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How To Restore Economic Growth: Increase The Velocity of Money
The Velocity of Money Rollercoaster
There is an endless debate regarding how to restore economic growth to mature industrialized economies that have fallen into a rut of subpar growth below 2%. Much of the debate centers on a particular economic philosophy, such as increased government spending to create demand or tax cuts to put more money in consumers’ and investors’ hands. The never-ending debate is a distraction from the core reason why economic growth has been subpar for so many years. One of the most important factors that has been impeding economic growth for decades is all too often overlooked: the “velocity of money.”
How the “Velocity of Money” Has Changed
Unless you have taken a course in macroeconomics or read a lot of articles about how the economy works, the “velocity of money” is probably a term you are not familiar with. In essence, it is a measure of how quickly money changes hands in an economy over a given period of time, such as a year. In other words, how fast money passes between individuals over the course of a year. Each time money passes between people, economic activity is occurring.
Take a look at the chart below, which shows the “velocity of money” in the United States economy over the past several decades, dating back to the late 1950s.
Velocity of Money in the United States
Money moved around the United States economy at a rate of 1.7 to 1.9 times per year for three decades, until a strong surge to 2.2 took place during the dot.com boom of the 1990s, as many people’s financial condition improved and they spent money more quickly on goods and services. Money movement remained elevated around 2.0 during the housing-boom years of the first decade of the 21st century, as people spent money on their homes or used equity from their homes to spend money on other things. When the 2008/2009 Great Recession occurred, money velocity took a nosedive. Contrary to what usually occurs as the economy recovers from a recession, the downward trend in money velocity has continued during the gradual economic recovery of the 2010s, reaching a record low of less than 1.45 in 2016.
What does this mean in the real world day to day economy? It means that money that used change hands between individuals for a variety of goods and services is now increasingly locked away from the economy in some form or another, either in savings or investments. It is no longer being exchanged and moving through the economy, which has a negative impact on economic growth.
How Increasing The “Velocity of Money” Would Positively Impact Economic Growth
Increasing the rate at which money changes hands is the key to restoring economic growth to a more robust level. Increasing fast money changes hands and subsequently increasing the rate of economic growth is quite simple: put more money into the hands of people who spend it quickly.
This would not only provide the economy an immediate boost in growth, it would have far reaching positive effects for a number of years. This is because when money is spent at a higher velocity, it has multiplier effect throughout the economy. When tens of millions of low wage earners have more buying power and start spending money at a faster rate, it spreads through an economy like wildfire, causing an uptick in demand for goods and services. This in turn creates more jobs and higher wages in everything they spend money on, from manufacturing to leisure services. The people who work in those industries then have more money to spend and further bolster the economy. In an economy that is 70 percent consumer-driven, increased consumer demand plays a big role in increasing the rate of economic growth. This is why putting money in the hands of people who will spend it, and as a result increasing the “velocity of money”, is so important.
Of course, there are limits to how long an increase in the “velocity of money” can continue to have a positive impact on economic growth. Eventually the economy will overheat from the tidal wave of spending and face inflation pressure. However, given the historically low rate at which money is currently moving around the economy, there is a great amount of room to increase it before negative impacts creep in and choke of the economic expansion that would ensue.
Why The “Velocity of Money” Has Dropped Sharply
The steep decline in the “velocity of money” in recent years appears to have its roots in income inequality that has been increasing for decades. This is not meant to be an economic critique of how much money people should earn; however, the fact is that people living paycheck to paycheck or with little savings at the lower rungs of the economic ladder spend money much faster than those at the higher ends of the income spectrum. People at the lower ends of the income bell curve quickly spend all of their income on the necessities of life, be it food, clothing or shelter. People who make more money, tend to save more money, thus slowing down the rate that money circulates through the economy.
As lower-end earners get a smaller portion of the economic pie and high-end earners increasingly take a larger percentage income, there is less money readily available to move through the economy, since more of it is locked away in various savings accounts and investment schemes. Yes, high-end earners spend a lot of money, but not nearly as fast as the multitude of low-end earners that have less money and buying power than they did in prior decades. Those at the top of the income spectrum tend to hoard money and take it out of circulation by putting it into fixed investments, such ase real estate and bonds, thus slowing down the speed at which money moves through the economy.
Persistent Decline In The Velocity of Money Since 2006
How To Increase The “Velocity of Money”
Getting more money to low-wage earnings to increase the rate at which they spend it is a difficult task. Nobody can wave a magic wand and give tens of millions of workers a raise that is significant enough to increase their rate of spending.
Government policies could be changed, such as raising the minimum wage by a substantial amount or providing more generous tax credits to the working poor, but such policy changes are controversial and difficult to enact. It would ultimately come down to a society as a whole deciding collectively that enough is enough. The super-rich cannot keep taking ever larger pieces of the income pie and squirrel it away in non-productive investments. Ultimately, a collective decision that for the sake of the economy, more income needs to be shared with the lower income earnings, so they can will spend money faster and stimulate economic growth. Of course, that sounds too much like socialism for most people, so it is not likely going to be implemented.
In decades past, lower wage earners were able to boost their incomes and keep the velocity of money elevated because labor unions were strong enough to win substantial pay increases and a lack of external competition from foreign workers did not cap their wages. But, it is a different world now in the 21st Century. Labor unions are a shell of what they once were and the workers in advanced developed economies have to compete with workers throughout the world that work for much lower wages.
This is the quandary that we face. Is drastic action needed or even possible to increase the pay of tens of millions of low paid workers to enjoy the benefits of an increase in the “velocity of money?”
The “Velocity of Money” Explained
To understand what the “velocity of money” actually is, consider this example of a very small economy.
Tinyville, Arkansas is a town with five people, which includes a farmer and his wife, a store owner and his wife and a wealthy landowner that owns the farm that the farmer runs. The town has a money supply of $10,000. In the springtime, the farmer purchases $10,000 worth of supplies from the store owner. The store owner in return purchases $10,000 worth of fruits and vegetables from the farmer during the summer and fall. The $10,000 the farmer spent in the spring changed hands twice in that year when he received it back in payment for fruits and vegetables for a total of $20,000 worth of economic activity. This is a money velocity rate of 2.0 ($20,000 of economic activity divided by the $10,000 money supply equals a 2.0 rate of money velocity).
If the store owner in the next year instead only purchases $7,500 worth of fruits and vegetables from the farmer and invests the other $2,500 into foreign bonds, the money velocity rate in the Tinyville would be 1.75 ($17,500 of economic activity divided by the $10,000 money supply equals a 1.75 rate of money velocity). In this scenario, the farmer would only have $7,500 to spend on supplies the following spring. If the store owner decided to spend the entire $7,500 that year on fruits and vegetables produced by the farmer, it would result in $15,000 of economic activity. Divide the $15,000 of economic activity by the $10,000 money supply and the rate of money velocity drops to 1.5, or 50% lower than it had been just two years prior when $20,000 worth of economic activity was occurring.
As you can see from the example above, this is not a scenario in which an economy can grow. The removal of money from the economy and the subsequent decline in the “velocity of money” causes a significant decline in economic activity. Multiply this very small economy by a much larger developed economy, and you see how a declining rate of money exchange among the participants in a large economy would have a negative overall impact on economic activity. Conversely, if money changes hands at a faster rate over time, the effect on a large developed economy would be positive, as more money is moving through the economy, spurring economic growth.
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© 2016 John Coviello