Econ 101 part 6 (Money Velocity and Inflation)

We have seen that the central bank is the main engine of inflation and that inflating the currency leads to higher prices and the boom-bust cycle. But we need to look a bit closer at how the inflationary cycle works. That means looking at a thing called "velocity", or fast money! :-)

Economists talk about "velocity" and they mean the speed at which money is changing hands. For example, imagine I sit 20 regulars around a table (assuming none kill another) and each has a dollar and a pencil. Each buys a pencil from the guy to his left (to the "left", get it?) with his dollar. Every dollar was used one time and so "velocity" was one. Now imaging the same situation but there is only one dollar. Mr. Jones has that dollar and buys a pencil from the guy on his right (a different example, eh?) and the guy on the right does the same all around the circle. Twenty pencils have been sold and one dollar was used 20 times. Hence, "velocity" is 20. So we see that a small amount of money can do the same job as a large amount of money given the right conditions.

Professionals define "velocity" as M/PQ but that hurts my head to think about!

The dollar responds to the law of supply and demand and when demand for the dollar falls then people are more willing to spend the dollar than hold it. They buy more goods and services and keep less dollars. On the other hand, if demand for the dollar rises then people then to buy less and keep more dollars. Get it? So, we see money demand is what causes changes in velocity. Economists look at "velocity" to figure indirectly the demand for dollars at a given time. Simple really.

Now we can look at the three stages of inflation. Let us imaging you want to buy a new aluminium mountain bike.

If the prices are stable (1) and the item has been the same for a long time, say $600, then there is no real hurry to get one and you hope that the price might fall a bit and you can pick up a bargain. But instead the price rise (2) to $650 and you decide to buy the darn thing before it can go up any more! Your good friend does the same and he was not even going to get one until Christmas! Then the price goes up steeply (3) to $1,000 and you buy another one as an investment because bikes look to be a better deal than holding dollars.

In the first stage the velocity was low and you held on to your dollars. In the second stage velocity has gone up and you spend dollars. Velocity is going up. In the third stage everyone is looking to get "stuff" and not hold dollars and velocity is way up. Velocity is always very high in the third stage of inflation. There are many examples of this one can look at; the USA in the 70s would be a good example.

The depression of the early 80s was the correction from the economic mismanagement of the 70s. Remember that inflation goes through three stages, caused by money demand, and one can look at velocity to see what stage a country is in.