Deflation Fears Surge as Velocity of Money Declines

One of the most common economic assumptions is that when central banks create liquidity, inflation goes up. Meaning the value of money disappears simply because there is too much of it, which chases fewer goods. 

That is one of the basic economic principles in monetary theory, but there is a caveat. It stands true if the money velocity (M2) rises, all the additional money created by central banks will not go to where it is needed (i.e., the real economy). With no velocity of money, the GDP is contracting, meaning there is no inflation possible.

Velocity of Money in Free Falling in the Last Two Decades

Central banks use different measures to quantify the amount of money in circulation. For instance, in the United States, M1 includes cash and checking deposits. M2 on the other hand, encompasses M1, but it also considers savings deposits, money market securities, mutual funds, and other time deposits.

M2 is one of the most widely used measures used to analyze the money supply. Also called “near money”, the  M2 shows that from the year 2000, the velocity of money has been in a declining trend in the US.

A quick look at other developed countries reveals that M2 declines in other parts of the world too. Europe, Japan, and even China show a similar trend for the M2 velocity of money.

Consider the chart above. It shows the relationship between the M2 money supply and the M2 velocity of money. From 2000 to the present time, the velocity of money continues to decline in a consistent trend, while the money supply has increased dramatically.

In the last few months of 2020, the money supply accelerated dramatically. Yet, at the same time, the velocity of money declined further.

The conclusion is that, when using the same broad money measure (in this case, M2), no matter how much money is created out of thin air (i.e., central banks buying their own government bonds), inflation will not pick up anytime soon.

Just the contrary – if the velocity of the same money supply measure continues to decline despite the huge amounts of money being created, we should worry about deflation, and not inflation for the period ahead.

Modern central banking targets a 2% inflation as a level needed for sustainable economic growth. But only money creation will do no good in sending inflation to target if the money simply sits in some bank accounts or covers “black holes” in an economy.

Until people and businesses regain the confidence to spend and invest, we should worry about deflation, and not inflation.

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