Can Money Run? Introducing Monetary Goldilocks
How fast can money run? Fast enough to destroy an economy. Paradoxically, also slow enough to destroy an economy.
But what exactly is money velocity?
There’s nothing complicated to the fancy term actually, it is simply how quickly money changes hands in an economy.
Here’s a simple illustration:
Imagine that you’re a dollar in the system. Someone takes you out of their pocket to pay for a can of coke, you end up in someone else’s pocket. This new person takes you out to pay for some bread, again you change hands, but this time you end up spending the night in a piggy bank.
You (or rather, the dollar), changed hands twice in one day.
Next consider a scenario where the dollar changes hands five times a day. This could be as it was used by different people for breakfast, lunch, coffee, dinner, then a beer at a bar. The dollar definitely worked harder here, but it still seems like a pretty manageable day.
Now imagine the dollar changes hands 100 times in the same day.
In terms of our hypothetical scenario that’s a lot of people buying a lot of meals, all in 24 hours!
This scenario is what happens in hyperinflation, and is a result of incredible fear that the value of the dollar would depreciate by the hour. Anecdotes from the Weimar hyperinflation about bread prices skyrocketing within the span of a single day are a good example of this.
So if someone ever riddles you with, “When is it cheaper to board the bus in the morning than at night?” The answer is: When money velocity is way too high!
Finally, consider a scenario where the dollar only changes hands once a day. Someone takes it out of their pocket to pay for breakfast, after which the dollar sits in a cash register for the rest of the day.
Obviously things aren’t going well here either, because people are not spending.
This scenario is called deflation, where people simply refuse to spend.
Deflation is a very different beast compared to hyperinflation, and is often caused by multiple factors.
These could include economic shocks due to internal or external factors, a currency that is too strong relative to its peers, a currency that is pegged to a currency that is too strong, and/or a lack of meaningful money supply growth.
In general however, deflation can be attributed to a lack of confidence in future economic prospects.
When people are not confident in their ability to find consistent work (as opposed to hourly contractual work), work with meaningful compensation, or for that matter any kind of work, their natural reaction is to slash their spending. Money then begins to flow through the economy at a slower pace, and prices for various goods and services fall in response to the drop in consumer demand.
If this carries on for long enough, producers can no longer supply their goods/services at a profit and begin to shut up shop, which can perpetuate the deflationary cycle, wreaking economic havoc.
Turns out that money velocity is one of those Goldilocks things; too hot and it burns, too cold and it turns.
It has to be just right.
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