Quantity theory of money
Velocity of money
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.
- P is the average price level for the economy during the month.
- Q is the total number of items purchased during the month with the particular kind of money represented by M. For example, if M represents Federal Reserve notes (green paper dollars) then Q is the quantity of goods bought with Federal Reserve notes. If M represents Federal Reserve notes plus checking account dollars, then Q represents the quantity of goods bought with paper or checking account dollars. Textbooks carelessly define Q (or "y") as the total quantity of goods produced in the economy (i.e., real gross domestic product). But this can lead to serious errors. For example, if only 30% of goods are bought with paper or checking account dollars, and if the quantity of this type of dollars doubled, then it might happen that the quantity of goods bought with paper or checking account dollars would double from 30% to 60%, while real output of goods (and P and V) are unaffected.
The left-hand side of the equation above equals the total amount of money spent during the month. The right-hand side equals the amount of money received. This is comparable to saying that the amount of rain falling from the sky equals the amount hitting the ground--a statement that is true but useless. This is a major weakness of the quantity theory, and has led to a good deal of criticism.
Given this identity, the velocity of money can be measured as
- V = P*Q/M
In an early work espousing the quantity theory, velocity is defined as 'the ratio of net national product in current prices to the money stock.'Template:Fn
Historically, the main rival of the quantity theory has been the real bills doctrine, which says that the value of money is determined by the assets and liabilities of the money-issuing entity, rather than by the ratio of money to real GDP.
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
See also
References
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