What is Velocity of Circulation?
Velocity of Circulation refers to the average number of times a single unit of money changes hands in an economy during a given period of time. It can also be referred to as velocity of money or velocity of circulation of money. It is the frequency with which the total money supply in the economy turns over in a given period of time.
If the velocity of money is increasing, then the velocity of circulation is an indicator that transactions between individuals are occurring more frequently. A higher velocity is a sign that the same amount of money is being used for a number of transactions. Hence, a high velocity indicates a high degree of inflation.
The GDP equation is as follows:
Gross Domestic Product (GDP) = Money Supply x Velocity of Circulation
Velocity of Circulation = Gross Domestic Product (GDP) / Money Supply
Consider the following example. Let us assume that an economy consists of two individuals, a carpenter and a grocery shop owner. Over the course of a year, they exchange $100 to buy goods/services from each other in just four transactions, which are as follows:
- The carpenter buys vegetables from the grocer for $50.
- The carpenter also buys milk worth $50 from the grocer.
- The grocer gets some repair work done from the carpenter and pays him $30.
- The grocer also gets wooden shelves constructed in his shop by the carpenter for $70.
We can observe that $200 changed hands throughout the year even though initially there was only $100 in the economy. It was because each dollar was spent on new goods and services twice a year. We can say that the velocity of circulation is 2/year.
However, only monetary transactions are considered in this situation. For example, if the carpenter gifts something to the grocer, it will not be considered a transaction to be added to the calculation.
Velocity of Circulation and Money Demand
Whenever the interest rate on financial assets is high, the desire to hold money falls as people try to exchange it for other goods or financial assets. As a result, the velocity of circulation rises. Hence, when the money demand is low, the velocity will be high. Conversely, when the opportunity cost/alternate cost is low, money demand is high and velocity of circulation is low.
Factors Affecting Velocity of Circulation
- Money Supply – Money supply and velocity of money are inversely proportional. If the money supply in an economy falls short of the required amount, then in such situation, the velocity of money will rise and vice versa.
- Frequency of Transactions – As the number of transactions increases, so does the velocity of circulation.
- Regularity of Income – Regularity of income enables people to spend their money more freely, leading to a rise in the velocity of circulation.
- Payment System – It is also affected by the frequency with which labor is paid (weekly, monthly, bi-monthly) and how fast the bills for various goods and services are settled.
- There are several other factors involved, including value of money, volume of trade, credit facilities available in the economy, business conditions, etc.
Monetarism and Keynesian Economics
There is a conflict of belief between Monetarists and Keynesian economists regarding the concept. Monetarists believe in the stability of the velocity of circulation and argue that there is a direct relationship between money supply and price levels, and between the rate of growth of money supply and rate of inflation. On the other hand, Keynesian economists believe that velocity of circulation is an unstable concept that can change rapidly, leading to changes in money supply.
Velocity of Circulation is a beneficial and constructive tool in not just ascertaining inflation levels in an economy, but also in helping economists understand the overall strength of an economy.