Velocity of Money Defined
Velocity of money is the rate at which money flows through the economy. Consideration of an economy's money supply, or the total amount of its currency and other liquid financial products, is useful in understanding economic behavior. Economic activity, money supply, and gross domestic product are all correlated and, when monitored over time, trend upward or downward together. Money supply may be divided into two sectors: M1 and M2 money supplies.
M1 money supply is the portion of the money supply that has the highest degree of liquidity. In other words, M1 money supply can be swiftly transformed into cash. M1 money supply includes traveler's checks, currencies, and checkable deposits. M2 money supply is the entirety of the M1 money supply, as well as savings accounts, money market securities, and money market mutual funds. A money market mutual fund is an investment portfolio made up of short-term debt securities. The savings accounts, money market securities, and money market mutual funds are less liquid than the M1 portion of the money supply but contain another essential component of money: the store of value (money's ability to represent the same worth over time). Thus, M2 money supply encompasses two of the essential components of money: medium of exchange and store of value.
Money movement through an economy is important for a stable economy. The gross domestic product (GDP) is a general gauge of the overall economic status of a country in terms of goods and services produced by that country. Dividing the gross domestic product by the money supply provides the turnover ratio, which is the number of times the money supply must move through the economy to yield the gross domestic product. This ratio is the velocity of money.The velocity of money is a useful tool for investors to decide the strength of a specific economy. An economy's velocity of money directly correlates to its gross domestic product. Thus, during recessions, the economy's velocity of money decreases proportionally to production losses.
Velocity of Money during Recessions
Money Supply Control and Velocity of Money
The velocity of money, or the flow rate of money in an economy, can be controlled by moving money through an economy. Changes to the money supply or gross domestic product directly affect the velocity of money. For example, if the gross domestic product remains constant while the money supply increases, the velocity of money is reduced. This outcome is known as inflation.
Inflation is a continual increase in the average price levels of goods and services. In practice, inflation is a decrease in the buying power of money. It occurs when the money supply is increased at a rate that outpaces gross domestic product growth. Besides causing inflation, increasing the money supply can also affect interest rates. When the money supply is greater than demand, it causes a decrease in interest rates. It is helpful to look at interest rates as the "cost" of money, because the interest paid on a loan is the extra paid on top of the principal, or the initial amount of money, excluding interest, that was borrowed. Thus, when interest rates are reduced, the "cost" of money is also reduced, which will likely lead to an increase in the borrowing of money. For example, Mary is able to secure a one-year loan, borrowing $100,000. If interest rates drop from 10 percent to 8 percent, Mary may be tempted to borrow more than $100,000. Mary rationalizes that if she is able to afford $10,000 toward an interest payment, she should borrow $125,000 and pay back $135,000 at the end of the year. In this scenario, Mary pays $125,000 to the principal and $10,000 in interest. An abundance of money is likely to result in an increase in investing and greater consumption of resources. These behaviors serve as a catalyst to increase the gross domestic product.There can also be a number of consequences for decreasing an economy's money supply. For example, the effect of decreasing the money supply is an increase in interest rates. This results in the "cost" of money increasing and likely a decrease in borrowing. In turn, the interest rate increases are likely to reduce investment spending and consumption. Reduced investment and consumption will then influence whether the gross domestic product halts or decreases.