Velocity of money formula: What is it?

Cracking the Velocity of Money: Investopedia’s Definition

Updated March 2023

Economies with a higher velocity of money than others often indicate a higher level of development. The velocity of money tends to fluctuate along with business cycles. During an economic expansion, consumers and businesses are more willing to spend money, increasing the velocity of money. On the other hand, during an economic contraction, consumers and businesses tend to be more cautious with their spending, resulting in a lower velocity of money.

Given the correlation between the velocity of money and business cycles, it is also associated with key economic indicators. Typically, the velocity of money rises alongside GDP and inflation. Conversely, it is expected to decline when GDP and inflation indicators decrease in a contracting economy. https://cutt.ly/kQ8wc3B

This is what the Fed has to say on the topic

Let’s start with the velocity of money formula

MV = PQ

In this equation:

M stands for money.

V represents the velocity of money (or the rate at which people spend money).

P stands for the general price level.

Q stands for the quantity of goods and services produced.

According to the equation for the velocity of money, assuming a constant velocity, when the money supply (M) grows at a faster rate than actual economic output (Q), the price level (P) is expected to increase to compensate for this difference. In line with this perspective, it was projected that inflation in the U.S. would be approximately 31 per cent per year between 2008 and 2013. During this period, the money supply grew at an average pace of 33 per cent per year, while output experienced an average growth rate just below 2 per cent. However, contrary to these projections, inflation remained persistently low, below 2 per cent.

Factors Contributing to Persistent Low Inflation

1. Fluctuations in the Velocity of Money: The assumption of a constant velocity of money may not hold true in real-world scenarios. Changes in consumer and business behaviour, such as increased savings or reduced spending, can impact the velocity of money and disrupt the expected relationship between money supply, output, and inflation.

2. Economic conditions and confidence: The period from 2008 to 2013 was marked by significant economic challenges, particularly the global financial crisis. Uncertainty and decreased confidence in the economy can lead to reduced spending and investment, which affects the transmission of money supply growth to inflation.

3. Actions taken by central banks: Central banks, such as the Federal Reserve, play a crucial role in managing monetary policy and controlling inflation. Central banks can influence the money supply and its impact on inflation by adjusting interest rates and implementing quantitative easing.

4. Additional factors influencing inflation: Inflation is controlled by many factors beyond just money supply growth and output, including labour market conditions, productivity, global trade dynamics, and government policies. These factors can interact and counterbalance the direct impact of money supply growth on inflation.

As a result, the persistence of low inflation during the 2008-2013 period can be attributed to the intricate interplay of these factors, challenging the straightforward relationship predicted by the velocity of money formula.

Declining Velocity Of Money

Now that we have covered the velocity of money formula let’s look at what happens when VM starts to decline.

The challenge lies in the dynamic nature of the velocity of money, which is evident in the provided figure. Historically, the velocity of money has never remained constant, as it can fluctuate significantly. During periods of expansionary monetary policies, if there is a rapid decline in the velocity of money, it can offset the increase in the money supply and potentially result in deflation rather than inflation.

The velocity of money is calculated by dividing the nominal gross domestic product (GDP) by the money supply (V = PQ/M). This calculation helps assess the economy’s strength and people’s spending propensity. When a higher volume of transactions occurs within the economy, the velocity of money increases, indicating economic expansion. Conversely, when there is a decrease in transactional activity, the velocity of money declines, signalling a potential economic contraction. https://cutt.ly/XQ8w2Bg

The Velocity of Money: A Concerning Decline and AI Disruption

The observed trend in the velocity of money raises concerns about the authenticity of the economic recovery from its inception. If we examine the velocity of money, it appears to have experienced a significant decline, reaching new lows before stabilizing. This begs the question: What could be the underlying cause? One plausible explanation could be that the market is already factoring in the disruptive potential of artificial intelligence (AI). The advent of AI threatens established business practices and numerous industries that have been slow to adapt, including large banks, law firms, many mega-corporations, and even governmental institutions, which are considered the most significant contributors to this issue.

Let’s zoom in

The Rise of AI and Robots: A New World Order for the Workforce

Option 2: It could be signalling that this so-called economic boom will go up in smoke without a very accommodative Fed. As we hinted, Forever Q.E. is here to stay forever or until a new monetary system is launched. Still, A.I. will be in charge when that happens, and there will be a whole new world order. This new world order will not be what the current NWO members expected or envisioned. However, that discussion is beyond the scope of this publication.

One thing is all but sure; the human workforce will be a lot different just 60 months from today. A.I. and Robots will replace a vast swath of the workforce. And this just came out from Tesla.

Tesla CEO Elon Musk said the company expects to build a humanoid robot with artificial intelligence next year to complete simple physical tasks most workers detest. Musk unveiled the “Tesla Bot” concept on Thursday during its “A.I. Day,” which the company streamed on its website. Musk said the bipedal gadget is meant to “navigate through a world built for humans.”

“Tesla is arguably the world’s biggest robotics company because our cars are like semi-sentient robots on wheels,” Musk said. “In the future, physical work will be a choice. If you want to do it, you can. But you won’t need to do it.” https://cutt.ly/GQ8rPCy

When business owners can replace the many mediocre workers they are forced to hire, they will gleefully replace them with robots. And Tesla is not the only company attempting to build affordable robots.

Low Velocity of Monetary Base: Impeding Economic Growth

The velocity of the monetary base, which indicates how many times a dollar in the monetary base is spent within the economy, reached a historically low level of 4.4. This signifies that each dollar in the monetary base was utilized only 4.4 times over the past year, a significant decrease from the pre-recession figure of 17.2. This indicates that despite the substantial increase in the monetary base resulting from the Federal Reserve’s extensive asset purchase programs, there has not been a corresponding proportional rise in nominal GDP. The notable decline in velocity has counteracted the substantial growth in the money supply, resulting in minimal changes in nominal GDP, including both price levels (P) and real economic output (Q).

