Velocity of Money
Velocity means speed. And indeed, velocity of money refers to how fast money changes hands and how fast it passes from one holder to the next. It is commonly defined as the rate at which money is exchanged from one transaction to another. Simply put, the velocity of money is the number of times one dollar is spent to buy goods and services per unit of time.
It is the value of transactions (GDP) divided by the supply of money. For example, if the velocity is 2, it means that a $10 bill is financing $20 worth of transactions in a given period. Therefore, the higher the velocity of money is, the more transactions are occurring (and vice versa). This is why it is considered a good indicator of real economic activity.
Why we are writing about the velocity of money? The reason is that it is at its lowest level since 1959. Let’s take a reasonably broad measure of money, M2 – all the banknotes and coins in circulation, plus short-term deposits and some money market funds. As one can see in the chart below, the velocity of M2 money has been on a declining path since 1997. And it just plunged after the financial crisis, when banks and the private sector started hoarding cash. Money doesn’t turn as much during a deflationary shock.
Chart 1: The velocity of M2 money in the United States from 1959 to 2016.
The declining velocity of money partially explains why the Fed’s easing hasn’t made its way into the real economy as much as it could. The U.S. central bank can expand the money supply however much it wants, but if people remain conservative, do not spend money and increase their cash reserves instead, the real economy isn’t affected much. Talk about leading a horse to the river and the horse decides it doesn’t want to drink. This is why the link between monetary policy and inflation has become loose recently.
Velocity of Money and Gold
Why should gold investors care about velocity of money exactly? Whether high or low, velocity sends a message about the state of the economy and risks ahead. It’s logical that in times of heating inflation, people look to preserve their purchasing power, and exchange their IOUs for real, tangible goods (and services). Velocity of money rises. When the horizon darkens and uncertainties and shocks abound, people are more interested in return of their money than in return on their money – and this is making them reluctant to part with their cash. Velocity of money falls.
Currently, the velocity of money is declining. It should be positive for the gold market, as it indicates sluggish economic activity (the GDP grows slower than the money supply) and ineffective monetary policy. However, there is no clear correlation between gold prices and the velocity of money, therefore investors should not invest in gold based on this indicator alone.