What is the Velocity of Money and should I care?

The Velocity of Money is a term used to describe the rate at which money is exchanged from one transaction to another.

Investopedia explains Velocity of Money this way! Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is. It is usually measured as a ratio of GNP to a country's total supply of money. We talked about GNP in the last Blog.

Let’s talk about this on a microeconomic scale first so that you can understand what I am talking about. Just to give you an example; the Velocity of Money is higher for Ford Motor Company Car Division than it is for the Tank Division that builds tanks for the US Army.

Most of the time, the Army does not do anything productive. They buy equipment like tanks and the tanks do nothing at all. Very few times are they sold to another Army compared to cars. The army uses them in mass when we are at war. That is the time when they may need a great deal of maintenance.

Most of the time, Ford Motor Company makes cars. These cars are sold to the public. The public uses the cars to make money for the family. Then the car breaks down and must be fixed at a maintenance shop. The maintenance shop needs mechanics. Also the car maintenance shop needs suppliers. The Suppliers need raw material and labor. To make the raw materials that go into parts, they need another supplier that can make these sub-assemblies such as light bulbs and door handles. Then you need a light bulb company that makes the light bulbs. These light bulbs are broken down into parts and someone must make them.

Ford may sell tanks to the US Army but the orders are limited. The parts orders are limited. When Ford makes cars, they make cars all the time. The supplier makes parts all the time. The cars are used in production of other goods and services all the time.

So the Velocity of Money is higher making cars than making tanks because the activity around cars when it comes to production is higher than with tanks. Money changes hands more with cars than with tanks.

On a Macroeconomic scale, the more companies that a nation has that has high Money Velocity, the higher the employment of that country will be. The higher the Money Velocity, the higher the stocks of these companies will be. This is what we had in the 1960s. Our factories were making things and these factories where selling things to the nation and around the world. This is what kept us employed.

The reason why we have been moving toward a Great Depression for the past 30 to 40 years is because our political leaders allowed our factories to leave the United States. In its place we have service companies making hamburgers. We have service companies that push gambling, insurance, talking on the cell phone, and computer games. The Velocity of Money is not there. We buy products and services but the factories that make the parts and the full product are in other countries. So the Velocity of Money is very low and getting lower in the United States.

Couple that with a rise in the age of the national populations. With an older population, your Velocity of Money will be lower because more of your people in this country do not need as many goods and services. The children born in the 1920s, 1930s, and 1940s are dying at a faster and faster rate. They are leaving behind a large supply of houses, cars, furniture, and etc. Why buy them when grandmother will just give them to you?

Look back between 1920 and 1940 and you will see that the US population was older. Few children were born in the 1930s. This helped maintain the Great Depression of the 1930s. The baby boom did not come until 1946. That accounts for the prosperity years between 1960 and 1980. These baby boomers had to buy home, cars, clothing, and other goods to make life more comfortable. Now these same people are retiring and starting to die out.

This is why the Velocity of Money will remain low for years to come. The Depression will remain with us for some time. Inflation will continue to be low. Cash will continue to be “king.” Stock prices in the United States will remain stagnant but the Bond Market will continue to be bullish.

Next time we will talk about bubbles brought about because of market fads. As of Friday, Sept. 3, 2010, my bond portfolio is up 21.64% for the year, 72.09% since January 2009 while the Dow is down for the year. Some people say that I am in a bubble. We will talk about bubbles next time.