Zombie Concepts: Velocity of Money

Published on January 19, 2021 by Free

In this series I will talk about dead macro concepts that refuse to die. Today’s installment of Zombie Concepts features the velocity of money – a concept often discussed but easily shown to be useless. I will draw heavily from a excellent recent IMF paper on the subject by central banking expert Peter Stella et al. Basically, the velocity of money is a useless concept because it is not stable nor mean reverting. It cannot be used to link money supply to GDP. It is not stable because 1) its measurement does not include transactions that do not contribute to GDP, and 2) it’s affect by technological changes. There is no justification in thinking that velocity will eventually rises, leading to higher GDP growth on account of the larger M2 money stock.

What is the Velocity of Money

You may have heard of Milton Friedman’s famous quote “Inflation is always and everywhere a monetary phenomenon,” a quote that encapsulates the viewpoint of monetarists. Monetarists view inflation and growth through the lens of the quantity of money – where higher quantities of money spur temporary increases in short-term real growth as people spend more, but eventually prices adjust and all you are left with is higher longer term inflation.

In this framework, the mechanism through which the increased quantity of money leads to higher short-term economic activity is a concept called the Velocity of Money. Velocity of Money is just GDP / Money Supply, which can be rearranged as GDP = Money Supply x Velocity of Money. If you assume that velocity is fixed in the short-run, then higher money supply would mechanically lead to a higher GDP. Sounds reasonable, but it is wrong.

Velocity of Money Excludes Non-GDP transactions

The earliest form of the velocity of money was formulated to show a relationship between the quantity of money and the value of all transactions. This is very different from the current formulation, which draws a relationship between the quantity of money and GDP, which is the income of a country. GDP only includes transactions that contribute to the final demand for goods and services, but does not include things like buying TSLA call options. Buying a brand new construction house would contribute to GDP, but buying a house already built would not contribute to GDP (it’s already built, so no new labor or materials expenditures. See also this excellent piece by Richard Werner on the topic.)

The Velocity of Money could potentially work if the ratio of GDP to non-GDP transactions made stays constant, but in real life that is easily disprovable. If you give a homeless person a $100,000, he will buy lots of food, clothing, goods etc. So he will spend a large proportion of his windfall on transactions included in GDP. But give him a $1 billion, and a large proportion of that will be spent on transactions excluded from GDP – buying stocks, bonds, gold, TSLA calls etc. Because the portfolio allocation decisions of a country change according to the level and distribution of its wealth, the Velocity of Money is not stable nor mean reverting.

Velocity of Money Changes According to Technology

Peter Stella et al. compiled the table below showing the velocity of demand deposits (basically checking account deposits at commercial banks), which constitutes the vast majority of “money”). Their measure would exclude currency (paper bills), which is included in M1. There isn’t good data on transactions settled in currency as those do not have an electronic record. The table below shows that the velocity of demand deposits is not stable, and can fluctuate rather significantly. In 1927 GDP divided by the stock of demand deposits was 5, but that same ratio shot up to 27 in 1996. The authors attribute these changes to improvements in payments technology, which allows each deposit to be used more intensely. For example, over the past decades we moved from mailing paper checks and waiting for them to clear, to instant electronic payments. We don’t need to hold as as many demand deposits as a liquidity buffer since money is sent and received quickly. These technological shifts mean the link between the stock of money and GDP is always changing.

A Volatile Velocity of Money is Useless

The usefulness of the velocity of money as a concept hinges on its stability. If it is stable, then increasing the quantity of money could lead to higher GDP. (To be more precise, the monetarist believed that the central bank could increase the level of reserves, which would lead to more credit creation via a ‘money multiplier,’ and thus increase the money supply. Their view of the connection between reserves and credit creation is also incorrect, but that is for another post).

But as we see, the velocity of money is not a stable nor mean reverting measure. The recent explosion in M2 did not lead to an exploding GDP, but an imploding velocity of money. There is no reason to assume the velocity would pick up and lead to higher a GDP, because the velocity of money is not a mean reverting variable.

Looking at soaring asset prices, the explosion in M2 appears to be circulating though asset markets instead of real economy transactions that show up in GDP. There are ample anecdotes of people taking their stimulus checks and putting them into financial markets, and retail brokerages are opening up record numbers of new accounts. Maybe they will withdraw their winnings and spend it on goods or services, but there doesn’t seem to be any indication of that yet.

3 comments On Zombie Concepts: Velocity of Money

  • very interesting, thank you

  • “To be more precise, the monetarist believed that the central bank could increase the level of reserves, which would lead to more credit creation via a ‘money multiplier,’ and thus increase the money supply.” doesn’t increase of level of reserves increases the money supply even without credit creation? when reserve increase, bank deposit also increase accordingly, and bank deposit is part of money supply, is it correct?

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