Economics 101 | Inflation & Money

Great Debates
1

Executive summary (AKA: tldr):

[ol]
[li]Inflation is not just about the supply of money. There are three other factors that are equally important.[/li][li]Commercial banks create money by lending it; that same money is destroyed when the debt is paid back.[/li][li]Commercial banks, left to their own devices, naturally and inevitably create financial and economic instability.[/li][li]Every dollar in existence, represents someone else’s debt.[/li][/ol]

The definition of inflation is: “The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.”

There are two parts to the definition: (1) purchasing power, and (2) the general level of prices. They are necessarily linked, because the purchasing power of money is measured by the amount (and quality) of stuff you can buy.

I’m going to focus on “purchasing power,” but I’m doing that for convenience. The two are ultimately the same.

The value of money, like the market value of everything, is determined by the mechanism called “supply and demand.” Supply and demand, in the case of money, has four distinct features:

[ul]
[li]The supply of money.[/li][li]The demand for money.[/li][li]The supply of goods and services.[/li][li]The demand for goods and services.[/li][/ul]

The single biggest mistake people make, when they’re talking or thinking about inflation, is to focus on the first item, while ignoring the rest. While it’s true that, if you were able to hold everything else constant, increasing the supply of money would cause inflation; it’s also true that it is virtually impossible to hold everything else constant, when it comes to money.

For example, in an economy where there is unemployment, increasing the supply of money can - and usually will - reduce the level of unemployment. The additional work done by newly hired workers results in more goods and services. Those additional goods and services, competing in an open marketplace, push prices down. The result is that adding money to the economy does not necessarily create inflation.

But to go back for a moment, I want to explicitly state the effect of each of the four factors:
[ul]
[li]Increasing the amount of money tends to be inflationary. Decreasing it tends to be deflationary.[/li][li]Increasing the demand for money tends to be deflationary. Decreasing the demand for money tends to be inflationary.[/li][li]Increasing the supply of goods and services tends to be deflationary. Decreasing the supply of goods and services tends to be inflationary.[/li][li]Increasing the demand for goods and services tends to be inflationary. Decreasing the demand for goods and services tends to be deflationary.[/li][/ul]

This may seem to be obvious, but I’m trying to emphasize that each and every one of these four factors affects inflation, and deflation.

At this point I need to talk about what money is, and how it gets created. Historically, all kinds of things have been used as money: beans, feathers, rocks, salt, and gold, among others. One definition of money is something that (1) is a medium of exchange, (2) is a store of value, and (3) is a unit of account.

Modern countries almost exclusively use what is sometimes called “fiat” money. Fiat money has some very special features, which I’m going to explain. One of those features is that it can only be created by institutions that are legally authorized to do it. With few exceptions, these institutions are called banks.

Banks, in turn can be divided into two categories. The first is commercial banks. Commercial banks are the banks that you and I are used to seeing: The Bank of America, Wells Fargo, etc. They are where we go to apply for loans, deposit our paychecks, and to conduct transactions.

The other kind of bank is a very special kind of bank, and it’s called a central bank. A central bank is where commercial banks go to borrow money, make deposits, and conduct transactions. In the US, the central bank is called the Federal Reserve. It’s also called “the Fed” for short. The Fed is the only institution in America that can issue banknotes, also known as currency. It has regulatory power over other banks, and by its nature, it’s an extraordinarily powerful institution.

In America, there are essentially two kinds of money: money created by commercial banks, and money created by the Fed.

It’s easy to tell them apart. Every dollar created by a commercial bank is on deposit somewhere in the banking system. Every dollar created by the Fed is either a banknote (a dollar bill) or is in a reserve account.

Now we get to the important part. As far as banks are concerned, deposits are liabilities, not assets. The money you have in your bank account is an asset to you, but a liability to the bank. It is money the bank owes you.

Similarly, loans are assets to banks, not liabilities. When you borrow from a bank, you get money, but you also get an obligation to pay back a larger sum of money, to the bank. That obligation is an asset, to the bank. Banks create money by lending it. They simply add an asset and a liability to their accounts, and the money appears. That’s how banking works. Now, obviously it’s more complicated than that, but for the moment it’s enough to know that banks create money by lending it.

It’s also important to know that banks destroy money, when loans are paid back. If this seems strange to you, consider this simple example: you have a debt you owe to your bank for $10,000. At the end of the year, you get a $10,000 bonus, which is deposited in your bank account. You decide to pay back the loan. What happens? The $10,000 in your account disappears, and the loan disappears as well. Remember, deposits are liabilities to banks. So when your $10,000 deposit disappears, the bank is $10,000 better off. The $10,000 doesn’t go anywhere. It’s just gone.

