RECORD QUARTERLY REAL GDP GROWTH HELPS U.S. M1 VELOCITY TO RISE! BUT CAN IT LAST?

 

The U.S. Bureau of Economic Analysis (U.S. BEA) announced yesterday (October 29, 2020) morning that U.S. real GDP increased at a seasonally adjusted, annualized rate of approximately 33.1 per cent in the third quarter of 2020.  Based on estimates from the U.S. BEA accessed from the Saint Louis Federal Reserve FRED web page, this is the largest quarterly percentage increase since the sample period of quarterly real GDP data began with the first quarter of 1947.  This record growth, after a record decrease in the second quarter of 2020, was probably the main factor behind U.S. M1 velocity increasing in the third quarter of 2020, with increases in U.S. M1 velocity seemingly have become much less common since the start of the Great Recession.

The velocity of the U.S. M1 money stock largely measures how many times on average each U.S. dollar, be it in the form of currency or in a checking account with unlimited check writing privileges per month (as long as the checks can clear), trades in transactions that are counted as part of U.S. gross domestic product in a time period.  Nominal GDP values each good produced at its price in the period in which it is produced, so that nominal GDP (for the most part) measures spending on the items that are part of GDP.  Because the buying power of money changes when prices in the economy change, comparing nominal GDP from two different periods could give misleading conclusions about during which of either of the two periods the economy was more productive, and by how much.  Real GDP solves this problem by valuing each good or service produced at its price in the base period or the base year.

Thus, readers can infer that the U.S. economy produced more in the third quarter of 2020 than in the second quarter of 2020.  This surge in production helped to drive U.S. M1 money velocity higher in the third quarter.  We can calculate money velocity as nominal GDP divided by the measure of the monetary aggregate or money supply level.  Equivalently, we can calculate money velocity as the product of real GDP and a price index (the implicit deflator divided by 100) divided by the monetary aggregate.  With the implicit deflator divided by 100 in the formula (before dividing the product of the price index and real GDP by the money stock), real GDP multiplied by the price index equals nominal GDP.

Focusing for now on the formula with the implicit deflator, real GDP, and the money stock for calculating money velocity; all three components of the formula increased in third quarter of 2020, with the largest percentage increase not being the aforementioned increase in real GDP.  That was the second greatest increase.  Using seasonally adjusted monthly data from the St. Louis Federal Reserve FRED website, I calculate that the U.S. M1 money supply increased at an annualized rate of more than thirty-five per cent in the third quarter, making that the greatest percentage increase.  With the monetary aggregate located in the denominator of the formula to calculate velocity, all other things the same (including real GDP and the price level), an increase in the money supply would lead to a decrease in the velocity of that monetary aggregate.  The combination of both the increase in real GDP and an increase in the implicit deflator of about 3.7 per cent according to the U.S. BEA and accessed from the St. Louis Fed FRED website was more than enough to spur an increase in U.S. M1 money velocity last quarter from about 3.89 times per year in the second quarter of 2020 (after a sharp decline between the first and second quarters) to about 3.91 times per year according to data on the FRED web page of the St. Louis Federal Reserve. (Readers may want to note that the percentage growth in M1 velocity may not have been annualized.)

I mentioned in my published book It’s Velocity, Stupid! (short title) and I plan to mention in my forthcoming book (although it probably will comprise a relatively small percentage of the book) the possibility of a time-varying money supply level above which money velocity will automatically decrease if the money stock rises above that level.  I referred to this money supply level as either the non-decreasing-velocity money supply level (NDVMSL) or the maximum constant velocity money supply level (MCVMSL).  If such a money supply level exists, then the U.S. M1 money supply must have been below that level in the third quarter of 2020 in order for the velocity of that monetary aggregate to have increased.  However, that was not the case in many relatively recent quarters during which M1 velocity fell, starting with the first quarter of 2008, as well as some earlier periods.

I and likely many others attribute the strong growth in U.S. real GDP last quarter to two main factors.  First, the expansionary fiscal policy and monetary policy measures implemented this year provided funds for households and businesses to spend.  Many recipients probably spent at least some of these funds, helping to create demand for goods and services.  Was expansionary fiscal policy the main factor causing an increase in spending?  Second, reopening following the COVID-19 coronavirus shutdowns helped to allow both the production and the consumption of more goods and services than in the second quarter of 2020. 

Given that at least partial shutdowns may be coming again and additional stimulus funds may not be coming soon, how long can the rapid rise in U.S. real GDP continue?  And, if the U.S. M1 money supply continues to grow at a rapid rate, then would that imply that U.S. M1 velocity is likely to fall in the fourth quarter of 2020?

In my view and probably in the view of many others, expansionary fiscal policies such as increasing government spending and reducing taxes could be extremely helpful in promoting economic growth and continuing the economic recovery.  A possible benefit of government purchases (for example, government expenditures on roads and highways) over other expansionary policies is that such spending guarantees that funds are spent on items that are part of real GDP.  By contrast, both (a) other types of government expenditures such as social security payments and (b) tax reductions could be saved by the recipients of greater after-tax incomes and thus not directly increase GDP.  Additionally, expansionary monetary policies such as increases in the money supply and reductions in interest rates do not necessarily result in additional GDP spending and could result in the velocity of money falling. 

Given that the velocity of the U.S. M1 money stock is less than half of its value from soon before the Great Recession, perhaps strategic fiscal policy and monetary policy designed to stimulate spending can help to restore not only some of the real GDP that the U.S. economy has not yet recovered.  In light of the possibility that the U.S. economy may have sufficient dollars but a need to get dollars trading in GDP transactions more frequently, maybe expansionary policies, particularly expansionary fiscal policies, can also increase money velocity.

(Readers should realize that subsequent data revisions could change the analysis above.)