St. Louis Fed: "What Does Money Velocity Tell Us about Low Inflation in the U.S.?"

From the Federal Reserve Bank of St. Louis:

Inflation is typically described as a persistent increase in the general price level, such as in the consumer price index. One of the most important theories to explain inflation is the monetarist view that, according to Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.”¹ In other words, inflation occurs because there is too much money available to buy the same amount of goods and services produced in the economy. This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:

MV = PQ

In this equation:

• M stands for money.
• V stands for the velocity of money (or the rate at which people spend money).
• P stands for the general price level.
• Q stands for the quantity of goods and services produced.

Based on this equation, holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period?

Declining Velocity
The issue has to do with the velocity of money, which has never been constant, as can be seen in the figure below . If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation.

The velocity of money can be calculated as the ratio of nominal gross domestic product (GDP) to the money supply (V=PQ/M), which can be used to gauge the economy’s strength or people’s willingness to spend money. When there are more transactions being made throughout the economy, velocity increases, and the economy is likely to expand. The opposite is also true: Money velocity decreases when fewer transactions are being made; therefore the economy is likely to shrink....MUCH MORE

HT: Reason's Hit & Run blog who says the 'missing' money is probably in the shadow economy.