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Reviewing the Velocity of Money


We must understand the basics to make sense of where the economy is and where it's headed.

This week we do some review on a very important topic: the velocity of money. If we don't understand the basics, it's hard to make sense of the hash that our world economy is in, much less understand where we're headed.

The Velocity of Money

The Federal Reserve and central banks in general are running a grand experiment on the economic body, without the benefit of anesthesia. They're testing the theories of Irving Fisher (representing the classical economists), John Keynes (the Keynesian school), Ludwig von Mises (the Austrian school), and Milton Friedman (the monetarist school). For the most part, the central banks are Keynesian, with a dollop of monetarist thrown in here and there.

Over the next few years, we'll get to see who's right about debt and stimulus, the velocity of money, and other arcane topics, as we come to the End Game of the Debt Super Cycle -- the decades-long cycle during which debt has grown. I have very smart friends who argue that the cycle is nowhere near an end, as governments are clearly increasing debt. My rejoinder is that it's nearing an end, and we need to think hard about what that end will look like. It won't be pretty for a period of time. The chart below shows the growth in debt, both public and private.

But the end of this debt cycle involves more than just debt reduction. There are a number of ideas we have to get our heads around, including the velocity of money. Basically, when we talk about the velocity of money, we're speaking of the average frequency with which a unit of money is spent. To give you a very rough understanding, let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, we'll have $2,400 of annual "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply, but how fast that money moves through the economy. Stated as an equation, it is P=MV, where P is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing P by M. By the way, this is known as an identity equation. It's true at all times and all places, whether in Greece or the US.

Our Little Island World

Now, let's complicate our illustration a bit, but not too much at first. This is very basic, and for those of you who will complain that I'm being too simple, wait a few pages, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island is $4,000,000 (4 x $1,000,000 quarterly production). The velocity of money in that economy is four.
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