Thursday, November 19, 2009

Money and Velocity

Almost 9 months ago the government pumped in $757 Billion, that is right Billion, into the economy, but for some reason, they still do not realize that what they did, though noble, was not the most effect way of stimulating the economy. Why? It is because they do not understand the power of money’s momentum. Essentially, the faster money flows, the stronger you economy. Why? Well, as money moves through the system, its “effect” in multiplied by the number of times it exchanges hands. This velocity of money actually makes it seem like there is more money in the system than there actually is, or that the multiplicative effect of the existing money is greater as the velocity increases.

Back in school, I learned a few interesting equations about how velocity effects things. These include momentum, kinetic energy, and finally Einstein’s equation of relativity. To review these equations are:

momentum = mass * velocity

Kinetic Energy (KE)
KE = ½ mv
2 (where m=mass and v=velocity)

Finally, we all know the formula that Einstein came up to describe his theory of relativity, e=mc2 where “e” is energy, “m” is for mass and “c” is the speed of light.

While most economist focus on the “supply” of money in the form of M1, M2, and M3, in terms of the health of the economy, I really believe it is the velocity (or exchange per day, week, month, etc.) that have a much more profound effect on our present state of affairs.

Traditionally, money supply is defined in terms of M1, M2 and M3 and the definitions as Released by Fred (Federal Reserve Economic Data @ St. Louis) are listed below:

The terms M1, M2, M3 refer to the monetary aggregates. For quite some time it was thought that there was a perfect one to one relationship between these numbers and the rates of inflation. Recently this relationship seems to have broken down, and the money supply numbers have lost some of their appeal to market participants. It is still important to watch for strong growth in the money supply which might lead to inflationary pressures as money inflates aggregate demand.

M1: Technically defined this is the sum of: the tender that is held outside banks, travelers checks, checking accounts (but not demand deposits), minus the amount of money in the Federal Reserve float.

M2: The sum of: M1, savings deposits (this would include money market accounts from which no checks can be written), small denomination time deposits (where small is less than $100,000), retirement accounts.

M3: M2 plus the large time deposits (for any of you with more than $100,000 deposits you add to this...). Eurodollar deposits, dollars held at foreign offices of U.S. banks, and institutional money market funds.

While these are great indicators to show where money is being used, they are not the best in determining the health of the economy.

The main reason why the stimulus is NOT working is because the powers that be are not focusing on generating enough velocity of money. The reason why our economy went into a tailspin after the financial bailout was that the velocity of money in the hands of consumers went almost to one. This in turn made everyone “feel” poorer because know the multiplicative effect of money essentially was one. In addition, I have developed a formula for what I believe is a good indicator of how the velocity of money affects the strength of the economy below:


Where “E” stands for the economic health, “M” is the money supply, “k” is a constant yet to be determined, and “v” is the number of turns of money per month with its minimum being 1. Looking at this equations (which is similar to the formula for kinetic energy and Einstein’s theory of relativity equation), as “v” approaches 1, the strength of the economy becomes directly proportional to the total amount of money in the system.

In contrast, as you increase the velocity of money, its effect is exponential. As an example, if you can make the number of turns “v” increase to 4, then the multiplicative effect of that velocity is a 16 times increase.

This equation is valid more for M1. With M2 and M3, “v” tends to stand around 1 or 2. The only place where v increases to a more robust number is with M1. So, when the Government poured $757 Billion dollars to expand M2, they did very little in expanding the “effect” of the money they placed into the economy. In contrast, if they had focused on putting the money directing to consumers (M1), they might have had to put in far less money ($40 Billion) to get the same effect, or if the put in $700 Billion into M1, we would probably already be out of the Great Recession.

I am shocked that no one has brought this obviously glaring “miss” in the Stimulus Package, but then again, it seems like they all had their own agendas.


Anonymous said...

Nice. But you assume that changes in Money Velocity affect the Economy, instead of the other way around. Here are some good charts that show the relationship of the Economy (proxied by the stock market), and the velocity of money:

From these, it appears that Money Velocity is affected by the Economy, and it is hard to say for sure that the Fed can simply change the Money Supply to change the Money Velocity.

Interesting analysis nonetheless. I will keep checking back, as I like your thinking.

Profit Profit said...

Good point made! While I do enjoy the ups and downs of the Stock market, they are not a realistic reflection of the health of the economy, but are a good indicator of what people "bet" the economy will do. Interesting enough, the S&P 500 still went up as the velocity stayed the same or actually decreased.

Still, the relationship is undeniable and thanks for your insights. Greatly appreciated.

Still, I think M1 was were the money should have been poured into.

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