Money Velocity and Inflation

posted in: Fundamental Analysis | 0

The Velocity of Money is an important factor in determining inflationary pressures. It represents the speed at which the total stock of money in an economy is spent. Imagine Bill sells his car. With the money he turns around and buys some woodworking equipment from Cliff. Cliff takes those funds and buys new furniture. The velocity of that money is thus 3.

The basic equation:

MV=PQ

is the manner in which the metric is calculated. MV equals money velocity, P represents price, and Q equals quantity. When money velocity increases, it means that more dollars are chasing after a set quantity of goods (be they cars, woodworking equipment, or furniture). This pushes up the price level, and thus inflation in those items.
Inflation manifests itself in many ways. Not just in the manner of rising wages. Increases in stocks, homes, and other goods with rising prices can be a result of excessive money growth, and thus inflation.
Given the lack of inflation in our general economy begs the question of why with all the money printing it hasn’t appeared. I believe the chart below explains a lot.

Since the late 1990‘s money supply has collapsed precipitously. Infusions of central bank money printing have caused blips in the overall trend. Yet the trend continues down. I believe there are several reasons for this, and thus the lack of inflation.
Most importantly is demographic. The mid 90’s when money velocity peaked was at the time that the baby boomer generation was in the age range of 39-49. A peak time to become begin to start saving aggressively. Since stashing away money in savings does not flow into an economy, money velocity and thus inflation have suffered.
There are a lot of variables that are involved in the equation of inflation (“I’m a poet and didn’t know it”). This is a major factor that should not be overlooked.