Adjust Text Size

Velocity: The “Speed” of Money

Written by Nickel - 20 Comments

Economists have a term for how quickly money cycles through the economy. They call it “velocity,” and it’s defined as the average frequency with which a unit of money is spent in a specific period of time. As spending increases, or the money supply tightens, velocity increases, and vice versa. In practice, velocity is often calculated as the Gross Domestic Product (GDP) divided by the money supply.

In simple terms, higher values reflect a relatively more free-spending society, with each dollar cycling through the economy more quickly. Lower values, on the other hand, indicate a relatively stingier society, in which each dollar circulates through the economy more slowly.

Wikipedia has a nice example of this… Consider the case of a very small economy consisting of a farmer and a mechanic, with just $50 between them. Further assume that, over the course of a year, they buy goods and services from each other as follows:

  • Mechanic buys $40 of corn from farmer
  • Farmer spends $50 on tractor repair
  • Mechanic spends $10 on barn cats from farmer

Even though there is just $50 in play, $100 exchanged hands over the course of the year. This is because each dollar was spent twice, such that the velocity of money in this economy was two.

With that as a backdrop, I wanted to highlight a graph of the veolcity of money over the past 30 years that I ran across in a recent article in Forbes.

Notice anything unique about the very recent past? Of course you do. In late 2008, the velocity of money in the United States dropped by roughly 50%. In other words, due to a slowdown in lending, a decrease in consumer spending, and increase in the money supply, and so on, the typical dollar was spent just half as often as normal.

So… The answer to our economic problems is clear. Get out there and start spending! Take your money out of the bank, and go buy something. Anything. Just spend.

(I kid, I kid.)

Published on March 19th, 2009
Modified on August 14th, 2009 - 20 Comments
Filed under: Economy

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

Related articles...

» Texas Raises Speed Limit
» Should Speeding Tickets Cost More for the Wealthy?
» Improve Your Gas Mileage by Slowing Down
» How to Improve Your Gas Mileage (and How Not To)
» Monday Roundup – Speeding Ticket Edition
» Broadband Internet Coming Soon(er than Expected)
» Greenspan Speaks: U.S. Economy in a Recession
» Gas Prices Falling Fast

Was this article useful? Please sign up to receive our content via e-mail:

You will receive only the daily updates, and can unsubscribe at anytime.

20 Responses to “Velocity: The “Speed” of Money”

  1. 1
    OblivousInvestor Says:

    My background is in accounting and taxation rather than economics, so there’s something I’ve always been confused by here.

    I know that banks are only allowed to lend a certain amount, and it’s a function of the reserve requirement (aka reserve ratio) set by the Fed and of the total of their customers’ deposits.

    So doesn’t keeping your money in the bank actually allow them to lend more? (And in fact, a multiple many times the amount of your actual deposit?) And don’t these loans provide money to other people who eventually spend it?

    In short, is the decrease in velocity really the result of us spending less? Or is the problem simply that the banks aren’t loaning?

  2. 2
    Nickel Says:

    ObliviousInvestor: As I understand it, both of these factors come into play. If banks fail to lend (as is happening now) then money circulates much more slowly (it just sits there in the bank). Likewise, if people fail to spend (and perhaps seek to borrow less) things will also slow down.

  3. 3
    OblivousInvestor Says:

    OK, that makes sense. Thanks for the further explanation.

  4. 4
    Dedicated Says:

    This is a fabulous post – Thanks!

  5. 5
    RAJEEV'S TIPS Says:

    This is the triued and tested way of muscling ones way out of recession first proposed by Keyenes. This was also among the learnings of Great Depression of 1930s. There are quite a few observers this time who feel this alone may not do the trick. Since its financial debacle which led to this slowdown, guess, there is need for recapitalising the banking system and above all restoring faith in the whole finacial system. faith in banks to lend, faith in customers to borrow, faith in employers to hire and faith in citizen to feel secure and spend.

  6. 6
    awd Says:

    Terrific graph and post. Thanks!

    But as far as spending goes? If we could get a decent INTEREST RATE on our savings we’d have more money to spend!

