Economists Do It With Models

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The Velocity Of Money, In Handy Cartoon Form…

April 14th, 2014 · 4 Comments

Many people think of money and wealth as fairly synonymous, whereas economists are careful to point out that money serves a number of specific functions in the economy. Most notably in the context of the discussion we’re about to have, money is the thing that we use to buy stuff. Therefore, people want to hold money, even though it doesn’t pay any interest and other assets do, since they need it to buy all of the cool stuff that they want.

We know that the amount of money in an economy, i.e. the money supply, is set by the Federal Reserve, so how does the supply of money relate to the amount of stuff bought and sold in an economy? Luckily, economists have a handy-dandy identity to describe this relationship:

So what does this mean? Let’s see…

  • M represents the amount of money available in an economy (i.e. the money supply)
  • V is the velocity of money, which is how many times within a given period, on average, a unit of currency gets exchanged for goods and services
  • P is the overall price level in an economy
  • Y is the level of real output in an economy (usually referred to as real GDP)

If you think about it for a second, the relationship makes a lot of sense- let’s say, for the sake of argument, that an economy has $100 of money in it. (It’s a small economy, in case that wasn’t obvious.) If stuff in that economy costs $5 on average (i.e. P=5) and the economy makes 60 units of stuff (i.e. Y=60), then, in order to make the transactions happen to sell the stuff that was produced, it must be the case that a unit of currency changes hands 3 times on average (i.e. V=3), since the dollar value of the transactions totals $300 and there is only $100 of money to go around. (In case you’re curious, the velocity of money is thought to be pretty stable in the long run, so changes in the money supply eventually translate to corresponding changes in prices.)

The velocity of money is a very important concept in macroeconomics, even at the introductory level, but it’s a concept that is often less than intuitive for students. Luckily, I stumbled upon this comic that illustrates the concept quite adorably:

(Obviously you have to click to see it full size unless you have superhuman vision.) I get how electronic currency (I mean debit cards, not Bitcoin) is super convenient and efficient, but it’s just somehow not as cute. And this doesn’t even count the sheer hug-worthiness of the fact that my grandpa collected two sets of state quarters for me (apparently there are separate series for the Denver and Philadelphia mints or something) while he sorted change from his condo’s laundry machines and gave them to me as a holiday gift. You’ve gotta admit that a collection of debit or credit cards just doesn’t have the same warm and fuzzy factor, even when the cards look like this:

Sometimes I feel like the world is marketing directly to me.

Tags: Macroeconomics

4 responses so far ↓

  • 1 Wilson Dizard // Apr 15, 2014 at 2:34 am

    Dear Jodi:

    Thank you for an illuminating article. Among other benefits, the velocity of money piece reminded me of the crucial differences between financial benefits and economic benefits. The latter, of course, include countless goods and services that speak to the human heart in voices louder, more soothing, more enchanting, more ennobling and sometimes more horrific than any change in financial resources could utter.

    I’ve chanted the threefold “what is money” mantra to myself (silently), countless times (store of value, unit of account, medium of exchange), since I first learned it in the autumn of 1968 in my first economics course.

    But, last night and today, one ineffable quality of currency and coin (M0) proved useful in a way that’s rarely discussed but hits a sweet spot of behavioral economics.

    Over the weekend and into this morning, my wife, Avery, has had a severe toothache. She’s seen one dentist and has scheduled a root canal for later this week.

    I should mention that as of April 17, Avery & I will have been married for 32 years. Controlling the toothache pain with as little medicine as reasonably feasible became an important issue. I’m sure you’re aware of several such methods (meditation, music, massage &c).

    Turns out, handling M0, meaning, touching dollar bills and coins, is another method of easing physical pain without pharmaceuticals or over-the-counter medicines.

    Here’s a link to an article in the peer-reviewed journal Psychological Science describing six separate studies in which test subjects who were allowed to handle money benefited from higher pain thresholds for as long as 10 minutes after they stopped counting the currency:

    And here’s the abstract of the article:

    “People often get what they want from the social
    system, and that process is aided by social popularity or by having money. Money can thus possibly substitute for social acceptance in conferring the ability to obtain benefits from
    the social system. Moreover, past work has suggested that responses to physical pain and social distress share common underlying mechanisms. Six studies tested relationships
    among reminders of money, social exclusion, and physical pain. Interpersonal rejection and physical pain caused desire for money to increase. Handling money (compared with
    handling paper) reduced distress over social exclusion and diminished the physical pain of immersion in hot water. Being reminded of having spent money, however, intensified
    both social distress and physical pain.”

    So, you might consider keeping an emergency stack of dollar bills in the medicine cabinet, in case someone gets a toothache at 3:00 a.m.!



    PS: The article title is:

    Research Article
    The Symbolic Power of Money
    Reminders of Money Alter Social Distress and Physical Pain

    and the authors are:
    Xinyue Zhou,
    Kathleen D. Vohs,
    and Roy F. Baumeister
    Department of Psychology, Sun Yat-Sen University;
    Marketing Department, Carlson School of Management, University
    of Minnesota, Minneapolis; and
    Department of Psychology, Florida State University

  • 2 Article Collection 04/02/14 | Moningtonomics // Apr 15, 2014 at 8:57 pm

    […] A [terrible] cartoon which [kinda] explains the velocity of money. […]

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