• Over the past eight years, the velocity of money has collapsed. Since its peak in 2007, the velocity of narrow money seems to have fallen off a sheer vertical cliff, as illustrated in the chart below. However, over the past year or so, there are early signs that the velocity of money has stabilized, albeit at exceptionally low levels.

• Does this stabilization mark a turning point for the velocity of money? Has the velocity of money reached its nadir? And what factors might drive the velocity of money higher in 2016 and beyond?

• The view of The Money Enigma is that the velocity of money has probably reached its low point. More specifically, there are three possible factors that could drive the velocity of money higher in 2016.

• First, the US economy could reaccelerate, requiring a higher turnover of money to facilitate the extra transactions in the economy.

• Second, the Federal Reserve could begin to reduce the monetary base. All else remaining equal, if there is less money in the system, then the money that remains needs to turn over more often to “get the job” done, i.e. to facilitate the same monetary value of economic transactions.

• Third, the value of money could decline. All else remaining equal, if each unit of money (each dollar) becomes “less valuable” in an absolute sense, then each unit of money must change hands more times in order to complete the same “absolute value” of economic transactions.

• The view of The Money Enigma is that the velocity of money is close to its nadir. Why? Well, either the Fed will significantly reduce the monetary base, leading to an almost mathematically certain rise in the velocity of narrow money, or the Fed’s inaction will cause a significant decline in the value of money and a concomitant rise in the velocity of money.

• The relationship between the velocity of money and the “value of money” is poorly articulated by mainstream economics. In order to fully explain this idea, we will discuss a new model for the velocity of money and focus on the relationship between each of the three factors described above and the velocity of money. More specifically, we will explore the critical relationship between the value of money and the velocity of money.

A Brief Overview

Since 2007, the velocity of narrow money has collapsed. The chart immediately below illustrates how the velocity of M1 has fallen sharply over the past eight years.

In the last 12 months, the velocity of money seems to have stabilized at exceptionally low levels, levels that have not been seen since the early-mid 1970s. Interestingly, the chart above does seem to suggest that the velocity of money tends to fluctuate within a wide band. Indeed, many economists still believe that the velocity of money tends to “revert to the mean” over long periods of time. So, will the velocity of money begin to revert to the mean in 2016? And if it does, what are the implications for inflation?

In order to understand what might drive the velocity of money higher in 2016 and beyond, we need to do two things.

First, we need to derive a model of the velocity of money that is “useful”, not just a rearrangement of the famous equation of exchange. The view of The Money Enigma is that a useful model for the velocity of money must incorporate an explicit role for the “value of money”.

Second, we need to review the experience on the last eight years in terms of this model. In this week’s post, it will be argued that the reason the velocity of money declined so sharply over the past eight years is because the massive expansion in the monetary base did not trigger a concomitant fall in the value of money.

Once we complete these two steps, then we will apply our model to the outlook for 2016. The view of The Money Enigma is that there are, as always, three key factors that could drive the velocity of money higher. But, in practice, only one or two of these factors are likely to drive a sharp rise in the velocity of money over the next few years.

A Model for the Velocity of Money

In this section, we are going to explore how the model for the velocity of money below is derived and, more importantly, what it means.

There are two key terms in the model above that will be unfamiliar to new readers. The first is the “market value of the basket of goods”, denoted “V_G”. The second is the “market value of money”, denoted “V_M”. In both cases, the property of market value is measured in terms of a “standard unit”. I shall explain what this means in a moment.

At a high level, the model for the velocity of money above suggests that the value of money, “V_M”, plays a critical role in the determination of the velocity of money. All else remaining, as the value of money falls, the velocity of money rises.

The view of The Money Enigma is that the standard equation for the velocity of money (v=pq/M) is not a useful predictive or explanatory model. Simply rearranging the equation of exchange to put the velocity of money on the left hand side and nominal output divided by money supply on the right hand side tells us very little about what actually drives the velocity of money.

More specifically, if a model for the velocity of money is to be useful at explaining why the velocity of money can rise and fall so sharply, then it must incorporate an explicit role for “the variable that economics forgot”, the “value of money”.

However, in order to incorporate the value of money in our model for the velocity of money we must first isolate the value of money as an independent variable.

