J Brauer | © Stone Garden Economics
Velocity is the rate at which each dollar in an economy must turn over for the economy’s output to be purchased. In annualized terms, for example, in the third quarter of 2008 the dollar-value of goods and services purchased (nominal GDP) was $14.42 trillion. But the available stock of money to make these purchases was only $7.7 trillion. To make possible the purchase of $14.42 trillion worth of goods, each dollar must therefore have been used 1.87 times. That is turnover, or money velocity.
For the years 1959 to 2008, the chart to the left shows quarterly velocity data for two measures of money, called M2 and MZM. The former ranges from about 1.6 to 2.1 and is fairly stable over the nearly 200 data points. MZM is more unstable but, on the whole, it is either rising (until the early 1980s) or falling (since then).
From a consumer point of view, M2 is the more relevant measure of money to use. For the most part, it includes the cash in your wallet, the value of your checking and savings accounts, certificates of deposit you may own (under $100,000) as well as the value of your retail money market mutual funds (MMMFs) – that is, money that earns little or no interest but is fairly easily accessible (liquid) to you. In contrast, MZM includes commercially owned funds. So, if the turnover rate or velocity of M2 is relatively stable – let’s say it is equal to the number 2 – then in order to purchase more goods and services each year, M2 must increase. For example, if GDP is $14 trillion and V is 2, then money must be $7 trillion (because 2 x $7 trillion equals $14 trillion). Thus, if GDP increases to $16 trillion and velocity is still equal to 2, then the amount of money available must be $8 trillion.
One policy implication of this is that the Federal Reserve Bank may print money, inject it into the spending stream, and thereby stimulate a flagging economy out of recession. In the long term, this may just work because the velocity of M2 is fairly stable as seen in the first chart. But in the short term, this is not quite so, as seen in the second chart. That chart shows the annual percentage change in velocity, and illustrates that, year-over-year, the percentage change in velocity can be quite drastic, ranging from about -5 to +5 percent.
Another policy implication is that when the Fed intends to inject money into the economy, instead of stimulating lending, borrowing, and ultimately the purchasing of more goods and services, economic actors simply use each available dollar less often. They hoard cash. For example, if the economy runs at $14 trillion (with V=2 and M=$7 trillion) and the Fed wants to speed up the economy to $16 trillion (with V=2 and M=$8 trillion), people may instead respond by slowing down velocity from V=2 to V=1.75 (a 12.5 percent decline in velocity), so that $8 trillion worth of available money times a velocity of 1.75 still buys only $14 trillion worth of goods. This is happening now. Even as the Fed pumps money into the economy (making it monetary based), commercial banks and other financial institutions simply seem to soak it up, building cash reserves. Meanwhile, investors pull out of the housing, stock, bond, and other asset markets to generate cash. Money, in other words. In part this is done to pay off debt but the lender receiving the payment is then refusing to reloan the funds, so that the money again is “stuck” in the economic pipeline.
In sum, as explained in last month’s column, there is only so much the Fed can do. President-elect Obama’s incoming economic team has been vigorously talking up a fiscal, rather than monetary, stimulus, which is hence welcome. Of course, it would be nice if the fiscal stimulus were spent on things that help with long-term productivity gains and long-term economic growth, such as fixing infrastructure, and improving the crumbling health and educational systems. Whether that happens, remains to be seen.
J Brauer is Professor of Economics, James M. Hull College of Business, Augusta State University, Augusta, Georgia, USA.