Velocity of Money: Definition, Formula, and Examples

This is technical, but note that the Fed changed the definition of M1 and M2 in 2020, so comparing these figures to historic values is difficult. This also applies when comparing different countries—sometimes the data is comparable, and sometimes it isn’t. 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.

  1. But other factors are more demographic in nature and speak to some of the long-term trends in the economy.
  2. Where V is velocity, P is the price level, Y is real output, and M is a measure of the money stock.
  3. That lowered interest rates on long-term bonds, including mortgages, corporate debt, and Treasurys.
  4. The equipment company pays the sports player £1000 to do some promotional work for them and, in turn, the sports player spends £1000 on merchandise from the sports equipment company.
  5. You should consider whether you understand how this product works, and whether you can afford to take the high risk of losing your money.

It directly transfers money from your checking account to the vendor. IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority. Stay on top of upcoming market-moving events with our customisable economic calendar. If you’re an investor, you don’t have to calculate anything for the U.S. measure of velocity, you can simply look this up on the FRED website and see the latest calculations from the Federal Reserve. If you’re a finance student, then the main formula is as follows.

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. At the end of the day, the GDP of the economy is £2000, but only £1000 has changed hands.

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. 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. 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.

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. Think of it as how hard each dollar works to increase economic output. When the velocity of money is high, it means each dollar is moving fast to purchase goods and services. 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.

Factors Influencing the Velocity of Money

Expansionary monetary policy, used to stop the 2008 financial crisis, may have created a liquidity trap. That’s when people and businesses hoard money instead of spending it. 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.

Put another way, if population growth slows, the demand for loans won’t be as high as there will be fewer requests for banks to consider. As a result of these policies, banks’ excess reserves rose from $1.8 billion in December 2007 to $2.7 trillion in August 2014. Banks should have used these reserves to make more loans, putting the credit into the money supply. 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). In some formulations, that translates into a stable relationship between the velocity of money and a nominal interest rate—for example, the short-term Treasury bill rate.

Velocity of M1 Money Stock

As a result, boomers are downsizing and pinching pennies, in turn slowing economic growth. 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. Members of Congress threatened to default on the debt in 2011. They threatened to raise taxes and cut spending with the fiscal cliff in 2012.

Velocity of money as a market indicator

The U.S. velocity of money was 1.427 in the fourth quarter of 2019. 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. M2 adds savings accounts, certificates of deposit under $100,000, and money market funds (except those held in IRAs). The Federal Reserve uses M2, which is a broader measure of the money supply.

Nominal Gross Domestic Product

For example, from 1959 through the end of 2007, the velocity of M2 money stock averaged approximately 1.9x with a maximum of 2.198x in 1997 and a minimum of 1.653x in 1964. Velocity is a ratio of nominal GDP to a measure of the money supply (M1 or M2). It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.

It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. In short, in the forget day trading! buy and hold these 3 stocks 2020 way that all squares are rectangles but not all rectangles are squares, an increasing velocity of money is a strong inflation indicator, but the reverse is not necessarily true. This has implications both at home and abroad, as of 2022, the US dollar trades at a high and increasing premium ( to the value implied by trade (purchasing power parity).

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