Ask Mint | Velocity of money tells you how many times money changes hands

Ask Mint | Velocity of money tells you how many times money changes hands
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First Published: Mon, Jun 22 2009. 12 32 AM IST

Updated: Mon, Jun 22 2009. 12 32 AM IST
Money on the move has no fixed abode. From one wallet to another, from one shopper to the next, from one bank account to another, that is the life of money. But curiously, many of us want to cling on to every bit of money that we may have. The motto: Give me your money if you can, but please don’t ask me to take out mine.
We often forget that we are all playing a game of money in which everybody must take out his wallet at one time or the other. This game can’t continue if all of us just roll over and play dead when it comes to spending our money.
Johnny: Money on the move? Sounds typically like a newspaper headline. I often hear economists talking about “velocity of money”. Can you explain what the term means, Jinny?
Illustration: Jayachandran / Mint
Jinny: “Velocity of money” is a term used to denote the number of times a unit of money in an economy changes hands during a certain period, say, one year. Here, by money, economists generally mean what is known as the base money in terms of money supply, which is the most liquid money consisting of currency and coins in circulation and bank reserves with the central bank. But it could also mean any of the other measurements of money supply, such as M1, M2 and M3.
Different measurements of money supply would show different velocity. But if you are not too comfortable with the nuances of money supply, such as base money, narrow money or broad money, then for understanding the concept of velocity of money, you can just think of money as the value of the total stock of currency notes and coins available in an economy.
It is generally observed that in an economy, the value of a stock of money available for transactions is less than the value of all goods and services actually produced. This means that the existing stock of money has to change hands many times if people want to buy and sell their goods and services.
Johnny: So just like the game of soccer, where just one ball gets kicked again and again, in the game of money, the same unit of money keeps on rolling around.
Jinny: That’s true. Suppose an economy consists only of three people A, B, and C, and the total value of all goods and services produced by them is Rs300. Suppose A is a barber who currently holds all the stock of money valued at Rs100 in our imaginary economy. The barber needs bread so he goes to B, the baker, and hands over his Rs100 and takes bread worth that much in exchange.
The baker needs clothes so he goes to C, the merchant, and exchanges his Rs100 for clothes. The merchant badly needs a haircut and so he goes to the shop of A, the barber, and the Rs100 note is back with its original owner. You might have noticed that among A, B and C, the Rs100 note changed hands three times, generating a total transaction of Rs300. In this example, the velocity of money is three.
Johnny: The life of money looks so simple when it is just moving from the baker to the barber. But what about the actual economy, where countless number of people are using different units of money for small and big transactions? How do we actually calculate the velocity of money in a real economy?
Jinny: The velocity of money is what is called a derived statistic, which means that in the real economy, the velocity of money can be known only after all buy and sell transactions are over.
There is no way we can directly know about the velocity of money on a real-time basis. We calculate velocity of money by dividing the value of the gross domestic product, or GDP, which represents the total value of all goods and services produced by an economy, by the value of money supply.
As I said, you can choose any of the different measurements of money supply such as M0, M1, M2, M3 and so on. But since different measurements of money supply would show different values, you would get different velocity of money. So if the value of GDP is, say, Rs10 lakh and the value of the base money or M0 is, say, Rs1 lakh, then the velocity of money would be 10. Likewise, if the value of M3 is, say, Rs2 lakh, then the velocity of money would be five.
But you may ask, which one is the true velocity of money, 10 or five? It is both. In the present example, 10 is the velocity of money in its most liquid form—the currency and coins actually in circulation. As we move up the ladder of M1, M2, and M3, the liquidity of money decreases and so does its velocity.
Johnny: That’s only natural, Jinny. After all, a ball can’t roll forever.
What:“Velocity of money” is a term used to denote the number of times a unit of money in an economy changes hands during a certain period.
How: Velocity of money is calculated by dividing the value of GDP with the value of money in circulation.
Why: Velocity of money is called a derived statistic because it can be calculated only after knowing the value of GDP.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Jun 22 2009. 12 32 AM IST