The speed of money is the frequency with which a unit of a currency is used to buy goods and services for a certain period of time. That is, it is the number of times that for example a dollar is used to buy goods and services per unit of time. If the speed of money increases, it means that more transactions are taking place between the individuals participating in that economy.
Know if consumers and companies are saving or spending money
The frequency with which a unit of money is exchanged serves to determine the speed of a particular component of the money supply and allows us to know if consumers and companies are saving or spending money.
The speed of money can be calculated as a ratio between the nominal GDP of a country and its money supply. If the transactions in an economy increase, the speed of money increases and the economy is in the expansion phase. If, on the contrary, fewer and fewer transactions are made, the speed of money is reduced and the economy contracts.
During the 4 quarter of 2015, in the US the speed of money marked a ratio of 1.48 , the lowest of the last 50 years. This means that every dollar of the money supply has been spent only 1.48 times during the previous year. A figure far removed from the 1.98 times ratio we had before the arrival of the financial crisis in 2007.
Now look at this equation
MxV = PxQ
In this equation we have to:
M = money supply
V = speed of money or ratio at which people spend money.
P = Price level
Q = Quantity of goods and services that are produced
PxQ = GDP
Quantity of goods and services produced by an economy
According to this equation, if the speed of money remains constant and the money supply increases at a faster rate than the quantity of goods and services produced by an economy, then the difference must be compensated by an increase in the P or the price level.
According to this equation and in view of the monetary injections made by the Fed, inflation in the US between 2008 and 2013 should have been 33% with the production of goods and services growing at an annual rate of 2%. And yet …… something has failed resoundingly in theory since inflation has remained well below 2% and we have the cause in the sharp drop in the speed of money.
What has happened is that the increase in the unprecedented monetary base that the Fed has carried out via QE injections has failed to provide proportional increases of 1 to 1 in nominal GDP. The sharp drop in the speed of money has surpassed the increase in the money supply leading to much smaller changes than would have been expected in nominal GDP.
One of the explanations of why the speed of money has fallen is that companies, individuals, and banks have preferred to save money or pay debts instead of spending it. In other words, the appetite for money has increased. High levels of debt are undoubtedly playing an important role.
Profitability of many assets
This appetite for money may partly come from the dramatic fall in interest rates that has caused the fall in the profitability of many assets which causes them to lose attractiveness to investors as profitability continues to fall and they prefer have your money parked before invested.
In fact, before the financial crisis, every 1% drop in the 10-year treasury bond yield caused a 0.17 point drop in the speed of money. However, with the crisis, as the Fed has continued to push bond interest rates toward zero or negative returns, the speed of money has fallen much faster than the traditional regression model it has with the fall in profitability. of the bonds. This is because at zero or negative profitability the risk-free asset has ceased to be short-term bonds and has become liquidity.
And if it is true, the fall in yields inflates the price of assets making the rich feel even richer but has not unleashed consumption or at least only unleashes it in a minority and is also destroying the intermediation margin of banking so why lend money.
And yet, it seems that the Central Banks, especially now the ECB, continues to insist on reducing interest rates to ridiculous levels never seen before. Welcome to the liquidity trap. Now it seems that the last desperate movement is to take the whole economic theory upside down and try to get people to charge for taking a loan and pay to lend their money.
By the way if the fall in the speed of money in the US seems worrisome, look at the fall in the speed of money in China. It is at 0.50x.
And China is not alone. The Euro Zone of Draghi is at a ratio of 0.55x and Japan at 0.50x.