The Fiat Money Economy

The Velocity of Money Concept and the Riba-Based Monetary Principles

The velocity of circulation of money looks at how many times a currency unit like the U.S. dollar or any other domestic currency flows through the economy and is used by the various members of a society to transact their business needs. In a simple economy of a developing country, the citizen's needs conduct only to a few transactions like buying food, paying rent for a place to live, paying medical and educational fees, and paying for transportation. In this primitive economic structure, the velocity of money circulation is too low. Compare this with a sophisticated economy that involves a huge matrix of economic and business transactions' activities that may include many needs like food, home mortgages, utilities, durable goods, insurance of different types, construction, entertainment, medical care, maintenance, investing, manufacturing, domestic and international trading, and the list goes on. In this case, the velocity is very high. Obviously, if a country wants to achieve economic vibrancy, one of the most important factors to develop would be an infrastructure that will help increase the number of times the local unit of currency changes hands or to increase the velocity of money. In other words, the velocity-of-money indicator tells economic planners how efficient money supply (M) is used by citizens to create a vibrant local economic activity. The faster money travels — in other words, the higher the velocity of money (V) — and the more transactions in which banknotes are used, the healthier the economy, the richer the citizens, and the more vibrant the financial system. In order to model this, an “Equation of Exchange” was first introduced by Economist Irving Fisher (1867- 1947). It should be noted that during his time in 1911, when he introduced this equation, there was no GDP or money supply data.

The Equation of Exchange states an ideal situation of equilibrium between supply and demand:

Aggregate supply side of the Equation of Exchange is expressed by the quantity of products and services offered (Q) multiplied by its price (P). That is, the aggregate supply is equal to aggregate gross domestic production, which equals the quantity of production (Q) multiplied by the average price (P). The outcome of that multiplication process is called the gross domestic product or GDP.

Aggregate demand side of the Equation of Exchange is expressed by the total money supplied to the economy in the hands of the customer (M) multiplied into the velocity of money (V).

The Equation of Exchange, then, can be expressed as follows:

V (Velocity of Money) × M (Money Supply) = Q (Quantity of Supply) x P (Prices of Goods and Services)

In order to study options available to policymakers, the Equation of Exchange can be expressed as follows:

1. Factors influencing prices (P)

Using the equation to express prices (P):

P = V × M / Q

So, if policymakers wanted to reduce the price, they would have to devise policies that would lead to reduction in M (money supply) or to the increase of Q (production). Money velocity (V) is assumed constant. Money velocity is a long-term tool because changing it needs fundamental changes in the economic chain like offering new services, opening new stores, opening new cities, and expanding these services to cover a larger number of people and that takes time and may be generational changes.

2. Factors influencing velocity of money (V), as implied by the Equation of Exchange:

V = P × Q / M

Based on the preceding, the velocity of money increases with an increase of production (Q) in addition to other factors like expanding the exchange chain of goods and services throughout the country by, for example, building new shopping centers, transportation routes that connect cities, and new cities. Obviously, it takes years if not generations to make an impact on the velocity of money with the objective of significantly increasing it. This should be an important parameter to follow by governments in developing nations that aspire to grow and prosper.

It is important to note here that the Equation of Exchange is a simplified equation that can be used to model the monetary and economic exchange in a country under equilibrium conditions. There are many other factors that influence the outcome, some of which may not be quantifiable. For example, Henry Hazlitt (1894-1993) criticized the concept of the velocity of money, citing that the equation used to calculate it ignored the psychological effects that also have a significant role in determining the value of a currency. However, the equation can be used conceptually and directionally to discover relationships between monetary and economic factors that can be optimized to lead to a wise central bank policy that fits domestic variables in a particular country.

Another use of the Equation of Exchange is to apply it to two different world economic blocks and use the ratios of the equation to study variations in the parameters to come up with policies that tailor goals for the State Department, the Department of Treasury, the Department of Defense, and the central bank (the Fed).

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