Velocity of Money: Definition, Formula, and Examples

what is the velocity of money?

The velocity of money is how often each unit of currency, such as the U.S. dollar or euro, is used to buy goods or services during a period. The Federal Reserve describes it as the rate of turnover in the money supply. Economies that exhibit a higher velocity of money relative to others tend to be more developed. The velocity of money is also known to fluctuate with business cycles.

It represents the number of times a unit of currency is used to purchase goods and services during a specific time frame, typically a year. GDP is usually used as the numerator in the velocity of money formula though gross national product (GNP) may also be used as well. GDP represents the total amount of goods and services in an economy that are available for purchase.

In the denominator, economists will typically identify money velocity for both M1 and M2. Economists use the velocity of money to measure the rate at which money is used for goods and services in an economy. While it is not necessarily a key economic indicator, it can be followed alongside other key indicators that help determine economic health like GDP, unemployment, and inflation. GDP and the money supply are the two components of the velocity of money formula.

  1. Money velocity appeared to have bottomed out at 1.435 in the second quarter of 2017 and was gradually rising until the global recession triggered by the COVID-19 pandemic spurred massive U.S.
  2. As a result of these policies, banks’ excess reserves rose from $1.8 billion in December 2007 to $2.7 trillion in August 2014.
  3. GDP is usually used as the numerator in the velocity of money formula though gross national product (GNP) may also be used as well.
  4. Almost everyone saw their net worth plummet along with the stock market and housing prices.

Neither M1 nor M2 includes financial investments (such as stocks, bonds, or commodities) or home equity or other assets. These financial assets must first be sold before they can be used to buy anything. The velocity of the M1 money supply has steadily decreased since the recession of 2008, according to figures from the Federal Reserve Bank of St. Louis. The CBO says debt level forecasts aren’t looking good, the FED can’t lower rates past zero (basic math), and in general, there is a long list of problems most respectable experts agree on.

The velocity of money

It measures how quickly money changes hands from one transaction to another. During times of prosperity, the velocity of money tends to be high, indicating bustling activity and frequent transactions. During an economic downturn, the velocity slows, indicating that consumers are less willing to spend money or make transactions.

Banks had even more reason to hoard their excess reserves to get this risk-free return instead of lending it out. Banks don’t receive a lot more in interest from loans to offset the risk. Banks have little incentive to lend when the return on their loans is low.

Federal regulations may have also played a role, as the Dodd-Frank Act increased the reserve requirements and leverage ratios for banks. Because these institutions were required to keep more of their assets, rather than lend or spend them, there was less money to move in the economy. For this application, economists typically use GDP and either M1 or M2 for the money supply. Therefore, the velocity of money equation is written as GDP divided by money supply.

what is the velocity of money?

Of course, if we simply stop shopping at the big box store, some lose their jobs, and this can result in a slowdown in spending as well. Many people lost their homes, their jobs, or their retirement savings. Those who didn’t were too scared to buy anything more than what they really needed.

Why Does Velocity of Money Matter?

The velocity of money is a key concept that helps us understand the speed at which money changes hands within a given period of time. By exploring the definition, formula, and examples of velocity of money, we can gain valuable insights into the dynamics of an economy. Gross domestic product (GDP) measures everything produced by all the people and companies within a country’s borders. Nominal GDP measures this output without adjusting for inflation. To calculate the velocity of money, you must use nominal GDP because the measure of the money supply also does not account for inflation.

what is the velocity of money?

The Dodd-Frank Bank Reform and Consumer Protection Act allowed the Fed to require banks to hold more capital. That meant banks continued to hold excess reserves instead of extending more credit through loans. The Fed pays banks interest on money it “borrows” from them overnight.

Solutions For Increasing Velocity of Money

The determinants and consequent stability of the velocity of money are a subject of controversy across and within schools of economic thought. For an economy to stay healthy, money needs to change hands at a steady frequency. Every dollar traded represents either prices or products produced, and that equates directly to jobs, wealth, and even our credit rating. The velocity of money played an important role in monetarist thought. For example, monetarists argued that there exists a stable demand for money (as a function of aggregate income and interest rates).

Velocity of Money

Consider an economy consisting of two individuals, A and B, who each have $100 of money in cash. Then B purchases a home from A for $100 and B enlists A’s help in adding new construction to their home and for their efforts, B pays A another $100. Individual B then sells a car to A for $100 and both A and B end up with $100 in cash. Thus, both parties in the economy have made transactions worth $400, even though they only possessed $100 each. Generally, there is wisdom in both “letting the market correct itself” and lightly guiding the market to ensure a steady economic growth and the right balance of debt and credit. The ideal solutions likely lay somewhere in the middle and require some high-level economics, diplomacy, ethics, and lots of political capital to get get moving.

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 Fed lowered the fed funds rate to zero in 2008 and kept them there until 2015. It sets the rate for short-term investments like certificates of deposit, money market funds, or other short-term bonds. Since rates are near zero, savers have little incentive to purchase these investments. Instead, they just keep it in cash because it gets almost the same return for zero risk. The velocity of money estimates the movement of money in an economy—in other words, the number of times the average dollar changes hands over a single year.

It means families, businesses, and the government are not using the cash on hand to buy goods and services as much as they used to. Instead, they are hoarding it, investing it, or using it to pay off debt. Empirically, data suggests that the velocity of money is indeed variable.

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