Loading the player...

What is the 'Velocity Of Money'

The velocity of money is the rate at which money is exchanged 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.

BREAKING DOWN 'Velocity Of Money'

Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle and should have a higher rate of inflation — all things held constant.

Simply put, 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.

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.

  1. Equation Of Exchange

    An economic equation that showcases the relationship between ...
  2. M2

    A measure of money supply that includes cash and checking deposits ...
  3. Monetarism

    Monetarism is a set of views based on the belief that the total ...
  4. Monetarist

    A monetarist is someone who believes an economy should be controlled ...
  5. Broad Money

    Broad money is an economics term that represents the calculation ...
  6. Monetarist Theory

    The monetarist theory is a concept which contends that changes ...
Related Articles
  1. Investing

    Velocity of Money: My Favorite Financial Term

    Michael Kramer, Founder of Mott Capital Management, shares his favorite financial term.
  2. Insights

    Monetarism: Printing Money To Curb Inflation

    Learn how Milton Friedman's monetarist views shaped economic policy after World War II.
  3. Personal Finance

    5 Mistakes You're Making With Money Market Accounts

    Money market accounts can be helpful "parking spots" for investors. Here are five key things to keep in mind when opening an account.
  4. Investing

    The Pros and Cons of Money Market Funds

    Find out whether socking your money away in these accounts will stand up to the test of time.
  5. Trading

    Overbought Or Oversold? Using The RSI To Find Out

    The Relative Strength Index is a technical indicator that measures the velocity and magnitude of changes in a stock’s price.
  6. Insights

    Understanding How the Federal Reserve Creates Money

    Read about how the Federal Reserve actually targets and creates new money in the economy, and find out why the savings and loans system magnifies this process.
  7. Investing

    Get A Short-Term Advantage In The Money Market

    This investment vehicle is often the perfect stop-gap measure for growing your money.
  8. Insights

    How Central Banks Control the Supply of Money

    A look at the ways central banks pump or drain money from the economy to keep it healthy.
  1. What happens when M2 money supply grows faster than the overall economy?

    Find out what happens if the total supply of money and money substitutes expands at a faster rate than the productive output ... Read Answer >>
  2. What types of money are included in money supply?

    Read about several different monetary aggregates used to define the money supply, both at the Federal Reserve and by outside ... Read Answer >>
  3. How do changes in interest rates affect M2?

    Learn about the effects of changes in interest rates on M2. M2 includes M1 and other less-liquid short-term investments that ... Read Answer >>
  4. Why do Bitcoins have value?

    Performing with transactional anonymity, Bitcoin has value as a private digital currency, investment tool and social networking ... Read Answer >>
  5. What are the risks involved in keeping my money in a money market account?

    Setting aside funds in a money market account can be a safe investment strategy, but investors should be aware of the risks ... Read Answer >>
  6. How does a government raise the economy's money supply?

    Learn about methods the government uses to expand the money supply and how it can loosen money by raising interest rates ... Read Answer >>
Hot Definitions
  1. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  2. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  4. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  5. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center