    :)

  7. 7
    Nickel Says:

    awd: I think it’s all inter-related. With less money being lent, your deposits are worth less, hence the interest rates being offered are lower (not to mention that the Fed has slashed rates to the bone).

  8. 8
    Trevor @ Financial Nut Says:

    Great post.

    The economic term for the benefit of spending money in an economy is the “multiplier effect.” My dollar spent today at Mcdonald’s will go to the owner of Mcdonald’s, who then uses it to pay his/her employee, who then goes and buys a new stereo at Wal-mart, which is then used to pay an employee there, which is then used to pay for groceries, which is then used… etc…

    Spending is good. That’s why I believe in CUTTING TAXES to stimulate the economy.

  9. 9
    DDFD at DivorcedDadFrugalDad Says:

    Nice post. Great way to simplify a complex economic concept.

  10. 10
    Kristy @ Master Your Card Says:

    nickel, where the hell were you when I was taking economics? I could have used you to simplify this stuff! LOL. What you wrote here makes sense. What a bunch of babbling academics wrote did not!

    In terms of banks lending less being a factor, I’d like to weigh in on this a bit. Yes, the amount we lend out is based on Fed regulations and the amount in deposits we have. Theoretically speaking, if people are leaving their money in the bank accounts, banks and credit unions should have more to lend and can therefore lend a hand in stimulating the economy. But, don’t forget, people have lost confidence in the banking system. The trend that we’re seeing is that people are withdrawing their money from the account to take and keep at home. This decreases the amount that banks can lend because they balances aren’t there. But, another problem we’re seeing with the lack of confidence is the fact that the creditworthy borrowers are not the ones looking to take out new loans. We’re seeing an influx of people who have some challenges looking to their banks and credit unions to bail them out. The reality is, banks who’ve already undertaken risky loans are in a position where they have to turn people like that away because the books can’t handle any more risk, nor will the stockholders allow it. Likewise, a bank with bad mortgages and other investments on the books has to keep enough capital to cover any that fall under. That limits them even further on what they can lend.

    There’s a lot more that goes into it than banks just not lending. All of these things are tied together and the only way we’re really going to be able to get this big machine moving is to restore consumer confidence.

  11. 11
    Paul Says:

    Very interesting post! I’ve thought all along that the government needs policies that promote faith in the exchange of money. Clearly that hasn’t happened recently. I’m not convinced the $780B+ stimulus will be efficiently addressing the issues.

    There may be several reasons we are in the current debacle. One mega-trend might be the fact our economy has been too much service oriented, and not enough manufacturing oriented. Perhaps we have over-valued services to the point the bubble burst?

    Perhaps the stock market started a precipitous sell-off once investors started fearing an Obama election and Obama’s campaign promises to significantly raise the capitol gains tax, as well as fears of other tax hikes? Perhaps most of us average Joe’s are saving more and spending only what is necessary in reaction to our 401k’s being decimated?

  12. 12
    Mike J Says:

    Paul,

    Obama’s imminent election was apparent before the selloff — if you were reading fivethirtyeight.com.

    The continuous decline was related to the increasingly obvious disastrous 4Q companies were about to have. Indeed, the S&P 500 earnings were negative (in aggregate, not just financials) for the first time EVER.

    Also, the money identity is M*V = P*Q — velocity is technically independent of money supply. What’s happening now is that M is ballooning while V is cliff-diving, resulting in *generally* stable prices.

    King Picker of Nits,
    -Mike J

  13. 13
    TaxRascal Says:

    Interesting that we had long-term growth and a long-term decrease in the velocity of money. Looks like it dropped from the 18-20 range to the 15-17 range while the economy was doing okay, then fell precipitously later on. Maybe it’s volatility in the velocity of money that’s a problem, rather than just velocity.

  14. 14
    thomas Says:

    Banks really need to start lending money to small businesses to get the economy wheel turning.

  15. 15
    Danielle Says:

    @awd – A better interest rate on my savings would not encourage me to spend any more $.

    This graph and story is really interesting. It is nice to hear some new terminology used to explain the same thing we all know… the economy is still in the toilet!

