Velocity of Money or Circulation

 written May 2013

A High Rate of Transactions in an Economy Gives a High Velocity of Money

A High Rate of Transactions Creates a High Tax Revenue for Governments

The velocity of money reveals the economic activity in an economy. Its a useful statistic to know, I'm sure you'll agree. A high velocity of money is a sign of growth and reveals an optimistic, or desperate population that is spending money fast.

Governments are especially interested in the rate of spending because each spend-transaction brings in a tax revenue (e.g. VAT) so the higher the velocity of money, then the higher the tax revenues go to the government.

But as you will see later, there are question marks over the way money velocity is calculated and it can be abused in what it purports to show or prove. The devil is in the details of the calculation, so try not to get suckered into believing something that may not be true.

Lets Build Up A Simple Velocity of Money Calculation for a Small Island.

In an island economy with only $50 total money supply owned by one lucky farmer, the farmer gives a fisherman his entire $50 wealth for a basket of fish. (Lets pretend please!) Then the fisherman gives the entire island wealth of $50 to the farmer to buy $20 of potatoes and $30 (equalling $50 too) of wheat.

What is the velocity of money?

Velocity of money = Total money changing hands/Total money in economy
                               =  50+20+30/50
                               = 2

If the farmer then goes back to the fisherman and buys his boat for $50 then what is the new velocity of money.


New Velocity of money = Total money changing hands/Total money in economy
                                       =  50+20+30+50/50
                                       = 3

Now we will do a similar calculation for a whole country.

Velocity of money = number of transactions times average transaction price/total money supply

To cut out a lot of boring working, we end up with V = M2/GDP

Of course, this is where it largesse and fudge steps in. What is the total money supply to use?
Is it M0, M1 or M2 or an estimate of the now-deprecated M3. Is it the total amount of cash or the cash plus savings? Or cash plus credit card and PayPal? Should we include the amount of money printed by the FED or central banks as reserves that are just sitting there waiting to be loaned out? What about money going abroad? All these will give different results and you know what politicians, forecasters and reporters can be like.

Nevertheless, more perceptive readers will realise that a credible, transparent version of money velocity would be useful to know as long as we are familiar with it workings. Lets not ignore it completely for fear of misuse.

GDP and exactly how its calculated is debated - some say its a completely wrong measure - & indeed the velocity of money uses GDP in its calculation. It also uses money supply and simply divides money supply into GDP to get the result. So velocity of money divides one debatable amount by another debatable amount. Oh boy! But lets press on...

Now we run straight into the money supply dichotomy (that 'famous' dichotomy, haha): Do we use real or nominal money supply? That is do we use the money after inflation or the simple numerical value of money before inflation etc. A prickly issue amongst theorists. The Keynesians and the monetarists reject this classical dichotomy, because they say that prices are 'sticky' meaning prices do not change quickly - its a debatable assumption to use sticky prices, but hey ho & off we go.

A Lot of Transactions Makes More Tax for Governments

Every time a transaction takes place the government gets a piece of it  http://www.joshuakennon.com/the-velocity-of-money-for-beginners/.

In a recession a self-fulfilling spiral develops of low velocity of money, therefore fewer transactions resulting in less tax revenues. A government is then less able to support a country.

Similarly for corporations. Fewer products and services are purchased as the rate of buying falls.

The unemployed are actually good spenders of money since they cannot afford to save much and will increase velocity of money by lots of small transactions when they buy goods and services that increase the tax take and corporation income. They are unlikely to save or hoard money and will circulate money at high velocity efficiently. Instead of infrastructure spending on large wasteful projects it might be better to distribute the same money among these busy-bee unemployed spenders. All they need to do is carefully choose products and spend all their money - which they do naturally.

Humans are natural savers for a perceived bad winter ahead:

But saving is not a particularly good human attribute for a thriving economy.

