There are two different meanings for
money velocity. One is simply a description of the process itself (frequency at which a given quantity of money exchanges hands); the other is the actual theory that holds that this process affects the general level of prices, with low velocity leading to
price deflation and high velocity leading to
price inflation.
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In 1988 two members of the Federal Open Market Committee (FOMC), Jerry Jordan and William Poole, expressed concern regarding the strong momentum of the money supply. Year-on-year in July money M3 increased by 9.2 per cent. These two men feared that the strong monetary momentum was likely to lift the rate of inflation in months to come.
Consequently they advocated that the Fed adopt a tighter monetary stance to prevent the acceleration in the rate of inflation. Many noted Wall Street economists regarded this fear as totally misplaced. It was held, that this thinking ignored the fact that the velocity of money was currently falling. This fall in money’s velocity, it was argued, neutralised the rising monetary momentum, thereby preventing a future increase in the rate of inflation.
What do they mean by velocity? The idea that there is such a thing as velocity is based on a view that money circulates. It is alleged that when the velocity of money rises all other things being equal, the buying power of money falls, i.e., prices of goods and services rise. The opposite occurs when velocity declines. If for example it was found that the quantity of money had increased by 10 per cent in a given year, while the price level as measured by the consumer price index, had remained unchanged, it would mean that there must have been a slowing down of about 10 per cent in the velocity of circulation.
But is that true? Does so-called velocity of money affect general price levels? Ludwig Von Mises argued that it did not, based on the fact that demand for goods and services are not set arbitrarily but rather consciously and purposefully. I take issue with that, as what Mises did not consider, in my opinion, were all the market distortions (supply and demand) due to malinvestment, and aggregate manipulation of the money supply (both magnitude and direction), which also affects individual preferences, which is is equally conscious and purposeful.
The actual velocity of money in itself is a very generalized theoretical observation, and not a very critically thinking one at that. It is like using terms such as "the economy" or "economy-wide", without any regard to WHOSE economy is affected. 100% of the wealth of "an economy" can be divided equally into parts A and B. If A steals all of B's wealth, "the economy" can be said not to have suffered at all, as it still has 100%. Likewise, "velocity of money" makes no distinctions, and it is truly ironic that the term velocity was even used.
Velocity is a vector quantity that describes both speed (magnitude)
and direction. Direction implies points of origin as well as destinations. But like with any other
non-Austrian theory, these little Detail Devils are disregarded in this aggregate-jumbling dog-wagging scenario. If you want to talk about
true velocity, you must consider origins and destinations - not just frequency of changing "hands", as if all hands were somehow fungible.
They are not. The "velocity" of money may slow to a crawl in one part of the economy (e.g., wagoners, ferriers and blacksmiths) as a result of acceleration in another part (automobiles). Or, in the case of any bubble, the velocity of money might flow (in both magnitude and direction) toward malinvestment -- and few would argue that this was not
price inflationary on the assets that were overvalued as a direct result. Then comes the Value Collapse, which affects everyone, including those who did not benefit from the distortion wave.
The Fed has control over both interest rates and the actual base money supply (both magnitude). Commercial banks, also consciously and purposefully acting, have control over the source of money that competes directly with privately accumulated capital (savings), including WHO has access to credit (the direction component of velocity), and what they are willing to lend for.
It is also a well-established fact that saving and spending (both directly related to supply and demand), affects prices. Saving and spending (NOT IN THE AGGREGATE) can be accurately described in terms of velocity, since both the magnitude (amount saved or spent) and direction (spent on what) can be quantified. That holds true in ANY economy, including one where the total quantity of money in existence is not artificially distorted. In a perfectly competitive free market with a sound currency, savers are the spenders best friend, as aggregate savings SHOULD increase the relative value of all other currency in circulation. The Keynesian-spawned Fed can distort this self-equilibrating market dynamic by making savers/savings a non-issue. It can, through central control over base money and interest rates, and then by proxy through the commercial lending channels it facilitates, produce an army of
spenders-who-are-not-borrowing-directly-from-savers. All of that "velocity" (magnitude and direction through preferred lending and spending channels) does very much affect prices. As a short term business cycle dynamic. Long term price inflation, however, is not based on the velocity of money but the increase in the amount of new money put into existence.
I know that's not the simple answer you're looking for, but that's my take on it.
