Cash flow is to our financial lives as air is to our bodies. In commercial real estate, your focus is mainly on one thing – your Return on Investment (ROI). When considering the velocity of money, the most critical question is not what your Return on Investment is; it is how long it will take for it to come back to you so you can reinvest.

Is Money Velocity Calculated Using Nominal Or Real Money Supply Calculator
Is Money Velocity Calculated Using Nominal Or Real Money Supply Is Called
Is Money Velocity Calculated Using Nominal Or Real Money Supply Definition

Velocity is the inverse of the percentage of income that people keep in the form of money. If nominal income is $100B and the money supply is $10B, then velocity is 10 – which means that average money holdings equal 10% of annual income. Velocity is therefore essentially a measure of income-adjusted money demanded. Note that the monetary value of output in 1985 was $4010 billion in the United States and 1418 billion cruzados in Brazil. Calculate the velocity for the two countries in 1985. Why do you think the velocity was so much higher in Brazil? The velocity of money, V, is defined as the ratio of real GNP to real money holdings, V=(M/P).

Therefore, a definition for the velocity of money will be the speed at which your money works for you, which is a direct result of spending it. In general, you can quickly tell from the velocity of money the rate at which money in circulation is actively spent buying goods and services.

How Does the Velocity Of Money Work?

To grasp how the velocity of money works, you need to comprehensively understand that investing in cash flow is entirely different from investing for capital gains. Supporting capital gains will more likely ignore the question of time (speed of returns).

On the other hand, funding for cash flow considers time to be a significant part of the transaction. Consider how hard each dollar works to boost the GDP. When money moves quickly to purchase goods and services, it is said to have a high velocity. It reflects a high level of demand, which results in increased output.

When speed is low, each dollar isn’t used to buy products nearly as often. Instead, it is put to work in the form of savings and investments. Because of the low demand, less production or output is generated. For residential real estate investors, house flipping is a very efficient way of sustaining cash flow and utilizing the dynamic power of the velocity of money.

Example of Velocity of Money

A typical example of the velocity of money is a traveling salesman who had a flat tire on his way, passing through a rural area. A passer-by gives him a lift to the nearby city to borrow a jack and lug wrench. The city’s cash and cruise repair shop is willing to loan him the tools for a $1,000 cash deposit until he returns the borrowed tools. He gives them money and promises to return the devices within an hour.

In the meantime, the shop owner takes the $1,000 to the parts store next door and pays for the parts he puts on hold, which he needs to fix a car that a customer is coming to pick up in one hour. The parts store owner takes the $1,000 across the street to the grocery store to buy some meat for the company barbeque that evening. The grocery store immediately pays $1,000 to the butcher for the meat he cut for the store that day.

Moments later, the salesman returns the tools and gets his $1,000 back; he finds the town booming in business. We can see that the money has been turned over three times at this point, and $3,000 worth of transactions was made within an hour.

How to Calculate Velocity of Money

The velocity of money is calculated by dividing your economic output by your money supply using this equation.

V = PQ/M

Given that:

V = Velocity of Money

PQ = Nominal Gross Domestic Product (NGDP)

M = Money Supply

How the Velocity of Money Affects the Economy

Keep in mind that the Velocity of Money implies how rapidly money moves about in a given economy. From our traveling salesman example, we can see that if the salesman had not given the repair shop the $1,000 and subsequent results, that town would have remained in inflation. Therefore, we say that the faster the money is used and reused, the lower the recession in a given economy and vice versa.

Major Takeaways

The money velocity formula calculates how quickly one unit of money or currency is exchanged for goods and services in a given economy.

The speed at which cash is cycled and recycled is higher in expanding economies.

Learning Objectives

By the end of this section, you will be able to:

Analyze whether monetary policy decisions should be made more democratically
Calculate the velocity of money
Evaluate the central bank’s influence on inflation, unemployment, asset bubbles, and leverage cycles
Calculate the effects of monetary stimulus

In the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.

As a result of this chain of events, monetary policy has little effect in the immediate future. Instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.

Excess Reserves

Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves above the legally mandated limit. For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans.

When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession, because they recognize that firms’ sales and employees’ jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP.

Japan experienced this situation in the 1990s and early 2000s. Japan’s economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s. By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0%. It kept it there most of the time through 2003. Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the country’s money supply by about 50%—an enormous increase. Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand. Japan’s economy continued to experience extremely slow growth into the mid-2000s.

Is Money Velocity Calculated Using Nominal Or Real Money Supply Calculator

Should monetary policy decisions be made more democratically?

Should a nation’s Congress or legislature comprised of elected representatives conduct monetary policy or should a politically appointed centr