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The velocity of money is like the heartbeat of economic activity. It is the measurement of how often currency is exchanged to purchase goods and services.
When the velocity of money is low, it means people are spending less and saving more. When velocity is high, people are spending more.
Higher money velocity leads to increased economic output. Low velocity typically indicates economic contraction or recession.
Velocity of Money Formula
The formula takes a countries gross domestic product (GDP) and divides it by its money supply.
V = PQ/M
V = (Velocity of Money) PQ = (Nominal Gross Domestic Product) M = (Money Supply)
GDP is the monetary value of goods and services produced by a country, and nominal GDP is calculated at present-day market prices.
M1 and M2 Money Supply
Money supply is all of the currency and cash equivalent instruments within a nation’s economy.
The Federal Reserve (US central bank) uses two definitions of money based on liquidity.
M1 money supply, also called “narrow money,” includes cash and currency that is in circulation as well as highly liquid cash equivalents.
M2 money supply includes M1 with the addition of savings, certificate of deposits, money market funds, and time deposits.
Historical Look at Money Velocity
The FRED chart illustrates the velocity of money has been in a downward spiral since its peak in the late 1990s.
It’s common for velocity to slow during recessions. The 2020 COVID recession has caused velocity to reach record-breaking lows.
On the other hand, M2 Money supply has never been higher.
Velocity of Money and Inflation
The US currently has a record high of money supply and a record low of money velocity. This singularity has mostly prevented inflation growth.
If the velocity of money were to pick up, both inflation and GDP growth would likely accelerate.
Federal Reserve’s practice of Quantitative Easing has seemingly caused artificial asset inflation.
The central bank’s balance sheet has grown alongside the recent rise in stocks, real estate, gold, and other assets.
One would think that the massive increase in money supply would cause inflation. This has not happened. Many believe it is due to the low velocity of money.
If the velocity of money increases, it’s feared it will cause hyperinflation due to the record amount of money supply.
Due to the Federal Reserve’s monetary practices, some economists think velocity is no longer relevant. Economist Richard Duncan believes velocity of money is antiquated due to modern monetary practices, like the Fed’s ability to print endless amounts of money.
The correlation between low money supply and low inflation growth is hard to dismiss.
While many think hyperinflation will happen once velocity increases. That idea may be unfounded.
You could even argue that velocity may never significantly increase. Why has it continued to decrease despite all the money printing? What will it take to get money moving again within the US economy?
It’s tough to predict. But it seems central banks have very little control over inflation and the velocity of money despite their aggressive actions. It is also possible their main goal is to mainly increase asset inflation, which is working well so far.