Velocity of Money
It calculates how quickly cash moves in a given economy. You can calculate the velocity of money as a ratio of gross domestic product (GDP) to a country's M1 or M2 money supply.
How Velocity of Money Works
The velocity of money helps determine how much money in circulation you spend on goods and services. The velocity of money is a metric determined by economists, who use it to assess an economy's health and vitality. You can correlate a high velocity of money with a stable, developing economy. The low velocity of money is commonly associated with recessions and contractions.
It depicts the speed at which you exchange money for goods and services in a given economy. While it isn't necessarily a critical economic indicator, it is used in conjunction with other important indicators such as GDP, unemployment, and inflation to determine the state of the economy. The two elements of the velocity of money formula are GDP and the money supply. Economies with a higher velocity of money than others are more established.
The velocity of money is known to fluctuate in response to business cycles. When an economy increases the velocity of money, customers and companies are more willing to spend money. Consumers and companies are more hesitant to invest while the economy is shrinking and the velocity of money is smaller.
Example of Velocity of Money
Consider a scenario in which two people, A and B, each have $100 in cash. Individual A buys a car for $100 from individual B. B now has $200 in his pocket. Then B buys a house from A for $100 and enlists A's assistance in adding new construction to their home, for which B pays another $100 to A.
Individual A now has $200 in his or her pocket. Individual B then sells a car to individual A for $100, leaving both A and B with $100 in cash. As a result, despite having just $100 between them, both parties in the economy have made transactions worth a total of $400.
In this economy, the velocity of money will be the two individuals resulting from the $400 in transactions separated by the $200 in the money supply. The velocity of money in an economy allows for this multiplication of the number of goods and services traded.
The Velocity of Money vs. The Economy
Economists disagree about whether the velocity of money is a good measure of a country's economic health or, more accurately, inflationary pressures. According to "monetarists," who adhere to the quantity theory of money, the velocity of money should be stable absent shifting expectations. However, a change in money supply will alter expectations and thus the velocity of money and inflation.
Since there is more capital pursuing the same amount of goods and services in the economy, an increase in the money supply could theoretically lead to a proportional rise in prices. The reverse could happen with a drop in the money supply. Critics claim that the velocity of money is highly volatile in the short term, and prices are resistant to adjustment, resulting in a poor and indirect relation between money supply and inflation.
Data shows that the velocity of money is variable, based on empirical evidence. Similarly, there is an unstable relationship between money velocity and inflation. For example, the velocity of M2 money stock averaged around 1.9x from 1959 to 2007. Since 2007, the velocity of money has dropped sharply as the Federal Reserve increased its balance sheet to fight the global financial crisis and deflationary pressures.