The Velocity of Money

In a recent article entitled “The Velocity of Money,“author  John Mauldin, takes on the daunting task of explaining how the speed and frequency with which money moves from person to person and business to business affects the health of our economy.  

The flow of money works like this:  Money circulates locally when I pay my mechanic $200 to fix my car, he uses that $200 to invest in tools from a hardware store, and the store owner uses the same $200 to pay one of his employees.  The employee then uses the same $200 to buy groceries for his family, and the grocer uses the $200 to have his delivery van serviced by the mechanic.  

The effect of that money on the local economy is multiplied each time it moves from hand to hand.  If money isn’t circulating because people and businesses are hoarding cash because of worries about layoffs or recession, then…

…the whole local economy grids to a halt.

With the recent $700 Billion financial bailout, this seems like a good time to learn more about how our country’s economic plumbing works.  For the sake of blog brevity, the following is a “Reader’s Digest” version of Mr. Maudlin’s original article:

When most of us think of the velocity of money, we think of how fast it goes through our hands – and with Christmas looming, the velocity, at least in terms of how fast money seems to go out the door, seems faster than normal.

In this week’s letter we talk about what most market observers are not seeing, and why you should be paying attention.

I cannot overly stress how important this is. If you want to understand the markets, the dollar, gold, and more, you have to have this information down. You will need to put on your thinking cap, as much of what I am writing is counterintuitive and certainly not considered as received wisdom in much of the financial-commentator media.

What is the velocity of money? It is the average frequency with which a unit of money is spent. Let’s assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our “gross domestic product” from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of “GDP” from our $100 monetary base.

Gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy.

Now, let’s complicate our illustration just a bit. Let’s assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses buy and sell the same amount every month. There are no winners and losers as of yet.

Now let’s complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14. Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall.

It is basic supply and demand.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, plus some more for new population, and you have to factor in productivity. If you don’t then deflation will appear. But if the central bank increased the money supply too much, you would have too much money chasing too few goods, and inflation would rear its ugly head.

Within a few quarters, we will be facing outright deflation. The Fed is going to monetize at least a portion of what will be a $1+ trillion dollar US deficit. They have announced they are going to purchase $800 billion in mortgage-backed and other types of consumer loan assets. That will be a direct infusion of dollars into the economy. That is serious monetization.

We will soon see which additional deflation-fighting policies the Fed will adopt. It is quite possible that we will see the Fed start to set rates on longer-term bills and even bonds in an effort to pull down longer-term rates for corporations and individuals.

There will come a time when the Fed will have to “take back” some of the liquidity they are going to provide. That means we could be in for a multi-year period of slow growth after we pull out of this recession. And this recession could easily last through 2009.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week.

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