Saturday, December 13, 2014

Velocity -- the Long Run, and What Counts

The Federal Reserve has a limitless supply of money just waiting to be issued into the economy. Why don't we count that money when we figure Velocity?

Because it's not in the economy, that's why.

The same is true of the money we in the private sector accumulate but do not spend. It's not in the economy. It ought not be counted when we figure Velocity.

This is what FRED has on Velocity, 1869 to 2014:

Look at the older data first. There is a peak a few years after 1875, followed by a long, sweeping downtrend that gradually flattens, then finally explodes in the colors of the newer data.

There is a small peak shortly before 1925, a small decline shortly after 1925, and an up-down-up wiggle just before 1950. Those three are World War One, the Great Depression, and World War Two. It is true that, compared to nearby tiny changes in the purple line, those three are significantly large. But in the big picture, they are not big events.

Compared to general trends, Depressions and World Wars are trifles. For Velocity at least, this is the case. For the economy as a whole, I think.

The newer data begins in 1959. We have a choice. We can focus on the blue line, which seems to continue the flattened trend, stretching it to the whole of the 20th century. Or we can focus on the green line, which seems to continue a repeating, wavelike pattern of peak-and-decline.

The red line, odd man out, just doesn't seem to fit. Still, it shows a pretty definite increase (until the crisis) so maybe it speaks on behalf of the green line and the wavelike pattern. But then, after 1981, the green line falls while the red rises to a new and more extreme peak. It's not tidy.

It's not inexplicable. The lines show different things. They consider different pools of money. The blue and green lines measure much larger pools of money than the red. They include all the money measured by the red line, and other money besides. When you divide by these bigger numbers to get Velocity, the Velocity number comes out on the low side. Divide by the smaller number that the red line uses, and the Velocity number is on the high side.

But remember: We're measuring velocity, a measure of how often a dollar is spent. We spend the dollars in our pockets. We don't spend the dollars in our piggy banks. The velocity of piggy-bank money is zero. Does it really make sense to include the money we don't spend when we're figuring how often the average dollar is spent? When we figure average driving speed, do we include parked cars in the calculation?

The velocity of the money we actually spend is much higher than the number we get by including the money parked in savings in our calculations. Much higher, as the red line is much higher than the green and blue.

It matters, because some people have no savings.


jim said...

M1 Velocity trends downward after its peak in 1981 if you use M1 adjusted for sweeps as the money stock.

The Arthurian said...

Thanks Jim! I should have looked.