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.