Cash flow is to our financial lives as air is to our bodies. In commercial real estate, your focus is mainly on one thing – your return on investment (ROI). When considering the velocity of money, the most critical question is not what your return on investment is; it is how long it will take for it to come back to you so you can reinvest.
Therefore, a definition for the velocity of money will be the speed at which your money works for you, which is a direct result of spending it. In general, you can quickly tell from the velocity of money the rate at which money in circulation is actively spent buying goods and services.
How Does the Velocity Of Money Work?
To grasp how the velocity of money works, you need to comprehensively understand that investing in cash flow is entirely different from investing for capital gains. Supporting capital gains will more likely ignore the question of time (speed of returns).
On the other hand, funding for cash flow considers time to be a significant part of the transaction. Consider how hard each dollar works to boost the GDP. When money moves quickly to purchase goods and services, it is said to have a high velocity. It reflects a high level of demand, which results in increased output.
When speed is low, each dollar isn’t used to buy products nearly as often. Instead, it is put to work in the form of savings and investments. Because of the low demand, less production or output is generated. For residential real estate investors, house flipping is a very efficient way of sustaining cash flow and utilizing the dynamic power of the velocity of money.
Example of Velocity of Money
A typical example of the velocity of money is a traveling salesman who had a flat tire on his way, passing through a rural area. A passer-by gives him a lift to the nearby city to borrow a jack and lug wrench. The city’s cash and cruise repair shop is willing to loan him the tools for a $1,000 cash deposit until he returns the borrowed tools. He gives them money and promises to return the devices within an hour.
In the meantime, the shop owner takes the $1,000 to the parts store next door and pays for the parts he puts on hold, which he needs to fix a car that a customer is coming to pick up in one hour. The parts store owner takes the $1,000 across the street to the grocery store to buy some meat for the company barbeque that evening. The grocery store immediately pays $1,000 to the butcher for the meat he cut for the store that day.
Moments later, the salesman returns the tools and gets his $1,000 back; he finds the town booming in business. We can see that the money has been turned over three times at this point, and $3,000 worth of transactions was made within an hour.
How to Calculate Velocity of Money
The velocity of money is calculated by dividing your economic output by your money supply using this equation.
V = PQ/M
V = Velocity of Money
PQ = Nominal Gross Domestic Product (NGDP)
M = Money Supply
How the Velocity of Money Affects the Economy
Keep in mind that the velocity of money implies how rapidly money moves about in a given economy. From our traveling salesman example, we can see that if the salesman had not given the repair shop the $1,000 and subsequent results, that town would have remained in inflation. Therefore, we say that the faster the money is used and reused, the lower the recession in a given economy and vice versa.
- The money velocity formula calculates how quickly one unit of money or currency is exchanged for goods and services in a given economy.
- The speed at which cash is cycled and recycled is higher in expanding economies.