The velocity of money is the average number of times per year that a unit of currency (e.g., U.S. dollar, Japanese yen, German mark, etc.) is spent on goods and services. From a theoretical perspective a percentage change in the velocity of money can have the same impact on prices or other economic variables as an equivalent percentage change in the money supply.
Sir William Petty (1623–1687) may have been the first writer on economics to describe the velocity of money. He advanced the plausible view that the velocity of money was determined by the frequency of people’s pay periods. The famous philosopher John Locke (1632–1704) wrote on monetary economics and referred to the ratio of a country’s money stock to its trade, a concept bearing a marked resemblance to velocity. By the mid-twentieth century, the concept of velocity was a cornerstone of monetary economics, which is the study of the relationship between the money supply and prices, interest rates, and output.
A measure of velocity can be calculated by dividing a measure of a nation’s output (i.e., Gross Domestic Product or GDP) by a measure of the money supply. Between 1945 and 1981 one measure of velocity varied between two and seven. Whether velocity is stable or fluctuates in a narrow range, conditional upon stability in other parts of the economy, remains one of the important theoretical questions in monetary economics.
Under conditions of hyperinflation money loses its value quickly and people try to spend it faster. During the classic case of the German hyperinflation after World War I workers were paid at half-day intervals, and took off work to spend their wages before they lost their value. These are the conditions that set velocity soaring, further feeding the inflationary momentum that begins with excess money supplies.
A depression economy, particularly when coupled with falling prices, may lead households and businesses to hoard money because they are afraid that stocks and bonds are unsafe investments and perhaps because they hope to capture the benefits of falling prices. These conditions produce declining velocity, having the same effect as declining money supplies, sending the economy into a steeper descent.
Many modern economists argue that if the government stabilizes the money supply growth rate at a modest rate, perhaps 3 to 5 percent annually, velocity will also stabilize, and the growth path of the economy will mirror the stability in the monetary growth rate.
McCallum, Bennett T. 1989. Monetary Economics.
Sargent, Thomas. 1993. Rational Expectations and Inflation. 2d ed.