In the economy, at any given moment, there is only so much money in circulation, while the number of goods that we produce continues to grow and grow (usually). With these limitations, how does an economy succeed in getting each of the citizens the currency that they need? How does the economy continue to operate despite limited spending power? For this reason, there is an economic principle that economists consistently measure in their determinations of how an economy is succeeding. This principle is called the velocity of currency.
What is the velocity of currency?
To put it simply, velocity of currency is the measurement of how fast money passes from one holder to the next. The velocity of currency gives an economy more energy, despite its limited resources, because if the money moves fast enough it will give everybody an economic boost off of the same currency. Here is an extreme hypothetical example: If a town only has one dollar to spend, but it gets spent $1 million times, then the economy is actually worth $1 million. Despite this, only currency spent on new domestic products raises the GDP.
Difference between income velocity of money and transaction velocity of money
Income velocity refers to the number of times that currency is used to buy newly produced domestic goods. This is the kind of velocity that raises GDP and gives manufacturing industries a big boost. Transaction velocity refers to the number of times that currency changes possession for any reason, whether the goods are new or not. It’s important to note that more money will not necessarily raise the velocity of currency. It more so depends on the confidence that the spending population has in the market.
Why is this important
While not a clear picture of the entire story, the velocity of currency is a good gauge of how robust the economy is, at the moment. A high velocity of currency will be able to increase everyone’s spending power beyond the limitations of how much currency is in circulation. This ensures a continuous stream of investment and success of businesses. If people stop spending money, and the velocity of currency drops, the GDP will fall to the level of available currency, or even lower. This is typically why economists prefer policy that attempts to speed of the circulation of currency in order to create greater success for each business, which will raise GDP over time.