The velocity of money is a crucial concept in economics, reflecting the rate at which money circulates in an economy. It helps economists and investors understand the relationship between money supply, economic activity, and inflation. The Velocity Of Money Equation provides a framework for this understanding.
The basic formula for the velocity of money (V) is expressed as:
V = (P x T) / M
Where:
- P = General Price Level
- T = Total Transactions (or sometimes approximated by real GDP, representing the total amount of goods and services produced)
- M = Total Money Supply in circulation
This equation essentially shows how many times a unit of money is used in transactions within a specific period. A higher velocity suggests that money is changing hands more frequently, indicating a potentially vibrant and active economy. Conversely, a lower velocity can signal economic slowdowns or shifts in how people and businesses are using money.
Since the late 1990s, a notable trend has been the decline in the velocity of money. This trend became more pronounced during the Covid-19 crisis. This decrease largely reflects a combination of factors, including sluggish economic activity and substantial monetary and fiscal support measures implemented by governments and central banks worldwide. During periods of uncertainty, individuals and businesses tend to hold onto money rather than spend or invest it, leading to a lower velocity.
Interestingly, while the velocity of money in the real economy has been decreasing, the velocity of money in the financial sphere has shown an upward trend. This is evidenced by the increase in asset prices. Money may not be circulating rapidly in the everyday economy for goods and services, but it has been moving more quickly within financial markets, driving up the prices of assets like stocks and real estate.
However, when considering a consolidated view that encompasses both the financial and real sectors, the overall velocity of money might appear higher than traditional measurements suggest. This broader perspective acknowledges the significant financial activity that might be offsetting the slower pace in the real economy.
Looking ahead, there’s an expectation that excess liquidity in the market will eventually be absorbed, and this could lead to increases in the prices of goods and services. As economies recover and uncertainty diminishes, the velocity of money in the real economy could rebound, contributing to inflationary pressures.
In the longer term, there’s discussion about a potential regime shift in the global economic order. This shift could involve governments taking greater control over monetary policy, accompanied by sustained, potentially double-digit monetary growth over several years. This could be part of a broader transition away from free-market principles, independent central banks, and rules-based policies towards a more centrally directed economy. Increased money creation, possibly to fund initiatives like the energy transition, could simultaneously stimulate both the financial and real sectors. This scenario could lead to a sustained period of rising asset prices and inflation in goods and services.
This potential regime shift could also create a lag between rising inflation and interest rates. Interest rates might be deliberately capped for a period, a form of financial repression, before authorities eventually lose control over yield curves. This loss of control could then lead to a fundamentally new monetary order.
Furthermore, it’s crucial to recognize the psychological dimension of inflation and its impact on money velocity. Psychological factors, such as memory and forgetfulness, play a significant role. Short-term memory can create persistence effects, like the underestimation of inflation in 2021 due to the recent memory of secular stagnation. Conversely, forgetfulness can be most influential at economic cycle peaks and troughs. As inflation persists and memories of disinflation or deflation fade, market attention is likely to shift towards historical inflationary periods, such as the 1970s.
This process is not always linear and can be abrupt and self-reinforcing. In a regime shift, where deviations from a perceived “normal” economic environment occur, there can be an intense focus on the most recent economic data to confirm any departures from established patterns. This is arguably the current situation with inflation. Eventually, the fundamental forces of money and the relevance of the monetary equation will regain prominence. However, this may coincide with a decrease in the control and credibility of central banks. This point will likely mark the true realization of the regime shift and lead to a reassessment of risk premiums across markets.
In conclusion, understanding the velocity of money equation is essential for navigating the complexities of modern economies. From short-term fluctuations to potential long-term regime shifts, the velocity of money provides valuable insights into economic activity, inflation, and the evolving role of monetary policy.
