When the velocity is low, each dollar is not being used very often to buy things. Instead, it’s used for investments and savings. This low demand doesn’t generate as much production.
What Is the Velocity of Money?
The velocity of money is how often each unit of currency, such as the U.S. dollar or euro, is used to buy goods or services during a period. The Federal Reserve describes it as the rate of turnover in the money supply.
Formula
The velocity of money is calculated by dividing the nation’s economic output by its money supply. It uses this equation.
Nominal Gross Domestic Product
Gross domestic product (GDP) measures everything produced by all the people and companies within a country’s borders. Nominal GDP measures this output without adjusting for inflation. To calculate the velocity of money, you must use nominal GDP because the measure of the money supply also does not account for inflation. Where: V = Velocity of Money PQ = Nominal Gross Domestic Product M = Money Supply
Money Supply
Central banks use either M1 or M2 to measure the money supply. M1 includes currency, travelers’ checks, and checking account deposits (including those that pay interest.) M2 adds savings accounts, certificates of deposit under $100,000, and money market funds (except those held in IRAs). The Federal Reserve uses M2, which is a broader measure of the money supply. Neither M1 nor M2 includes financial investments (such as stocks, bonds, or commodities) or home equity or other assets. These financial assets must first be sold before they can be used to buy anything. The money supply does not include credit card purchases or amounts. Credit cards aren’t a form of money, although they are used as such. Instead, they are a form of debt. The credit card company loans you the money to make the purchase. When you pay it back from your checking account, then that affects the money supply.
U.S. Velocity of Money
The U.S. velocity of money was 1.427 in the fourth quarter of 2019. That means a dollar was used 1.427 times in the past year. That’s its lowest level since at least 1960. It means families, businesses, and the government are not using the cash on hand to buy goods and services as much as they used to. Instead, they are hoarding it, investing it, or using it to pay off debt.
Velocity of Money Chart
This chart shows you the decline in the velocity of money since 1999. It also shows how the expansion of the money supply has not been driving growth. That’s one reason there has been little inflation in the price of goods and services. Instead, the money has gone into investments, creating asset bubbles.
Four Reasons Why the Velocity of Money Is Slowing
The velocity of money is slowing, but why? Expansionary monetary policy, used to stop the 2008 financial crisis, may have created a liquidity trap. That’s when people and businesses hoard money instead of spending it. How did this happen? A perfect storm of demographic changes, reactions to the Great Recession, and Federal Reserve programs.
Expansionary Monetary Policy
The Fed lowered the fed funds rate to zero in 2008 and kept them there until 2015. That the rate banks charge each other for overnight loans. It sets the rate for short-term investments like certificates of deposit, money market funds, or other short-term bonds. Since rates are near zero, savers have little incentive to purchase these investments. Instead, they just keep it in cash because it gets almost the same return for zero risk. The Fed’s quantitative easing program replaced banks’ mortgage-backed securities and U.S. Treasury notes with credit. That lowered interest rates on long-term bonds, including mortgages, corporate debt, and Treasurys. The Fed began paying banks interest on their reserves in 2008. Banks had even more reason to hoard their excess reserves to get this risk-free return instead of lending it out. Banks don’t receive a lot more in interest from loans to offset the risk. The Fed initiated another new tool called reverse repos. The Fed pays banks interest on money it “borrows” from them overnight. The Fed doesn’t need the money. It just does this to control the fed funds rate. Banks won’t lend fed funds for less than they’re getting paid in interest on the reverse repos. The Dodd-Frank Bank Reform and Consumer Protection Act allowed the Fed to require banks to hold more capital. That meant banks continued to hold excess reserves instead of extending more credit through loans. As a result of these policies, banks’ excess reserves rose from $1.8 billion in December 2007 to $2.7 trillion in August 2014. Banks should have used these reserves to make more loans, putting the credit into the money supply. Instead, they were reluctant to lend after the recession. In addition, there wasn’t as much demand from borrowers.
Contractionary Fiscal Policy
The Fed’s not completely to blame. Congress should have worked with the Fed to boost the economy out of the recession with more sustained expansive fiscal policy. Members of Congress threatened to default on the debt in 2011. They threatened to raise taxes and cut spending with the fiscal cliff in 2012. They cut spending through sequestration and shut down the government in 2013. These austerity measures forced the Fed to keep an expansionary monetary policy longer than it should have. Low interest rates meant banks didn’t make as much money on loans as they would have liked. That made them less willing to lend.
Wealth Destruction
The Great Recession destroyed wealth. The median family wealth in the United States declined from $146,600 in 2007 to $87,800 by 2013. As of 2016, it had only risen to $101,800. That’s less than what it was in 1998.
Demographic Changes
Last but not least are demographic changes. Baby boomers are entering retirement without enough savings. According to the Boston College Center for Retirement Research, less than half of Americans will have enough in retirement to maintain their planned standard of living. The 2008 financial crisis made this worse. Almost everyone saw their net worth plummet along with the stock market and housing prices. After the Fed lowered interest rates, savers received a much lower return on fixed-income investments. At the same time, many investors became fearful of re-investing in stocks. The Employee Benefit Research Institute (EBRI) found that nearly half (48%) of workers retire before they planned to. Some are forced into early retirement due to layoffs. Others have sick parents or spouses that need care. Many need to quit working because of their own unexpected illnesses. As a result, boomers are downsizing and pinching pennies, in turn slowing economic growth.
