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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.
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.)
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