After rising to 2.198 in Q3 1997, the ratio of US Gross Domestic Product (GDP) to money supply M2 fell to 1.433 by Q3 2017. Since then the ratio has bounced slightly to 1.457 in Q1 2019. Economists label this ratio as the velocity of money.
Some experts regard the steep decline in the ratio as an ominous sign for the economy in the months ahead since it raises the likelihood of a sharp decline in the growth rate of prices.
This in turn raises the likelihood of price deflation and in turn of a severe economic slump. It is also held that a fall in the ratio raises the likelihood that monetary injections by the Fed are going to become ineffective in the event that the US central bank will attempt to revive the economy once it falls into an economic slump.
What is the rationale behind this way of thinking?
The Popular View of Money Velocity
According to popular thinking, the idea of velocity is straightforward. It is held that over any interval of time, such as a year, a given amount of money can be used repeatedly to finance people's purchases of goods and services.
The money one person spends for goods and services at any given moment can be used later by the recipient of that money to purchase yet other goods and services. For example, during a year a particular ten-dollar bill can be used as follows: a baker John pays ten-dollars to a tomato farmer George. The tomato farmer uses the ten-dollar bill to buy potatoes from Bob who uses the ten-dollar bill to buy sugar from Tom. The ten-dollars here served in three transactions. This means that the ten-dollar bill was used three...