  16. 16
    kitty Says:

    Good post and comments.

    One thing I’d like to add to comments about banks not lending. One other reason they aren’t lending in addition to the fears of default is the fear of future losses in collateral debt obligation (CDOs) and need to have enough money in reserve for this. Recent relaxation of mark-to-market may help somewhat.

    Here is how it works with mark-to-market. A bank has a certain amount of money invested in CDOs. The value of these CDOs is counted among the amount of the bank’s capital. CDOs are backed by mortgages, some bad, some good with the majority of mortgages still performing and bringing interest. But with mortgage defaults, the value of CDOs drops as fewer people want to buy them. Mark-to-market requires a bank to value CDOs at today market value, so as soon as the value of CDOs drops, the bank has to write down the losses in paper value and put more money into reserve to compensate. At this point, banks may want to get rid of CDOs, even CDOs it would rather hold to maturity. Since no bank can trust CDOs credit rating, no bank wants to buy them, and their value drops further until the point the market value of a CDO is well below the value of underlying loans. But more losses are still expected. Since the bank doesn’t know how big these losses will be, the bank hoards the money – just in case. I.e. to allow for future losses. It’s possible that the current relaxation of mark-to-market will help with lending.

    There is also an issue of panic. Last October some people were withdrawing their deposits and putting them into pillows. So banks need additional money in reserve in case there is run on banks.

    Normally, bank keeps about 10% in reserve. I.e. for every $100 it gets in deposits, it keeps $10 and lends the rest. I am not sure about now, but in January major banks kept over 100% in reserve – all the deposits and part of government TARP money just for future losses.

  17. 17
    James Says:

    In reply to your joke at the end: I see that there IS some validity to that argument, which is being made by a number of people. However, as the farmer and mechanic example shows, lending the money would be better, as it would mean that the money is used at least twice (more so if the money was spent for something else). Not that I suggest that we all go out and get ourselves into more debt or anything!

  18. 18
    gordon Says:

    Go spend money, on anything? Granted, this article was published a while ago, but WOW. I can’t believe people believe this mentality.

    While you’re at it, why not borrow more money to spend, that’s got to help, right? Has it ever helped?

    You Keynesians need to wake up and stop preaching this nonsense. Fractional Reserve Banking is a ponzi scheme, which the bankers win and WE lose.

    Read this article which explains it all “What has Government done to our Money?” By Murray Rothbard.

    http://mises.org/money.asp

    Here’s a quote from the article which debunks the myth that money must be constantly ‘circulating’:

    “Economists err if they believe something is wrong when money is not in constant, active “circulation.” Money is only useful for exchange value, true, but it is not only useful at the actual moment of exchange. This truth has been often overlooked. Money is just as useful when lying “idle” in somebody’s cash balance, even in a miser’s “hoard.” For that money is being held now in wait for possible future exchange–it supplies to its owner, right now, the usefulness of permitting exchanges at any time–present or future–the owner might desire.”

  19. 19
    Nickel Says:

    gordon: Did you miss the part where I said “I kid, I kid”?

  20. 20
    Ron Coyles Says:

    Thanks for input and understandable logic. My problem is unease with current circumstances. I’m trying to understand the economics and picture: Decreasing number of jobs: Imbalanced balance of payments: Rising disparity in the purchasing power of the rich (1%), the middle group and the poor: What seems to be a slide in the quality/compensation re the jobs that are being created: The unemployment rate among young people.
    I am a child of the depression, so I am aware of the situation when you are offered a shirt for a dollar, but you haven’t a $1 in your pocket and no foreseeable way of earning one. It’s degrading, depressing, there is a feeling of disengagement the that eventually gives rise to anger and change! I rather like what we have going, so I would like to understand the situation and employ objective measurements which pertain (no political spin).
    I don’t know that you monitor an old post. But in case you do: Any comments/suggestions.

Leave a Reply

Disclaimer...
Because rates and offers from advertisers shown on this website change frequently, please visit referenced sites for current information. This website may be compensated by companies mentioned through advertising, affiliate programs or otherwise.

FiveCentNickel User Survey