in countries experiencing hyperinflation. On payday the person goes out and spends his money right away before it becomes worthless.