The FED or Central Banks increase bank reserves of money (so-called printing money) waiting to be lent out at low interest rates. But people & companies are not borrowing that money as expected.  This has surprised many economists and politicians, but doesn't surprise the ordinary people. After all, its them that are not borrowing and they do know why.

A List of Common Money Supply Measures Published by the FED
More at: http://research.stlouisfed.org/fred2/tags/series/?t=m1

The Adjusted Monetary BASE - The 'printed reserves' plus cash:

M1 Money Stock

M2 Money Stock: Basically cash plus Savings without the reserves

MZM Money Stock: Money at Zero Maturity - or simply cash (no bank reserves included):

Nominal GDP: Used to calculate Velocities

M1 Velocity:

M2 Velocity:

MZM Velocity:

You can see that the velocity of money (or circulation) is lower now (May 2013) - you may be able to pick out other salient details too - please tell me what you find!

A low velocity is not very surprising because the banks are wary about lending after regulation and impaired loans debacle in 2008, and households and companies are cautious about borrowing money because they cannot see a return on it or believe they will not be able to pay it back. Seems a no-brainer to me, but Keynesians, Austrians, Monetarists and a lot more are looking at this situation because the economic conditions are different from previous recessions.

Some Theoretical Explanations

1) Monetarism: Milton Friedman would have predicted inflation caused by increased money supply probably (if he were still alive) - but that has not happened.

2) Keynesian: Paul Krugman's favourite Keynesian liquidity trap ISLM model (see my last blog) predicts it. At zero interest rate (ZIRP) increased money creation does not shift the IS curve where interest rates increase because its stuck at zero. You could say more simply that there is no good reason to shift money from low interest rate bonds to low interest investment loans when you do not believe you will get a better return.

3) Hawtrey (Austrian-like): - banks are too cautious to lend and borrowers are too cautious to borrow. Small changes in interest rates do not overcome the cautious attitudes of companies and people of 'fear of losses'.

Caveats and Provisos

1) Velocity of money is not so simple because most people are paid monthly or weekly by a company or the government and are not paying and buying from each other as our simple model says. But it is nevertheless a useful common-sense measure of how well the economy is performing. The idea of number of transactions made and their rate is clearly pertinent to the health of an economy and the tax revenue take. 

2) The present (May 2013) low velocity of money is a key indicator but clouded by the relatively high amount of QE that appears to increase money supply but not proportionately the GDP.

The *reasons* for the apparent low economic activity is the number one question at this time (May 2013). If you are reading this in the future, then you already know the answer. Please try to time-travel the correct answers back to us :)

       

ISLM Curve

The IS-LM Curve for Macroeconomic Analysis & The Liquidity Trap

This well known Keynesian macro economic model is used by Paul Krugman to explain 'the Liquidity Trap' but he admits that the economic model could be all wrong. Its still worth examining, because of its popularity in topical macroeconomic discussions and debates. There is a heated albeit wonkish debate between Steve Keene and Paul Krugman about it.

We begin with an intuitive explanation rather than thread together an academic, jargon laden exposition. Later we will add provisos, gotchas and include more academic arguments.

Basic IS-LM Curve

The curve has two parts, a 'goods, services, production' part called IS (investment savings) and a monetary, bonds, cash part called LM (liquidity money).

They are treated as kinda separate although in reality that is not the case. An equilibrium point is where the two lines cross giving us a GDP and interest rate values.

1) IS Curve (goods market)

Loneable funds viewpoint - Look at the IS ( investment / savings) line where the amount of investment in goods & services decreases as the interest rate increases. If a bank is offering higher interest rates we will save more and invest less. If the interest rate is low we will save less and invest more because we can make more money from growth-aimed investment than we can get from savings interest.

2) LM Curve (money market)

Liquidity preference viewpoint - Look at the LM (liquidity preference money supply) line. Money in bonds and treasuries is illiquid because its stuck there for the time period of the bond (short or long). Money in cash is liquid because we can invest or spend it immediately. When the GDP is high there are more transactions and the demand for money (cash) is high, so it costs more. 

