What about the velocity of money?
Despite massive amounts of money pumping into the economy, inflation has basically remained flat. When economists or the media refer to inflation they usually mean an increase (or lack thereof) in the Consumer Price Index. As the reasoning goes, if a larger amount of money is divided over a given amount of products, the general price level of those products rises. Makes total sense. So why don’t we see a rise in consumer prices despite massive money injections in recent months and even years?
Many professional economists point to a low velocity of money as a reason. The velocity can be thought of as the number of times a given amount of money changes hands over a certain time period and is commonly derived by dividing the product of real GDP and the Consumer Price Index by the total Money Supply. But is velocity really a factor and is it even calculated correctly?
When relating money supply, the velocity of money, and inflation, professional economists implicitly or explicitly refer to what is known as the quantity theory of money or the Fisher equation, named after the economist Irving Fisher who first came up with the ‘equation’.
The Fisher equation looks as follows:
M∙V=P∙TR
where M is the money supply, V the velocity of money, P the general price level, and TR the number of transactions that took place in a given time span. From this relationship, it appears that if the velocity rises, then prices rise for a given money supply and level of economic activity.
The problem with this interpretation, however, is that the velocity of money is a concept that is included in the relationship to balance the two sides. In other words, the velocity of money is a derivative variable that has no economic meaning and certainly is not a causal factor explaining price levels. Put differently, if consumers become more confident and decide to spend more, the number of transactions will increase which results in a higher velocity, by definition. So, it is not the velocity that causes consumers to spend more. And by consumers, we not only refer to end consumers but every person or entity that demands a good or service to buy, including capital goods.
Thus, an increase in the general level of prices, i.e. in all prices, can only come about through an increase in the money supply. Relative prices, of course, can change as a result of changes in the demand and supply of individual goods and services. This will not, however, result in a general increase in prices but rather leads to substitution among goods and services. The ones that see their prices increase will be substituted for cheaper goods and services. In other words, resources will be allocated differently among the multitude of goods and services that are being produced in the economy.
Another problem is how the equation is used. As we already stated, the velocity is derived from the other variables of which only the money supply can be measured and directly controlled. Practitioners use the Consumer Price Index as a substitute for general prices and real GDP as an approximation of the total number of transactions in the economy. It should be clear, however, that P in the equation is to be interpreted as a vector or matrix of all prices at which transactions have taken place in a certain time period. Similarly, TR is the vector or matrix of all transactions in the economy. Limiting them to the CPI and GDP respectively is a gross oversimplification and makes inferences based on them useless.
To further illustrate the absurdity of using real GDP and the CPI, on the left-hand side the entire money supply is used while on the right-hand side only part of the economy is included. Put differently, it is as if the entire available money supply is spent on only part of the entirety of economic transactions. I suppose the rest is settled in kind. What’s more, those transactions are multiplied by a price index that represents only a part of real GDP. Not to mention the economic nonsense of a consumer price index, but let’s ignore that here.
Given these oversimplifications, it should come as no surprise that, indeed, it is possible for the money supply to increase without increasing the Consumer Price Index. However, the reason is not a decrease in the velocity of money — which is an effect of how and what numbers are plugged in — but rather that the extra money does not show up in spending on consumer goods. Also, the fact that the Consumer Price Index does not rise does not mean that there is no inflation of prices elsewhere in the economy or even within certain categories of consumers’ goods.
If one were to believe in the validity of the Fisher equation all economic transactions and the prices at which they occurred should be included. If, for example, also financial transactions, real estate transactions as well as other asset-related transactions and investments were considered, already a more comprehensive picture of the effects of massive increases in the money supply could be obtained.
Oftentimes practices are so ingrained in the minds of practitioners that there seems to be a total lack of reflection on what it is they are feeding into their ‘equations’ and how the inputs relate to each other and to what they are theoretically supposed to be. It has become so automatic and subconscious that the underlying economics or original interpretation are completely ignored and economic significance is given to variables that should have none. In short, don’t give too much credibility to the concept of velocity, especially in the way it is commonly calculated. Actually, don’t pay attention to it even if it were correctly calculated.
