Written by The velocity of money is a measurement of the average number of times money is transferred or exchanged from one person to another.
It is the speed at which money circulates or changes hands in an economy over a given period of time.
The velocity of money in circulation also refer to the rate at which money is spent on goods and services in the economy.
Simply put, it is the average number of times that each unit of money is spent on purchase of goods and services during a given period.
The velocity of money is calculated by dividing the nominal Gross Domestic Product (GDP) by the money supply in the economy.
For example, if the nominal GDP of an economy is N10 trillion, and the money supply is N2 trillion, then the velocity of circulation of money would be N10 trillion/2 trillion, which is equal to 5.
This means that the total money supply of N2 trillion is spent five times in the economy during that period.
Factors that affect the velocity of money in circulation
The velocity of money is influenced or affected by the following factors:
1. Quantity of money: Every country requires a certain quantity of money to conduct its exchange operations in a given period.
In general, when the supply of money is less than the requirements for exchange operations, the velocity of circulation will go up.
Conversely, if the supply of money exceed its requirements, the velocity of money will fall.
2. Frequency of cash transactions: This has a direct relationship with the velocity of money.
That is, the higher the frequency of cash transactions, the higher the velocity of circulation of money.
The reason for the direct relationship between the frequency of cash transactions and velocity of money is not far-fetched.
If the frequency of cash transactions is high, it means that money is changing hands quickly in the economy.
This result in an higher velocity of circulation of money, as each unit of currency is being used multiple times to buy goods and services.
On the other hand, when the frequency of cash transactions is low, it means that money is changing hands slowly in the economy.
This result in a lower velocity of circulation of money as each unit of currency is being used fewer times to buy goods and services.
3. Credit facilities: The rate or volume at which the people are given credit facilities in an economy also influenced the velocity of circulation of money.
If credit facilities are readily available, individuals and businesses will be encouraged to spend money that they don’t have, which will increase the velocity of money in circulation.
4. System of wages payment: The wage payment system affect the velocity of money in an economy.
When wages payments are made frequently, such as weekly or bi-weekly, the velocity of money in circulation may increase.
The reason is that, when employees are paid at shorter interval, it encourages them to spend money more frequently, knowing fully well that they would soon receive another wages within a short time.
In contrast, if wages payments are made monthly, employee will need to keep larger cash balances with themselves to meet their daily requirements till when their next wages will be paid.
As a result, the velocity of money will decrease.
5. Stability of income: If the income of majority of the people in an economy is relatively stable, then the velocity of circulation of money will be higher since individuals and businesses with stable source of income are likely to spend on goods and services.
On the other hand, If the income of majority of the people in an economy is violate and unpredictable, the velocity of money circulation will be lower because Individuals and businesses who earn violate income would be more caution with their spending
The velocity of money will, therefore, decreases.
6. Propensity to consume: The velocity of money in circulation is directly proportional to the propensity to consume.
In a country where there is higher propensity to consume, all things being equal, there shall be higher velocity of circulation of money.
A higher propensity to consume means that people spend a large proportion of their income on goods and services.
For example, if people have a high propensity to consume, they will spend more on food, clothing, and other goods and services, leading to more transactions and more money changing hands.
The result is that the velocity of money in circulation will increase because more transactions of goods and services are taking place in the economy.
By the same reasoning, in a country where the propensity to consume is low, the velocity of money will be low since people will tend to save a major portion of their income instead of spending it on the consumption of goods and services.
7. Liquidity preference of the people: This refers to people’s desire to keep cash balances with themselves, instead of investing in long-term assets or spending money on goods and services.
If a large percentage of the populace decide to keep large cash balances to meet their requirements, then the velocity of circulation of money will go down because fewer transactions will take place within the economy.
The reverse is the case where the people have a lower liquidity preference because more transactions will take place within the economy, and ultimately leads to a higher velocity of money.
8. Business cycle: The velocity of circulation varies with the phases of business cycle.
During period of economy boom, transactions will occur frequently and rapidly so that the velocity of money will naturally go up.
But where there is a recession, transactions will occur less frequently as the level of economy activity will decline, so that the velocity of money in circulation decreases.
Summary
We just learn about the meaning, formula and factors that affect velocity of money in circulation.]
For a recap, here is a three-point things summary of what we discuss.
- The velocity of money is the average number of times that money changes hand in the economy. It refers to the rate at which money is calculated.
- Velocity of money is calculated as nominal GDP divided by total money supply
- The factors that affect or influence the velocity of money are quantity of money, frequency of transactions, credit facilities, systems of wage payment, stability of income, propensity to consume, liquidity preference of the people, and business cycle.
