# Understanding the Velocity of Money: Definition, Formula, Real-World Examples

## What Is the Velocity of Money?

Velocity of money is the rate at which currency moves within an economy and indicates the frequency of financial transactions. It is measured as a ratio of [gross domestic product](https://www.investopedia.com/terms/g/gdp.asp) (GDP) to a country's M1 or M2 [money supply](https://www.investopedia.com/terms/m/moneysupply.asp). Usually, when the velocity of money is high, the economy is strong and expanding. When low, the economy may be in recession and indicating a reluctance by people and businesses to spend. Economists calculate the velocity of money by dividing GDP by M1 or M2.

### Key Takeaways

*   The velocity of money measures how quickly money circulates in an economy, reflecting the frequency of monetary transactions.
*   Money velocity tends to rise during economic expansions and falls during contractions, indicating economic health.
*   High money velocity usually signifies an active economy, while low velocity may suggest recession or reluctance to spend.
*   The formula for the velocity of money is GDP divided by the money supply, using either M1 or M2.
*   Factors affecting money velocity include the money supply, consumer behavior, and payment system efficiency.

![Velocity of Money: A measurement of the rate at which money is exchanged in an economy.](https://www.investopedia.com/thmb/aOGioxNwLYGiDyJa3O2r45sRBFk=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/velocity.asp-final-15ab99d7e58f42b4ab1a678204943a2d.png)

*— Investopedia / Paige McLaughlin*

## How the Velocity of Money Reflects Economic Activity

The velocity of money is important for measuring the rate at which money in circulation is being used for purchasing goods and services. It is used to help economists and investors gauge the health and vitality of an economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.

Economists use money velocity to see how quickly money is spent on goods and services. While it is not necessarily a key economic indicator, it can be followed alongside other key indicators that help determine economic health like GDP, unemployment, and inflation. [GDP and the money supply](https://www.investopedia.com/ask/answers/070615/what-correlation-between-money-supply-and-gdp.asp) are the two components of the velocity of money formula.

[Economies](https://www.investopedia.com/terms/e/economy.asp) that exhibit a higher velocity of money relative to others tend to be more developed. The velocity of money changes with business cycles. When the economy expands, people spend more, increasing money velocity. When an economy is contracting, consumers and businesses are usually more reluctant to spend and the velocity of money is lower.

Since the velocity of money is typically correlated with business cycles, it can also be correlated with key indicators. Therefore, the velocity of money will usually rise with [GDP and inflation](https://www.investopedia.com/ask/answers/112814/why-does-inflation-increase-gdp-growth.asp). Alternatively, it is usually expected to fall when key economic indicators like GDP and inflation are falling in a contracting economy.

## Real-World Example: How Does Money Move in an Economy?

Consider an economy consisting of two individuals, A and B, who each have $100 of money in cash. Individual A buys a car from individual B for $100. Now B has $200 in cash money. Then B purchases a home from A for $100 and B enlists A's help in adding new construction to their home and for their efforts, B pays A another $100. Individual A now has $200 in cash. Individual B then sells another car to A for $100 and both A and B end up with $100 in cash. Thus, both parties in the economy have made transactions worth $400, even though they only possessed $100 each.

In this economy, the velocity of money would be two, resulting from the $400 in transactions divided by the $200 in money supply. This multiplication in the value of goods and services exchanged is made possible through the velocity of money in an economy.

## Calculating Velocity: The GDP and Money Supply Equation

While the above provides a simplified example of the velocity of money, the velocity of money is used on a much larger scale as a measure of transactional activity for an entire country’s population. In general, this measure can be thought of as the turnover of the money supply for an entire economy.

Economists usually use GDP with [M1](https://www.investopedia.com/terms/m/m1.asp) or [M2](https://www.investopedia.com/terms/m/m2.asp) as the money supply. Therefore, the velocity of money equation is written as GDP divided by money supply.

$\text{Velocity of Money} = \frac{ \text{GDP} }{ \text{Money Supply} }$

GDP is usually used as the numerator in the velocity of money formula though gross national product (GNP) may also be used as well. GDP represents the total amount of goods and services in an economy that are available for purchase. In the denominator, economists will typically identify money velocity for both M1 and M2.

M1 is defined by the Federal Reserve as the sum of all currency held by the public and [transaction deposits](https://www.investopedia.com/terms/t/transaction-deposit.asp) at depository institutions. M2 is a broader measure of money supply, adding in savings deposits, time deposits, and real money market mutual funds. As well, the St. Louis Federal Reserve tracks the quarterly velocity of money using both M1 and M2.

## Impact of Money Velocity on Economic Health

There are differing views among economists as to whether the velocity of money is a useful indicator of the health of an economy or, more specifically, inflationary pressures. "Monetarists," who follow the [quantity theory of money](https://www.investopedia.com/terms/q/quantity_theory_of_money.asp), think velocity should be stable unless expectations change. However, if money supply changes, so might expectations, and thus, velocity, and inflation.

