The velocity of money is an economic metric that tracks the speed and rate at which money travels through the wider economy. In simple terms it tracks the number of times that money shifts from one entity to another, and also how much a unit of currency is used over a specific time frame. By gathering this data, the velocity of money indicates the rate at which individuals and businesses within an economy are collectively spending their money. It is usually calculated as a ratio of the GDP of a country to its M1 or M2 money supply.
M1 is defined by the Federal Reserve as the sum of all currency held by individual members of the public as well as deposits in institutions. M2 is a wider measure, which also includes money in savings accounts as well as real money market mutual funds.
How the velocity of money is used
Economists and investors use the velocity of money as a yardstick to gauge the overall health and vitality of an economy. When the velocity of money is high, the economy is usually active and expanding, while low velocity of money generally indicates a period of contraction or recession. This metric is used alongside others such as unemployment and inflation to understand the general state of an economy.
How the velocity of money works in practice
The principles of the velocity of money can be simplified to exchanges between two individuals treated as a closed economy. Within this economy each individual has $100. Person X buys a bicycle from Person Y for $100, and then Person Y buys a car from Person X for $100. Later, Person Y decides to remodel their home and pays Person X $100 to help with the project, after which Person X sells Person Y $100 worth of furniture. In this scenario the economy of X and Y has made transactions worth $400 even though they only had $100 each.
The velocity of money in this case would be $400 worth of transactions divided by $200 in the money supply, giving a figure of 2. The difference between the money in the economy –$200 – and the value of transactions – $400 – is made possible by the velocity of money.
The velocity of money formula
Although the example above is simplified, it sets out the basic mechanics of the velocity of money. When applied to the economy of an entire country, the calculation used represents the turnover of money throughout that economy. It is set out as follows:
Velocity of Money = GDP ÷ Money Supply
In this formula, GDP represents the total amount of goods and services available to purchase within an economy, while the money supply is usually calculated using M1 and M2.
How useful is the velocity of money?
Economists differ over the usefulness of the velocity of money as a measure of the state of an economy. Some argue that any change in the money supply can impact directly on the velocity of money and inflation, while others downplay the importance of the money supply and the velocity of money, arguing that the link between the two is indirect and fairly weak, due to the short-term volatility of the velocity of money. A study of the data shows that the link between the velocity of money and inflation is actually highly variable.
The velocity of money in recent years
The global financial crash of 2007–08 saw the Federal Reserve pump money into the economy in an effort to stave off the threat of a financial crisis. During this period the velocity of money in the economy hit its lowest point in 2017 at 1.435, after which it was gradually rising until the economic shutdown triggered by the COVID-19 pandemic occurred. By the second quarter of 2020 the velocity of money based on the M2 money supply was 1.104, the lowest it had ever been.
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