Effect of changes in money supply on economic activity and prices is a velocity of money.
It is alleged that when the velocity of money rises, all other thing being equal, the buying power of money declines ie the prices of goods and services rise. The opposite occurs when velocity declines.
If, for example, it was found that the quantity of money had increased by 10% in a given year, while the price level as measured by the consumer price index has remained unchanged it would mean that there must have been a slowing down of about 10% in the velocity of circulation.
Main stream view of what velocity is
According to popular thinking the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used again and again to finance people’s purchases of goods and services. The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services.
For example, during a year a particular ten-dollar bill might have been used as following: a baker John pays the ten-dollars to a tomatoe farmer George. The tomatoe farmer uses the ten-dollar bill to buy potatoes from Bob who uses the ten dollar bill to buy sugar from Tom. The ten-dollars here served in three transactions. This means that the ten-dollar bill was used 3 times during the year, its velocity is therefore 3.
A $10 bill, which is circulating with a velocity of ‘3’ financed $30 worth of transactions in that year. Consequently, if there are $3000billion worth of transactions in an economy during a particular year and there is an average money stock of $500 billion during that year, then each dollar of money is used on average 6 times during the year (since 6*$500 billion =$3000).
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