Velocity of Money Ratio
The velocity of money refers to the rate at which money changes hands. A country's central bank -- the Federal Reserve in the United States -- measures the velocity of money through a ratio of money supply to gross domestic product. The velocity of money affects the overall price level in a country and is a major factor in inflation.
Other People Are Reading
-
Velocity of Money
-
In any given country, a central bank puts currency into the economy, creating the money supply. People use currency to purchase goods and services, and when an economy functions normally, one unit of currency trades hands regularly. A factory worker receives wages, uses some cash to buy groceries, the grocer in turn uses some of his revenues to replenish his inventory, the wholesaler then pays a farmer and the exchange continues. Called the velocity of money, this is the rate at which $1 or 1 peso changes hands.
GDP
-
The velocity of money keeps resources flowing and allows for the gross domestic product -- the aggregate value of goods and services sold in an economy -- to be higher than the value of the money supply. For example, in a hypothetical economy that consists of two people and has a money supply of $2, six purchases of $1 throughout the year create a GDP of $6, even with only two $1 bills.
-
Ratio
-
In measuring velocity, economists use a ratio of money supply to GDP. Ratios display division, and the velocity of money is GDP divided by the money supply. GDP can only be higher than the money supply if money changes hands more than once every year. In the hypothetical economy, the velocity ratio is 2-to-6, simplified to 1-to-3, meaning that each dollar changes hands three times in a year.
Using the Ratio
-
The higher the ratio, the more economic activity occurs. If the ratio in the hypothetical economy rises to 1-to-4, that means that each dollar changes hands four times a year, for a GDP of $8, or a 25 percent increase. Consequently, as the velocity increases, people have more money at their disposal in a given year and inflation tends to increase -- note that some inflation is healthy for an economy. Increasing the money supply also increases inflation, but only if the velocity stays the same or increases.
-
