SUBCOMMITTEE FINANCE (March, 1945)
Part II~ THE MONETARY SYSTEM IN UNIVERSAL USE
6. VELOCITY OF CIRCULATION
It is generally assumed that the purchasing power of money
is increased or decreased by its velocity of circulation. However,
this theory will not bear examination in the light of the facts regarding
the issue and withdrawal of money under the established system.
For purposes of analysis the following simple illustration of
the velocity of circulation theory will suffice:
A wage-earner A. uses a $10 bill of his income to buy two
pairs of shoes from a shoe merchant B., who immediately goes into the
adjoining store and spends the $10 to purchase some shirts from C.,
C in turn immediately goes across the street to grocer D. and buys
some provisions costing $10, grocer D. then takes the $10 bill across
to the local garage E., to buy some gasoline and oil.
The contention is that the $10 bill provided purchasing
power to the extent of $40 during the day by virtue of its "velocity of
circulation" in enabling $40 worth of goods to be purchased by consumers.
On the face of it this would appear to be the case, but on examination
it will be found to be a complete fallacy.
Because all money issued creates a debt of the corresponding
amount at its source of issue, for all practical purposes merchants
B., C., D., and E. can be assumed to be operating on credit loans
from their banks with some "savings" invested in their stock.
The proceeds of every sale they make can be divided into three
parts: (1) repayment of a bank loan before a new line of credit can
be obtained to replace stock, (2) payment of operating costs and
(3) net profit- i.e. personal income for services. Suppose that in
each case B.,C., D., and E. work on a 15% net profit. From each
purchase amounting to $10 they would be obliged to set aside - say,
$8.50 repayment of their bank loans for replacement of stock and overhead
costs, and only $1.50 as personal income.This is likewise true of C. and D. Therefore, by spending the $10 both of them created a liability against their future purchasing power.
When A. obtained the $10: in wages there was against it a
corresponding cost in the prices of goods coming on the market. This
liability must be kept in mind.
On buying the two pairs of shoes from B., A. surrendered his
right to $10 purchasing power and B. acquired the right to $1.50 of
this, the balance going for the repayment of his bank loan and cancellation
of the money as shown previously. (If he was operating on his
own capital it would make no difference, for the $8.50 would have to
go to the replacement of working capital with the same result.)
If B. does not repay his bank loan, but spends the whole $10,
he will have a liability of $8.50 outstading which will constitute
a debt against future purchasing power. In other words he will have
to sell over $50 worth of goods without getting any portion of it for
his own use in order to make good the deficit.
Thus while it is true that in the example quoted ,the $10
bill resulted in $40 worth of goods reaching consumers, there was
created a trail of debts against their future purchasing power amounting
to $10 (the liability against the original issue of the money) plus
$8.50 (B.'s undischarged liability) plus $8.5O (C.'s undischarged
liability) plus $8.50 (D.'s undischarged liability)- making a total
of $35.50. Suppose E. now meets his obligations of $8.S0, he retains
$1.50 as his net profit--:ie.,as purchasing power.
It will be evident that the effect is exactly the same as
if A. bought gasoline, etc., from E., and B. and C. and D had obtained
goods from each other "on time", pledging their future purchasing
The so-called "velocity of circulation" did not incredase purchasing power at all.
The fallacy in the theory lies in the incorrect assumption that money "circulates",wheras actually it is issued against production, and withdrawn as purchasing power as the goods are bought for consumption.