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Thesis: Money velocity measures how well economies are doing, consumer sentiment, and the inflation rate. Economic policy can be determined by money velocity. Yet, sometimes it can be completely pointless.

If you haven’t read my Economics Primer, I’d highly recommend it before reading this article as some of the terminology associated with this subject may be difficult to understand.

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Credit Richard Duncan Economics

Money Velocity

Money velocity is a cool concept I heard about in one of my economic classes that I thought would be interesting to dive further into.

So, let’s start with the basics and then build up to some critical economic monetary policy basics.

What is money velocity?

Investopedia explains money velocity as the following:

The velocity of money is a measurement 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. The velocity of money 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 consumers and businesses in an economy collectively spend money.

Paraphrased simply, money velocity refers to the number of times that a unit of currency is used to purchase goods and services within a given time period. It could also be referred to as the turnover rate of currency through an economy.

But what does that mean in actuality?

Let’s take an extreme example of $10 over the course of one day. You wake up in the morning to a fresh $10 bill, ready to be spent that day. On your way to work, you spend that $10 on a coffee. Luckily, the coffee shop owner needed some cash to pay for his next round of gambling at the casino next door. After losing all of his money playing roulette, the coffee shop owner went back to work. The casino owner wanted some ice cream so he sent his assistant to the store to buy 2 tubs of ice cream with the $10 bill. The grocery store manager wanted to surprise his daughter with a new baby chick for their farm, so he drove right over to the local farming store to buy a new baby chick with his $10 bill. The farm store owner had been working all day and needed a bite to eat for dinner, so he took that $10 bill to the local McDonald’s and bought a burger. The McDonald’s owner kept the $10 for the rest of the day.

Let’s relate this wild story back to money velocity. Each transaction is detailed below:

• We started with $10
• Transaction 1: $10 from you to the coffee shop owner
• Transaction 2: $10 from the coffee shop owner to the casino owner
• Transaction 3: $10 from the casino owner to the grocery store manager
• Transaction 4: $10 from the grocery store manager to the farm store owner
• Transaction 5: $10 from the farm store owner to the McDonald’s owner
• The McDonald’s owner ended with the $10.

So, if we sum up the value of all of the transactions that occurred over the course of the day, that $10 bill created $50 in transactions.

That $50 is possible because the $10 bill was spent on new goods and services 5 times in one day, that is to say, the velocity was 5/day ($50 divided by $10).

Credit Bankrate

Okay, that’s cool, but why should I care?

The velocity of money measures how many times money is changing hands. So, it can be directly related to measuring the size of economic activity. For instance, if money is changing hands more often, you would expect that the economic activity in that area is increasing.

Put another way, if the velocity of money is increasing, more transactions are happening, more people are buying things, which all signal a healthy economy.

Ultimately, the velocity of money is useful as a variable to help determine inflation and GDP.

Credit FRED

How does money velocity factor into GDP?

Gross domestic product (GDP) is a measure of the market value of all final goods and services produced by a country over a certain period of time, usually a year. It’s often used to measure the size of a country’s economy.

Thinking back to our money velocity concept, $1 cash doesn’t always equate to $1 GDP. In some instances, it will. If you put $1 in a safety deposit box in a bank for a year, it will not impact GDP as nothing was produced. But if, instead, you spent that $1 to buy a candy bar and then that $1 bill was put into a safety deposit box for a year, that $1 would add $1 to the GDP for that year.

I hope you see where I’m going. Neither of these answers is truly the case as $1 bills usually get spent more than 1 time over the course of a year.

Let’s start putting numbers to it.

The total value of United States currency (dollars) in circulation currently is around $2.26T. Yet the United States GDP is around $25.44T. It’s infinitely more complicated than this in practicality, but for our theoretical purposes, this would mean each dollar gets spent approximately 11.25 times over the course of a year.

That would mean if you paid for a product or service on January 1st, by December 31st, that dollar would have been used, on average, a little more than 11 times, most likely by 11 different people.

Credit Forbes

How does money velocity relate to the health of an economy?

Money velocity is the measure of how many times a piece of currency is spent over a time period.

