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Macroeconomics
Course: Macroeconomics > Unit 5
Lesson 3: Money growth and inflationVelocity of money rather than quantity driving prices
How velocity of money can drive price increases. Created by Sal Khan.
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Is it the number of transactions itself that drives price increases or is it that the transactions and confidence creates a situation where capacity is fully utilised and it gives the farmer and the landlord an ability to raise prices?(38 votes)
The confidence drives the transactions i.e. demand, which cause the prices to go up.(40 votes)
- At first, the farmer pays landlord 2 coins for land. Then the landlord pays the farmer 4 coins for food. Then, the farmer pays the landlord 3 coins for more houses (so prices went up), but then the landlord pays the farmer 3 coins for more food? Doesn't that mean price of food went down? (first 4 coins, then 3 coins for same amount of food production?)(18 votes)
- I think it was a mistake I think he meant to use 2 gold coins for the food originally. Notice at2:50the builder says "Give me what you gave me that last time for 2 gold coins"(18 votes)
Why is there a low velocity of money when people want to hold a lot of money?(7 votes)- Because the velocity of money is effectively the frequency of money circulation as purchasers pay for the goods/services that they have bought. If people decide to hold more of their money (decide not to spend it on goods/services) then this circulation (velocity) decreases.(5 votes)
- I can see how, hypothetically, prices would increase following such logic. Wouldn't that bring us to a point where the available money supply would not be able to pay for any more inflation? And then people would just buy less because money would not suffice, making producers cut supply because of overstock, then cutting profit just to get revenue...(8 votes)
First of all, you have to understand that this is a hypothetical situation. Money supply here is constant as you can see (only 4 coins). However, in the real world, money supply is not constant. In fact, it increases and decreases as central banks deem necessary for the overall benefit of the economy. Central banks can print money and buy treasuries if they want to increase money supply and they can sell treasuries if they want to decrease the money supply.
Try to picture a bank in this example with the ability to print money and take deposits. As the farmer and the builder get their coins from each other they deposit it. Each one of them thinks that he's got 4 coins in the bank (8 total perceived coins) when in reality the whole money supply is actually 4 coins.
Your question is exactly what caused the demise of the gold standard (when the dollar was fixed to a certain amount of ounces of gold). It seemed that the mining of gold could not keep up with rate of wealth creation in the world as a whole and thus led to this current system of floating currency (Fiat money not pegged to gold).(5 votes)
- It seems to me that if labor adds value every time around, more currency would be needed to represent that amount of new wealth. If no more money is coined, how does that affect the prices long term?(3 votes)
- If this did occur, prices may actually decrease (deflation) so that every dollar would be able to purchase more.(7 votes)
Why do you call it a misconception. Does it mean prices are never dictated by quantity of money? Or both the principles have a role. If so, how do you find out?(1 vote)
I know this is just an overly simplified example with a two-person system but what purpose do the gold coins serve? The farmer needs buildings and the builder needs food....why over-complicate it by paying each other, and in ever-increasing quantities of gold? Wouldn't it make more sense if the builder supplies the buildings and in exchange the farmer supplies the food? I know it'd put economists out of a job, and sounds fairly Marxist (From each according to his ability, to each according to his need) but why doesn't that make sense?(3 votes)- You need the coins to help you establish what the relative price should be. How many buildings does the builder have to give to the farmer for a month's supply of food? Although the two of them could establish their own exchange rate, once you introduce a 3rd and a 4th party into it, it will be very helpful if they can all just use gold as a common currency. That way if the farmer doesn't want bread from the baker but the builder does, the farmer can still sell food to the baker in exchange for gold instead of bread. You really can't operate an economy on barter. That's why even the most ancient civilizations had some sort of standard item to use as money. In ancient Rome, soldiers would be paid in salt, because salt was something everyone needed, and the soldiers could easily trade for it. That's where we get the word salary, from salt. In prison, inmates develop monetary systems using cigarettes as currency. Native Americans used beads, shells, and beaver pelts.(2 votes)
- So again it seems the change of causation in this video is:
-Confidence and Optimism cause increase in Demand --->
-Increase In Demand raises the price of each good, because the Opportunity Cost of producing goes up (e.g. I want to spend time with my family, etc) --->
-Because the price of each good has gone up, velocity increases since velocity in a given time period = (nominal value of all transactions)/(money supply).
So two questions:
1) Why does the OC go up in response to optimism? Is it because of an increase in demand in general (e.g. as the farmer if I choose to fulfill your order for food I think I'm missing out on more orders from other people), OR because of capacity restraints on the supply side (e.g. I am already working x hours a day and cannot produce more without cutting into family time)
2) Sounds more like the title should be "Prices drive Velocity of Money", rather than the other way around? Please correct me if I'm missing something.
But thanks for a great video - much better than my macro class. :)(2 votes)- To answer the first part of your question, it is important to go back to the basic laws of supply and demand. If demand is going up, that means that the entire demand curve shifted to the right, so it is now intersecting the supply curve (which didn't move) further to the right and at a higher equilibrium price and quantity. The supply curve can be thought of as the OC curve as well. It is the minimum price level required to induce the market to supply a given quantity. It (typically) curves up and rightward for several reasons. Your example of the farmer already working x hours and values his remaining time more highly is one good example.(2 votes)
If the Price Level rises, Inflation rises. I did not get the reasons clarified of this. Could anyone please help me, kindly??(0 votes)
Does this video imply that human natural instinct also has it's role as a determinant of price, besides other factors ?(1 vote)
2:50Video 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.