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Velocity of Money Definition Formula and Examples

Velocity of Money Definition Formula and Examples

Velocity of Money: Definition, Formula, and Examples

What Is the Velocity of Money?

The velocity of money is a measurement of the rate at which money is exchanged in an economy. It is the number of times money moves from one entity to another. The velocity of money also refers to how much currency is used in a given period of time. Simply put, it’s the rate at which consumers and businesses collectively spend money.

The velocity of money is usually measured as a ratio of gross domestic product (GDP) to a country’s M1 or M2 money supply. The word velocity is used here to reference the speed at which money changes hands.

Key Takeaways

– Velocity of money is a measurement of the rate at which money is exchanged in an economy.

– The velocity of money equation divides GDP by money supply.

– The velocity of money formula shows the rate at which one unit of money supply currency is being transacted for goods and services in an economy.

– The velocity of money is typically higher in expanding economies and lower in contracting economies.

Understanding the Velocity of Money

The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Economists and investors use it to gauge the health and vitality of an economy. High money velocity is usually associated with a healthy, expanding economy, while low money velocity is associated with recessions and contractions.

Economists use the velocity of money to measure the rate at which money is used for goods and services in an economy. While not necessarily a key economic indicator, it can be followed alongside other indicators like GDP, unemployment, and inflation. GDP and the money supply are the two components of the velocity of money formula.

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Economies with a higher velocity of money tend to be more developed. The velocity of money also fluctuates with business cycles. During expansions, the velocity of money increases as consumers and businesses spend more. During contractions, the velocity of money decreases as spending decreases.

Since the velocity of money is correlated with business cycles, it is also correlated with key indicators. It usually rises with GDP and inflation, and falls when GDP and inflation decline in a contracting economy.

Example of Velocity of Money

Consider an economy consisting of two individuals, A and B, who each have $100 in cash. A buys a car from B for $100. Now B has $200 in cash. Then B purchases a home from A for $100 and pays A another $100 for their help in adding new construction. Now A has $200 in cash. B sells a car to A for $100, and both have $100 in cash. Thus, both parties have made transactions worth $400, even though they only possessed $100 each.

In this economy, the velocity of money would be two (2) from the $400 in transactions divided by the $200 in money supply. The value of goods and services exchanged is made possible through the velocity of money.

The Velocity of Money Formula

While the above provides a simplified example, the velocity of money is used on a larger scale as a measure of transactional activity for an entire country. Economists typically use GDP and either M1 or M2 for the money supply. The velocity of money equation is GDP divided by the money supply.

Velocity of Money = GDP Money Supply

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GDP is usually used as the numerator in the velocity of money formula, though gross national product (GNP) may also be used. GDP represents the total goods and services available for purchase. Economists consider both M1 and M2 for money velocity.

M1 is all currency held by the public and transaction deposits at depository institutions. M2 is a broader measure, including savings deposits, time deposits, and real money market mutual funds. The St. Louis Federal Reserve tracks the quarterly velocity of money using both M1 and M2.

Velocity of Money and the Economy

There are differing views among economists regarding whether the velocity of money is a useful indicator of an economy’s health or inflationary pressures. Monetarists argue that money velocity should be stable absent changing expectations, but a change in money supply can alter expectations, money velocity, and inflation.

Empirically, data suggests that the velocity of money is variable, and its relationship with inflation is also variable. For example, the velocity of M2 money stock averaged approximately 1.9x from 1959 to 2007. Since 2007, the velocity of money has fallen sharply, especially in 2020 due to the COVID-19 pandemic and economic stimulus measures.

Factors Affecting the Velocity of Money

Several factors can affect the velocity of money in an economy. These include:

– Money supply: The velocity of money is inversely related to the supply of money. When the money supply increases, economic transactions pace also increases, potentially leading to inflation.

– Consumer behavior: Velocity is affected by the behavior of economic actors. Saving rather than spending slows transactions and decreases the velocity of money.

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– Payment systems: Features of the monetary system, such as credit availability or electronic banking, affect the velocity of money. Few barriers increase velocity, while difficulties in spending decrease it.

Why Is the Velocity of Money Slowing Down?

The velocity of the M1 money supply has steadily decreased since the 2008 recession. Demographic changes, the effects of the Great Recession, and federal regulations have contributed to this decline. The COVID-19 pandemic has also caused a significant drop in the velocity of money due to economic uncertainty and stimulus payments.

What Does Velocity of Money Measure?

The velocity of money estimates the movement of money in an economy, indicating how often an average dollar changes hands in a year. High velocity indicates a bustling economy with strong activity, while low velocity suggests reluctance to spend.

How Do You Calculate the Velocity of Money?

The velocity of money is calculated by dividing a country’s GDP by the total money supply. This can use either M1 or M2 money supply, which includes different measures of currency and deposits.

Why Is the Velocity of Money So Low?

The velocity of money in the United States has fallen sharply, likely due to the COVID-19 pandemic and increased consumer savings amid economic uncertainty.

The Bottom Line

The velocity of money represents the heartbeat of an economy, measuring how quickly money changes hands in transactions. High velocity suggests prosperity and frequent transactions, while low velocity indicates decreased willingness to spend or transact during economic downturns.

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