Question

1. Define the velocity of money.
2. What does it mean if the percent change in velocity is negative?
3. Give a real-life example of how this could be possible?
4. What central banking nightmare can occur if we see the percent change in velocity of money turn negative and the Fed does not react?

Answer 1

A.

Velocity of money refers to the exchange of money from one hand to another hand in the economy. When velocity of money increases, with money supply remains constant. Then, nominal GDP of the economy increases. Though, the economy shrinks when velocity of money decreases, other factors remain constant.

B.

If % change in velocity of money is negative, then economy is slowing down and real output decreases. It is the indication of recessionary effect in the economy. There can be negative inflationary effect, making people hold on to money, rather spending the money. It makes  % change in velocity of money to be negative.

C.

When there is a negative inflation or deflation, then people think that real value of money will increase in the future. It makes them spend less and keep the money with themselves. It causes decrease in velocity of money and economy suffers in reality.

D.

It will make borrowing less and spending of consumption and investment will decrease. It will decrease the aggregate demand and real GDP will decrease if Fed does not act.