Velocity of money

Velocity of money

What is the velocity of money

The velocity of money is a measure of the speed at which money is exchanged in an economy. This is the number of times money is moved from one organization to another. It also refers to how many currency units are being used in a given time period. Simply saying, it’s the rate at which consumers and businesses in an economy collectively spend money.

The velocity of money is important for measuring the rate at which money in circulation is used to purchase goods and services. Economists and investors use it to measure the rate at which money is used for goods and services in an economy, and to assess the health and viability of an economy. A high velocity of money means a healthy and expanding economy. The slow velocity of money vice versa means recessions and contractions.

Velocity of money and the economy

While the velocity of money isn’t necessarily a key economic indicator, specialists can track it along with other key indicators that help determine economic health, such as GDP, unemployment rate, and inflation. GDP and money supply are the two components of the money velocity formula.

Countries with a higher velocity of money compared to other countries tend to be more developed. It’s also known that the velocity of money circulation fluctuates depending on business cycles. When the economy is in a growth stage, consumers and businesses tend to be more willing to spend money, increasing the velocity of money. When an economy contracts, consumers and businesses tend to be more reluctant to spend money, and the velocity of money is slower.

Since the velocity of money usually correlates with business cycles, it can also be correlated with key indicators. Thus, the velocity of money usually increases along with GDP and inflation. Alternatively, it’s usually expected to fall when key economic indicators such as GDP and inflation fall in a shrinking economy.

The velocity of money formula

As a rule, the velocity of money is used on a much larger scale as a measure of the transactional activity of the population of an entire country. In general terms, this indicator can be represented as the turnover of the money supply for the entire economy. In addition, the St. Louis Federal Reserve tracks the quarterly velocity of money using both M1 and M2.

Economists usually use GDP and M1 or M2 for the money supply. M1 is a narrow measure of the money supply that includes currency, demand deposits, and other liquid deposits, including savings deposits. M2 is a measure of the money supply that includes cash, checkable deposits, and easily convertible near money.

 Therefore, the equation for the velocity of money is written as GDP divided by the money supply.

Velocity of money = GDP ÷ money supply

GDP is usually used as the velocity of money formula numerator, although gross national product (GNP) can also be used. GDP is the total amount of goods and services in an economy available for purchase. In the denominator, economists usually define the velocity of money for both M1 and M2.

An example of the velocity of money

Let’s imagine an economy using just two individuals, A and B. Each has $100 in cash. Person A buys a car from person B for $100. B now has $200 in cash. Then, B buys a house from A for $100 and B enlists A's help to build a new house, and for their efforts, B pays A another $100. Person A now has $200 in cash. Person B then sells car A for $100 and both A and B end up with $100 in cash. Thus, both parties in the economy made $400 worth of transactions, even though they each had only $100.

In this economy, the velocity of money would be two. It’s the result of dividing $400 by $200. This multiplication of the value of exchanged goods and services is made possible by the velocity of money in the economy.

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2022-09-19 • Updated

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