Velocity of Money

There seems to be a lot of confusion about the velocity of money.  It is even misunderstood by some from the Austrian school of economics.  Richard Maybury (writer of the Early Warning Report) has a good grasp on the subject.

The velocity of money is how fast money is changing hands.  Put another way, it is the demand for money.  When there is high velocity, the demand for money is low.  When there is low velocity (which is occurring in the U.S. now), the demand for money is high.  Low velocity means that money is changing hands more slowly.

Besides production and technology, there are generally two things that drive the overall price level of goods and services.  The first thing is the supply of money.  The second thing is the velocity or demand for money.  This is why price inflation does not correlate exactly to monetary inflation (ignoring excess reserves and fractional reserve banking).

Let's say that the Federal Reserve is pumping money into the economy and causing monetary inflation of 20% per year.  However, the Fed announces that it will withdraw all of this money next year.  If people believe what the Fed is saying, then price inflation could go down (or even negative), just on the expectation that there will be monetary deflation in the future, even though there has been an increase in the money supply.

But velocity is not just about expectations of monetary inflation.  It just reflects the general mood of the public.  When the recession became apparent in the fall of 2008, the Fed more than doubled the monetary base.  However, most of this money ended up as excess reserves held by the banks.  But people have been scared and they started to save more and spend less.  High unemployment rates are scaring people and the future uncertainty is scaring people.  While the massive debt should be inflationary, the increase in demand for money has led to price stability.  People are more scared about their own debt and their own income than they are about future inflation.

Mises said that during the crack-up boom (hyperinflation), the rate at which prices increase can go much higher than the rate of increase of the money supply.  This is due to extremely high velocity.  People are desperately trying to get rid of their dollars for anything tangible because they expect an ever increasing rate of inflation.

You should understand that velocity exists and that it does affect prices.  Just because there is monetary inflation or deflation doesn't mean that prices will necessarily follow.  Prices are likely to follow over time, but you should be careful in your speculations.  That is why investing is so difficult.  Not only do you have to read the minds of politicians and central bankers, but you have to read the mood of the public.