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Money Supply and Velocity

Money Supply: Above on the left is a graph of M2 (Money Supply) as measured by the St. Louis Federal Reserve for 2008. To encourage economic activity to increase, the Federal Reserve increases the supply of money in the system.

You can see that starting in late September, coincident to the Lehman Brothers bankruptcy, the Federal Reserve began pumping a significant amount of money into the US financial system in an effort to jump start it and/or rescue it.

Velocity of Money: the other part of the equation is the actual activity in the economy. As the money supply increases, you need to have people make financial transactions with each other to get the money circulating – that is called the velocity of money.

Jack Wilkinson wrote that "the rate at which money circulates, changes hands, or turns over in an economy in a given period is its velocity. Higher velocity means the same quantity of money is used for a greater number of transactions and is related to the demand for money. It is also called the velocity of circulation.

"Simply put, velocity is the movement of money in the economic system. It is ESSENTIAL to the health and vitality of our system that the money moves. The faster the better. A healthy economy is one in which there is a lot of activity, with its citizens buying and selling goods and services. There are plenty of fancy equations and wordy theories for this, but it all comes down to “activity.”

"If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy goods and services from each other in just three transactions over the course of a year:
• Mechanic buys $40 of corn from farmer.
• Farmer spends $50 on tractor repair.
• Mechanic spends $10 on barn cats from farmer

"$100 has changed hands in the span of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent an average of twice a year, which is to say that the velocity was 2 / yr.

"Velocity is, in fact, one of the greatest concerns in our current credit crisis. Specifically, the slowing of velocity. Credit is the fuel of an economy. The use of credit enables a business to buy products or services and generate more income, thus fueling its growth. If an operating business cannot buy the goods of a producer, as in the previous example, the supplier will not be able to buy the goods he needs/wants and the chain is broken.

If I have million dollars that I hoard in my mattress, it neither earns interest nor is it loaned, as it would be if deposited in the bank. It really does no one much good. However, if it is deposited in the bank and the bank won’t make a loan how is it different than the mattress? It isn’t. But, should we just lend or borrow simply to keep the system going? I think not. Look at the situation we are in now. Of course, a prudent lender would never make a loan to a borrower who is not able to pay. That lack of prudence on the part of many lenders is at the core of our current economic downfall .

"Many of us are not buying goods from others right now. Retail sales, the most obvious of exchanges, are down. The retailers are constrained from buying goods supplied by the manufacturers, who have to reduce labor. The people who no longer have an income are certainly unable to buy things other than necessities, thus, further reducing the number of exchanges in the economy."

The best forecast for Velocity is generally the Consumer Confidence Index. As confidence begins to increase, then consumers begin to spend. What we are seeing is that confidence crashed along with the economy, but people are starting to get complacent and begin to spend again. Above on the right is a graph showing the most recent data with confidence numbers beginning an uptick.

Probably even more relevant is the Expectations Index. This sub-index of the Consumer Confidence Index characterizes consumers perceptions about the economy over the coming six-month period. This index increased from a reading of 35.7 in October to 46.7 as of November 26th. If this becomes a trend, then we should see consumers begin to spend and the velocity of money in our economy increase.

Given the increased money supply, even a small increase in the velocity of money can have a significant impact on our economy, further raising the Expectations Index and the Consumer Confidence Index.

We are no where close to out of the woods, but these indicators do provide some hope that an economic recovery in mid-2009 is possible.