We’ve recently received a few questions from Dow Theory Letter subscribers regarding the velocity of money. I thought I would take a moment to describe this measure and its implications for the economy as well as price stability.
The velocity of money is typically defined as how quickly money makes its way from one owner to the next. It’s measured as the number of times that one dollar is spent to buy goods and services, per unit of time.
A related measure that may help to grasp this concept is that of inventory turnover. A store owner, or frankly, every retailer on the planet, is always interested in the productivity of their inventory. Inventory that sits on the shelves without moving is a drag on the business. As a result, retailers measure inventory turnover, or how many times they sell through their stock of inventory per year.
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By boosting “turns” as it’s called, a retailer can enhance the productivity of their inventory and thus the bottom line (all else being equal).
Extrapolate this idea to the entire country, and that’s the concept behind the velocity of money. It represents how many times a dollar turns over during a period of time, typically measured per year. It’s often assumed that if the velocity of money is increasing, more transactions are occurring between individuals in an economy. As we’ll see, this is not necessarily true. On the other hand, if the velocity of money is zero, trade has effectively stopped.
The velocity of money provides some unique insight into the state of our economy. But exactly what insight is up for debate. Many people contend that the velocity of money is an indicator or predictor of inflation; unfortunately it’s not that simple.
First we need to understand how the velocity of money is calculated so that we have more insight into what may be driving the changes in velocity.
The velocity of money is calculated as the ratio of nominal GDP to the amount of money in circulation. This brings up an interesting question, what measure of the money supply should we use when looking at velocity?
Without getting into the weeds, there are several components of the money supply (M0, MB, M1, M2, MZM etc.), which vary in terms of what types of funds are included. The velocity of money can be calculated for each component of the money supply. For our purposes, we’re going utilize MZM, which stands for Money with Zero Maturity.
MZM is considered the broadest measure of the money supply, and it includes all types of money that is immediately available to spend (hence the term, zero maturity). This measure includes notes and coins in circulation, traveler’s checks, demand deposits, checkable and savings deposits and all money market funds. One important distinction is that reserves (deposits held by banks at the Fed, remember all that QE?) are not considered part of M1, M2, or MZM, because that money is not available for spending by public or private institutions to chase goods and services).
When we look at a chart of the velocity of money (below), we see that it has been in a downtrend for quite some time. What’s causing this? And does it imply a coming day of reckoning?
To answer those questions we need to go back to the calculation, which once again is as follows:
Velocity = Nominal GDP / Money Supply (MZM)
Note: For the economic folks, the equation is typically seen as V = PQ/M (quantity theory of money), with P representing the overall price level, Q representing the quantity of goods and services produced, and M representing the money supply. We can simplify this to the equation above, which is the exact calculation displayed in the chart above.
At a very basic level we can infer that velocity falls when the money supply grows faster than the economy (GDP). Or in times of recession, when the economy collapses in size faster than the money supply contracts.
In prior articles, I’ve discussed how money is created and destroyed, which is ultimately a function of how much credit is being created in relation to how much debt is being eliminated (by default or payoff). If credit creation is occurring at a faster pace than debt is being extinguished, then the money supply increases, and if debt elimination is occurring faster than credit is being extended (think financial crisis), the money supply contracts.
The continuous decline in the velocity of MZM since the early 1980’s indicates that over that time, the growth of the money supply (as measured by MZM) has generally outpaced the growth of our economy. I find it somewhat interesting that this decline in the velocity of MZM coincides very well with the long-term bull market in bonds, seen in the chart below.
It would seem as though continually declining long-term interest rates have fueled borrowing (credit creation), which has boosted, yet outpaced, nominal GDP growth.
Moving on, the velocity of MZM appears to have a relationship with inflation, but this relationship is rather deceiving. In the chart below, you can see that the CPI appears to be vaguely correlated with the velocity of MZM.
Some schools of thought suggest that the velocity of money is an indicator or predictor of inflation. The chart above would suggest that there is an element of truth to this, but lots of data demonstrates that the relationship between various measures of the money supply and variables such as GDP growth and inflation are unstable.
Consider the following: If credit creation exactly matched debt destruction, and the money supply remained constant, then a growing economy (rise in GDP) would produce an increase in velocity. But GDP is a function of Prices and the Quantity of goods and services produced. It’s possible that rising GDP could be a result of declining prices, offset by a larger increase in the quantity of goods and services. Thus, it’s entirely possible for prices to drop while velocity is increasing.
Further problems exist as a result of there being so many different measures of the money supply, and hence so many versions of the velocity of money. One could calculate the velocity of money based on any component of the money supply. Each would yield a somewhat different result, driven by differences in the components of the money supply used.
While the chart above may make it appear that the CPI has a mild correlation with the velocity of MZM, separate research shows that using a more narrow version of the money supply (M2), there is no statistically significant relationship between the velocity of M2 and the CPI … none.
Part of the confusion stems from the issue that the velocity of money is not something that can be measured. Instead, it must be inferred based on the movements of other semi-measurable variables. We can get into trouble when we make incorrect inferences from extrapolated data, as is often the case with the velocity of money.
Price levels and the purchasing power of money can act independently from the size of the money supply. For example, if every person was given $10,000, but each person kept this money under their mattress or in a bank (it did not chase goods and services), then price levels would remain constant even though the money supply had increased substantially. On the other hand, if each person spent that money on goods and services, it could drastically increase price levels.
The key determinant here is whether people choose to use their money, and that is a function of the purposeful actions of individuals and companies, behaving in what they believe is their own best interest.
In sum, all we can really say with regard to the velocity of money is the following:
- It increases when GDP rises faster than the money supply, or when GDP falls slower than the money supply
- It decreases when GDP rises slower than the money supply, or when GDP falls faster than the money supply
Any further extrapolation from purely a velocity of money perspective is questionable.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
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