Money circulation speed
The speed of money circulation is the frequency with which the money available in an economy is spent on goods and services, during a certain period of time.
The speed of money circulation refers to how fast a monetary unit changes hands in an economy. It can be calculated as the number of times that a monetary unit passes from one hand to another in the process of buying and selling goods and services.
Example of speed of money circulation
Suppose that in an economy only 100 euros are available. These 100 euros are obtained by an entrepreneur, who decides to buy a day's work from a bricklayer, who receives the 100 euros in exchange.
The bricklayer for his part, with his 100 euros pays 60 to a cook and 40 to the merchant for provisions. As we can see, although there are only 100 euros in the economy, the expenses incurred are 100 + 60 + 40 = 200 in expenses. The speed of money circulation is 2 during the period of time analyzed.
Determinants of the speed of money circulation
There are several factors that determine the speed with which money passes from one hand to another in an economy, below we describe some of them:
- Interest rate: High interest rates for deposits make it more attractive to save, so the speed of money circulation falls (people spend less to save)
- Inflation: If there are high inflation expectations, people and entrepreneurs will prefer to spend more now before prices continue to rise (especially if it is raw materials and other goods that can be stored).
- Preferences: Individuals and companies may have different preferences for spending and saving in a certain country, period of time, etc.
How to measure the speed of money circulation
In practice, we do not have all the information about the number of transactions that take place in the economy that imply that money changes from one hand to another. In order to be able to measure the speed of movement in practice, indirect methods are used.
In this way, if national income is considered to be an estimate of the total value of economic transactions carried out during a period of time, the speed of money circulation would be calculated as the quotient between national income and the total amount of money ( or money supply).
Quantity theory of money
The quantity theory of money was originally devised by Martín de Azpilcueta but its formalization in the terms that is known today is due to Irving Fisher.
This theory establishes a relationship between the amount of money and the real variables of the economy. The basic expression of the quantity equation is the following:
M x V = P x Y
- "M": the amount of money (M1, M2, M3 or M4).
- "V": the speed of money circulation.
- "P": the price index (measured by the CPI or by the GDP deflator).
- "Y": the product or national income in real terms (measured by real GDP).
Following this equation, we can calculate the Speed of circulation of money in the following way:
V = (P x Y) / M
Or what is the same, divide the value of nominal GDP by the amount of money
If we assume that Y and V are constant (at least in the short term), an increase in M would lead to a proportional increase (and in the same direction) in P.
The strictest monetarists assume that the velocity of money is stable and that changes in the money supply only influence the price of products (more inflation) and not higher production. Keynesians, on the other hand, believe that an increase in the money supply can have a positive effect on production. The increase in prices is only partial since the circulation of money is not constant and absorbs part of the impact.
Example of calculating velocity with quantity theory of money
Suppose that in, in one year, in economy A 100 loaves are produced, each one sold for 10 euros. The total expenditure of the economy in the year was 1000 euros and the amount of money was 50 euros. For this expense to have been feasible with 50 euros, the money changed hands 20 times in the year.
V = (100X10) / 50 = 20