Isolating the value of money as an independent or “standalone” variable is something that mainstream economics has consistently failed to achieve. The reasons for this are complex and are discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

In essence, the problem relates to how economics measures the property of “market value” or what others might refer to as “value in exchange”. In order to isolate the value of money as an independent variable, we must measure the market value of money in absolute terms, not relative terms. Moreover, we can only measure this property in absolute terms if we adopt a “standard unit” for the measurement of market value.

While most people think of “market value” and “price” as synonymous, the view of The Money Enigma is that “market value” and “price” are not the same thing. Rather, price is merely one method of measuring the property of market value.

Market value is a property that all economic goods possess. For example, an apple has market value and, in order to acquire an apple from you, I must offer you something valuable in exchange. The market value of that apple will fluctuate, completely independent of changes in the market value of any other good.

The price of a good is a relative measure of the market value of one good in terms of the market value of another. For example, if an apple is twice as valuable than a banana, then the price of apples in banana terms is two bananas. Moreover, the price of apples in banana terms can rise for one of two reasons: either, (a) apples become more valuable, or (b) bananas become less valuable.

The point is that “market value” is a property and “price” is a relative measure of this property. This observation leads us to our next question: if market value can be measured in relative terms, then can it be measured in absolute terms?

The simple answer is “yes”. However, in order to measure any property in absolute terms, one must adopt a “standard unit” for the measurement of that property. A “standard unit of measurement” is a theoretical unit of measure that is invariable in the property being measured. While no good is invariable in the property of market value, we can create a theoretical good that is invariable in that property and use this as our standard unit.

Now, how does all this relate to the “value of money”?

Typically, economics measure the “value of money” in relative terms. Most commonly, the value of money is measured in terms of the value of the basket of goods. This is known as the “purchasing power of money” and is simply the inverse of the price level.

The problem with measuring the value of money in this way is that it doesn’t allow us to isolate the value of money as an independent variable. For example, if the purchasing power of money falls, then we don’t whether it was because (a) the value of money fell, or (b) the value of the basket of goods rose.

However, if we adopt a standard unit for the measurement of market value, then, at least theoretically, we can isolate the value of money and the value of the basket of goods as two separate variables and analyze them separately.

Moreover, we can extend our observation that “every price is a relative expression of market value” to the price level. If every price is a relative measure of market value, then the price level is also a relative measure of market value. More specifically, the price level is a relative measure of the value of the basket of goods in terms of the value of money.

Mathematically, we can express the price level as a ratio of two values, an idea that was discussed at length in a recent post titled “Ratio Theory of the Price Level”. In simple terms, if we denote the market value of the basket of goods as measured in terms of the standard unit as “V_G” and we denote the market value of money as measured in terms of the standard unit as “V_M”, then the price level is simply the first term divided by the second term.

What does Ratio Theory imply? In simple terms, Ratio Theory states that the price level can rise for one of two reasons: either (a) the value of the basket of goods rises, or (b) the value of money falls.

Now, let’s return to our discussion of the velocity of money. How can Ratio Theory help us understand the possible drivers of the velocity of money?

The great advantage of Ratio Theory, in regards to this discussion, is that it allows us to substitute out the price level “p” in the equation of exchange and replace it with the two variables described above.

Suddenly, we have a new model for the velocity of money that can provide us with some useful and rather intuitive insights into what really drives the velocity of money. More specifically, we have a model for the velocity of money that contemplates an explicit role for the “value of money”: all else remaining equal, as the value of money falls, the velocity of money rises.

Now, let’s take this model for the velocity of money and think about what has happened over the past eight years.

Why Has the Velocity of Money Collapsed?

Let’s take our new model for the velocity of money and think about why the velocity of money may have collapsed over the past eight years.

From a theoretical perspective, there are four variables that could drive a decline in velocity. However, in practice, the two variables in the numerator tend to be relatively stable. Rather, most of the major variations in the velocity of money occur because of changes in the two variables in the denominator.

The view of The Money Enigma is that the value of the basket of goods VG and real output q are both relatively stable macroeconomic variables in principle and, over the past eight years, are unlikely to have contributed to the major decline in velocity.

