The money multiplier and velocity of money are two metrics that used to be highly informative measures for economists to monitor a country’s level of economic growth.

Goldman Sachs’ Favorite Books List – Options/Derivatives

textbook photo
Photo by DariuszSankowski, Pixbay

The velocity of money or income velocity of money is the frequency at which the average unit of currency is used to purchase newly domestic produced goods and services. The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. As the central bank prints money, the money multiplier measures how much broader money aggregates change while the velocity of money relates money aggregates to overall economic activity.

Criminally Overlooked Books on Finance and Economics

In theory, these two economic concepts should be highly relevant to today’s monetary policy environment. In the years before the financial crisis, monetary policy became all about changes in interest rates and broader financial conditions, but since we’ve entered the new era of QE, the money multiplier and velocity of money should have become key concepts used by economists to monitor changes in the money supply.

The changing face of economics

According to Bank of America Merrill Lynch’s Global Economist Michael S. Hanson, the two money measures don’t really have much to say about the world’s current monetary policy.

Dark Side Of IRR – Leverage, Wealth Destruction

Research note sent out to clients today, Hanson explains that, “in the textbooks, a drop in the money multiplier is typically seen as a bad sign: either households are hoarding cash (and not depositing it into banks) or banks are not lending (and thus not “multiplying” the notional amount of deposits among them).” However, in the real world, this economic theory isn’t playing out as expected. While the money multiplier (ratio of M1 (currency plus demand deposits and other checking accounts) to the monetary base (currency in circulation plus bank reserves)) has dropped since 2009, growth rates for M1 have been positive. Hanson believes the drop in the multiplier can be blamed on central bank QE programs:

“Whenever a central bank engaged in asset purchases, the money multiplier declined. That dynamic reflects the fact that increases in bank reserves were a consequence of central banks’ asset purchases rather than a policy objective themselves.”

“Put another way, QE programs are really misnamed: the central bank’s goal is not to increase the money supply in the hope that banks will lend more. And banks don’t base their lending decisions on how many reserves they have. Rather, both are looking at interest rates: banks look at the expected rate of return on a loan relative to holding other yield-bearing assets, and make a lending decision based on that comparison. Central banks buy assets in order to bring down yields more generally to entice borrowers — and to make it less enticing for banks and other lenders to just tie up funds in safe, low-yielding assets instead of lending to help expand private activity.”

BoA 1

The velocity of money is also falling, although rather than this being an adverse economic signal, it should be interpreted as a misleading data point. Innovations like automatic teller machines and cashless transactions reduce the average amount of cash a consumer needs to hold. Furthermore, liberalised capital markets are helping connect investors with companies that need capital. So, more transactions are financed for any given amount of money in circulation, regardless of central bank policy.

BoA 2

The world of economics is changing rapidly, and it seems as if economists are struggling to keep up with the new standard.