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
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 :)
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