Sunday, July 25, 2010

With all the infusion of money into the economy, why do we not have Inflation? Hello! It's due to Velocity of Money! Did you not know that??? Nice chart enclosed.

Below is an excellent explanation of the velocity of money and its impact on economic recovery AND why we are not experiencing inflation with the increase (real or perceived) in the nations money supply.  Velocity of money is simply how many times the money supply turns over on itself to purchase GDP.  If GDP for a given year is $14 Trillion and there are only $7 Trillion in circulation, how can that be? The $7 Trillion turns  over on itself twice to buy $14 Trillion dollars worth of "stuff".  Some dollars turnover more than others (some sit in the seat cushions of your couch) and others circulate many times over.  I will do another blog entry to further explain this in the context of an equation called the Equation of Exchange...Fun! Fun!

Bartlett: Hoarding Cash Could Stifle Growth and Halt the Recovery
""The Wall Street Journal reported somewhat breathlessly on June 10 that nonfinancial businesses in the U.S. are sitting on $1.84 trillion in liquid assets, or 12.6 percent of the gross domestic product (GDP). The implication is that this money could immediately be mobilized to invest and create jobs. This isn’t quite so, but excessive cash holdings by households, businesses and banks are symptomatic of a fundamental problem plaguing the economy: the low level of monetary velocity.
The $1.84 trillion figure is a bit misleading because businesses always have a lot of liquid assets. At the end of 2007, before the financial crisis hit, they were sitting on $1.53 trillion in liquid assets, which represented 11.1 percent of all their financial assets. At present, liquid assets represent 12.9 percent of financial assets, roughly comparable to the 12.5 percent share in 2005.
It’s difficult to say what would be a normal percentage for liquid assets, but it’s doubtful that businesses are sitting on much more than $150 billion or so of precautionary liquid assets . If they were to spend these funds on hiring or investment or even dividend payments to shareholders, it would help the economic situation, but not by all that much.
However, to the extent that businesses and households are hoarding cash it reduces the rate of turnover of money in the economy—the number of times dollars are spent in the aggregate—which economists call velocity. In the simplest terms, velocity is the ratio of the money supply to GDP in nominal (money) terms.
For many years, economists treated velocity as if it was a constant like pi (π), the ratio of the diameter of a wheel to its circumference. Throughout the 1960s and 1980s, velocity was fairly stable at around 1.6/1.7. But in the 1990s, it began to rise due to financial innovations, such as debit cards, that allowed people and businesses to use their cash more efficiently. Throughout the 1990s, the velocity ratio was more than two, meaning that if you multiplied the money supply by two, that would approximately equal GDP.
In the 2000s, velocity fell to the 1.8/1.9 range. On the eve of the financial crisis it was about 1.93, as shown in the table. But in mid-2007, it began to fall, hitting a low of 1.68 in the middle of last year, a level not seen since the 1980s

A decline in velocity has the same economic effect as a decline in the money supply, which creates deflation—falling prices. This is what happened during the Great Depression. At that time the money supply fell because there was no deposit insurance, so when banks failed, their deposits literally disappeared. (Most of the money supply is in the form of checking accounts or demand deposits that exist only in an accounting sense.) Between 1929 and 1933, the money supply shrank by 30 percent. Since the price level is a function of the quantity of money times the goods and services available for sale, this caused the Consumer Price Index to fall by about 25 percent.""
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