- The money velocity is the speed at which money circulates in an economy and mainly describes how fast money passes from one holder to the next. Velocity of circulation fluctuates over time and can also be affected by a change in demand for cash (the so-called ‘cash ratio’). Although central banks affect short-term interest rates, it is the velocity of money which determines the amount of income in the economy and hence influences prices.
- The velocity of circulation is a factor determining the level of inflation, because it is one determinant for how much demand there will be for money. If money is spent quickly then there will be less demand for money, which makes inflation low or even deflationary. In other words: if people want to hold on to their cash, they would save more and spend less. In this case there’s no need to increase interest rates in order to curb spending and slow down economic growth. But if people spend faster than desired by central banks, it’ll mean that there’s too much demand for goods and services which in turn causes prices to go up: inflationary pressures.
- Since 2008 there has been a huge decline in the velocity of circulation across most countries around the world. The graph below by Peter Stella, a lecturer at the department of economics at the University of New York shows how money supply and inflation have been deteriorating since 2008.
- Money supply has been rising consistently since 2009, but velocity of circulation has been declining for most countries which mean that banks are sitting on their cash instead of re-circulating it back into loans. This is one reason why central banks around the world have kept interest rates low even though they’ve printed a lot more money to increase liquidity in financial markets. Yet this hasn’t caused much inflation because people aren’t spending as much as desired by central banks leaving demand far behind rising prices. In other words: due to low velocity of circulation there’s no need for higher interest rates in order to curb inflation. On the other hand, since central banks are sitting on their cash reserves, this has led to a huge liquidity trap in financial markets which in turn is one of the reasons why interest rates have been so low for so long.
- Although it’s true that there’s too much debt around the world right now and it’ll take years of deleveraging before new borrowing can stimulate growth again, focusing only on demand won’t do good either because there isn’t enough money being spent to get economies growing again at their pre-crisis speed says Peter DeCaprio. That’s where velocity of circulation comes into play. There are many factors which affect velocity of circulation apart from interest rates, but if central banks try to increase by keeping interest rates close to zero then economies will continue to stagnate since velocity of circulation is low. The challenge for central banks therefore, is to reduce interest rates when there’s too much debt around in order to re-boost the economy and increase money circulation without increasing inflationary pressures. That can be done by focusing on fiscal policy, such as raising pensions and wages (reducing presenteeism) or investing more into infrastructure. If central banks can get their hands on things that stimulate demand – like loans for people who might actually spend the borrowed money – they should go ahead and do so since it increases velocity of circulation and helps the economy recover from the crisis.
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Inflation is caused by too much money supply, not because people spend faster or slower. If the velocity of circulation stays the same and central banks increase the money supply, prices will rise. Vice versa inflation falls if the velocity of circulation rises. So what does this have to do with business cycles? As per Peter DeCaprio velocity of circulation fluctuates over time and this has an impact on how fast the economy can grow without increasing inflationary pressures. For example, if it takes 5 years for a bank to recirculate all money from its customer’s accounts back into new loans, then GDP could theoretically double every 5-10 years (assuming that there’s no deflation). Alternatively, if velocity increased so that it took only one year for a bank to circulate all its deposits into new loans, then the economy could double every year. That’s why during periods of financial stability central banks try to raise velocity of circulation by keeping interest rates low (in order to make it cheap to borrow money). However, if inflation is already high – like over 3% (the level at which central banks usually act) or too close for comfort – then raising interest rates will make bank account holders think twice before spending their cash because they need to keep their savings in interest-bearing assets like government bonds. All these factors come together and determine how fast the economy can grow without increasing inflationary pressures (and vice versa).