Over the past eight years, real output has increased, albeit marginally, and this growth in real output has not contributed to the decline in velocity. It is possible that the value of goods, as measured in absolute terms, has declined slightly over the past eight years driven by globalization and excess supply, particularly in commodities. However, it is unlikely that a decline in the market value of goods can explain the steep drop in the velocity of money that we have seen over the past eight years.

Therefore, we need to focus on the two variables in the denominator of our model. Clearly, the large increase in the monetary base could easily explain the decline in the velocity of money. All else remaining equal, as more money is injected into the system, each unit of money needs to change hands fewer times in order to complete the same value of transaction.

But what about the second variable: the value of money? Could a rise in the value of money explain the decline in velocity?

Frankly, this seems very unlikely. Rather, it is much more likely that the value of money was relatively stable over the past eight years, a phenomenon that was reflected in the relative stability of the price level over that same period.

It is worth remembering that when the Fed first introduced quantitative easing, there were many market commentators who argued that such an expansion of the monetary base would lead to a rise in inflation. However, in practice, this didn’t occur. Rather, the price level remained relatively stable and the velocity of money collapsed. So, what happened? Why didn’t prices rise sharply when the Fed expanded the monetary base and why did the velocity of money collapse?

There is a simple answer to this question: the expansion of the monetary base didn’t trigger a collapse in the value of money. With no collapse in the value of money there was no rise in prices and, as the monetary base expanded, the velocity of money had to fall.

If the value of money had fallen, then prices would have risen and the velocity of money may have remained relatively stable. But this didn’t happen. Indeed, without a decline in the value of money over the past eight years, every injection of new money led to a further decline in the velocity of money.

The Outlook for the Velocity of Money

While predictions regarding major economic variables are notoriously unreliable, attempting to forecast the velocity of money is particularly difficult because of the wide range of factors involved. Nevertheless, let’s take another look at our model and think about what might happen to the velocity of money in 2016 and beyond.

The first factor that could drive an increase in the velocity of money in 2016 is a reacceleration in broader economic activity (higher V_G and q). Frankly, this seems unlikely given the bias of the Fed towards tightening monetary policy, but it is possible. However, even if the US economy does accelerate in 2016, the magnitude of the shift in our numerator is unlikely to lead to a significant rise in the velocity of money.

The second factor that could drive an increase in the velocity of money in 2016 is a major reduction in the monetary base by the Federal Reserve. Once again, this seems unlikely. Even if we accept the consensus forecast that the Fed will raise short-term interest rates in 2016, any major reduction in the monetary base is unlikely given the current planning of the Fed.

If there is a major rise in the velocity of money in 2016, then it is most likely to be caused by the third and final factor: a significant decline in the value of money.

All else remaining equal, a rapid and marked decline in the value of money would have two effects. First, the price level would rise: as money becomes less valuable in absolute terms, the basket of goods becomes “more valuable” in relative terms. Second, a decline in the value of money, all else remaining equal, must lead to an increase in the velocity of money. Why? Well, thinking in absolute terms, if money becomes less valuable, then each unit of money must change hands more times to complete the same total value of economic transactions.

The obvious question that needs to be asked is why would the value of money suddenly decline in 2016? After all, the value of money has been relatively stable for the past eight years despite a fivefold increase in the monetary base.

The view of The Money Enigma is that most major fiat currencies have held their value relatively well over the past eight years because most market participants view the current experiment with quantitative easing as “temporary” in nature. In other words, most people believe that quantitative easing will be reversed in due course and that the balance sheets of the central banks will be restored to more normal levels.

The concern that has been expressed here many times is that the “temporary” flirtation with monetary base expansion will turn into a more “permanent” exercise. At the point the markets realize this is the case, the value of the major fiat currencies could decline significantly leading to a rapid rise in inflation in those countries and, all else equal, a surge in the velocity of money.

Those readers who are interested in exploring this issue further might like to read “Monetary Base Expansion: The Seven Stages of Addiction”, “The Case for Unwinding QE” and “What Factors Influence the Value of Fiat Money”.

In summary, the view of The Money Enigma is that the velocity of money has probably reached its nadir. If the Fed surprises the market and does significantly reduce the monetary base, then it is almost a mathematical certainty that the velocity of money will increase. In contrast, if the Fed fails to reduce the monetary base over the course of the next few years, then the value of money is likely to decline sharply leading to both a rise in the rate of inflation and an increase in the velocity of money.