Each unit of money was spent on final goods just over five times in the year
Velocity is nominal GDP divided by the money supply: 21,000 over 4,000 is 5.25. It counts how many times, on average, each unit of money changed hands in transactions that make up final output during the period. It is a derived figure, computed from two measured quantities rather than observed directly.
The measure depends entirely on which aggregate you use. Velocity against a narrow measure like M1 is much higher than against a broad one like M2, because the denominator is smaller. Quoting a velocity figure without naming the aggregate makes it uninterpretable, and comparing velocities computed on different aggregates is meaningless.
Stable velocity turns money growth into price growth; unstable velocity breaks the link
Monetarist analysis rested on velocity being reasonably stable, because if it is, MV = PY means money supply growth translates predictably into nominal output growth. On that basis, controlling the money supply controls inflation.
The empirical foundation weakened substantially from the 1980s onward. Financial innovation, changing payment technology and shifting demand for money made velocity move in ways that were hard to predict, and after 2008 US M2 velocity fell sharply and persistently as money was created and held rather than spent. Large increases in the money supply during that period did not produce proportional inflation, and the velocity collapse is most of the explanation.
Money is being held rather than circulated
Velocity falls when people and firms hold money rather than spend it — during uncertainty, when expected returns elsewhere are poor, or when precautionary saving rises. It is therefore a rough indicator of how willingly money is being used, and sharp declines have accompanied every major recent crisis.
It also rises. Periods of high inflation tend to lift velocity, because holding money is costly when it loses value quickly, and people spend faster. That feedback is part of why high inflation can accelerate: falling demand for money raises velocity, which raises nominal spending against unchanged output.
Every transaction that is not final output
GDP counts final goods and services only, so velocity computed this way excludes intermediate transactions, financial trades, asset purchases and second-hand sales — an enormous share of the payments actually made in an economy. Transaction velocity, which counts all of them, is far higher and is not what this figure measures.
Both inputs must also cover the same period and geography, and the money supply figure should be an average over the period rather than a single date, since the stock moves. Published velocity series handle this; a figure computed from a year-end money supply and an annual GDP will be slightly off.
Sources & References
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