Velocity of Money

March 02, 2012

This week’s chart shows the change in the velocity of the money from 1959 through 2011 along with the growth in the monetary base. Velocity measures the frequency with which a unit of money changes hands in an economy over a given period of time. This figure can be viewed as a general gauge of activity taking place within an economy. The monetary base represents liquid currency as well as close substitutes for money including currency in circulation, bank vaults, and bank reserves. In monetary economics, the quantity theory of money states that money supply multiplied by velocity equals real GDP times the price level.

Money Supply * Velocity = Real GDP * Price Level

This implies that the price level has a direct relationship with the supply of money in an economy. As the chart shows, the monetary base is at the highest level on record, which would normally lead to an increase in the price level (inflation). However, velocity is at the lowest level since record keeping began in 1959 and is the primary reason inflation remains subdued, despite the large increase in the money supply.

The Federal Reserve has more than doubled the monetary base since December 2007 through quantitative easing in hopes of stimulating borrowing and spending. However, increases in the monetary base have largely sat idle in bank reserves as banks increased their capital ratios, tightened lending standards, and overall loan demand levels decreased, causing the velocity of money to fall. Given the current economic slack in the U.S., it is unlikely that the Federal Reserve’s monetary policies will cause inflationary issues in the near term as long as velocity remains low. However, once economic activity begins to pick up, policy tightening will be essential to reduce potential inflation pressures.