Tuesday, November 15, 2011

Velocity of Money

The Velocity of Money is a principle of conventional Economics that persists today even though it is an absurd extraction.  The equation of this principle was first stated by Irving Fisher, one of the stalwarts of 20th century American Economics.  The equation is MV = PQ.  P is Price and Q is quantity of products.  So the price of all the products sold in a period is equal to the quantity sold times the price and this is equal to MV.  M is Money and V is velocity of sales in a period.  Make V = 0 and all the products sold in a period are equal to all the Money used to make the purchases.  Very logical, but there is one complication.  Since money is not consumed after the sale the merchant has the Money to use and make an additional personal or business transaction within the same period.  In calculating PQ we added all the purchases within a period so we need to know how many times the same Money was used in a period to assign a value to V.  To do this in the United States we rely on figures from the Federal Reserve to determine the amount of money available to make purchases.  This allows us to fix the amount of Money in the economy during a period.  V now becomes the factor in the equation necessary to equalize the equation.  It turns out this factor called Velocity is usually between 2 and 3.

From this principle Economists derived a couple of assumptions.  First, it seems increasing velocity means increasing sales.  Second, it implies if the amount of Money increases and Velocity does not change then Sales will still increase.   That is the priciple.  The next jump is where the principle falls apart.  Economists stated increasing Sales implies economic growth.

Let's see how this theory works in the real world.  Imagine yourself as a Day Trader with $100,000 to invest.  In the first hour of the market you purchase a stock for 100 k.  One hour later you sell the stock and pocket a 5 k profit.  Thirty minutes later you buy a new stock for 100 k and sell it 30 minutes later at a profit of 5k again.  Just before lunch you buy another stock and sell a couple of hours later for a profit of 10 k.  So far you are up 20 k.  But in the afternoon you make another 100 k purchase and immediately the stock starts to fall, by the end of the day you feel you must sell and loose 20 k ending the day and the period just where you started.  According to the "quantity equation of exchange (MV = PQ)"  the equation looks like this 100,000 * 4 = 100,000 * 4.  The equality works, but was there any economic growth?  No, Money just went back and forth between the Day Trader and his Broker. 

You could craft a similar scenario between a Grocer who supplied milk to the Barista across from his store.  It does not matter how many times the Barista spent her earnings to purchase milk at the grocery.  What does matter for economic growth is the profit she made and the profit the grocer made.  The Day Trader can contribute to economic growth, but he needs to make a profit.  Spending Money without making a profit does nothing for economic growth.  The Velocity of Money is just a calculation of how many times consumers divide their spending.  It does not tell us anything about how Money grows.  Profit is the primary economic growth mechanism.

When government taxes their citizens and spends the funds on a new fire truck no one makes any money.  If the price of the fire truck is $300,000 then PQ = 300,000 * 1 = 300,000 * 1 = MV.  No economic growth occurs, but if the fire truck is purchased from a private firm the PQ = MV possibly looks like this:  300,000 * 1 = (250,000 + Profit) * 1.  The private firm makes a $50,000 profit on the sale.  The $50,000 is additive to the economy stimulating economic growth.

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