For example, an increase in the money supply should theoretically lead to a commensurate increase in prices because there is more money chasing the same level of goods and services in the economy. The opposite should happen with a decrease in money supply. Critics, on the other hand, argue that in the [short term](https://www.investopedia.com/terms/s/shortterm.asp), the velocity of money is highly variable, and prices are resistant to change, resulting in a weak and indirect link between money supply and inflation.

Empirically, data suggests that the velocity of money is indeed variable. Moreover, the relationship between money velocity and inflation is also variable. For example, from 1959 through the end of 2007, the velocity of M2 money stock averaged approximately 1.9x with a maximum of 2.198x in 1997 and a minimum of 1.653x in 1964.

Starting in 2007, money velocity fell sharply when the Federal Reserve expanded its balance sheet to fight the [global financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp) and deflation.

Money velocity appeared to have bottomed out at 1.435 in the second quarter of 2017 and was gradually rising until the global recession triggered by the COVID-19 pandemic spurred massive U.S. Federal economic stimulus. At the end of the second quarter of 2020, the M2V was 1.128, the lowest reading of M2 money velocity in history. After another dip in the third quarter of 2021, the M2V has been increasing slowly.

## What Influences the Speed of Money in the Economy?

There are several factors that can affect the velocity of money in an economy. These include:

*   **Money supply:** the velocity of money is inversely related to the supply of money. When the supply of money is increased by the central bank, the pace of economic transactions also increases. This can potentially lead to inflation.
*   **Consumer behavior:** velocity is also affected by the behavior of economic actors. When consumers prioritize saving rather than spending, the pace of transactions slows and the velocity of money declines. When consumers prioritize spending, the velocity of money speeds up.
*   **Payment systems:** The velocity of money is also affected by features of the monetary system, such as the availability of credit or electronic banking. Money velocity rises with fewer transaction barriers and falls when spending is harder.

## Why Is the Velocity of Money Slowing Down?

The velocity of the M1 money supply has steadily decreased since the recession of 2008, according to figures from the Federal Reserve Bank of St. Louis.

Demographic changes and the Great Recession largely caused the decline. As baby boomers approached retirement and household wealth decreased, many people chose to save more.

Federal regulations may have also played a role, as the [Dodd-Frank Act](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp) increased the reserve requirements and leverage ratios for banks. Because these institutions were required to keep more of their assets, rather than lend or spend them, there was less money to move in the economy.

One factor in the slowing velocity of money is not a mystery: the COVID-19 pandemic. The velocity of money fell sharply in 2020, likely due to the increased economic uncertainty combined with the influx of stimulus payments. However, since 2021, the velocity has risen slightly.

## What Does Velocity of Money Measure?

The velocity of money estimates the movement of money in an economy—in other words, the number of times the average dollar changes hands over a single year. A high velocity of money indicates a bustling economy with strong economic activity, while a low velocity indicates a general reluctance to spend money.

## How Do You Calculate the Velocity of Money?

The velocity of money is calculated by dividing a country's gross domestic product by the total supply of money. This calculation can use either the M1 money supply, which includes physical currency, checkable deposits, and certain other figures, or the M2 supply, which also includes savings deposits and money market funds.

## Why Is the Velocity of Money So Low?

The velocity of money in the United States fell sharply during the first and second quarters of 2020, as calculated by the St. Louis Federal Reserve Bank. While there is no definitive explanation, the fall is likely due to the diminished activity incurred during the COVID-19 pandemic, as well as an increase in consumer savings due to economic uncertainty. Since 2021, the velocity of money has ticked upward slightly.

## The Bottom Line

The velocity of money indicates how frequently money changes hands in an economy. During economic expansion, the velocity of money tends to be high due to frequent spending. During an economic contraction, velocity slows due to reduced spending. The velocity of money is often linked with economic indicators like GDP and inflation for a better understanding of economic health. Usually, the velocity of money increases as GDP and inflation increase. It tends to decrease as GDP and inflation decrease.  

> **Article Sources**
>
> 1.  The Federal Reserve. "[What Is the Money Supply? Is It Important?](https://www.federalreserve.gov/faqs/money_12845.htm)"
>     
> 2.  Federal Reserve Bank of St. Louis. "[Money Velocity](https://fred.stlouisfed.org/categories/32242)."
>     
> 3.  Federal Reserve Bank of St. Louis. "[Velocity of M2 Money Stock](https://fred.stlouisfed.org/series/M2V)."
>     
> 4.  Federal Reserve Economic Data. "[Velocity of the M1 Money Supply](https://fred.stlouisfed.org/series/M1V)."