velocity of money

pog it

Hey folks,

You will see in a second I have no degree in economics :pac: but I have just come across this term 'velocity of money' and I have a basic understanding of it.

Apologies for this basic question, but I was wondering if anyone could tell me if say the government injection of c.50 billion into the banks will affect the velocity of money? As in will a lot of that money be tied up in the banks for a while to come, and hence not get circulated into the economy.

Also what is the correlation between velocity of money and inflation? Or can you relate them

Would appreciate any pointers at all.

Time Magazine

Hiya.

NAMA won't really affect V, I don't think.

The economy, in first year undergraduate terms, can be interpreted by the identity:
MV = PY
where M = money, V = velocity of that money, P = price level, Y = actual output.

Think about that equation for a second. For example, if V falls to zero, nobody is buying anything, so the right-hand side of the equation will also fall to zero. Another example is that if more stuff is produced, but M and V stay the same, prices must fall. Handy enough to get your head around, I hope!

NAMA can be interpreted in a few ways. I think for the most part the problem with the recession is with Y rather than V. Yes, people are more cautious with their money, but there are hundreds of thousands of people who aren't working (i.e. increasing Y) anymore. (It's interesting to think about how V affects Y, but you need a far more complicated model to do that with any relevance, so ignore that for the minute.) (It's also interesting to note that lowering interest rates increases M in the hope that Y stay high.)

One function of the banking system is to provide credit to businesses. At the moment the credit crisis is more confined to businesses than to consumers (afaik). NAMA is designed to facilitate Y increasing again or at least to stop it falling. An increase in Y will probably lead to an increase in V.

Inflation is a change in P. That's mostly caused by M, but obviously if M and Y stay constant, then an increase in V leads to an increase in P.

Slippers

Time Magazine wrote: »

(It's also interesting to note that lowering interest rates increases M in the hope that Y stay high.)

But if lowering interest rates increases M, paying off debt reduces M. Under this system the only way to keep M stable is to keep the economy borrowing more each year than it did the year before because previous borrowers pay back more than they borrowed (principal + interest). This doesn't happen every year and when it doesn't the resulting decrease in M causes an economic contraction, which causes a further slowdown in borrowing, which causes a further decrease in M and down we go.

Another problem is that there's no way for the ratio of Debt:M to adjust downward without widespread defaults because paying off Debt causes a decrease in M and Debt is always growing faster than M due to interest charges.

Time Magazine

Slippers wrote: »

But if lowering interest rates increases M, paying off debt reduces M.

Says who?

Slippers

The only way lowering interest rates could increase M is if increasing borrowing increased M.

The majority of M is bank deposits. Deposits are just liabilities of the banks. Like bonds, but with embeded put-options and no coupon. The only way the banks are going to be persuaded to put them into circulation is if they get something in return. Some of them are issued in exchange for cash when a customer deposits cash. Some of them are issued in exchange for an increase in the bank's balance at the central bank when a customer receives a transfer from another bank. However, most of them are issued in exchange for contracts for repayment with interest (debt).

However they were issued, when someone pays the bank with them they cease to exist, as the bank can't owe itself money.