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.
Thanks! Until now I thought fiat money was money used to buy an inexpensive Italian sports car.
ReplyDeletePaul, you are always so funny!
DeleteNeil from Michigan:
ReplyDeleteThis is a very informative article. Without restating all the points made, the credit card debt is the most disturbing. This undermines resiliency in a downturn, discretionary cash, and, of course, savings. If people paid with cash at the gas pumps and restaurants, we would see changes in behavior almost immediately. The tips at restaurants alone amount to 80% of the cost for making the same meal at home.