High Inflation and the Dollar’s Velocity of Circulation

A friend had asked me recently about the velocity of circulation of money in an inflationary economy like ours.

Velocity of circulation of money is better understood through the quantity theory of money model.

Our dollar is deemed fiat money because our government said so long time ago before people began questioning the out-of-control printing of it. The dollar has not been backed by gold since 1971 during the Nixon administration. The dollar is only worthy because the government says so and we must take its word for it. Fiat means “let it be” in Latin.

Fiat money (our paper dollar denominations and coins) is used in circulation because barter is too cumbersome - it must rely on a coincidence of wants - you want something I have to barter, and you can offer me some other good or service in exchange.

Let us assume that there are $10 trillion worth of transactions in an economy in a particular year and there is a money stock (supply) of $2 trillion in that year. This means that each dollar of that money stock circulated on the average about FIVE times that year. The number FIVE is the velocity of circulation, the speed with which money circulates in general but not necessarily all of it.

What is money stock (supply)? It is divided into M1 and M2. M1 is the supply of all coins and paper money in circulation plus some checkable deposit balances at banks and savings institutions. M2 is broader, it includes M1 and most forms of savings account balances, plus shares in money market mutual funds. There is also near moneys, close substitutes for money such as credit cards. Credit cards balances are huge in our economy. It is estimated that the total U.S. credit card balances in 2021 was $856 billion, with Alaskans leading the pack at over $8,000 per person. 2022 Credit Card Debt Statistics (lendingtree.com)

It is impossible to measure exactly the velocity of circulation of each dollar in the economy so a formula must be used to give an approximation. Economists decided to use nominal Gross Domestic Product (GDP) divided by the money stock (supply). Nominal GDP is the product of real GDP times the price level. (in simpler terms, nominal GDP is real GDP plus the inflation rate at that moment)

The problem with using nominal GDP is the fact that nominal GDP ignores many transactions that use money such as large volume of activity in financial markets.

Velocity = Nominal GDP/Money stock          

Velocity of circulation of dollars is not a constant number, it is a variable number, and it depends on other factors, the most significant being interest rates (decided by the Federal Reserve System, which neither federal nor reserve, it is an actual corporation) and the efficiency of payments mechanisms.

1.      Interest rates – the higher the interest rate, the greater the opportunity cost of holding money. As interest rates rise, people tend to hold smaller cash balances. Existing stock of money circulates faster, and velocity of circulation rises.

2.      Efficiency of payments mechanisms – money is convenient to make transactions, but cash does not pay interest and ordinary checking accounts pay extraordinarily little interest.

You remember how, prior to electronic transactions, students would write a check for rent, with insufficient funds, knowing that the bank would take 3-5 days to clear the check, and, in the meantime, the student would be paid by his/her employer and the check would be covered.

Predicting people’s economic behavior is not very dependable. “The incentive to limit cash holdings depends on the ease and speed with which it is possible to exchange money for other assets” – which is what is meant by the ‘efficiency of the payment mechanisms.’

Velocity has risen as banks have added electronic bookkeeping because funds can be transferred rapidly between checking accounts and other assets and funds, and credit cards/debit cards are used instead of cash, thus the need to hold money balances has declined.

Milton Friedman said that “inflation is always a monetary phenomenon. And the growth rate of the money supply is the principal cause of the inflation rate in all places and at all times.”

Thank Congress for its out-of-control spending and the Federal Reserve’s System of printing money not backed by goods and services. We print money we do not have to send financial help to third world countries and military aid to Ukraine in the form of $40 billion which was approved by U.S. Senate yesterday.

People hoarding cash in their homes for rainy days would make velocity of circulation slower. Underground cash economy’s velocity of circulation would be hard to predict, of course. Take cash away and make everything digital, there is no way to hide cash anymore and all transactions are rapidly monitored and taxed by the government. If one’s social score is low, then punishments can be meted via travel restrictions, medical care restrictions, housing restrictions, financial and monetary lack of transactions allowed, remarkably like China’s social credit score system.

In a high inflationary economy, people spend money as soon as they earn it because, if they wait, prices for things they are going to need will escalate in price drastically from day to day, or hour to hour as it was the case in the Weimar Republic’s galloping inflation or more recently in  Venezuela where inflation is in the hyperinflation range. There is no reason why an oil rich country like Venezuela should be in such economically dire situation if it was not so badly mismanaged by the socialist government. https://tradingeconomics.com/venezuela/inflation-cpi

Which brings us to our country, an oil exporting country during President Trump’s administration, turned into an oil importing country from day one when President Biden reversed the fossil fuel policy of his predecessor because the Biden regime wanted to destroy the fossil fuel industry and install the solar and wind energy of his Build Back Better green energy fiasco. When he took power, gasoline was $1.69 a gallon. Now, sixteen months into his presidency, gasoline is over $4 a gallon, fast approaching $5 in all 50 states and far exceeding $6 and $7 a gallon in certain cities in California.