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### Course: Macroeconomics>Unit 5

Lesson 3: Money growth and inflation

# Velocity of money rather than quantity driving prices

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

## Want to join the conversation?

• 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?
• The confidence drives the transactions i.e. demand, which cause the prices to go up.
• 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?)
• I think it was a mistake I think he meant to use 2 gold coins for the food originally. Notice at the builder says "Give me what you gave me that last time for 2 gold coins"
• Why is there a low velocity of money when people want to hold a lot of money?
• 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.
• 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...
• 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).
• 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?
• If this did occur, prices may actually decrease (deflation) so that every dollar would be able to purchase more.
• 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?
• 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.
• 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. :)