What is the velocity of money?

How does one define velocity of money? Simply put, it is the number of times one unit of currency is exchanged for goods and services in a certain period. The velocity of money increases as more transactions are completed, so it is one of the factors that influences the rate of inflation in a country’s economy.

Developed economies tend to have a higher velocity of money than developing countries as their populations have higher purchasing power. The velocity of money rises during periods of economic expansion and declines during recessions.

Where have you heard about the velocity of money?

The velocity of money is a measure that is used by investors and economic observers to indicate the health of an economy. You may have heard of it being referred to in financial media coverage or economic reports. In the US, the St Louis Federal Reserve tracks the velocity of money on a quarterly basis to help inform monetary policy.

What do you need to know about the velocity of money?

Now that you know the meaning of the velocity of money, let’s take a look at how it is calculated. The velocity of money is typically measured by looking at a country’s gross domestic product (GDP) in relation to its M1 or M2 money supply. M1 money supply refers to the cash in circulation in an economy, while M2 money supply includes savings deposits as well as cash transactions. That allows economists to compare the speed at which consumers are willing to spend money and how quickly they are saving it.

The velocity of money formula is calculated as a ratio, in which GDP is divided by money supply.

To take a recent velocity of money example, the number dropped sharply in the US in 2020 to unprecedented levels as the Covid-19 pandemic reduced consumer spending because of lockdowns and a rise in unemployment. In the second quarter of 2020, at the start of the global pandemic, the velocity of M2 was at its lowest level since records began in 1959, while M1 fell to a fresh low during the fourth quarter.

Money velocity had already been at its lowest levels since the 1970s when it started falling sharply in 2007 as the Federal Reserve increased liquidity on the financial markets in response to the global financial crisis. The M2 ratio fell to a low of 1.104 in 2020, indicating that money was only being exchanged once quarterly. That was down from 1.427 at the end of 2019, 2.021 in 2006 and a high of 2.198 in the second quarter of 1997, according to data from the St Louis Federal Reserve.

Despite the purposes of quantitative easing, individual consumers and private businesses have tended to increase their savings rates in the face of ongoing economic uncertainty, rather than increasing spending as intended. Record-low interest rates have reduced demand for assets like government bonds and driven investors towards liquid money or stocks.

Check out our glossary, which has more information on economic indicators like inflation and GDP, and how they can affect your approach to managing your portfolio.