Velocity of money

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How quickly is money moving through transactions?

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The velocity of money is a metric representing the rate at which money circulates in an economy as goods and services are purchased. A dollar spent by one person becomes income that another person can spend, allowing the same dollar to support multiple transactions.

As a means to measure economic health, high velocity can mean that people and businesses are actively spending money, suggesting a busy and potentially strong economy. Low velocity, on the other hand, can indicate that people and businesses are actively saving money, pointing to a slowing economy or a recession.

Velocity can be derived from the equation of exchange, isolating V by rearranging MV = PQ: 

V = PQ/M

The equation is also commonly written as MV = PY, with Y representing real (inflation-adjusted) economic output. PY represents nominal gross domestic product (GDP), the value of goods and services produced at current prices. 

Individual transactions in an economy aren’t counted. Instead, the velocity of money is calculated by dividing nominal GDP by a measure of the money supply, typically M1 or M2 in the United States (more on this below).

The velocity of money plays an important role in the quantity theory of money, which links changes in the money supply to changes in prices across the economy. But the effect of money supply growth on prices depends in part on how quickly that money circulates. A central bank or monetary authority can sharply increase the money supply to boost the economy. But if the money remains unspent, low velocity can limit its effect on prices or output.

The U.S. saw this in 2020 and 2021 during the COVID-19 pandemic, when the government issued stimulus checks directly to citizens while expanding unemployment benefits. Many households saved some of that money or paid down debt, and velocity fell sharply even as the money supply increased—an example of the paradox of thrift, in which saving that makes sense for individuals can reduce spending across the broader economy.

For velocity to rise, people and businesses have to increase their spending. Economic optimism, low interest rates (and thus lower borrowing costs), and easier payment methods can all encourage consumers and businesses to spend, borrow, and invest. Rising inflation can also speed up the rate of consumption, as people accelerate purchases to avoid higher prices later on.

On the flip side, economic recessions and financial crises discourage spending, as the fear of job losses or slowing economic growth can encourage people and businesses to save their cash. A surge in the money supply can also cause circulation to slow, especially if the money supply increases faster than people are able or willing to spend it.

Velocity also depends on which measure of the money supply is used. In the United States, M1 is a narrower measure that includes cash and checking accounts, while the broader M2 adds savings accounts and certain money market holdings. Because M2 is larger than M1, velocity calculated using M2 is generally lower than velocity calculated using M1.

Velocity tracks the collective spending habits of all consumers, but most individuals don’t track it the way they do other economic indicators. Nevertheless, it can provide useful context: Falling velocity suggests collective economic caution and possible budget constraints, while rising velocity can indicate stronger economic activity or accelerating inflation.

For policymakers, velocity is essential to interpreting the effect of money supply changes in the economy. Changes in M alone don’t determine what happens to spending, output, or prices. As both the Great Depression and the COVID era demonstrated, changes in money supply and inflation don’t always move in sync. Within the equation of exchange, changes in velocity account for the difference—but the equation itself doesn’t explain what causes velocity to change.