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What Is the Velocity of Money?
Let me explain the velocity of money directly: it's the rate at which money gets exchanged in an economy. You can think of it as how many times a single unit of currency moves from one person or business to another over a set period. In simple terms, it's about how fast consumers and companies spend money collectively.
We usually measure it as a ratio of gross domestic product (GDP) to the country's M1 or M2 money supply. The term 'velocity' here just means the speed of these money handoffs.
Key Takeaways
Velocity of money tracks how fast money moves in an economy. It's higher in growing economies and lower when things are shrinking. Economists calculate it by dividing GDP by the money supply.
Understanding the Velocity of Money
You should know that velocity of money helps measure how actively money in circulation is used to buy goods and services. Economists and investors like me use it to assess an economy's health. When velocity is high, it points to a strong, growing economy. Low velocity often means recessions or slowdowns.
It's not a top economic indicator on its own, but track it with things like GDP, unemployment, and inflation. The formula relies on GDP and money supply. More developed economies tend to have higher velocity, and it follows business cycles—up in expansions when spending is easy, down in contractions when people hold back.
Velocity also ties to indicators like GDP and inflation, rising with them in good times and falling in bad.
Example of Velocity of Money
Here's a straightforward example to show you how it works. Imagine two people, A and B, each starting with $100. A buys a car from B for $100, so B now has $200. Then B buys a home from A for $100 and pays A another $100 for construction help. A ends up with $200, then B sells A another car for $100, leaving both with $100.
In total, they've transacted $400 worth, but only had $200 in money supply. So the velocity is two—$400 divided by $200. This shows how velocity multiplies economic activity.
The Velocity of Money Formula
On a bigger scale, velocity measures turnover for a whole economy's money supply. We use GDP divided by money supply, often M1 or M2. GDP is the total goods and services available; sometimes GNP is used instead.
M1 includes public currency and transaction deposits. M2 adds savings, time deposits, and money market funds. The St. Louis Fed tracks this quarterly.
Velocity of Money and the Economy
Economists debate if velocity is a solid indicator for economic health or inflation. Monetarists say it's stable unless expectations change, and money supply shifts can affect it and inflation. More money supply might raise prices since more cash chases the same goods.
Critics point out velocity varies short-term, and prices don't change easily, so the link to inflation is weak. Data shows it's variable; M2 velocity averaged 1.9x from 1959 to 2007, peaked at 2.198x in 1997, bottomed at 1.653x in 1964.
It dropped sharply after 2007 with Fed actions against the financial crisis, hit 1.435 in 2017, then 1.128 in 2020 due to COVID stimulus, and has risen slowly since.
Factors Affecting the Velocity of Money
Several things impact velocity. Money supply is key—it's inversely related; more supply from the central bank speeds up transactions, possibly causing inflation. Consumer behavior matters too: saving slows velocity, spending speeds it.
Payment systems affect it—if credit or electronic banking is easy, velocity rises; barriers slow it down.
Why Is the Velocity of Money Slowing Down?
M1 velocity has dropped since 2008, per St. Louis Fed data. Blame demographics and the Great Recession—baby boomers saving for retirement, reduced wealth pushing savings. Regulations like Dodd-Frank raised bank reserves, limiting lending and money movement.
COVID-19 caused a sharp drop in 2020 from uncertainty and stimulus, but it's edged up since 2021.
Frequently Asked Questions
What does velocity of money measure? It estimates how money moves in an economy—the times an average dollar changes hands yearly. High means strong activity; low means reluctance to spend.
How do you calculate it? Divide GDP by money supply, using M1 or M2.
Why is it so low? It fell in 2020 from COVID shutdowns and savings spikes, but has risen a bit since 2021.
The Bottom Line
Velocity of money is like an economy's heartbeat, showing how fast money changes hands. It speeds up in good times with lots of transactions and slows in downturns when spending drops.
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