E The US Velocity Of Money Is At A 25 Year Low

The velocity of money is an indicator which does not receive much attention anymore. Perhaps this lack of attention is justified. 

The velocity of money is usually calculated as a ratio of gross domestic product (GDP) to a country's M2 money supply. In other words, GDP and the money supply are the two key components of the velocity of money formula.

This concept measures the rate at which money in circulation (in this case M2) is being used for the purchase of goods and services in the economy. 

In theory the velocity of money shows the rate at which money is being transacted for goods and services in an economy. 

It is often though that the velocity of money estimates should provide economists and investors a gauge of the health and vitality of the economy. i.e. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions. 

In other words, the velocity of money often was used not only gauge the economy's strength but also to probe household willingness to spend. Some economists faithfully follow it alongside other key indicators that help determine economic health -- such as GDP, unemployment, and inflation. 

However, as the accompanying chart indicates, the velocity of the M2 money supply in the US recently fell to a 25-year low. 

One way to think about this trend is that it takes an increasing amount of credit (including bank credit to the federal government) to generate the same amount of GDP. 

How can we explain the significant secular decline in the velocity of money? I have no easy answer, other than to point out that M2 might not be the best measure of the money supply. Clearly money velocity has declined due to a longer-term robust increase in the money supply relative to nominal or real GDP. 

Nonetheless, as an analytical tool, this concept clearly has its limits. In the current environment, the low velocity number does not signal a weak US economy. 

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