You’re spending the day by a river...but on what kind? A nice, trickle-of-a-stream, raging rapids, or something in-between? The main difference among the types of rivers? Velocity of water: how fast it’s going.
The velocity of money is the same, except with money. The velocity of money refers to the speed at which money is flowing in an economy. It’s the rate at which people spend money. The more people spend in a certain timeframe, the higher the velocity of money is. We can hear the increasing velocity of "ka-ching"s now.
In the aggregate, velocity of money for a country can be calculated by dividing nominal GDP (nominal meaning using current market prices, unlike real GDP, which calculates out inflation effects) by the average amount of money in circulation. That’s basically everything sold divided by the amount of actual dollar bills floating around in the system. When the velocity of money increases, then money is switching hands at a faster rate than before. Since it uses nominal GDP, it implies that prices change in proportion to the total money supply to get the same velocity of money.
When the velocity of money slows down, it means people are spending less, which will likely lead to lower GDP and potentially other negative macroeconomic factors, like increased unemployment. One man’s purchase is another man’s income, so fewer purchases means less income all around.
Yet the velocity of money has been criticized by some for its use in economics. Because it takes an aggregate look, rather than starting from the actions of individual actors, it’s argued that it can be misleading when not put into the proper context.
Another criticism of the velocity of money can be said to imply that prices change in proportion to changes in the total money supply, but that’s been shown to be untrue. Unlike in physics, velocity in economics is much more controversial.
Inflation makes everything more difficult. Since the value of a dollar changes over time, becoming worth less and less with inflation, the idea of what the velocity of money actually means also changes. Some economists find the velocity of money and the money supply essential for successful macroeconomic policy, while other economists would prefer to do away with it altogether.
Related or Semi-related Video
Econ: What is an Economic Multiplier?3 Views
and finance Allah shmoop What is an economic multiplier All
right people To understand how injections of investments in cash
affect the economy macroeconomist often turned to the keen Zeon
idea of the economic multiplier Every time you spend a
dollar well that dollar eventually becomes someone else's income Likewise
every dollar you get was once someone else's income that
they spent The more we all spend in dollars while
the more dollars we all have to spend every time
Dollars which hands While that's a ching that stimulates even
Mohr Chuck Ching's in the economy this money going around
around as referred to as the circular flow of income
and in theory more spending and investment leads to even
more spending and investments It's kind of a domino effect
which ripples outward into the entire economy boosting output GDP
and employment well The economic multiplier measures how a change
in aggregate demand affects nationwide output Usually GDP like that's
the big measure through the ripple effect of the circular
flow of income Well as demands for goods services and
investments rise more money is flowing through the pipes of
the economy raising GDP and increasing economic growth Yeah Ching
city When demand for goods services and investments fall the
reduction in money flowing through the pipes contracts the economy
making GDP slow down to a trickle or even go
negative Sometimes when the economy slows down the Fed a
k a The Federal Reserve or the U S Central
bank may decide to lower interest rates Lowering interest rates
means things like business loans car loans credit cards stuff
mortgages and other types of debt are then cheaper in
theory encouraging consumers to borrow more Lowering interest rates the
equivalent of the Fed putting debt on sale which draws
in investors and spenders who then use that money spurring
more spending hopefully from their spending raising interest rates has
the opposite effect Reducing the demand for investing been spending
since is more expensive than to rent money Well for
instance let's say the Fed lowers interest rates Around the
same time Farmer Frannie was thinking about expanding her chicken
business Farmer Franny decides that taking out the loan is
worth it since she only has to pay one point
five percent interest on it Farmer Franey then uses her
loan to build Mohr chicken coops increasing the income of
the local farm outlet store and making room for Mohr
chickens to be grown and more eggs and more feathers
for beds Well some of those eggs turn into chickens
and some chickens have more eggs and to say which
came first Well farmer friend he's selling chickens and eggs
left and right and she easily pays off her really
inexpensive loan Now friend he has more money than she
would have had before which she then spends Will those
dollars travel and become other people's incomes creating Mohr economic
growth Eventually Farmer Frannie's farming business is doing well enough
that she takes out a loan to expand her farm
even further buying up the latest in farming equipment and
hiring more workers Tio take care of the whole thing
Well Farmer for any second loan puts money in the
pocket of the landowners she bought The land from right
also spends money on the companies selling to her the
new farm equipment and the incomes of her new employer
That money keeps branching outward into the economy Is it
continues this circular ripple effect like a pebble in a
pond to be spent turning into someone else's paycheck or
business investment And of course the money will only continue
to ripple outward if people keep spending it well Factors
like taxes consumer confidence in the economy and government spending
can determine how strong those ripples are how strong that
economic multiplier is at any given time for instance consumers
also have varying propensities to consume and safe depending on
how much well they're paying Tax high taxes might make
people buy less usually does just because taxes cut into
their buying power which would lower the economic multiplier Right
Well don't get too excited about all this The economic
multiplier isn't necessarily a good argument for the reason your
tax bill should be lower If taxes air low making
government revenue low well then the government may find itself
borrowing money from abroad And all that can cause interest
rates to rise over time reducing demand for investment and
spending in reducing the economic multiply right well another important
factor that affects the economic multiplier imports Yeah imports The
more money that's being spent in foreign markets will the
more that's leaking out of our national income producing our
economic multiplier of the home country U S A U
s A and our GDP when there's a change in
taxes or interest rates or confidence in the economy Well
the multiplication effects kind of lesson all right But in
the long run economists expect things like reduced interest rates
tax cuts stimulus packages and renewed confidence in the economy
to have positive multiplier effect OK now get out there
and spend knowing that every dollar you spend is contributing
to someone else's income in the short run and the
economic multiplier in the long run Yeah way to be 00:04:55.887 --> [endTime] a team player by that portion
