In simple terms, money velocity is the number of times one dollar is spent to buy goods and services per unit of time. Therefore, if the money velocity is increasing, more transactions are occurring between individuals in an economy and vice versa. Considering the purpose it serves, money velocity is a good indicator of real economic activity.
The key reason for discussing money velocity at this point of time is the fact that the indicator of economic activity is at its worst level since 1959. Does it also imply that economic activity in the United States is at its worst level since 1959?
To answer this question, analysis beyond the money velocity graph is needed and before I discuss that, the chart below shows the velocity of M2 money stock from 1959 to 4Q15.
Clearly, money velocity has slumped and the decline is unabated.
In order to provide a clear picture to readers, the method of calculating money velocity is essential to be discussed. According to Investing Answers, the following is the following is the equation for money velocity –
Money Velocity = GDP/Money Supply
This equation clearly shows that even if GDP growth is stable, money velocity might continue to decline if money supply grows as a faster pace than GDP growth. This is precisely the reason for money velocity slumping in the last few years or trending lower in the last two decades. During this period, money supply has accelerated and GDP growth has been relatively muted.
The next question that readers will ask is why inflation remains low when so much money has been pumped in the financial system. The chart below, which gives the excess reserves of depository institutions with the fed, explains the point on inflation.
After the financial crisis, the excess reserve (above minimum balance requirement) of depositary institutions with the fed has surged and is still at $2.4 trillion. Therefore, banks and the private sector at large have been conservative after the financial crisis and there has been immense hoarding of cash.
