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Velocity of Money: GDP Unplugged

August 8, 2011

GDP Unplugged.

If you use the Federal Reserve definition, the Velocity of Money is “a ratio of nominal Gross Domestic Product (GDP) to a measure of the money supply (M1 or M2). Simply put, it can be thought of as the rate of turnover in the money supply – that is, the number of times one dollar is used to purchase final goods and services included in GDP.

This is best understood by thinking about the concept of the Economic Multiplier Effect. Essentially, if I earn $100 and I save (say) $10.00 then I will spend the other $90.00. The person who receives the $90.00 will spend some and save some. The next, so on and so on.

In the same manner, a $100 injected into the economy by the Central Bank grows to become a multiple of the original $100. So, you calculate the velocity of money by dividing the total GDP (a measure of the nations output) by the money supply.

If I haven’t bored you already yet, stay with me…

For a long time, I viewed inflation only as a general increase in prices and the cost of living. Sure, that is one form of inflation, but it is not the type of inflation that the Fed worries about that ultimately would lead to aggressive rate hikes to fight it.

Rather, the form of inflation the Feds worry about is an expansion of the money supply & credit; that may trickle through to wages. Acknowledging this, we can come to a simple definition for deflation: a contraction in the money supply & credit, and a correlating drop in the velocity of money.

So, what that means is that GDP is a function of not just the money supply, but how fast that money moves through the economy.

The higher the velocity of money, the stronger the economy as the same fixed unit of money freely flows throughout the system. In times of hyperinflation (rapid inflation), the velocity of money should surge.

In times of deflation, the velocity of money slows. Hyperinflation occurs when there is a large increase in the money supply not supported by GDP growth, resulting in an imbalance in the supply and demand for the money.

Deflation is a contraction in the volume of available money or credit that results in a general decline in prices. To fight deflation, the Feds have traditionally printed money. Deflation can devastate an economy, because consumers often stop spending, expecting prices to decline further. In the 1930s, a prolonged period of deflation triggered years of economic chaos and stagnant economic growth.

During times of deflation, businesses drop prices in a desperate attempt to get people to buy their products. Since the world has over-produced and over-regulated… the end result of both is deflation: a slowing of the velocity of money.

The world also has way too much debt. Debt is deflationary …adding debt slows the velocity of money. The overall velocity of money has slowed in 2011 and 2012 and 2013. And, most Economists worry that deflation will bring the country into a much deeper recession, when in reality, we’re in a sliding depression.

Over the past couple of decades, WAY too much of our GDP ‘gains’ came from government spending of borrowed money, not real increases in wealth or production. GDP, the primary indicator used to gauge the health of a country’s economy, represents the total dollar value of all goods and services produced over a specific time period. You can think of it as the total size of the economy.

Usually, GDP is expressed as a comparison to the previous quarter or previous year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.

For you formula geeks, GDP is defined as C (private consumption) + I (investment) + G (government spending) + X (export-import):

GDP = C + I + G + Net Exports

All together now: “ C + I + G…” That is, consumption by consumers, investment by businesses, and government spending are the 3 major parts of our economy and of most economies. (Foreign trade, conducted by exporters / importers, is the remaining sector).

So, if we decrease “G” (cut spending) GDP goes down.

If we increase taxes then either “C” or “I” goes down, since that which you tax, someone else cannot either invest or spend. That is because the taxed money has been taken out of the economy. Fairly basic arithmetic.

If we crank “G” (increase spending – as a deficit) up from 4% to 10% of the economy (a net increase of 6% of GDP, or about $850 billion annually) on a temporary basis (for a year or two) Keynesians believe it would “goose”, “prime”, or “kick-start” the private economy.

Sorry Charlie.

The Feds then attempt an offsetting increase to jump-start the economy back into growth by increasing the money supply to overcome the effects of the business cycle and the recession.

And, velocity drops during a recession. If velocity falls then the money supply must rise for nominal GDP to even grow. [Watch as Bernanke fires up the chopper again with QE3. Do we all get to vote on what QE3 will be called?]

In other words, if velocity slows by 10%, then one would argue the money supply would have to rise by 10% just to maintain a static economy. But with population growth, productivity gains and target inflation increases, no economy remains static.

Governments get their money from three ways: taxes, borrowing, and monetary inflation.

Government spending on goods and services averages about 20%, or one fifth, of total GDP. Ten (10%) of GDP goes to transfer payments (SS, Medicare, etc) rather than expenditures on goods and services.