3) Combined IS and LM Curves

This gives us the two opposite sloping lines on the ISLM model. They cross at an equilibrium point where the IS curve crosses the LM curve, which results in an equilibrium interest rate and its corresponding GDP.

4) The Liquidity Trap using this Model

If a central bank (or the FED) increases the real money supply by printing money, then there will be more money in the system. More money available *should* be less expensive to borrow it by simple supply and demand logic. When there is more of something (money) it is cheaper to borrow. BUT if the interest rate is already zero bound (ZIRP), then the cost of borrowing money cannot be any less and increasing the supply of money does not change its cost. This is the liquidity trap which neutralizes central bank attempts to stimulate an economy. Its limited by the central bank rule or regulation that disallows negative interest rates. So increasing the money supply will not make people borrow more or save more because there is no gain for them to do so. 

The liquidity trap in the ISLM model:

The demand for money stays constant even if the IS curve is shifted to the right by increasing money supply. The red line crosses the IS curve at zero interest rate regardless of money supply. There is 'low or zero money demand elasticity' with respect to the interest rate - because the rate is bound at zero. Then changes in the money supply has no effect on interest rates and thus investment borrowing is not encouraged - they are already as low as the FED or central bank will allow.

Alternative Non Keynesian Model of Credit Deadlock

The Keynesian ISLM model above was proposed by J. R. Hicks and is still keenly debated and used today even though, as Krugman admits, it could be all wrong.

A non Keynesian theory from Hawtrey, Sandiland explains the lack of growth through investment as banks too cautious to lend and investors too cautious to borrow.  Entrepreneurial pessimism to borrow because of perceived lack of adequate returns and banks wary to lend because of regulatory capital requirements and recent impaired loan losses suffered in the crises of 2008.  

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Lets Get More Geeky

1) The IS (goods and investment) and LM (money markets) curves are not in reality separate entities. A change in either can produce a change in the other. 

2) The ISLM is an *equilibrium* model. But, the presence of economic uncertainty is essential in deciding how much liquidity is needed. If investment success was entirely certain and known then there would be no need of liquidity since exact sums would be invested or saved. (BUT, see the deflationary reason to hold cash)

3) Deflation provides another reason for liquidity apart from purely transactional reasons. If there is real deflation, the real value of cash increases over time, but our ISLM model is zero bound.

4) Total spending = consumer spending + planned private investment + government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP).

5)  IS-LM model is used to study the short term run when prices are held or sticky.

6) No price inflation and is taken into consideration. 

7) For the IS curve: the real level of GDP is Y and then:

                                      Y = C(Y-T(Y)) + I(r) + G + NX(Y)

C is consumption, T is tax, I is interest rate, G is exogenous government spending, NX is net exports.

8) For the LM curve: M/P = L(Y, i)

M/P is the real money supply, L is the real demand for money which depends on the interest rate i, and Y the level of real income.

Here is Krugman's take:
http://krugman.blogs.nytimes.com/2013/03/19/misunderstanding-is-lm-wonkish-and-unimportant/
http://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/

Copper And Gold

Commodities are very volatile at this time (April 2013) and we can make a rough grouping of precious metals, metals, agriculture and oils.

There is some correlation between all of them but a large correlation between gold, silver and platinum. There are many many blogs and articles about gold in particular BUT we see that the price moves with silver and platinum and not usually gold on its own. Gold may decouple at some point from the other metals. For example, if CBs want to sell off their foreign exchange gold reserves.

Copper or Dr Copper is a traditional indicator of global output since it it used extensively by manufacturing industries. BUT it has a reputation recently of being used as collateral for loans especially in China.

One aspect to look for is the connection between commodities and shadow finance. There has been fractional reserve commodity selling where the same commodity has been used as collateral many times over. if too many creditors seek liquidation at one time, then its possible that a commodity run could happen. A commodity run would create debt impairment. The degree of debt impairment is a somewhat unknown quantity and yet another possible, so-called, black swan event