What is the Velocity of Money?
The velocity of money is a measure of the rate of trade within an economy. It is the number of times that funds are transferred between different entities. The velocity of money also refers to how much a unit of cash is utilized in a specific period. In a nutshell, it’s the pace at which firms and consumers in an economy spend money together.
The ratio of a nation’s GDP to its M1 or M2 money supply is often used to calculate the velocity of money. The speed at which money is transferred is referred to in this context as “velocity.”
Recognizing the Speed of Money
The velocity of money may be a factor in determining how quickly people use it to pay for goods and services. It is employed to assist investors and economists in determining the strength and vibrancy of an economy. A strong, growing economy is often linked to high money velocity. Low money velocity is often linked to contractions and recessions.
The velocity of money is a tool used by economists to gauge how quickly money is spent in an economy on goods and services. It may be tracked in conjunction with other important economic indicators, including GDP, unemployment, and inflation, even if it is only sometimes a crucial one for assessing the state of the economy. The two elements of the velocity of money formula are the GDP and the money supply.
Higher relative money velocity economies are often more developed than others. Business cycles are also known to cause variations in the velocity of money. Money tends to move more quickly during economic expansions because firms and consumers are more willing to spend it. Money moves more slowly, and individuals and companies tend to be less inclined to pay when the economy declines.
The velocity of money may be connected with essential indicators since it is often associated with economic cycles. As a result, inflation and GDP typically increase the velocity of money. On the other hand, in a declining economy, it is often anticipated to decline as important economic indices such as GDP and inflation decline.
A Money Velocity Example
Imagine an economy where two people, A and B, each have $100 in cash. For $100, person A purchases an automobile from individual B. B currently has $200 in cash. Then, for $100, B buys a house from A. B then pays A an additional $100 for A’s assistance in adding a new building to their home. Now, Person A has $200 in cash. After that, Person B sells A a vehicle for $100, and both A and B get $100 in cash. Consequently, despite only having $100 each, both participants in the economy have transacted for $400.
Given the $200 money supply and the $400 in transactions, the velocity of money in this economy would be two (2). The velocity of money in an economy allows for this multiplication in the value of goods and services traded.
The Money Velocity Formula
The velocity of money is employed on a much broader scale as a measure of transactional activity for the whole population of a nation, even if the example above is somewhat simplified. This metric is often equivalent to the money supply turnover of an entire economy.
Economists usually use GDP for this application and M1 or M2 for the money supply. As a result, the velocity of the money equation is equal to GDP minus the money supply.
Velocity of Money=GDP/Money Supply
The velocity of money formula typically uses GDP as the numerator, while it is also possible to use gross national product, or GNP. GDP is a measure of an economy’s total output of goods and services. Economists usually find money velocity for M1 and M2 in the denominator.
The Federal Reserve defines M1 as the total amount of money the general public owns and transaction deposits made at depository institutions. Savings accounts, time deposits, and actual money market mutual funds are included in M2, a more comprehensive measure of the money supply. Additionally, the St. Louis Federal Reserve uses both M1 and M2 to monitor the quarterly velocity of money.
Money’s Speed and the Economy’s
Economists have differing views on the usefulness of the velocity of money as a gauge of inflationary pressures or, more precisely, the state of an economy. According to the “monetarists'” quantity theory of money, money velocity should remain constant in the absence of changing expectations but changes in the money supply may have an impact on expectations and, consequently, money velocity and inflation.
For instance, because more money is chasing the same amount of goods and services in the economy, an increase in the money supply should, in theory, result in a corresponding price rise. If the money supply is reduced, the reverse should occur. However, detractors contend that there is only a tenuous and tangential relationship between the money supply and inflation since prices are set in stone and the velocity of money is very flexible in the short run.
Empirically, the evidence points to a fluctuating velocity of money. Furthermore, there is variability in the link between money velocity and inflation. For instance, the rate of M2 money stock averaged around 1.9x from 1959 to the end of 2007, peaking at 2.198x in 1997 and falling to 1.653x in 1964.
In an attempt to counter the global financial crisis and deflationary tendencies, the Federal Reserve significantly increased the size of its balance sheet beginning in 2007, which resulted in a sharp decline in the velocity of money.
Money velocity peaked in the second quarter of 2017 at 1.435, and it was then steadily increasing until the COVID-19 pandemic-induced worldwide recession prompted significant U.S. Federal economic stimulus. The M2V was 1.100 after the second quarter of 2020, the lowest M2 money velocity measurement ever recorded. Three Elements Impacting the Speed of Money
Several things impact the velocity of money in an economy. These consist of:
- Money supply: The relationship between money velocity and money supply is inverse. The rate of economic transactions rises in tandem with the central bank’s growth in the money supply. Inflation might result from this.
- Consumer behavior: the actions of economic players have an impact on velocity as well. Transaction velocity decreases, and transaction tempo slows when customers prioritize conserving over purchasing. Money moves more quickly when customers prioritize spending.
- Payment methods: The availability of credit and electronic banking are two examples of monetary system characteristics that impact the velocity of money. The money rate tends to rise when transaction barriers are low and fall when spending becomes more difficult.
Why is money moving at a slower rate?
The Federal Reserve Bank of St. Louis reports that since the 2008 recession, the velocity of the M1 money supply has been continuously declining.
The consequences of the Great Recession and demographic changes have been blamed for much of that reduction. Many consumers were more motivated to save than ever as baby boomers neared retirement and family wealth significantly decreased.
Given that the Dodd-Frank Act raised banks’ reserve requirements and leverage ratios, federal regulations could also have had an impact. There needed to be more money moving about in the economy because these institutions had to retain a greater portion of their assets rather than lend or spend them.
There is no doubt that the COVID-19 epidemic is a contributing reason for the decreasing velocity of money. In 2020, the rate of capital saw a significant decline as a result of the stimulus payments in addition to the heightened economic uncertainty.
What Is Measured by the Velocity of Money?
The velocity of money, or the number of times an average dollar is exchanged over a year, is a measure of money flow in an economy. A high money velocity indicates a thriving economy with robust activity, while a low rate characterizes a widespread unwillingness to spend money.
How is the velocity of money calculated?
To calculate the velocity of money, divide the gross domestic product of a country by the total amount of money in circulation. The M1 money supply, which comprises fiat money, checkable deposits, and a few other items, or the M2 money supply, which also includes money market funds and savings accounts, may be used in this computation.
Why is money moving at such a slow pace?
The St. Louis Federal Reserve Bank estimated that during the first and second quarters of 2020, the velocity of money in the United States dropped significantly. While there is no conclusive reason, the reduction is likely owing to the lower activity sustained during the COVID-19 epidemic and an increase in consumer savings due to economic instability.
The Final Word
The velocity of money represents the pulse of an economy. It gauges the speed at which money is transferred between transactions. Money often moves quickly during prosperous times, reflecting a flurry of activity and numerous transactions. The velocity decreases during a recession, suggesting that customers are less inclined to purchase or engage in other financial activities.
Conclusion
- The rate at which money is traded within an economy is measured as the velocity of money.
- Using the velocity of money equation, divide GDP by the money supply.
- The velocity of the money formula indicates the rate at which commodities and services are exchanged for one unit of money or currency in an economy.
- Growing economies generally have incredible money velocity, whereas collapsing economies have lower money velocity.
