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A plodding dollar: The recent decrease in the velocity of money

The velocity of money measures the number of times a dollar is spent to buy domestically produced goods and services per unit of time. It’s calculated as the ratio of nominal GDP to the average of the money stock. Nominal GDP measures the value of all final goods and services bought by consumers, firms, the government, and foreigners in a period of time; so, it’s used as a proxy for the value of all transactions that occur in an economy in that period of time.

Typically, statistical agencies calculate the velocity of money using one of two measures of the money supply: (1) M1, the supply of currency in circulation, is notes and coins, traveler’s checks (non-bank issuers), demand deposits, and checkable deposits. (2) M2, a broader measure of the money supply, is M1 plus saving deposits, small-denomination (<$100,000) certificates of deposit, and money market deposits for individuals.

The graph shows the evolution of the velocity of M2 for the United States from 1959 to 2015. During recessions (shown by gray bars), the velocity of money tends to decrease, since the amount of transactions in an economy decreases. Consumers tend to save more and firms tend to invest less—that is, they hoard cash instead of spend it. As the graph shows, this was the case during the “dot com bubble” crisis of 2001 and more recently during the financial crisis of 2007. In general, the velocity of money starts to increase after a recession is over, when confidence is restored. However, since 2007, the velocity of money in the U.S. has been decreasing, which means consumers and firms are still holding onto cash instead of spending it. This behavior, which also reflects a decrease in inflation, suggests that confidence in the recovery is still low. When confidence is restored, we should expect to see a rebound in the velocity of money.

How this graph was created: Search FRED for “M2 Money Velocity” and choose the series “Velocity of M2 Money Stock”, or M2V.

Suggested by Ana Maria Santacreu.

View on FRED, series used in this post: M2V

The velocity of money

The velocity of money played an important role in monetarist thought. For example, monetarists argued that there exists a stable demand for money (as a function of aggregate income and interest rates). In some formulations, that translates into a stable relationship between the velocity of money and a nominal interest rate—for example, the short-term Treasury bill rate.

The velocity of money is defined by

V = (PY)/M,

where V is velocity, P is the price level, Y is real output, and M is a measure of the money stock.

The graph shows the velocity of M1, with nominal gross domestic product as the chosen measure of PY. There are at least two interesting features in the graph: First, before the early 1980s, there was a more-or-less predictable trend increase in velocity. But after 1980, velocity exhibits wide swings. Basically, this reflects a fairly stable money demand relationship before 1980 and an unstable one afterward. Second, there’s a dramatic decrease in velocity starting at the beginning of the Great Recession, shown as the shaded area in 2008-09 in the graph. This is perhaps surprising, as short-term nominal interest rates have been essentially zero since late 2008. If the demand for M1 had been stable, velocity would be roughly constant; but since the beginning of the Great Recession, M1 has grown at a much faster rate than nominal GDP. This can be explained partly by a flight to the safety of insured bank deposits during the financial crisis.

How the graph was created: There are measures of the velocity of money available in FRED, but we can learn some useful things about FRED by constructing M1 velocity ourselves. First, go to the Categories menu, look under the category “Money Banking and Finance,” and select the subcategory “Monetary Data”: There you’ll find “M1 and Components.” Select “M1 Money Stock, Monthly, Seasonally Adjusted” and the graph will appear. Because we use quarterly GDP as our nominal income measure, we need M1 to be quarterly as well. So in the Frequency box, select “Quarterly.” This will convert the raw monthly M1 data to a quarterly frequency. Next, select ADD DATA SERIES and check the “Modify existing series” box. In the search box, type “gross domestic product” and add it to the graph. (Make sure you select “gross domestic product” and not “real gross domestic product.”) Now click “EDIT DATA SERIES 1” and select “Create your own data transformation.” M1 is series “a” and PY is series “b,” so enter the formula “b/a.” (See the V = (PY)/M equation above.) Next, under “Create your own data transformation,” scale the result by selecting “Index (Scale value to 100 for chosen period)” and then add the initial date of the series, 1959-01-01, in the Observation Date box.

Suggested by Stephen Williamson.

View on FRED, series used in this post: GDP, M1SL

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