Answer to Question #42544 in Economics for Sophie B

Question

If there is more Money Supply (M) in an economy, how does this decrease the velocity of circulation (V) ?

Answer 1

Henry Hazlitt 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. As an example, he shows that in a period of inflation, that when the money is newly introduced, the price level increases by a smaller proportion than the increase in the supply of money, but that when the money has been in circulation for a while, that the price level has increased by a greater proportion than the supply of money. He states that this is not due to a change in the velocity of money, but rather the discrepancy is due to "fears . . . that the inflation will continue into the future, and that the value of the monetary unit will fall further." Hazlitt offers an alternative to the quantity theory of money and the velocity of money concept that is a necessary consequence. He explains that what changes the value of money is the value that people place on the currency, and that it is not the velocity of money that determines the value of a currency, but rather the sum of individuals' value of the currency that determines the velocity of money.