How to Build Wealth Using the Velocity of Money

Though it may seem like some random economic term, did you know that the concept of the velocity of money could be used to generate wealth for you and your family?  

If you are interested in wealth generation, you may want to know how you could use the velocity of money to build your wealth.  This idea may just hold the secret to increasing your wealth exponentially.

And today we are going to find out how.

What is the Velocity of Money?

Not to be confused with velocity banking, the velocity of money is the rate at which money changes hands.  In more concrete terms, it is the measurement of the rate at which money is exchanged in an economy.  So, in short, it measures economic activity.

A look at how quickly money is changing hands in a given economy, could tell you whether the country is in an expansionary period or in a downturn.

During times of economic expansion, the velocity of money is typically high, as there are many transactions taking place in the market.  With more money changes hands, more things are getting done, more goods are being purchased, and value is being produced in the economy.  Thus, a high velocity of money could indicate a thriving economy.

In contrast, during a recession or contraction, there are fewer goods being made and purchased, less things getting done, and, overall, fewer transactions taking place.  So the velocity of money is low.

An Anomaly 

Since the early 2000s, the velocity of money has been dropping despite there being periods of expansion in the US economy.  Economist are not sure why though there have been theories about the affect of wealth and monetary policy on the velocity of money.

The Velocity of Money Formula

To calculate the velocity of money in a given economy, you can take the country's nominal Gross Domestic Product (GDP) and divide it by the money supply.  Sometimes, a country's Gross National Product (GNP) is used instead of the GDP.

Velocity of Money = GDP / Money Supply

One thing to note is there are two different numbers that can be used for the calculation of the money supply, M1 and M2.  

The M1 Money Supply

The M1 money supply is the sum of all money held by the general public including notes, coins, and traveler's checks.  It also includes the money that is held in checkable deposits and deposits that can be released immediately upon demand (liquid deposits).  

In short, the M1 money supply measures short-term consumption that consumers make on a daily basis.  So if you want to know the velocity of money, as it relates to the money currently in circulation, you would use the M1 money supply.

The M2 Money Supply

Unlike the M1 money supply, the M2 money supply includes savings deposits, CDs, and money in mutual funds in addition to the liquid cash that is in circulation (M1).  So, this calculation is a much broader one than the M1.  

Economist may choose to use the M2 money supply when calculating the velocity of money if they want a broader picture of the economy as a whole.

Note:  Money held in IRAs or Keogh plans are not included in either of these calculations.

An Example of the Velocity of Money

To understand what is meant by the velocity of money, it may be helpful to see it in action.

Let's say for simplicity sake that there are two people who make up our economy, a builder and a farmer.  The builder and farmer both have $50 each.

One day, the builder is in need of some chickens and veggies to feed his family. So he pays the farmer $30.  

Soon after, the farmer wants to have a proper chicken coop built so that his chickens can have a safe place to stay and lay eggs.  So he pays the builder $80 to build him one.

The builder sees how much money he could be making if he could reach more people.  So he decides to expand his business to neighboring countries and towns.  He goes to the farmer to buy a horse and pays the farmer $100.

Business is going well for the farmer and he too wants to expand.  He pays the builder $50 to build him a bigger fence around his expanding farm land.  

Now, the builder and farmer are seemingly back where they started with $50 each.  But, with a closer look, we see that in our small make-believe economy, there have been transactions totaling $260 this year.  All from the $50 that the builder and farmer each had.  

And even though the farmer started with just $50, he was able to make $130 that year.  How?  Because each dollar in our economy was given more than one job.

In our make-believe world, the velocity of money would equal 2.6.  This means that every $1 was used 2.6 times.  So it is not surprising that the farmer was able to 2.6x his money as well.

Inflation Rate and the Velocity of Money

It is thought that the faster the velocity of money, the better it is for the economy.  Because a little inflation is good for the economy.  And in fact, the velocity of money does play a role in determining the price of goods.

The faster money changes hands, the more prices will raise.  As is the case of a busy artist asked to commission yet another painting.  Chances are that extra painting is going to cost a lot more than the first one.

Thus, a high velocity of money may be a good indication of an expanding and thriving economy and rising interest rates.  But the velocity of money isn't the only thing at play here.  

In actuality, the money supply also influences the economy.  And as it turns out, the money supply can have a greater affect on inflation than the velocity of money.  Especially considering that the FED can manipulate the money supply simply by printing more money or raising/ lowering interest rates.

And try as they might, they cannot force people to buy things so they have less control over the velocity of money.

The Velocity of Your Money

How quickly you give and receive money can determine how fast you are able to build wealth.  Another way to look at it, is how fast you can get money to move through your investments or cover your debt. 

If you understand the concept of the velocity of money, you will realize that you can spend the same dollar more than once.  And if you spend and receive that dollar fast enough, you can use it to build wealth quickly.

It might be better to think of it as giving your dollar a job.  So, basically, you will want to give your dollars not just one job but many jobs.  

Sadly, most people tend to give their dollars just one job.  For instance, parking your money in a bank account, buying a car that you don't rent out, or buying a house to live in is giving your dollar just one job.  

Essentially, you buy the car or the house with your down payment.  And that's it.  Your money just sits there.

But, if you instead used that dollar to buy a property and rent it out, you would get that dollar back in the form of rent.  After a while, you could use that dollar to buy another property and collect even more rent.  And so on, down the line.

By doing this, you have essentially increased the velocity of your money and the number of jobs your dollar does.  And with this increased velocity of money, your wealth increases as well.

Tips for How to Build Wealth Using the Velocity of Money

Here's a few tips on how you can use the velocity of money to build wealth for you and your family.  As always, investing comes with risks so do your own research and make sure whatever you choose is right for you.

• Leveraging your money to buy a rental property.  Even better if you can do the BRRRR Strategy (Buy, Rehab, Rent, Refinance, Repeat).
• Using your money to buy a property that you can sell for a nice profit. (Flipping Houses)
• Buying a house for yourself and renting out rooms or your garage. (House Hacking)
• Buying a car and renting it out using apps such as Turo.
• Investing in stocks and bonds which pay dividends and reinvesting them.
• Trading stocks, options, cryptocurrencies, etc.
• Lending out money with interest
• Leveraging personal or home lines of credit to pay off expensive debt or make strategic investments.

All in All

Building wealth is all about learning how to make your money work for you.  And that is exactly what the proponents of the velocity of money want you to do.  This concept gives you a new way to look at your money and how you can use it to build wealth.

If you can recycle your dollars to do more than one job, you would truly have a system where your money is working hard for you.  Done right, you can even earn money while you sleep.

And when you can make money while you sleep, that's how you know you are on the right track to building lasting wealth.