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What is Velocity of Money? Denver Colorado

The Velocity of Money is an economic factor that can lead to inflation if left unchecked.  As I have blogged about before, inflation leads to higher mortgage rates.

So what is the Velocity of Money?  Simply put, the Velocity of Money is the rate at which the existing money supply changes hands over the course of a year.

To explain further, here is an example:

First, consider this equation:  GDP (G) = Velocity of Money (V) x Money Supply (M)

Let's look at an example of a small economy in which there are only 5 businesses.  Each business is doing $100,000 in sales each quarter, or $400,000 per year.  GDP is the amount of money that changes hand over the course of a year, so $400,000 per business x 5 businesses = $2,000,000 GDP.  Our money supply in this example economy is $1,000,000.  So the Velocity of Money in this example is 2,000,000 = V x 1,000,000 or 2. 

Now, let's assume that the economy starts to go into recession and productivity slows down, and all of our businesses are only doing $50,000 in business each quarter, or $200,000 per year.  If the money supply doesn't increase, our GDP is now only $1,000,000 and our Velocity of Money has decreased to 1 (1,000,000 GDP = V x 1,000,000 money supply).

As we have seen in recent years, the government usually steps in during a recession and offers "stimulus" packages.  Let's say in our example, that the government introduces stimulus money of $1,000,000 into the economy and the Velocity of Money does not increase.  This will cause GDP to double to $2,000,000 (G = V x M = 1 x $2,000,000).  Isn't this a good thing?  NO!

If GDP doubles, but there are still only 5 businesses in our economy, that means that production is the same, and that there is double the amount of money chasing the same amount of goods and services.  The price of goods and services will be bid up and inflation will ensue.

In our current economy, like in almost every recession for the past 100 years, Velocity of Moneyhas fallen.  In our current environment, banks are lending less, companies are spending less, etc.  So in order for the government to keep the economy and GDP growing, the money supply must be increased (remember GDP = MV).  Rates can also be decreased, as we have seen, which makes spending and borrowing more attractive, and increases the Velocity of Money.

The tricky thing is to pull back on increasing money supply or to raise rates once the Velocity of Money starts to increase, so that inflation doesn't ensue.  Bank lending is still falling at a rate of 15% annually, but what if that stops?  Corporations are more efficient than ever, but have not started to spend yet.  Corporations have the highest cash reserves in more than 50 years so what if they decide to start investing that money? 

The Fed is walking a fine line right now, and we have a front seat to see how their policy decisions affect the economy in the coming years.