Velocity of Money

8 Reasons Why Everyone Is Hoarding Cash Now

woman with money
The velocity of money is slowing because it's safer to hoard cash than invest or spend it. Photo: Blend Images/John Lund/Getty Images

Definition: The velocity of money is the rate at which people spend cash. Specifically, it is how often each unit of currency, such as the U.S. dollar or euro, is used to buy goods or services during a period. It is the turnover in the money supply.

Think of it as how hard each dollar works to increase economic output. When the velocity of money is high, it means each dollar is moving fast to purchase goods and services.

This demand generates production. When the velocity is low, each dollar is not being used very often to buy things. Instead, it's used for investments and savings. 

Formula

The velocity of money is calculated using this equation.

VM = PQ/M

Where:

VM = Velocity of Money

PQ = Nominal Gross Domestic Product. It measures the goods and services bought.  

M = Money SupplyCentral banks use either M1 or M2 to measure the money supply. M1 includes currency, travelers checks, and checking account  deposits (including those that pay interest.) M2 adds savings accounts, certificates of deposit under $100,000, and money market funds (except those held in IRAs). The Federal Reserve uses M2 since it's a broader measure of the money supply. Neither M1 nor M2 includes financial investments, such as stocks, bonds, or commodities. The money supply also doesn't include home equity or other assets. (Source: "The Money Supply," Federal Reserve Bank of New York.)

U.S. Velocity of Money

The velocity of money in the United States is at its lowest level in recent history. That means families, businesses, and the government are not using the cash on hand to buy goods and services as much as they used to. Instead, they are investing it or using it to pay off debt.

Expansionary monetary policy to stop the 2008 financial crisis may have created a liquidity trap. That's when people and businesses hoard money instead of spending it. How did this happen? A perfect storm of demographic changes, reactions to the Great Recession, and Fed programs has merged to create it.

First, the Fed lowered the fed funds rate to zero in 2008 and kept them there until 2015. That the rate banks charge each other for overnight loans. It sets the rate for short-term investments like certificates of deposit, money market funds, or other short-term bonds. Since rates are near zero, savers have little incentive to purchase these investments. Instead, they just keep it in cash because it gets nearly the same return.

Second, the Fed's quantitative easing program replaced banks' mortgage-backed securities and U.S. Treasury notes with credit. That lowered interest rates on long-term bonds, including mortgages, corporate debt, and Treasuries. Banks have little incentive to lend when the return on their loans is low. Therefore, they held the extra credit as excess reserves. 

Third, the Fed began paying banks interest on their reserves in 2008. That gave banks even more reason to hoard their excess reserves to get this risk-free return instead of lending it out.

Banks don't receive a lot more in interest from loans to offset the risk. As a result, excess reserves rose from $1.9 billion in 2007 to $1.5 trillion in 2012. Required reserves grew from $43 billion to $100 billion during that same period. (Source: "Why Did the Federal Reserve Start Paying Interest on Reserve Balances?" Federal Reserve Bank of San Francisco)

Fourth, the Fed initiated another new tool called reverse repos. The Fed pays banks interest on money it "borrows" from them overnight. The Fed doesn't need the money. It just does this to control the Fed funds rate. Banks won't lend Fed funds for less than they're getting paid in interest on the reverse repos.

Fifth, thanks to Dodd-Frank, the Fed has required banks to hold more capital.  That means banks continue to hold excess reserves instead of extending more credit through loans.

The Fed's not completely to blame. Congress should have worked with the Fed to boost the economy out of the recession with expansive fiscal policy. After the success of the Economic Stimulus Act in 2009, Congress turned toward damaging contractionary policies. It threatened to default on the debt in 2011. It threatened to raise taxes and cut spending with the fiscal cliff in 2012. It deeply cut spending through sequestration and shut down the government in 2013. These austerity measures forced the Fed to keep expansionary monetary policy longer than it should have.

A seventh reason is that the Great Recession destroyed wealth. Many people lost their homes, their jobs, or their retirement savings. Those that didn't were too scared to buy anything more than what they really needed.  Many younger people went to college because they couldn't get jobs. Now they are paying off school loans instead of starting families.  This keeps personal consumption low.

Last but not least are demographic changes. Baby boomers are entering retirement without enough savings. They are downsizing now, instead of expanding families as they did twenty years ago. This all cuts spending. (Source: "What Does Money Velocity Tell Us About Low Inflation in the United States?" Federal Reserve Bank of St. Louis, September 4, 2014.) 

Velocity of Money Chart

This chart shows you how the expansion of the money supply is not driving growth. That's one reason there is little inflation in the price of goods and services. As more money goes into investments, it creates asset bubbles instead.                                

Year  M2 GDP Velocity Comments
1999  $4.61   $9.66   2.09Tech stock bubble.
2000  $4.90 $10.282.10Recession.
2001  $5.40 $10.621.97 
2002  $5.74 $10.981.91Bush took office.
2003  $6.03 $11.511.91 
2004  $6.38 $12.271.92 
2005  $6.65 $13.091.97Housing bubble.
2006  $7.04 $13.861.97Subprime mortgage crisis.
2007  $7.44 $14.481.95Banking liquidity crisis.
2008  $8.16 $14.721.80Stock market crash. Bubble in oil prices.
2009  $8.47 $14.421.70Obama took office. Recession ended.
2010  $8.77  $14.961.71 
2011  $9.63 $15.521.61Debt crisis. Gold bubble.
2012$10.42 $16.161.55Treasuries yields hit 200-year low.
2013$10.99   $16.691.52Stock market bubble.
2014$11.64  $17.391.47Dollar strength increases.
2015$12.30 $18.041.47Dollar value up 25%.
2016$13.17$18.621.41Low business investment.

Money Supply and Nominal GDP in Trillions, of December. (Source: "M2 Money Stock," St. Louis Federal Reserve. "Nominal GDP," BEA.)