Velocity of money

The velocity of money measures the number of times that the average unit of currency is used to purchase goods and services within a given time period. The concept relates the size of economic activity to a given money supply, and the speed of money exchange is one of the variables that determine inflation. The measure of the velocity of money is usually the ratio of the gross national product (GNP) to a country's money supply. If the velocity of money is increasing, then transactions are occurring between individuals more frequently. The velocity of money changes over time and is influenced by a variety of factors. Because of the nature of financial transactions, the velocity of money cannot be determined empirically. If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year A farmer spends$50 on tractor repair from a mechanic. The mechanic buys $40 of corn from the farmer. The mechanic spends$10 on barn cats from the farmer. then $100 changed hands in the course of a year, even though there is only$50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was . Note that if the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy's gross domestic product (GDP). The velocity of money provides another perspective on money demand. Given the nominal flow of transactions using money, if the interest rate on alternative financial assets is high, people will not want to hold much money relative to the quantity of their transactions—they try to exchange it fast for goods or other financial assets, and money is said to "burn a hole in their pocket" and velocity is high. This situation is precisely one of money demand being low.