For example, if Bill and Bob live on an island and there is only $100 in the money supply but Bill sells a supply of coconuts to Bob for $100 in January and Bob sells a supply of mangos to Bill in February for $100 then the velocity of money is 2. If they continue to sell each other goods for the remainder of the year they will have created $1,200 of GDP with only $100 of money supply for a velocity factor of 10.
The reason we have not seen large scale inflation in our economy even though we have had increases in the money supply by the Fed through quantiative easing (printing money) is that the velocity of money in our economy has dropped precipitously over the last couple of years.
This chart from the Federal Reserve Bank of St. Louis tells the story of the drop in money velocity.
This is the chart on the increase in the M2 money stock from the same source.
Why has money velocity slowed? People are concerned. Banks are nervous. There is less spending and less need for borrowing. When someone does want to borrow, the banks are less willing to provide credit than they were a few years ago. A lot of it has to do with mobility. Fewer people are moving. This is a function of the economy and the housing meltdown.
Between 2010 and 2011 only 11.6% of Americans changed residences. This is the lowest rate since the Census Bureau began collecting this data in 1948. By comparison, in the mid-1980's, more than 20% of Americans moved each year. California, which historically was a magnet for mobility ("Go West Young Man"), is now populated principally by natives. More than half of California residents are natives for the first time since the late 1800's.
Another factor in the reduced money velocity is that just 950,000 new households were created last year. By comparison, about 1.3 million new households were formed in 2007. Fewer households means fewer rentals, mortgages, furniture and appliance purchases, cable hook-ups and everything else.
This chart from The New York Times provides the longer term perspective on household formations. We are at low levels that have not been seen in decades.
A big reason for this is that many young people are moving in with Mom. 14.2 percent of young adults are living with their parents. Among young men, 19 percent are living with Mom. This is driven in large part by the fact that just 74 percent of Americans ages 25 to 34 are working. If you don't have a job you move in with Mom. It keeps the expenses low but it also impacts money velocity.
When will we know that the economy is improving? Keep your eye on velocity, mobility and Mom.
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