The Slowing Velocity of Money

October 17, 2012

In this week’s Chart of the Week we take a look at the velocity of the Money Zero Maturity (“MZM”) money supply over the last ten years. Velocity of money can be defined as the rate of turnover in the money supply; in other words, the number of times one dollar is used to purchase final goods and services included in GDP. The MZM money supply is one of the more popular measures of the liquid money available for immediate consumption in the economy. Assuming all other factors remain constant, an increase in the velocity of money coincides with an increase in GDP. In addition, higher velocity of money is often associated with rising inflation.

The velocity of money has been dropping since 2005 and this trend accelerated during the financial crisis of 2008. Once the economy began growing again and exited recession in 2009, the velocity of money resumed growth as would be expected but soon began trending downward again. This continued downward trend in the velocity of money shows that as the Federal Reserve continues to increase the money supply through successive rounds of quantitative easing, each additional dollar injected into the economy has a decreasing effect on GDP. Conversely, if the Fed begins to reign in the supply of money and the velocity does not increase, GDP would likely decrease in response to any tightening policy enacted by the Fed. Going forward, the velocity of money will be another economic indicator to follow as we attempt to gauge the economy’s recovery.