In economics, the velocity of money refers to a key term in the "quantity theory of money," which centers on the "equation of exchange":
M*V = P*Q
where
M is the total amount of money in circulation in an economy at any one time (say, on average during a month).
V is the velocity of money, i.e., how often each unit of money is spent during the month. This reflects financial institutions and other economic conditions.
Q is the total number of items purchased during the month. This is often measured by the "real" gross domestic product but would better be measured as total turnover of goods and services, including purchases of financial items.
The right-hand side of the equation above equals the total amount of money spent during the month. The left-hand side also equals that amount, so that the equation is an identity, i.e., an equation that is always true by definition.
Given this identity, the velocity of money can be measured as
V = P*Q/M
Inflation
The equation of exchange can be used as a rudimentary theory of inflation. If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.
If V and Q are constant, then we can state the equation of exchange in terms of rates of growth:
the rate of growth of the money supply = the inflation rate
The demand for money is a function of wealth, the rate of return and the value of liquidity.
If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.
Money supply is endogeneous, as money is created by banks and other financial institutions in relation to a general optimism on the future return of investments.
This fall in moneysvelocity, it was argued, neutralised the rising monetary momentum, thereby preventing a future increase in the rate of inflation.
If the quantity of money has remained unchanged, but there has been a 10 per cent increase in the price level in a given period, it would mean that there must have been an increase in the velocity of circulation of money of 10 per cent in that period.
Money, therefore, cannot be a substitute to non-existent means of sustenance, and therefore its increase cannot cause economic growth.
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