The velocity of money is a topic that I find even many libertarians do not understand. Although it is impossible to accurately measure, it is a subject that is very important when looking at the economy. I have discussed this topic before, but I think it is important enough to warrant more discussion as it relates to the current economy.
The velocity of money is the speed at which money changes hands. If the velocity is high, then money is changing hands quickly. Another way to say this is that there is a low demand for money. Going the other way, low velocity means that money is slow to change hands. It means that there is a higher demand for money. In this case of low velocity, people are holding the equivalent of cash, usually in a bank. It means people are not spending as much.
When more people are paying down debt, I consider this almost equivalent to low velocity. People have a higher demand for money. But if someone has credit card debt with a high interest rate, it makes sense for that person to pay down the debt instead of holding cash that is earning little or no interest.
I believe there are two main reasons that we are not experiencing high price inflation, in spite of the fact that the Fed has tripled the adjusted monetary base since 2008. One reason is that the commercial banks have piled up this new money into excess reserves. This has prohibited the fractional reserve banking process. The other reason for a lack of massive price inflation is, I strongly suspect, a high demand for money.
People are not spending money as they were before the fall of 2008. Although the national government debt is growing exponentially, the average American has actually reduced debt from a few years ago. Americans (as well as others throughout the globe) are fearful of the future. There is high unemployment and high deficits. Future tax rates are uncertain and government regulations are causing huge uncertainty for individuals and businesses. Many companies are sitting on big piles of money, but they are not investing it right now. Excessive regulations (think Obamacare) and other uncertainties are causing Americans and American businesses to be conservative, fiscally speaking.
Since Americans are spending less, I believe this has helped keep a lid on price inflation. If the economy falls back into recession, which seems likely, I would predict that the velocity of money stays low. Of course, I don’t think we’ve ever really been out of the recession.
It is important to remember that just because there is high monetary inflation, it does not automatically translate into high price inflation, especially in the short term. On the other hand, velocity can go the other way too. If the Fed starts up a QE3 program (more money creation) and more Americans start to fear future price inflation, then the velocity of money can turn up quickly. You can have a scenario where prices are going up even faster than the money supply, especially if people think that the central bank is not going to stop creating new money in the future.
This is actually what can happen in a hyperinflation, or as Mises called it, the crack up boom. If the Fed keeps creating new money like crazy and people doubt whether it will ever stop, the dollar could actually become worthless rather quickly. I do not think this scenario is likely as I think the Fed would tighten up its monetary policy before it allowed hyperinflation to occur, although I will admit that anything is possible these days.
In conclusion, while velocity is hard to measure, you should at least know of its importance. Consumer prices will not always directly correlate to the money supply, at least in the short run. This is due to the demand for money. If consumers remain tight with their money, expect price inflation to remain much lower in comparison to the new money in circulation.