Author Topic: Will Prices Rise Significantly When Velocity of Money Picks Up?  (Read 239 times)

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Offline Oceander

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Will Prices Rise Significantly When Velocity of Money Picks Up?

Mike "Mish" Shedlock

Several people have written recently telling me that price inflation is under control only because the velocity of money (the alleged rate at which money circulates) is falling.

Reader Mark pinged me with this statement "Falling velocity is deflationary. It indicates people are saving their cash." Others have expressed similar opinions, typically in reference to this chart by the Fed.


Discussion of Ratios

That chart looks ominous. Is it?

First, please note the chart says velocity is a "ratio". A ratio of what?

Velocity = Value of Transactions/Supply of Money.
The value of transactions = Price * Transactions.
In other words
V = (P)(T/M) where V stands for velocity, P stands for average prices, T stands for volume of transactions, and M stands for the money supply.

Multiplying both sides by M  yields the frequently cited equation: M(V) = P(T).

Economists use real GDP as a measure of P(T).
Thus M(V) = GDP. And of course V = GDP/M

The ratio in the above chart is Real GDP/M2.  Clearly velocity is falling.

Velocity Theory

The widely presented theory is "prices will rapidly rise if velocity increases." One problem with making such assumptions is in regards to measurement.

What is Money? Is it M1, M2, M3 (discontinued), MZM, TMS1, or TMS2? Each one will give you a different measure of velocity. The Fed provides Three Measures of Velocity.

And what about GDP? Recall that government spending, no matter how useless, adds to GDP. If the government paid people to spit at the moon it would add to GDP by definition. And as stupid as that sounds, it would have been less destructive than bombing Iraq to smithereens, making enemies in the process, and reducing the supply of oil at the same time.

If GDP is debatable and money is debatable, and prices cannot be precisely measured in the first place, can velocity mean much?

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