What is the Velocity of Money
The velocity of money is the rate at which money is exchanged in an economy. It is the number of times that money moves from one transaction to another. It also refers to how much a unit of currency is used in a given period of time. Simply put, it's the rate at which people spend money. The velocity of money is usually measured as a ratio of gross national product (GNP) to a country's total supply of money.
Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services, as this helps investors gauge how robust the economy is, and is a key input in the determination of an economy's inflation calculation.
Velocity of Money: My Favorite Financial Term
Basics of Velocity of Money
The velocity of money can be thought of as the turnover of the money supply. For this application, economists use broad measures of money supply: M1 or M2. M1 is defined by the Federal Reserve as the sum of all currency held by the public and transaction deposits at depository institutions. M2 adds in savings deposits, time deposits and real money market mutual funds.
Example of Velocity of Money
Consider an economy consisting of two individuals, A and B, who have $100 each. A buys a car from B for $100. Then B purchases a home from A for $90. B has kids and enlists A's help in adding new construction to his home. For his efforts, B pays A $100. A also sells the car he bought from B back to him for $90. Thus, both parties in the economy have made transactions worth $400, even though they only possessed $100 each. This multiplication in the value of goods and services exchanged is made possible through the velocity of money in an economy.
How to Calculate the Velocity of Money
There's a simple formula used to calculate the velocity of money:
V = PQ/M
- V = velocity of money
- PQ = Nominal GDP, which measures the goods and services purchased
- M = total, average amount of money in circulation in the economy
Velocity of Money & the Economy
There are differing views among economists as to whether the velocity of money is a useful indicator of the health of an economy or, more specifically, inflationary pressures. The "monetarists" who subscribe to the quantity theory of money argue that money velocity should be stable absent changing expectations, but a change in money supply can alter expectations and therefore money velocity and inflation. For example, an increase in the money supply should theoretically lead to a commensurate 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 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, data suggest that the velocity of money is indeed variable. Moreover, the relationship between money velocity and inflation is also variable. For example, from 1959 through the end of 2007, the velocity of M2 money stock averaged 1.86x with a maximum of 2.21x in 1997 and a minimum of 1.66x in 1964. Since 2007, however, the velocity of money has fallen dramatically as the Federal Reserve greatly expanded its balance sheet in an effort to combat the global financial crisis and deflationary pressures. As of the first quarter of 2016, M2 velocity was just 1.46x — the lowest reading since it bottomed out at 1.15x during the Great Depression. Over the past 20 years, the correlation between M2 and core inflation in the United States is about 0.3, and there were periods in the 1990s when the relationship was actually negative, which is the exact opposite outcome as theorized by the monetarists.
- Velocity of money is the rate at which money is exchanged in an economy.
- The rate of velocity of money is variable, meaning it is difficult to derive between its value and inflation.