Suppose that everyone has a job, and is paid every fourteen days, and spends one fourteenth of the pay every day, so that all of the previous paycheck has been spent by next payday.
Now suppose that there is a rumor that prices are about to increase. Only a few people believe the rumor at first. The people who believe the rumor will try to buy things before prices increase. Instead of spending one fourteenth of their pay every day, they will spend all their pay on payday, buying everything they will need for the next fourteen days.
On payday, most people will buy the same amount of stuff from stores as usual. But a few people will buy more stuff than usual. So most stores will see an increase in the amount of stuff sold. The people who bought extra stuff spent all their money, so they will not be buying anything more until next payday. So even though more stuff was sold on payday, less stuff will be sold until next payday. Purchases have not increased or decreased, only moved to a different day. But the stores don't know that yet.
Stores see that the amount of stuff sold on payday increased, but the stores do not know why. Stores do not know if the amount of stuff sold will continue to increase or will return to normal. Stores also do not know if other stores also saw an increase in the amount of stuff sold.
It is reasonable to do nothing or to wait and see when you don't know what is happening. So it would be reasonable for a store to do nothing in response to an unexplained increase in the amount of stuff sold.
However, entrepreneurs and businesspeople are predisposed to optimism. If you thought that your store was going to go bankrupt, you would never have opened the store in the first place. When a store sees an increase in the amount of stuff sold, the store wants to believe that the increase will continue. Also, many businesses believe that they provide better service than their competitors, and many businesses believe that their customers do not fully appreciate their superior service. If the amount of stuff sold increases, many stores will think the customers are finally realizing that we provide superior service, and the customers are buying from us instead of from our competitors, and we are selling more while our competitors are selling less.
If the stores do nothing, the stores will eventually discover that the amount of stuff sold returns to normal. Nothing else will happen, and the rumor that prices are going to increase will fade away.
However, if a store jumps to the conclusion that the increase in the amount of stuff sold is permanent, then that store will change its policies. The store might order more stuff to sell, might hire more salespeople, might enlarge the store, and might open more stores.
Since the stores are ordering more stuff to sell, the factories which supply the stores are also selling more stuff. Like the stores, the factories might jump to the conclusion that the increase in the amount of stuff sold is permanent, and might order more raw materials, might hire more workers, might enlarge the factories, and might build more factories.
Both the factories and the stores might raise prices to cover the costs of expansion.
Since both the factories and the stores are hiring more people, wages will rise.
Since wages are rising, stores and factories will raise prices. Also since wages are rising, workers will spend more money.
Since workers are spending more money, stores will sell more stuff.
Meanwhile, the people who did not believe the rumor that prices were going to rise see that prices are rising. Now they believe the rumor, and they rush to spend their money before prices rise any more, so stores sell even more stuff.
This causes stores to order more stuff from factories, which causes factories to hire more workers, which causes wages to rise, which causes workers to spend more money, which causes stores to sell more stuff.
And it all started with a rumor that prices were going to rise. But what actually caused the economic boom was a change in how rapidly people spend their paychecks, a change in the delay between when people receive money and when people spend money. The economy changed because peoples' behaviour changed.
Some people call this an inflationary spiral, but I don't see what is spiral about it. I prefer to call it a positive feedback loop.
A rumor that wages were going to increase would have the same effect as a rumor that prices were going to rise. A rumor that businesses were going to hire more workers would have the same effect.
If there was a rumor that prices were going to decrease, or that wages were going to decrease, or that businesses were going to lay off workers, then there would be the opposite effect. People who thought prices were going to fall would delay purchases because they would wait for prices to fall, so they would spend less money today. People who thought they were going to lose their jobs would reduce expenses to save money so they would have some money to spend even after they lost their jobs, so they would spend less money today. These people have not really reduced spending, they have delayed spending. But the stores don't know that yet.
The stores see that the amount of stuff sold has decreased, so the stores order less stuff from the factories, so the factories lay off workers, so the workers spend less money, so the stores sell less stuff.
In the real world, many people save money for months or years for a major purchase like a car or house. Some people borrow money to spend, which is equivalent to spending your paycheck before you receive your paycheck. So people can change the time of purchases by more than just a few days. People can change the time of purchases by months or even years.
Also in the real world, some people save money instead of spending the money. Money which is deposited in banks is lent to other people, who spend the money. A change in the delay between when people receive money and when people deposit the money in a bank has the same effect as a change in how rapidly people spend money. A change in the delay between when money is deposited in the bank and when the bank lends the money out has the same effect. A change in the delay between when a person or business borrows money from a bank and when the person or business spends the money has the same effect.
For example, during the great depression, many banks failed, many people lost the money they had deposited in the banks, and so people were reluctant to deposit money in banks. There was a large increase in the delay between when people received money and when people deposited the money in banks. This was one of the factors which amplified the depression.
For another example, during the 2008 financial crisis, banks became unwilling to make loans. There was a large increase in the delay between when people deposited the money in banks and when the banks loaned the money to other people or businesses.
If there was a rumor that investment returns were going to increase, people would rush to invest their money. The delay between when people receive money and when people invest the money would decrease, which would have the same effect as a rumor that prices were going to rise.
If there was a rumor that investment returns were going to decrease, people would be in less of a hurry to invest their money, so the delay between when people receive money and when people invest the money would increase, which would have the same effect as a rumor that prices were going to fall.
Investment mistakes have the same effect as a rumor that investment returns are going to decrease. For example, before the 2008 financial crisis, house prices rose. People saw that house prices were rising, and reduced the delay between when they received money and when they invested the money in houses. Banks saw that house loans were profitable, and reduced the delay between when the received money and when they loaned the money to people to buy houses. This caused demand for houses to increase, which causes house prices to increase. Rising house prices made it more profitable to build houses, so builders built more houses. This led to an oversupply of houses, which caused house prices to fall. Then people realized that they had made a mistake to invest so much in houses. Banks realized that they had made a mistake to invest so much in house loans. When people realized that they had made a mistake in investing so much in houses, they became confused. They were reluctant to buy houses, and did not know what else to spend or invest their money in. So they did nothing. So the time delay between when they received money and when they invested or spent the money increased. When banks realized that they had made a mistake in investing so much in house loans, they became confused. They were reluctant to lend money for houses, and did not know what else to lend money for. So they did nothing. So the time delay between when banks received money and when banks loaned money increaed.
Spend That Cash; by Daniel Fisher; Forbes magazine; March 30, 2009; page 40; discusses the relationship between the economic cycle and changes in the velocity of circulation.