Given the amount of government percentage spend of GDP, any actual real fix to deficit accumulation means that GDP will of necessity ‘contract.’ Remember, if we decrease “G” (cut spending) GDP goes down.

Driving deficits from almost 12% of GDP to any percent surplus, which we desperately need to, over the next four or five years, means that GDP will of necessity contract enough from a deep recession to a “deep depression.”

Yet, to the Keynesian, one way to easily increase the velocity is “redistributing the wealth.” Ah! Now I get it! Obama Translation: tax the 1%, millionaires and corporate jet owners. Obama will always push to increase your taxes.

Remember, the increase or decrease in the velocity of money has a multiplier effect. Slowing velocity (tax increases) leads to a negative multiplier effect while rising velocity (tax cuts) leads to a positive multiplier effect.

Yet, to the Keynesian, they’ll argue circulation takes place in the economy from government spending from tax receipts. It does not. Why you ask? Because government spending does NOT pump “new money” into the economy because government must first ‘tax or borrow’ that money out of the economy. Get it?

Given that the Central banks never get the other half of the Keynesian equation (reducing the debt incurred by excess spending during an economic decline), it would be FAR better to reduce tax rates to revitalize C + I while cutting G spending in order to prime the private sector.

There is simply ‘insufficient economic engine’ to surmount this mountain (or quicksand) of debt. Money we put in the bank is usually as good as spent economically because it gets lent to someone else who, in turn, spends it into the economy. But these aren’t usual times; if the bank doesn’t re-lend the money, it might as well be in a mattress.

Obama’s continued talk of creating jobs with high speed trains, green energy projects, electric cars, stimulus spending on infrastructure, extended unemployment benefits, tax credits, and job training programs is just a continuation of ruinous “transfers of wealth” from the private sector to the government sector.

Money isn’t just a static thing. It has speed. Money isn’t money until it’s spent. You can have the same amount of money in a system, and if it passes from hand to hand more quickly, there will be more prosperity. If you lower taxes, consumers have more money to spend, consumption rises, business investment increases, GDP expands and the velocity of circulation increases.

When the economy is struggling, unemployment high, home prices falling, people are afraid to spend their money. This drives up the demand for money, slowing the velocity of money. Bottom line: GDP is a function of not just the money supply, but how fast that money moves through the economy.

Right now, it’s barely at a crawl.

3 Comments leave one →
  1. Sergio permalink
    October 1, 2012 1:56 am

    “Yet, to the Keynesian, they’ll argue circulation takes place in the economy from government spending from tax receipts. It does not. Why you ask? Because government spending does NOT pump ‘new money’ into the economy because government must first ‘tax or borrow’ that money out of the economy. Get it?”

    The same applies to a reduction of taxes, it does not pump ‘new money’ into the economy because that money was already in the economy. Duh. Lower taxes + Private investment or Higher taxes + Public investment are equivalent ways to increase GDP.

    • klsouth permalink*
      October 20, 2012 4:24 pm

      No. You obviously don’t understand the purchasing power of individual taxpayers and the effect they have on the economy’s aggregate supply. Producers and retailers are strongly influenced by aggregate demand. It is no surprise that income taxes deprive taxpayers of some of the money that they would otherwise have spent on consumption.

      Tax cuts put money in people’s pockets. Higher tax rates create a disincentive to work and invest. When individuals spend money velocity increases. In effect, the movement of money is the same as having more money; hence the term “velocity of money multiplier effect.” This multiplier effect is important when trying to understand why the government takes in more money after reducing taxes, and less when it raises taxes. The reason being that with lower tax rates more money is circulating through the economy and more people have more money to pay taxes on. When taxes go higher, there is less money circulating, meaning fewer people have less money to pay taxes on.

      Duh? as you say: “Lower taxes + Private investment or Higher taxes + Public investment are equivalent ways to increase GDP.” This is absurd. They are not equivalent. The sheer velocity of money at the hands of the individual will create and preserve jobs and encourage and foster greater entrepreneurialism, resulting in more jobs, more taxes and greater velocity in money. Lowering the tax rate would be a boost to a slow economy because it would give more people greater purchasing power, leading too more economic GDP growth, leading to greater tax receipts, leading to more jobs.

      “New Money” is derived from higher wages, more jobs, business expansion, greater consumption – all leading to higher wage earners and more taxpayers, thus, higher tax receipts. By eliminating the restrictions to velocity, and encouraging the American people to be successful, more money will flow into our treasury by way of income taxes. Individualism and collectivism are conflicting views. Try the veal.

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