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Understanding Money


The Velocity of Money

Let's say you have a dollar bill in your hand. Suppose you go to the grocery store and use that dollar to buy something. What happens to the actual dollar? The store will give it out in change to someone else, who will use it to buy something from a different store. That store will then give the same dollar to another person who will go to a third store, and so on. Over time, the same dollar bill can be used over and over and over.

The same is true for any type of money, even money that is stored electronically in a computer. Over time, all money — coin, paper or electronic — is used and reused.

From our discussion earlier in the essay, you know that the size of the money supply is crucial to the economy of that country, because money greases the wheels of commerce. If there is not enough money, commerce will slow down. If this happens for too long, there may be a recession. If there is too much money, prices will rise, which may cause inflation. This is why central banks, such as the U.S. Federal Reserve, work so hard to manipulate the money supply on a day-to-day basis.

Thus, if the economy is to be healthy, it needs just the right amount of money. However, when you consider what the right amount should be, you must remember that most of the money in circulation will be reused a number of times. For example, let's say that, in a particular year, the U.S. economy has $9 trillion worth of transactions. However, during that year, on the average, each dollar is used 9 times. This means that the actual amount of money that is needed is really only $1 trillion.

In order to talk about this idea, economists use the term VELOCITY OF MONEY to represent the average number of times a single dollar will be used in the course of a year. In our example, the velocity of money has a value of 9. (In practice, no one knows the actual velocity of money. It's really just an idea used by economists.)

There are two important ways in which the Internet affects buying and selling. First, the Internet helps companies and individuals expand their markets. Because of the Internet, people are buying and selling more than they would otherwise. Second, the Internet makes it easier and faster for the buyer to pay the seller. In these ways, the Internet serves to increase the velocity of money, which has the effect of increasing the financial well-being of our society. Here is why.

In a general sense, the health of the economy is directly related to the amount of business transacted. The more production, buying and selling, the healthier the economy, and the happier we all are as a society.

Economists estimate the amount of business transacted in a particular country by asking the question, "How much money is spent on goods and services in that country over the course of a year?" We call this value the Gross Domestic Product or GDP of that country. Here are several examples showing the 2000 GDP expressed in U.S. dollars for four parts of the world:

United States $10,227,000,000,000 (about $10.2 trillion)
European Union $9,887,000,000,000 (about $9.9 trillion)
United Kingdom $1,657,000,000,000 (about $1.7 trillion)
Canada $703,910,000,000 (about $704 billion)

Economists talk a lot about the GDP because it is the most comprehensive measure of how much a country produces in a year. One of the aims of both politicians and central bankers is to raise the GDP of their country as much as possible without causing inflation. In fact, it is an article of faith among politicians that:

High GDP + Low Inflation = Reelection

and among central bankers that:

High GDP + Low Inflation = They can relax for the weekend

One way in which the GDP can be understood is by looking at how much money changes hands during the course of a year. By definition, this value is equal to the total amount of money in the economy multiplied by the average number of times each dollar is used in a year. In other words:

Money spent =
    (Total number of dollars) x
    (Average number of times a dollar is used in 1 year)

To express this idea more simply, we can use M to represent the money supply and V to represent the velocity of money:

Money spent = M x V

If we assume that the GDP is equal to the total money spent in a year (a fair enough assumption for our purposes), we get:

GDP = M x V

Since the GDP is related to our economic happiness as a society, we can write:

Economic Happiness = M x V   (as long as inflation is low)

Thus, by increasing the velocity of money, the Internet raises the level of economic happiness of our society as a whole. Or, in plain English, the Internet allows us to be more productive without having to raise the money supply, which would increase the risk of inflation.

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