What is the velocity of money and how do you calculate it
The velocity of money gives an important indication of the overall health of an economy. Here, we explain what the velocity of money is, the formula to calculate it and why it is important to traders.
What is the velocity of money?
The velocity of money is the rate at which consumers and businesses spend money in an economy. Generally, the velocity of money is taken as the number of times that a unit of currency is used to purchase goods and services in a defined period.
Velocity of money formula
The velocity of money formula divides the gross domestic product (GDP) of an economy by the money supply, as demonstrated in the calculation below:
Velocity of money example
For a velocity of money example, let’s look at a transaction between a sports player and a sports equipment company. The equipment company pays the sports player £1000 to do some promotional work for them and, in turn, the sports player spends £1000 on merchandise from the sports equipment company.
At the end of the day, the GDP of the economy is £2000, but only £1000 has changed hands. If this transaction is repeated every day for 30 days, then the GDP of the economy would be £60,000 (30 x £2000), despite the money supply being only £1000.
To calculate the velocity of money in this scenario, we would divide £60,000 by £1000 which would give us a velocity of money of 60.
Velocity of money as a market indicator
The velocity of money is used as a market indicator of the overall health of an economy, especially in relation to its GDP. Higher velocity of money is often associated with an expanding economy in which goods and services are in high demand and GDP is increasing. Low velocity of money can indicate a restricting economy in which consumers are spending less on goods and services which causes GDP to fall.
Why is velocity of money important to traders?
Velocity of money is important to traders because they can use it as a possible indicator of when to go long on certain assets, and when to go short on others. This is because a high velocity of money is associated with an expanding economy and increased production, while low velocity of money is associated with a constricting economy and lower production.
With that in mind, traders might choose to buy manufacturing stocks in an economy with a high velocity of money with the assumption that there will be increased demand as industry expands. On the other hand, they might short manufacturing stocks in an economy with low velocity of money with the assumption that there will be reduced demand as industry contracts.
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