What is the velocity of money?
Many years ago, philosopher David Hume and other thinkers developed what's known as the "classical theory" of inflation. This theory introduced the idea that increases in the money supply were the leading cause of inflation. However, as I will point out in this article, to truly understand inflation, you must also consider what's known as the "velocity of money."
What is the velocity of money, and why should you care?
Playing a pivotal role in understanding how economies function, "velocity of money" refers to the speed at which money changes hands within an economy over a certain period. The velocity of money, therefore, is a measure of how efficiently capital circulates within an economy.
Often calculated as the ratio of the nominal GDP (Gross Domestic Product) to the money supply, the velocity of money expresses the frequency with which a unit of currency circulates within the economy.
A higher velocity of money indicates that people are spending and investing. A lower velocity suggests that people may be saving too much money or that cash is moving more slowly through an economy for other reasons.
When people get money, they eventually spend it by paying it to someone else in exchange for a product or service. In turn, the person who receives this cash will subsequently give it to someone else. As long as this earn-spend cycle continues, there aren't any issues. But, if the flow slows, is interrupted, or otherwise ceases, economic upheaval will occur. You can think of money velocity like a giant wheel of fortune. As long as the wheel keeps spinning, it's all good. But when it stops, watch out!
The velocity of money is one of several economic indicators with far-reaching implications for everyday people, particularly regarding their savings and retirement plans.
How can money velocity impact an economy?
- High money velocity can spur economic growth: A higher velocity of money is often associated with economic growth. When money changes hands frequently, it stimulates economic activity, leading to increased production, job creation, and a rising standard of living. This situation benefits businesses and individuals because it means more opportunities for employment and wage growth.
- Velocity impacts inflation: However, an increase in the velocity of money can contribute to inflationary pressures. When people spend money quickly, demand for goods and services rises.
This uptick often drives prices higher.
But, since this process takes time, increases in either the money supply or the velocity of money don't immediately raise prices.
- The velocity of money influences interest rates. If cash in an economy circulates too quickly, central banks may attempt to combat inflation by raising interest rates. If you are a saver, you're probably aware that higher interest rates can help you get better returns on your savings and investments. Unfortunately, though, savers and investors can lose some of those earnings if the costs of goods and services increase faster than the interest they're getting. For this reason, I make planning for inflation risk a key component of my clients' long-term financial plans.
The velocity of money and your retirement
As previously mentioned, individuals nearing retirement or already retired are affected by the velocity of money in specific ways. Many retirees rely on fixed-income investments, such as bonds and annuities, to create predictable and stable income streams. If the velocity of money leads to rising interest rates, these retirees will see increased yields on their investments and, thus, more income to support their lifestyles.
Unfortunately, the erosive effects of uncontrolled inflation undo this income bump by hiking the costs of necessities such as utilities, food, water, and gas.
In this situation, diversifying your portfolio with inflation-protected assets could be wise. For instance, inflation-protected annuities (IPAs) might work. Although similar to an immediate annuity, an IPA differs because its payments are indexed to the inflation rate. These products have limitations, however, and you should consult your retirement planning expert before purchasing. Treasury Inflation-Protected Securities (TIPS) are another financial vehicle to help safeguard retirees' purchasing power. There are other strategies and products that, when used creatively in a well-designed economic blueprint, could help you beat back the negative impact of inflation.
The velocity of money can change how you invest your money.
A rapidly circulating currency often favors growth investments, such as stocks, over fixed-income assets. I encourage retirees to avoid embracing a "set it and forget it" approach to portfolio design and management. You should periodically review your investment portfolio to ensure the right balance, adjusting for current economic conditions and aligning with your long-term goals and risk tolerance.
The velocity of money is a fundamental economic concept affecting many individuals' savings and retirement plans in subtle and not-so-subtle ways. This concept plays a role in determining interest and inflation rates and indicates overall economic growth. No one is immune to money velocity's implications, even those who've already retired.
To navigate these economic dynamics successfully, individuals must have a basic knowledge of the velocity of money, diversify their investments, and adjust their financial strategies to secure a stable and more prosperous retirement. Understanding that money circulates through the economy, benefiting various participants, is essential for making informed financial decisions in an ever-changing economic landscape.