What is the velocity of money?
Simply defined the velocity of money is the turnover in the money supply. A shop owner can measure how fast his inventory is selling by calculating “inventory turnover.” To do that he simply calculates Total Sales ÷ Average Inventory for the period in question. See: Inventory TurnOver for more information.
But if you expand the idea of turnover to the entire country you get the “Velocity of Money”.
Strictly speaking all the velocity of money tells us is how long people hold onto their money. But from that we can infer their motives and perceptions of the economy in general…
Velocity of Money Calculation
To Calculate the Velocity of Money you simply divide Gross Domestic Product (GDP) which is the total of everything sold in the country by the Money Supply. Thus Velocity of Money= GDP ÷ Money Supply. Now there is some debate about the proper measurement of the money supply. The most most restrictive measure of money supply is M1 which basically includes short term money i.e. money that is available immediately. So that would be cash and checking accounts, NOW accounts and demand deposits i.e. money you can get your hands on immediately.
There is a good argument that this is the best measure of velocity of money because you want to look for an increase in the cash people are looking to hold. If people are fearful of the economy they want to hold Cash or cash equivalents. They aren’t going to put money in a CD or long term holding. They want it readily available. So that if they lose their job or run into a credit crunch they will have the cash they need to continue living their lives.
In the chart below we see the velocity of money using the M1 money supply. The grey shaded areas are official recessions and you can see that during these periods the velocity of money is shrinking. Interestingly during those periods GDP and the money supply itself can also be shrinking. The GDP of course might shrink because demand for goods decreases due to people holding onto their money longer. But as people default on their debts or pay them off the money supply itself might shrink but that would probably be longer term money rather than M1 so that is another reason why using M1 might be the best indicator. See How Wealth Can Simply Evaporate for more information.
Velocity of Money Chart:
Back in April of 2010, I wrote Velocity of Money and Money Multiplier – Why Deflation Is Possible
During that time we were at the bottom of the slide in the velocity of money chart and leaving the official recession and entering into a slight increase in the velocity of money. But as you can see from the chart from the St. Louis Federal Reserve Bank the velocity of money has been falling again, indicating that we may never have left the recession or if we did, it is possibly resuming again.
What Does the Velocity of Money Tell Us?
Strictly speaking all the velocity of money tells us is how long people actually hold onto their money. But from that we can infer their motives and perceptions of their personal finances and on a broader scale the economy in general.
If people are fearful for their jobs they will want to hold more cash and thus the velocity of money will fall. If on the other hand, they feel “flush with cash” they will spend it faster. But there are other reasons people spend cash quickly. The primary one is that they fear inflation. So rather than feeling rich, a high velocity may also indicate a fear of the value of their money depreciating quickly. A perfect example of this would be during the Hyperinflation in Weimar Germany between 1921 and 1923. During this time inflation got so bad that people would pay for their meal before the meal because if they waited until the end it would cost more. This is the ultimate in money velocity where people rush out to spend the money because holding it for a few minutes longer might cause it to lose additional value.
What Can We Tell From the Current Falling Velocity of Money?
First of all, we can tell that the economy is not rebounding. In 2009 the velocity of money picked up a little bit. People were convinced that the recession was over and the economy would improve and so they began to spend a little bit more. This could have been the result of the QE1 stimulus. Not much in exchange for a Trillion dollars worth of debt. But the current fall indicates that people are not convinced that the recession is over and that they would once again rather hold cash than spend it. It also indicates that people are not afraid of inflation, at least in the short term they still want to hold onto their cash.
A similar idea in business is called Inventory Turnover Ratio.
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