Velocity of Money

Velocity, or demand for money, is a topic that is not understood real well.  When it comes to price inflation, the focus tends to be on the money supply.  While the money supply is extremely important and it has an effect on velocity, it is really only one half of the equation.

Velocity is the speed at which money changes hands.  It is also called the demand for money.  If the demand for money is high, then people are holding onto their money and spending less.  Another way of saying this is that the velocity is low.  Money is changing hands at a slow pace.  If people are spending money and it is changing hands quickly, then velocity is high and the demand for money is low.

After the fall of 2008, velocity slowed down.  People spent less money, paid down debt, and were cautious with their money because of fear of unemployment and a bad economy.

If there is an increase in the supply of money, this should raise the general price level.  If velocity slows down, this has a counter effect.  Low velocity is deflationary on prices.  The opposite is also true.  An increase in velocity acts as an inflationary effect on prices.

This is important to understand because prices will not always move with the money supply.  The money supply could increase and yet we might not see prices rise because people are scared and holding onto their money.  You can have more money in the system, but prices won't rise unless people are using the money to bid up prices.

By the same token, price inflation could also increase faster than monetary inflation.  That is a real threat that we have to worry about.  The Fed will not intentionally cause hyperinflation.  The Fed members and other bankers would essentially be destroying their own game.  Hyperinflation would be bad for almost everyone, including bankers and politicians.  The threat though is that the Fed tries to produce mild price inflation, as it is trying now, but gets carried away and can't stop the massive price inflation.  The Fed could slam on the monetary brakes, but if the general public views the U.S. dollar as risky to hold onto, then velocity could go up very quickly.  People might start spending money like crazy, knowing that it will be worth less every day that it is held.

If the general public thinks that the Fed will not stop and that high inflation will continue, then a hyperinflation of prices could occur.  This is not a prediction as I think the Fed will pull back eventually and the general public will realize it and we will have a deep recession or depression.  But it is good to know what it possible and runaway price inflation is possible because of velocity.  It all depends upon the attitudes of those holding the currency (which also includes foreigners).  So while we should pay close attention to the money supply and bank reserves, we should also pay attention to the views of the market and whether people are spending their money in fear of future inflation.

Velocity is almost impossible to measure, but we should at least try to get a sense of what the general thoughts and attitudes are of those holding U.S. dollars.