I took a similar class to Reno, and I too am not an expert.
The gist is that the Federal Reserve controls lots (billions? trillions?) of dollars in bonds. When the Fed wants to increase the money supply they buy lots of bonds from banks all over the country, who loan out their new found cash, etc and it trickles throughout society. When they want to tighten the supply, they sell the bonds and ‘take back’ all that money. There may or may not be any actual dollar bills involved in the transaction.
Literal printing of currency is done by the Treasury, usually in one-for-one exchange with old, worn out currency (or maybe more than one-for-one to account for inflation?). It doesn’t really effect the money supply.
Actually Mr. Jesus, I may not have answered your question; I don’t actually know what happens if those banks don’t loan out their cash.
I think Ben Stein is saying that if you make the dollar worth less (not worthless ;)) then banks will have more incentive to loan it out. Deflation definitely removes the incentive to loan money, so presumably inflation puts it back.
Sheesh so much misinformation on this thread. Basically Reno Nevada is right though I am not sure his last point is accurate. Anyway running a deficit doesn’t imply an increased money supply, that only happens if the deficit is monetized which isn’t the case in the US.
Posts in this thread have referred to the “multiplier” effect, but it hasn’t been explained.
Let’s say you have $10,000 in your savings account. As far as you know, you have $10,000, and that’s your money supply. However, the bank is allowed to take that $10,000 and lend it to someone else. In reality, it can’t loan out all $10,000 due to reserve requirements (another tool that the Fed can use to control money supply). So let’s say it lends out $8,000 to a business. Now you have $10,000 and the business has $8,000. Your $10 grand turned into $18 grand. The business takes the $8,000 and spends $4,000 on a consultant and saves $4,000 for a rainy day by putting it into its bank account. The consultant puts part of her $4,000 in the bank as well, which can be loaned out, increasing the money supply even further.
This is why money supply is measured in different ways:
I may not have this part completely correct but:
M1: All cash and checking deposits
M2: M1 plus savings, money market, CD investments smaller than some threshold
M3: M2 plus larger deposits…
This is the part I can never understand. You still have 10k, the business has 8k in assets, and the business also has 8k in debts. So the total is 18k in assets minus 8k in debts, for a total of 10k, same as it always was.
Unfortunately, the Federal Fund Rate is at such a low level (0-.25%) that the government would need to pay people to borrow money from it to have a greater effect. That is why they are looking at other things right not to increase the money supply, like buying stakes in the banks.
Can someone please explain this to me? I’m largely ignorant on this subject, but I don’t get why the U.S. government spending money it doesn’t have is any different than a bank loaning out money while it continues to sit in your bank account. Both just seem like they amount to “pretending there’s more money than there really is.” What’s the difference?
But someone else now has earned 4k in revenue of which a certain percent is profit. The multiplier is not a straightforward for every X amount invested there is 1.2*X in the money supply (although I am sure you can find averages somewhere). The point is that your 10k in money acts as more because you have a 10k savings account, and the business can spend 8K at the same time.
This is what is so frustrating. Normally we’d do things like reduce taxes, increase spending, and lower reserve rates but we’ve already used up that bag of tricks.
The original depositor has 10k in cash. This is a liability for the bank, which must pay back that money immediately whenever the original depositor wants it back. It’s liquid cash, which can be withdrawn and used at any time (just as long as all the depositors don’t want their money at the same time).
The bank lent out 8k of that 10k. This is also cash that goes out into the real world to be spent. Yes, the guy who took out the loan to buy a car has 8k of debt which must be paid back over time, but that 8k went to a car dealership in exchange for new wheels, and the car dealership used that 8k of very real cash to pay salaries, the electric bill, rent, etc. The liabilities/assets equation balances out, sure, but that doesn’t change the fact that there’s 18k of cash money out there when there was only 10k before. And the most important part: the lent out money is being spent on new stuff which is driving the economy. If the bank doesn’t lend the money, the car dealership goes bankrupt and lays off its workers, those workers start hoarding their savings instead of buying themselves, which means aggregate demand takes a dive, and this whole process can feed on itself and create a self-sustaining cycle which gets the whole damn system stuck.
Ordinarily, the Fed would just lower interest rates in that situation. But that particular technique has been used up, so they’ve got to try experimental approaches that have less easily understood effects.
Emphasis added. This is an inaccuracy in my post. I wanted to emphasize that it’s 18k of real money, but it’s not all cash.
The essential point remains the same: money that’s lent out by a bank gets used to buy stuff. Even though there’s 8k of debt to match the 8k increase in the money supply, that money starts circulating around instead of being stuck as digits on a bank computer. And once it’s spent, it doesn’t represent debt for the person who receives it. It’s just normal money, which can be used over and over and over again.
The difference is that the bank is under the obligation to pay back depositors immediately. These are “demand deposits”. This means that every depositor has their money available at will, while at the same time the loaned money is circulating through the economy buying up new goods and services. The system works because only a small percentage of depositors are going to want their savings at any given time. The bulwark of the system is the FDIC, which gives us all confidence that our money will still be there even if the bank itself goes under. This added stability cannot be overstated. We’re not in danger of the same wave of bank runs that caused so much harm during the Great Depression. This is a supremely valuable service that the government provides.
Unlike banks, though, the government itself is under no obligation to give back the money we lend to it until the stated time comes up. Treasurys are not demand deposits. The feds are not going to give back the money just because you want it early. The government has spent the money, and it’ll give it back only when the right time has come.
You can see, these are two very different sorts of lending practices. Banks create money precisely because they’re allowed to have more immediate liabilities than they can possibily pay back at any given time. Government borrowing doesn’t have to work that way. The Federal Reserve can print money, of course, but the government is not required to make money when it borrows.
I don’t believe that this is a correct explanation. The question was “Why don’t Federal deficits increase the money supply?”
The reason is that if the *Federal Government *wishes to, for example, buy up $1T worth of mortgage-backed securities, they have to borrow the money by issuing Treasury Bills (aka T-bills). These bills are bought by investors, who would otherwise be putting their money into GM bonds or some such. No new money is created. For this reason, Federal deficits mean that GM must compete with the government when they want to issue bonds–the cost of borrowing goes up. By the way, I should acknowledge that this point is economic orthodoxy, but is not universally accepted, as **erislover **noted.
When the *Federal Reserve Board *wishes to buy up $1T worth of mortgage-backed assets, they merely note in their books that they have an additional $1,000,000,000,000 US, and start writing checks. They don’t have to ask permission or anything. They just do it. That $1T is new money in the economy.
If the Federal Reserve Board decides that there is too much money in circulation, they will sell some of their assets, which soaks up money. If those mortgage-backed assets are now worth only $500,000,000,000, they are unable to soak up all the money they earlier injected, and will have to take other steps to reduce the money supply.
I specifically used the phrase “the feds” as a plural lower-case, in the same paragraph that I explicitly mentioned both “Treasurys” and the “government”. It was clear to me when I was writing that I was talking about the federal government, especially given the context. I was not talking about the Fed, capital and singular: The Federal Reserve System. In my defense, this distinction made perfect sense in my head.