Tuesday, June 28, 2011

Understanding Velocity in Our Economy

The velocity of money is a huge factor in our economy and yet many investors do not understand it or even know what it is.  I find that even many libertarians and followers of Austrian economics do not understand velocity.

The velocity of money is the demand for money.  It is how quickly money is changing hands.  If there is a high demand for money, then velocity is low.  This means that people are not spending as much.  Therefore, money is changing hands less frequently.  This has the same effect as monetary deflation.  With everything else being equal, a reduction in velocity will push prices down.

The opposite is true for high velocity.  There is a low demand for money and money is changing hands quickly.  This pushes prices up.  The most extreme example of high velocity is during a period of hyperinflation.  People get their paycheck and they run to the store and hurry up and spend it before prices are even higher.  When overall prices are rising every day, this is extreme hyperinflation and it means that the money being used will be worth nothing soon.

Velocity is determined by the attitudes of the people.  Right now in the U.S., velocity seems to be quite low.  It is almost impossible to measure, but you can usually take a good guess based on other factors.  With the economy down, unemployment high, and uncertainty high, people are afraid of the future.  They have cut back on their spending and are trying to pay down debt.  They are trying to save for a rainy day, or in this case a rainier day.

The adjusted monetary base has approximately tripled since 2008.  But consumer price inflation has been relatively mild.  I attribute this to two things.  First, the excess reserves held by commercial banks have dramatically increased.  Second, the velocity of money has been low.  The two of these things are even related in a way.  Banks are not lending due to fear and people are not spending due to fear.  This has kept us from having massive price inflation.

For some reason, people still run to the U.S. dollar in times of uncertainty.  I think is beginning to change and will continue to change.  Eventually, people will start running away from the dollar and will run to hard assets like gold and silver.

Because of velocity, it is possible to have rising prices without monetary inflation.  It is not likely, but it is possible.  If everyone became an Austro-libertarian tomorrow and knew that everyone else did too, then people might start dumping their dollars for hard assets.  High velocity alone could kill a currency.  If people no longer have faith in their money, it won't matter what the government does.  It will quickly become worthless.

Although it is impossible to measure velocity, it is important to keep it in mind when examining the economy and prices in general.  Human behavior plays a big role in our economy.  If velocity turns higher one day, we should watch out for big price inflation.  Then the Fed will have to decide if it wants to save the dollar.

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