The Velocity of Money: Safe at Any Speed?

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Mar 22, 2016 2:19:54 PM

and tagged Commentary

Leave a comment

FederalReserve_3.jpgRecently, concerns about the velocity of money have resurfaced. Several readers have asked whether declining money velocity presages a crash, a recession, or something equally bad. It’s a fair question. As with many such issues, though, we’ve been down this road before several years ago. Low money velocity didn’t mean problems then, and it shouldn’t mean problems now.

First, some definitions

Before we delve into the issue, we need to understand a couple of key terms.

Money stock: Conceptually, money stock is pretty straightforward—the total amount of money in a country’s economy at a given time. From there, however, it gets complicated. What counts as money? It should certainly include cash that people hold, but how about cash in banks? How about travelers checks? Bank accounts? Does it make a difference if the bank accounts are checking, which is available on demand, or savings, which may not be? How about money market accounts?

You get the idea. Nothing in economics is simple, but for our purposes, we can look at two of the most commonly used measures of money, known in the U.S. as M1 and M2:

  • M1 includes cash in circulation, travelers checks, and checking accounts.
  • M2 adds savings accounts, individual money market accounts, and CDs of less than $100,000.

These are reasonable reflections of the actual cash in circulation, or what the average person has available. The big thing missing here is the banks. A separate money classification—MB, or the monetary base—includes cash in circulation, cash at banks, and Federal Reserve bank credit that banks have access to but do not have in their physical control.

In other words, MB is the amount of money that banks have to create actual consumer money. This is the most liquid measure of money, but largely in its potential. The economy depends on the banks to translate MB into money that is working in the economy. The reserves aren’t actually part of the economy until the banks lend them out; therefore, they don’t show up in the usable money stock (M1 or M2) and don’t typically factor into money velocity calculations.

Velocity of money: Now that we have a grip on money stock, let's move on to the velocity of money, which is defined as the price level times the number of transactions, divided by the money stock. More simply, this is the economy as a whole (i.e., the gross domestic product) divided by the money stock.

Changes in money velocity are a function of two things: how fast the economy is growing and how fast the money supply is growing. You have to consider both. The reason to worry over a declining money velocity is if it reflects a shrinking economy. If, on the other hand, the declining velocity is due to the money supply growing faster than a growing economy, this should indicate a growth problem. Of course, that might lead to other problems, such as inflation, but it is not the current worry.

Is there reason for concern?

Let’s take a look at the two components of money velocity.

GDP growth, while not great, continues to chug along.

money_velocity_1.jpg

There is no sign of collapse, so any decline in money velocity over the past five years is not due to a drop in the economy.

Growth in the money stock, on the other hand, has spiked twice in the past 10 years and continues to outpace growth in the economy as a whole. (I have used M2 as the more inclusive monetary number here.)

money_velocity_2.jpg

If the money velocity equation is GDP/M2, and M2 is growing faster than GDP (which it is), you would expect money velocity to be on the decline. This is just what we do see over the past 10 years, as shown in the chart above. Note the substantial drops in 2008–2009 and 2011, just when the money stock spiked.

When it comes down to it, then, the decline in the velocity of money seems to be due to math rather than economic dysfunction. As always, though, it may not be that simple. Tomorrow, we’ll consider whether the increase in the money supply itself might be either a signal or a cause of future trouble.

  Subscribe to the Independent Market Observer

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®