What is the velocity of money?
The velocity of money is a measure of the rate at which money is exchanged in an economy. It is the number of times that money moves from one entity to another. It also refers to how much a unit of currency is used in a given period of time. Simply put, it is the rate at which consumers and businesses in an economy collectively spend money.
The velocity of money is generally measured as a ratio of gross domestic product (GDP) to a country’s M1 or M2 money supply.
Understand the speed of money
The speed of money is important in measuring the rate at which money in circulation is used to buy goods and services. It is used to help economists and investors assess the health and vitality of an economy. The high velocity of money is generally associated with a healthy and expanding economy. The slow speed of money is generally associated with recessions and contractions.
The velocity of money is a metric calculated by economists. Shows the rate at which the transaction of money for goods and services takes place in an economy. While it is not necessarily a key economic indicator, it can be followed in conjunction with other key indicators that help determine economic health such as GDP, unemployment, and inflation. GDP and money supply are the two components of the formula for the velocity of money.
Economies that exhibit higher speed of money relative to others tend to be more developed. The velocity of money is also known to fluctuate with business cycles. When an economy is expanding, consumers and businesses tend to spend money more easily, which increases the speed of money. When an economy shrinks, consumers and businesses are often more reluctant to spend and the velocity of money is slower.
Since the velocity of money is usually correlated with business cycles, it can also be correlated with key indicators. Therefore, the velocity of money will generally increase with GDP and inflation. Alternatively, it is generally expected to decline when key economic indicators such as GDP and inflation are falling in a contracting economy.
- The velocity of money is a measure of the rate at which money is exchanged in an economy.
- The equation for the velocity of money divides GDP by the money supply.
- The speed of money formula shows the rate at which a unit of money supply is transmitted for goods and services in an economy.
- The velocity of money is usually higher in expanding economies and slower in contracting economies.
Speed of money example
Consider an economy consisting of two individuals, A and B, who each have $ 100 of cash. Individual A buys a car from Individual B for $ 100. Now B has $ 200 in cash. Then B buys a house from A for $ 100 and B enlists A’s help in adding new construction to his house and, for his efforts, B pays A another $ 100. Individual A now has $ 200 in cash. Individual B then sells a car to A for $ 100 and both A and B end up with $ 100 in cash. Thus, both parts of the economy have transacted $ 400 worth, even though they only owned $ 100 each.
In this economy, the velocity of money would be two (2) resulting from the $ 400 in transactions divided by the $ 200 in money supply. This multiplication of the value of the goods and services exchanged is possible thanks to the speed of money in an economy.
The speed of money formula
While the above provides a simplified example of the velocity of money, the velocity of money is used on a much larger scale as a measure of transactional activity for the population of an entire country. In general, this measure can be considered as the turnover of the money supply of an entire economy.
For this application, economists typically use GDP and M1 or M2 for the money supply. Therefore, the equation for the velocity of money is written as GDP divided by the money supply.
Speed of money = GDP ÷ Money supply
GDP is generally used as the numerator in the formula for the velocity of money, although gross national product (GNP) can also be used. GDP represents the total amount of goods and services in an economy that are available for purchase. In the denominator, economists often identify the velocity of money for both M1 and M2.
The Federal Reserve defines M1 as the sum of all currency held by the public and transaction deposits at depository institutions. M2 is a broader measure of the money supply, aggregating savings deposits, time deposits, and real money market mutual funds. In addition, the St. Louis Federal Reserve tracks the quarterly velocity of money using both M1 and M2.
Speed of money and the economy
There are differing opinions among economists on whether the velocity of money is a useful indicator of the health of an economy or, more specifically, inflationary pressures. Monetarists who subscribe to the quantity theory of money argue that the velocity of money should be stable in the absence of changing expectations, but a change in the money supply can alter expectations and therefore the velocity of money and inflation.
For example, an increase in the money supply should theoretically lead to a proportional increase in prices because there is more money chasing the same level of goods and services in the economy. The opposite should happen with a decrease in the money supply. Critics, on the other hand, argue that in the short term, the velocity of money is highly variable and prices are resistant to change, resulting in a weak and indirect link between money supply and inflation.
Empirically, the data suggest that the velocity of money is variable. Furthermore, the relationship between the velocity of money and inflation is also variable. For example, from 1959 to the end of 2007, the velocity of the M2 money stock averaged about 1.9x with a high of 2,198x in 1997 and a low of 1,653x in 1964.
Since 2007, the velocity of money has fallen dramatically as the Federal Reserve vastly expanded its balance sheet in an effort to combat the global financial crisis and deflationary pressures.
The velocity of money appeared to have bottomed out at 1,435 in the second quarter of 2017 and gradually increased until the global recession triggered by the COVID-19 pandemic spurred a massive federal economic stimulus from the US at the end of the second quarter of 2020. , the M2V was 1,100, the lowest M2 money velocity reading in history.
Speed of money: my favorite financial term