So, if the money velocity increases, what does that mean? That would mean pieces of currency, on average, are being spent more times over that time period. This is generally associated with a healthy, growing economy. In contrast, a country with low money velocity may be experiencing a decline or a recession.

Furthermore, economies that have higher money velocity tend to be more developed. Why is that? Generally, with a more developed country comes more options to spend your money and more convenience. That isn’t always the case but hopefully it at least makes a little intuitive sense.

Credit WSJ

What factors influence the velocity of money?

The supply of money directly influences the velocity of money. As it is the denominator of the money velocity equation, any changes in the amount of money in an economy will directly change the velocity of money in that economy. If the amount of money in an economy increases, the velocity of money will decrease, and vice versa. This factor is determined by the central bank of the country which is in charge of monetary policy decisions.

Consumer behavior also directly affects money velocity. If consumers prioritize saving over spending, money velocity will decrease. This scenario is usually associated with inflation. When consumers prioritize spending, the velocity of money speeds up.

Money velocity is also affected by the payment infrastructure present in a country. If there is more availability of modern ways to pay for and transfer money, the ability to spend money more often is increased. So, we would expect countries with adequate electronic banking systems to have higher money velocities than cash-based societies.

Quantitative easing, when governments purchase assets from the banks and consumers in exchange for cash, increases the money supply in the economy and makes it easier for banks to lend money, hopefully increasing money velocity and spurring economic growth.

Austerity measures are when a government reduces its spending and increases tax revenues to hopefully avoid a national debt crisis. These measures can directly affect money velocity as they signal slower economic growth and potential economic volatility, meaning consumers may vary their spending habits significantly.

High interest rates encourage increased saving, reducing money velocity. In contrast, lower interest rates encourage borrowing and spending, leading to increases in money velocity.

Credit SignatureFD

Is money velocity a perfect indicator?

Money velocity is far from perfect and has many skeptics.

For instance, the “monetarists”, who believe in the quantity theory of money, argue that money velocity should be stable without changes in expectations. A change in the money supply can alter expectations and therefore alter money velocity and inflation.

An example of this would be the thought that an increase in the supply of money would lead to a somewhat equal increase in prices. Why? There would be more money in the economy but the same amount of products, so it would make sense that those products would cost more money.

Critics of monetarism argue that the assumption that there’s a direct relationship between money supply and inflation ignores the real volatility of economic conditions. Yes, there is a link between money supply, money velocity, and inflation, but it’s unclear at this point if it’s simply that easy.

What is the money velocity equation?

The most popular equation for money velocity is below:

Where

• M stands for the amount of money in the economy
• V stands for the velocity of money
• P stands for the average price level
• Q stands for the quantity of goods and services produced in an economy

The idea of this equation is that the number of goods and services in an economy multiplied by the average price is roughly equal to the GDP of that economy. Dividing GDP by the money in circulation in that economy produces money velocity.

Where this gets more interesting is when you rewrite the equation into MV = PQ.

In this circumstance, you can see how if the amount of money in the economy increases while money velocity stays the same, either the average price or the quantity of goods and services has to increase likewise.

If you, instead, only use the equation MV = GDP of a country, you can gain insights on a country’s economic outlook. For instance, if you assume that money velocity is relatively stable, you can simply multiply the money velocity by the supply of currency in the market to get an estimated GDP for that country.

Economists mainly have debates concerning money velocity about the stability of the current velocity. If the velocity is stable, then money can become a very powerful tool for tracking economic growth and development. If money velocity is unstable, then the value of money velocity as a metric to track economic growth and development becomes significantly diminished.

Credit Credit Karma

Takeaways

Will learning about money velocity change your life? Absolutely not.

Is it cool? I think so.

To end, I’ll cite a quote by Henry Ford and then a quote by James Avery:

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

- Henry Ford

Monetary success is not success. Career success is not success. Life, someone that loves you, giving to others, doing something that makes you feel complete and full. That is success. And it isn't dependent on anyone else.

- James Avery

Anywho, that’s all for today.

-Drew Jackson