Unprecedented Money Demand: Disrupting Velocity of Money

During the period before the recession, a consistent relationship was observed between the decrease in 10-year Treasury note interest rates and the decline in the velocity of the monetary base. For every 1 percentage point decrease in interest rates, the velocity decreased by an average of 0.17 points based on a linear regression model. Given that 10-year interest rates decreased by around 0.5 percentage points between 2008 and 2013, the expected decrease in the velocity of the monetary base would have been approximately 0.085 points. However, the actual decline in velocity was much larger, amounting to 5.85 points, which is 69 times larger than predicted.

This discrepancy can be attributed to the fact that the nominal interest rate on short-term bonds had essentially reached zero during this period. As a result, money became the preferred risk-free liquid asset over short-term government bonds. Consequently, there was an unprecedented increase in money demand as individuals and the private sector chose to hoard money rather than spend it. This significant surge in money demand has led to a substantial slowdown in the velocity of money, as depicted in the figure below. https://cutt.ly/GQ8rPCy

Based on the Fed’s (own) observations. It could be concluded that our economy is sick or possibly even contracting. Given the dramatic rate at which the velocity of money has been plunging since 1996. Great food for thought!!!!! And here is the kicker, the above article was published in 2014. The velocity of money has dropped from 1.53 in 2014 to 1.12.

The 107-year chart of the CPI illustrates that it would have to trade past 10 to break its downtrend line, suggesting that inflation might not be something to fret over from a historical perspective.

The key points to focus on are:

The velocity of money continues to fall, which clearly implies that all is not well. In other words, take away the money supply, and this magic cycle of prosperity will go up in smoke. Whatever happens, the Fed will not stop pumping money into this economy. They might hit the brakes on one program, but they will press the pedal to the metal on another. From a much higher vantage point, this development foreshadows the demise of the human workforce.

When talking about inflation, it matters what reference points one is using. Randomly selecting points to match one’s argument amounts to curve fitting. Theoretically, if one does that, one can make rubbish smell like roses.

Random Thoughts on the Velocity of Money

The velocity of money is supposed to rise when GPD rises, and economic activity expands. It is also believed to increase when consumers spend more. But it’s not. Perhaps this is why economics has been called the dismal science and why monkeys armed with darts can outperform experts and economists with PhDs.

Einstein viewed quantum entanglement as “spooky action”; perhaps that name should have been reserved for economics. It’s spooky how experts in the field of economics get paid so well when they are almost always wrong.

FAQ

Q: What is the velocity of money, and how does it relate to economic development?
A: The velocity of money refers to the rate at which money circulates within an economy. Economies with a higher velocity of money often indicate a higher level of development.

Q: Does the velocity of money change during different economic cycles?
A: Yes, the velocity of money tends to fluctuate along with business cycles. During an economic expansion, consumers and businesses are more willing to spend money, increasing the velocity of money. Conversely, during an economic contraction, cautious spending behaviour results in a lower velocity of money.

Q: What are the key economic indicators associated with the velocity of money?
A: The velocity of money is typically linked to GDP and inflation. It rises alongside economic growth and inflation and is expected to decline during periods of economic contraction when GDP and inflation indicators decrease.

Q: Why did the increase in the money supply not lead to proportional increases in the general price level or GDP?

A: The decline in the velocity of money played a significant role in offsetting the increase in the money supply and limiting the impact on the general price level or GDP. Factors such as fluctuations in the velocity of money, economic conditions and confidence, actions taken by central banks, and additional factors influencing inflation all contributed to this outcome.

Q: Why did the velocity of money decline significantly during the period analyzed?
A: The observed decline in the velocity of money can be attributed to various factors, including changes in consumer and business behaviour, decreased confidence in the economy, and the impact of artificial intelligence (AI) on industries. The rise of AI and its potential disruption to traditional business practices may have influenced the decline in the velocity of money.

Q: How does the decline in the velocity of money affect the economy?
A: When the velocity of money declines rapidly, it can offset the increase in the money supply and potentially result in deflation rather than inflation. This decline indicates reduced transactional activity and can indicate an economic contraction.

Q: What is the significance of the velocity of the monetary base reaching historically low levels?
A: When the velocity of the monetary base drops significantly, it implies that each dollar in the economic base is utilized fewer times within the economy. Despite substantial increases in the money supply, there has not been a proportional rise in nominal GDP. This highlights the impact of the decline in velocity on the relationship between money supply and economic output.

Q: Why was there a more significant decline in velocity compared to what was predicted based on interest rate changes?

A: The nominal interest rate on short-term bonds reaching zero played a role in the more significant decline in velocity. Money became the preferred risk-free liquid asset over short-term government bonds, increasing money hoarding. This surge in money demand contributed to a substantial slowdown in the velocity of money.

Q: What factors influenced the persistence of low inflation during the analyzed period?
A: The persistence of low inflation can be attributed to factors such as fluctuations in the velocity of money, economic conditions and confidence, actions taken by central banks, and additional factors influencing inflation. The interplay of these factors challenged the straightforward relationship predicted by the velocity of money formula.

Q: What does the decline in the velocity of money suggest about the economy?

A: The declining velocity of money raises concerns about the authenticity of the economic recovery and the potential contraction of the economy. It highlights the importance of the money supply and the possible consequences if a favourable velocity of money does not adequately support it.

Q: How does the velocity of money impact the workforce and the future of employment?
A: The declining velocity of money, along with the rise of artificial intelligence and robotics, suggests a transformation in the workforce. The increased automation and use of AI could lead to significant changes in