The velocity of money (let’s call it “V”) is the rate at which money changes hands, typically in a year. If V is, say five, that means that the average dollar changes hands five times a year. It is an important economic metric that gets little mention by the economic press.
When V is high, a dollar is changing hands frequently to purchase goods and services — suggesting that the economy is doing well. It reflects high demand, which generates more economic activity. When V is low, a dollar is not changing hands often to buy things — meaning that economic activity is sluggish. Instead, it is being saved and invested.
V is calculated by dividing the nation’s economic output, nominal GDP — GDP not adjusted for inflation — by the money supply. The measure of the money supply used here is so-called M2, which includes cash, checking accounts, savings deposits, money market securities, mutual funds and other time deposits.
This historical chart of V explains a lot. V has declined from a high of about 2.2 in the 1990s to a bit below 1.5 before COVID-19, and to 1.1 during the pandemic. So why is V so low and why has it been declining since the 1980s?
One reason is that the Federal Reserve Bank (Fed) has been pumping money into the economy, but to little avail because money is not changing hands. Another is that a lot of the money is concentrated among the richest Americans who are not spending most of their wealth. Look at the difference between mean and median family net worth. The larger the difference implies greater wealth inequality, which you can see has been increasing since the 1990s.
A lot of the country’s wealth is increasingly concentrated in the hands of the rich and the super-rich who do not spend most of their money — its V being zero — because they already own all they want to own. The richest 10 percent own about 70 percent of the country’s wealth. This is why long-term inflation is expected to remain low. The economy is awash in cash, but most of it is concentrated in the hands of a few who will not spend it. In contrast lower-and-middle income workers spend most of the money that they earn.
The Fed nor the private sector can correct the long-term decline in V, so economists such as Larry Summers are recommending that the government step in by borrowing money and spending on “green” infrastructure projects and on addressing climate change.
But notice the huge drop in V last year. The pandemic has caused most (responsible) citizens to stay home. Consequently, they are spending less and saving more. So, there is huge pent-up demand waiting to be unleashed once the country is vaccinated, especially in travel and leisure, suggesting that we can expect some short-term inflation in those sectors of the economy once the pandemic is controlled.
Given that the unemployment rate is 6.7 percent — meaning that most workers in the country are employed — and because they do not have available avenues to spend their money right now, it might not be wise to give an additional $1,400 in stimulus money. Most of it would be saved and would add to short-term inflation once the pandemic is over. Increasing unemployment payments, providing support to those experiencing food scarcity and assisting those without medical insurance would be a better way to target assistance.
Addressing wealth and income inequality should get more attention in the future, now that more and more working-class whites — the Republican party’s base — are falling through the cracks. Floridians are leading the charge by mandating an increase in the minimum wage. There are other and probably better ways of addressing the problem. I plan to write about that soon.
Murad Antia teaches finance at the Muma College of Business, University of South Florida, Tampa.