How Money Makes The Economy Move

By Hans Wagner | February 10, 2010 AAA
How Money Makes The Economy Move

Money, and how fast it passes through your hands, determines the gross domestic product (GDP) of an economy. So how does the stimulus from the Federal Reserve affect the economy?

A Real-Life Example
Let's go to our

Elm Street

economy and see what effect the supply of money has. One day you set up a lemonade stand selling a cold glass of your best lemonade for $1. Your friend sets up a cookie stand selling them for $1. Another friend sells Popsicles for $1. Each of you starts with $5 in cash for a total of $15, equivalent to a monetary base of $15. Things are a little slow, so you buy three cookies and two Popsicles from your friends, spending all of your $5. Your friends are thirsty and buy $5 worth of lemonade from you. Then your two friends spend their remaining $5 on cookies and Popsicles from each other. In the end, everyone ends up with $5 while enjoying cookies, Popsicles, and lemonade. Since the money spent has only passed through each hand once, the velocity of money for that day is one. The GDP is $15.

For the mathematicians, a simple formula of nominal GDP = Money * Velocity or Y = M*V.

The Following Day
On the second day, another friend opens a hot dog stand. She does not have any starting cash, so the monetary base remains the same at $15. You and your first two friends spend $5 buying and selling lemonade, cookies, Popsicles and hot dogs, earning the three original stores $4, and the new one $3. On average, each person ends up with $3.75. ($15/4=$3.75). At the end of the day, the three original friends figure that they are in a depression, as sales have plunged to $4. The new member is excited, as she now has $3.

So, What Happened?
GDP for the day stayed the same, at $15, spread among more members of the economy. The total aggregate of money did not change, remaining the same at $15.00. The velocity of money stayed the same. Three-quarters of the population had a severe recession, while one is happy with her newfound money. Overall, business is not good. (Learn the underlying theories behind these concepts and what they can mean for your portfolio, in The Importance Of Inflation And GDP.)

Day 3
The next day, a fifth neighbor spends $2 at each stand. If each friend still spends their money as before - $4 from the first three stores and the $3 from the new store - the GDP of Elm Street economy rose to $23 for the day ($15 + $8 from a benevolent neighbor = $23). The aggregate money supply rose to $23, as well. The velocity of money remained the same, at one for the day. The three original stores took in $6, and the new store took in $5. The economy is booming, thanks to the neighbor.

By injecting money into the economy, the neighbor acted like the Fed, growing the money supply to encourage economic growth.

Being enterprising individuals, you and your friends raise prices from $1 to $1.15. The next day, all stores sell five of their products, collecting $5.75. Three of the four stores saw a decline in sales. Rising inflation did not result in better economics, as the money supply and GDP remained the same at $23. The velocity of money stayed at one.

The Last Day
On the next day, everyone decides to save part of their prior day's earnings, keeping $1, bringing the day's sales for everyone to $19. The Elm Street GDP plunges to $19.00 from $23.00, causing a recession. While the aggregate money supply remains at $23 ($19 + ($1 * 4)), the velocity of money fell to 0.83 (19/23). While everyone has some money in their pockets, the slow down in spending caused a recession.

Conclusion
This story gives you an idea of how a central bank stimulates an economy and how money works in an economic system. In reality, the central bank provides money through banks in a more complicated process.

Next time you hear about a change in the money supply, stop to consider how it will affect the economy and prospects for inflation and deflation. (Learn more in What does deflation mean to investors?)

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