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Velocity of money rather than quantity driving prices

How velocity of money can drive price increases. Created by Sal Khan.

Video transcript

It's a common misconception that price levels are dictated purely by the quantity of money out there. And to see why this isn't the case, let's imagine an island that has two players in it. So it has a farmer, who obviously will produce food, and it also has a-- let's call him a landlord-- landlord slash builder, who will either rent out buildings or can build you more buildings or build themselves more buildings to rent out. And we're living in a reality where all you need is food and shelter. And let's imagine one reality where this island, this country, whatever you want to call it, they haven't discovered a lot of currency. So they only have a little bit of gold. So maybe the farmer only has a couple of gold coins to start off with, and the landlord slash builder also only has a couple of gold coins to start off with. They're very currency poor, only a little bit of gold. But they're very optimistic. The farmer says, hey, you know what, things are looking good, landlord. I want to rent a nice building from you for my family, and for you to build more buildings. So here, take both of these coins and build me or rent me out something nice. And he gets both coins over here. And then the landlord says, wow, things are good. The farmer seems pretty optimistic. Farmer, I want you to grow me a ton of really good food, because things are good. So here, take four coins from me and really grow me a ton of really nice food, the stuff that's really hard to grow. So grow a ton of food for me. So he gets those four coins now. These are now gone. The farmer doesn't have those anymore. Now the farmer's feeling really great, really optimistic. And then, of course, these are now gone now. The landlord has given them to the farmer. The farmer's feeling really optimistic. He says, landlord, you know what, I'm feel even better than I did before. Why don't you build me even a few more buildings. I want to expand my house even more. But now the landlord's like, man, you've already given me a lot of money, and I already have a lot of work to do. You've got to pay me more if you want me to work overtime, because that's going to take time away from my family and all the rest. And the farmer says, sure. Last time I paid you two gold coins for some buildings. I'll now pay you three gold coins for the same number of buildings. And so he gives three gold coins. And all he's going to get in return is what he used to get for two gold coins. So if you think about it, the price has gone up for whatever service or product the builder is providing. And then he gives those three gold coins to the landlord and the builder. And then the builder says, things are really good. I'm getting a lot of business from the farmer. I can get even more food from the farmer. And he goes to the farmer and says, hey, give me what you just gave me that last time for two gold coins. The farmer says, no, you know what? I'm really busy now. I'm almost tapped out. If you want me to work overtime or expand my facilities, you've got to give me three gold coins for what I gave before. And besides that, the cost of buying houses has just gone up to three gold coins, so you've got to give me three gold coins now. And so the builder says, oh, sure, I'll give you three gold coins. So the one thing I want you to notice in this video is we only started off with two gold coins for each of these players. But because they were really confident, because they kept spending it with each other, because there were a lot of transactions, there was a high velocity of the actual money that you actually had an increase in prices.