The velocity of money proves to be the speed at which money is changing hands. When the velocity of money is higher, then money is rapidly going from one hand to the next. This allows for a comparatively smaller amount of the money supply to cover a significant number of purchases. Conversely, if the velocity of money turns out to be lower, then the money is going from one hand to the next at a slower rate. This requires a greater supply of money to cover the same quantity of purchases.
The velocity of money is never the same. Such velocity will change along with the preferences of consumers. Besides this, it goes up and down as prices or money’s real value fall or rise. Should the real value of money prove to be lower, then the levels of prices are higher. A greater quantity of bills would have to be utilized to pay for purchases. Assuming that money supply is constant, velocity of money has to go up to be able to pay for all purchases. The velocity of money also shifts as the Fed changes the money supply. These changes might cause price levels and money’s value to stay the same.
The velocity of money turns out to be the single most critical factor in determining the impacts of any changes to the money supply. As an example, pretend that you buy a piece of pizza. The waiter takes the money that he is paid from this transaction and employs it to pay for dry cleaning. The dry cleaner owner next uses the money to wash his car. This goes on again and again until finally the bill is removed from circulation. Since bills can stay in circulation for literally decades, one bill will generally allow for a vast number of multiples of its face value to be transacted along the way.
The equation that demonstrates how velocity of money relates to the money supply, output, and the price level is expressed as M times V equals P times Y. In this equation, M represents the money supply and V stands for velocity, while P represents the price level and Y is the amount of output. Since P times Y yields the country’s Gross Domestic Product, you could also say that V equals GDP over M, or velocity is Gross Domestic Product over money supply. In practice, the equation tells you that a certain Gross Domestic Product level that contains a tinier money supply will require a higher velocity of money so that all purchases can be funded. This means that velocity will go up in this scenario.
Velocity of money equations can also be altered to give percent changes in velocity of money equations. With velocity of money equations, you might employ them to measure the impact that any changes in the velocity, money supply, and price level have on one another. Only the output, represented by Y, would be fixed in such changes, since quantity of output does not change in short time frames.