The velocity of money is the one of the factors that determines GDP. The well-known formula is GDP = M x V; that is, Gross Domestic Product equals the quantity of Money times its Velocity. Velocity refers to how many times a given quantity of money is spent during the period under consideration, usually one year. Less understood is how changes to money’s velocity come about. The formula makes clear that a decrease in velocity can adversely affect GDP and vice versa. But, that just begs the question, what causes changes in monetary velocity?
The primary determinant of how often a given quantity of money is spent is the desire of the public to hold money; that is, the public’s demand for money. When demand for money is high, meaning that the public wishes to hold more money in the form of cash balances, the velocity of money decreases. Likewise, when the public’s demand for money is low, velocity accelerates. Therefore, we have entered the realm of perception, which is not an exact science in the sense that one can establish a formula of the magnitude and time frame for changes in perception. Nevertheless, it is possible to establish the factors that eventually will change perception and, therefore, will cause the demand for money to increase or decrease.
The demand for money is influenced primarily by the quantity of money. This simple statement reveals something very important—that if the quantity of money changes very little, then the demand for money will change very little and the economy will experience stable conditions. Commodity money—that is, gold and silver—experiences very small changes in its quantity; therefore, one would expect that commodity money velocity would change very little. But even in the days of the gold standard, the demand for money varied. The reason was that the money supply was not backed one hundred percent by gold but, rather, only a fraction of the money supply was backed by gold. The rest of the money supply was anchored in bank loans instead. As banks increased lending during temporary boom times, the quantity of the fiduciary media, as Ludwig von Mises called this money not backed by gold, increased, which caused the demand for money to decrease and money’s velocity to rise. This is the very definition of a boom. However, eventually this increase in the money supply causes prices to rise, among other evils, revealing that the boom is unsustainable. There does not exist any new, real capital to fund it.
When bank loans become uncollectable, the quantity of fiduciary media decreases. Now the demand for money increases dramatically, as the public scrambles to convert their fiduciary media—bank checking accounts now of questionable value—into currency. This increase in the demand for money causes a decrease in money’s velocity, exacerbating the bust. The only way out of this predicament is for prices to fall, so that the remaining, smaller supply of money will be sufficient to allow the market of goods and services to clear.
All this can take quite some time. In today’s fiat money, central bank monetary system the bust phase can be papered over for quite some time with increases in fiduciary media. But the demand for money detects subtle changes, thusly precipitating changes in money’s velocity. For instance, rising prices are a signal to money holders to reduce their demand for money. A reduction in money demand causes its velocity to increase, putting further upward pressure on prices. If there exist other assets in which the public can easily invest, then one would expect to see upward price movements. Stock market and commodity price increases are symptoms of such movements out of money, reflecting reduced demand for money, furthering an increase in money’s velocity.
It is typical of such boom periods that credit is readily available. Businesses, then, are more prone to reduce cash holdings in the certainty that bank loans can be used as a substitute for ready cash to meet business needs. This drop in business demand for holding money is a further spur to an increase in money’s velocity. Furthermore, since central bank manipulation of the interest rate in a downward direction was the precipitous cause of the temporary boom, business has even less incentive to moderate its borrowing in lieu of holding cash. Better to invest in inventories that may rise in value than hold cash, especially when loans not only are easy to obtain but are cheap, too.
Therefore, what economists see as an increase in money’s velocity is actually a rational decision by market participants to reduce their demand for money following central bank intervention to lower the interest rate and ignite a temporary boom. But, when the boom turns to bust, the reverse happens. Now the market demands more cash at a time when fiduciary media is being wiped out by bank loan losses. Prices fall, making it wise to hold cash in the expectation of even further price reductions. Businesses begin to hoard cash when bank lending dries up in the face of falling bank capital ratios due to loan losses. And they stop investing in inventories that become less valuable each day. Finally, the public bails out of a falling stock and commodity market in favor of the comfort of cash holdings. Money velocity drops even more.
In a free market, capitalist economy marked by little government intervention and the existence of sound—that is, commodity—money, the demand for money and its inverse, the velocity of money, are of little interest to economists let alone the public. The demand for money reflects real choices based upon market forces rather than opportunistic or defensive choices based upon wild, temporary swings in economic fortunes based upon government and central bank intervention. Prices change very slowly. Banks are institutions of probity and practice good asset-liability management; that is, they match loan maturities to deposit maturities. This may sound dull to some, but it beats the wild boom/bust cycles that create millionaires one day and paupers the next.