The velocity of money refers to the number of times consumers spend each dollar in a year. Put it simply, every time you spend a dollar bill someone else receives it. Then they can buy something else with it. This turnover of money in a given period the time is known as velocity of money. Typically, increasing money velocity leads to higher inflation.
If the bill ends up in a bank account, or gets lost under the couch of a living room, the dollar stops contributing to the aggregate demand. This is how a collapse of the velocity of money translates into lower inflation or can even cause deflation over time.
On this post I will discuss he relationship between inflation and velocity of money by covering the following points:
- Money Velocity in Simple Terms
- How Velocity of Money Can Create Inflation
- Money Velocity and GDP
- Personal Saving Rate, Inflation and Money Velocity
- The Outlook for Money Velocity. A Technical Approach
Money Velocity in Simple Terms
Imagine that you spend $30 on a haircut. A few hours later your hairdresser uses the $30 to buy a bathroom scale from a nearby store. Then the owner of the store spends it to buy groceries. Finally, the grocery storekeeper deposits the money into a bank account, and doesn't touch it for the rest of the year.
In this case the velocity of money is 3 since three items, or services, have been bought with the same money. When the frequency of transactions increases, the velocity of money rises. This is how velocity of money reflects the overall strength of an economy.
How Velocity of Money Can Create Inflation
Money velocity is a gauge of the consumer’s willingness to spend money. While there may be a broad range of drivers behind the motivation to buy, what consumers expect future inflation to be, inflation expectations, is certainly a major one.
A Self reinforcing process
These expectations are important because they affect consumer's behavior. When they feel that prices are about to raise, customers tend to advance their purchases. Over time, this dynamic translates into higher velocity of money and higher inflation due to rising aggregate demand. It's a psychological, self-reinforcing process. Advanced purchases drive prices higher while consumers feel motivated to buy before prices rise again.
Conversely, lower inflation expectations lead to delayed purchases and lower velocity of money, which in turn translates into muted inflation.
Monetary Expansion Does Not Create Inflation
Trillions of dollars injected into the economy by the Federal Reserve has not caused an increase in GDP or inflation. Why? Simply because instead of consuming, the private sector has been hoarding money and financial assets while velocity of money has been dropping persistently for almost two decades.
The charts below illustrate this point. They show the velocity of:
- M1 money (paper money, coin currency, demand deposits and traveler's checks) and
- M2 money (M1 plus saving deposits and money market shares)
Money Velocity and GDP
We can average the number of times a single unit of money changes hands during a period of time by applying this equation.
The right side of the equation represents the Gross Domestic product.
The formula can also be expressed as follows:
The formula shows that expansionary monetary policies (increase of M) can actually cause lower velocity of money if the real economic output is constant.
Monetarism Theory and Money Velocity
Monetarism is a school of thought—with Milton Friedman being one of its prominent members— that underscores the importance of money supply. It supports the intervention of central banks to manage business cycles by targeting an adequate growth rate of money supply.
Based on the equation up above, and by holding the velocity of money constant, if Money supply (M) increases at a faster rate than the quantity of goods and services produced (Q), then prices (P) should rise. The problem is that velocity of money is never constant.
Personal Saving Rate, Inflation and Money Velocity
A key indicator to track velocity of money is the personal saving rate. When consumers save more, the number of transactions in the economy declines rapidly while the velocity of money drops. This dynamic can have a huge impact on inflation.
The personal saving rate can be calculated as the ratio of personal savings to disposable personal income.
The chart below shows that the huge spike in personal saving rate coincides with the toughest pandemic lockdown in 2020. Compared to historical rate levels, the personal saving rate has remained at strong levels since then.
The Outlook for Money Velocity. A Technical Approach
Technical analysis can be applied on economic indicators whenever human psychology plays a key role. As we saw above, this is the case of the money velocity.
Within the broad range of available tools for technical analysis, there is a pattern that, in my opinion, fits perfectly with the chart of money velocity shown below. The concept of climax is used to determine the end of market cycles. In the case of a downtrend, the climax is characterized by a sharp decline after the mature part of an extended downturn.
Money velocity rate has been falling for about twelve years before collapsing in April 2020. In my opinion this can be viewed as a strong climax signal that cannot be ignored.
- Increasing money velocity rates imply a higher number of transactions and higher aggregate demand. This dynamic can have a significant effect on inflation indexes.
- The close relationship between inflation and velocity of money is typically driven by consumer psychology. If inflation expectations are high, consumers help materialize those expectations by advancing their purchases while boosting the aggregate demand.
- Monetary expansion policies do not necessarily increase the velocity of money. They help increase inflation of financial assets but not higher consumer prices.
- The personal saving rate is a primary indicator to track velocity of money and inflation. It spiked in March 2020 and has remained at high levels since then.
- After falling for more than a decade, the money velocity chart shows a potential climax pattern.
- Federal Reserve Bank of St. Louis, Velocity of M1 Money Stock [M1V], retrieved from FRED, Federal Reserve Bank of St. Louis; April 18, 2021.
- Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis; April 17, 2021.
- U.S. Bureau of Economic Analysis, Personal Saving Rate [PSAVERT], retrieved from FRED, Federal Reserve Bank of St. Louis;April 17, 2021.