In this article, I hope to provide readers with a new perspective on one of the great enigmas of economics: the velocity of money. Using some of the basic concepts discussed in previous articles, we will derive a simple model for the velocity of money and examine the implications of this model.

This simple model for the velocity of money can be used to demonstrate that the velocity of base money is a dependent variable. More specifically, fluctuations in the velocity of base money merely reflect changes in the total market value of real output (V_Gq) relative to the total market of the monetary base (V_MM).

The short run is the time before the money supply can affect the price level in the economy. In Chapter 18 'Interest Rate Determination', Section 18.14 'Money Supply and Long-Run Prices', we consider the long-run effects of a money supply increase. In the long run, money supply changes can affect the price level in the economy. Definition: The nominal price of a good is its value in terms of money, such as dollars, French francs, or yen. The relative or real price is its value in terms of some other good, service, or bundle of goods. The term “relative price” is used to make comparisons of different goods at the same moment of time. The term “real price” tends to be used to make comparisons of. Velocity (V) and Real GDP (Y) are effectively constant in the short run, therefore any changes in money supply (M), will cause a proportional change in the price level (P). Re-writing the equation, we get: P = (M x V) / Y This equation demonstrated a direct relationship between price and money supply. Chapter 4: Money and Inflation (Long-Run Theory of Monetarism) The overall increase in prices is called inflation A price is the rate at which money is exchanged for a good or a service. In reality, the general price level is measured by either CPI or GDP deflator. The inflation rate is defined as the percentage change in the price level.

Moreover, the velocity of money is critically dependent upon the value of money. In the slide above, we isolate the “market value of money” V_M by measuring the market value of money in absolute terms using a “standard unit” for the measurement of market value. If the value of money V_M falls, then, all else remaining equal, the velocity of money of money must rise. If money is less valuable (in the absolute) and there is the same amount of base money outstanding, then the monetary base must turn over more times to cover the value of the transactions in the economy.

At the end of this post, we will briefly discuss a more complex expectations-based model for the velocity of money that is derived from the Discounted Future Benefits Model for Money (a valuation model for money developed in The Velocity Enigma).

Introduction: A New Perspective on the Velocity of Money

The velocity of money is a key concept in economics, primarily because the velocity of money is one of four critical variables in the famous “equation of exchange”. How to exhange counterfeit money for real money. Consequently, any quantity theory of money depends upon some assumption or theory regarding the behavior of the quantity theory of money.

Early proponents of the quantity theory of money argued that the velocity of money was relatively stable over the long term and, therefore, an increase in money supply that was in excess of a corresponding increase in real output over a certain period of time would lead to a rise in the price level.

While quantity theory remains a very useful concept over very long-term time horizons, it fails to be useful in any horizon less than 10-15 years because of the large variations that occur in the velocity of money. The velocity of money (or more specifically, the velocity of the monetary base) has experienced enormous swings over the past fifty years.

Despite much debate and discussion, economics has largely failed to produce useful models for forecasting major shifts in the velocity of money. The focus of this week’s post is to apply the basic principles of The Enigma Series to derive a simple equation for the velocity of money. Hopefully, this simple model for the velocity of money will provide readers with a better understanding of the key drivers of the velocity of money.

While we will discuss this model in more detail later, there are two key points that I want to highlight.

First, the velocity of base money is merely a ratio, a ratio that reflects the total absolute market value of real output transacted in a given period relative to the total absolute market value of the monetary base. If the absolute market value of the monetary base falls, say due to a fall in the absolute market value of money V_M , then the monetary base must turn over more times in order to achieve the same absolute market value of transactions (V_Gq). The key to understanding this point is noting that the market value of goods and money can be measured in absolute terms (in terms of a standard unit for the measure of market value), a concept that we shall discuss shortly.

Second, the velocity of money is a dependent variable. In other words, rising velocity of money does not cause inflation; rather, it is simply a dependent variable that responds to changes in other causal variables (it is the changes in these other variables that cause inflation). This view echoes the thoughts of Henry Hazlitt who wrote an article titled “The Velocity of Circulation” (1968) in which he concludes by noting that the “velocity of circulation is a result, not a cause.” Hazlitt further notes that the velocity of money is “a passive resultant of changes in people’s relative valuations of money and goods”, a notion that is clearly supported by the equation above.

In order to understand the simple model for the velocity of money, one must understand how the property of market value can be measured in both the absolute and the relative. So, let’s briefly discuss the measurement of market value and then use this to derive the simple model for the velocity of money.

Deriving a Simple Model for the Velocity of Money

The process of deriving our model for the velocity of money is very simple, however, the conceptual logic behind the model is not. At issue, is the concept of “market value”, or, more specifically, the various ways in which the property of market value can be measured.

The view expressed in The Inflation Enigma, the second paper of The Enigma Series, is that every price is a relative expression of market value. A “price” is merely one method of measuring the market value of a particular economic good. More specifically, it is a way of measuring the market value of one good in terms of the market value of another good.

The problem with measuring the market value of one good (the “primary good”) in terms of the market value of another good (the “measurement good”) is that the market of the measurement good is not constant. The price of the primary good, in terms of the measurement good, can rise either because (i) the market value of the primary good rises, or (ii) the market value of the measurement good falls.

The Inflation Enigma posits that there is an alternative way to measure the property of market value and that is in terms of a theoretical and invariable measure of market value called “units of economic value”. A unit of economic value is merely an invariable measuring stick of market value, just as an “inch” is an invariable measuring stick of length.

By measuring the market value of goods in terms of this invariable measure of market value, we have a way to measure what one might call the “absolute market value” of each good.

The price of the primary good, in terms of the measurement good, can now be expressed in mathematical terms as illustrated in the slide opposite

In our modern money-based economy, the measurement good mostly commonly used to measure the market value of other goods is money. Every “money price” is nothing more than a relative

Real Value Of Money In Price Level