One more thing about commercial banks: each and every commercial bank must have more assets than liabilities in order to be solvent. It applies to every commercial banks, and to the banking system as a whole. Furthermore, when banks lend, the amount lent is always less than the value of the loan. Put differently, the amount you must pay back is always more than the amount you get when you apply for the loan.

What that means is that the amount owed to banks is always more than the amount created. In other words, there is more money owed to banks than there is money. So when people say, “Americans should borrow less and save more,” they are literally speaking nonsense. If Americans paid off all their loans, they would eliminate all the money there is. And they would still owe more.

Commercial banks are inherently unstable. Although they agree to let people withdraw their money at any time, the amount of money they have (their reserves) is always only a fraction of the amount of their liabilities (deposits). What that means is that if too many people ask to withdraw their money at the same time, they (the banks) will not be able to pay them.

Furthermore, commercial banking is inherently pro-cyclical. What that means is that when times are good, they lend quickly and willingly. When times are bad, they stop lending. That behavior leads to booms (when banks are lending) and busts (when banks stop lending). It also means the banks themselves help create the booms, and make recessions worse. The Great Depression is one example. The Great Recession is another. In the Great Recession, the banks were actually directly responsible, since they were peddling fraudulent securities, which created a panic when people figured out what they were doing.

Finally, because money is created by lending (making loans) every dollar represents someone’s debt: specifically, the person who took out the loan in the first place. I hope that this conclusion follows naturally from everything I’ve already said, but if I’m wrong about that, I’ll give a very simple example.

Suppose I’m in business, and someone pays for my services using a credit card. What’s just happened is that she’s created money by taking out a loan from a bank. The money will appear in my account at my bank, and the debt will appear on her credit card statement. Her debt is my asset, mediated by a bank (for which it take a fee). If someone (me, for example) were to pay her an equivalent amount of money, and she used it to pay off her credit card, that someone (me, for example) would see that sum of money disappear from his balance at his bank. Simultaneously, when she paid off her credit card, her debt would disappear.
Please comment if you think I’ve got something wrong, or if you don’t, or if you just feel like commenting.
***More to come, probably.

2

So this all comes from the Positive Moneywebsite right?

3

I’ll leave a full rebuttal to someone more qualified (and to those more familiar with this exact kind of thread). But a couple of things stood out for me:

Actually I can’t really reconcile everything you’ve said here.

You say there are two types of money and then that all of it represents debt. What if I work for the federal reserve and they pay me…whose debt is that?
And how can physical currency somehow be different to money that banks loan, when one can readily be converted to the other?

This is just like saying that I can’t recommend people have fewer children because if everyone had zero children it would be the end of the human race. Or that I can’t tell people to drive more slowly because if everyone went at 0mph we wouldn’t get anywhere.

Also a scenario where there is no money, but still debt, doesn’t seem to sit well with your overall concept of what money is.

4

It used to be that the money banks created could readily be converted into gold or silver. Would you say then that bank money was identical to gold? Obviously it wasn’t physically identical. Bank money was ink on paper, so a lot of carbon with some other stuff. Gold and silver are different elements. But more abstractly, it wasn’t legally identical either. Bank money was a promise to pay precious metal on demand. Bank money was perceived as not valuable in itself, but only valuable because the bank money was the legal promise to pay the valuable metal. One kind of money was convertible into the other, but the precious metals themselves were not a legal promise to pay anything else.

In our current system, modern central bank currency works as a sort of artificial gold. Physical currency remains different from commercial bank deposits in almost exactly the same way that gold was before. Even though one kind of modern money is readily convertible into the other, they remain very different in the same important way.

Interesting analogy, and a cogent point, but I believe you’ve misinterpreted the statement.

The OP is trying to say that if Americans borrow less, that will necessarily mean that less commercial bank money will be created. And what are our savings? Why, commercial bank money, according to this idea. So following this train of thought for a brief moment: logically speaking, we cannot collectively as an economy both borrow less and simultaneously save more (money), because it is the borrowing itself that creates the money that makes up our savings. That’s the intended meaning.

I still consider the OP’s statement problematic, but the core issue is the implicit assumption that our “savings” is our monetary holdings, and absolutely nothing else. Very narrow thinking. “Americans should borrow less and save more” is not literally speaking nonsense, unless an uncharitable reader chooses to interpret it nonsensically. If we expand our idea of what the stock of savings means, beyond monetary holdings, then a fully sensible meaning presents itself. (This sort of idea has been the topic of more than one of the OP’s previous threads. This one is particularly good, and this is a follow-up. There is some small hope that if the idea is explained to LinusK four or five more times, it might eventually sink in.)

5

You say money is destroyed when a loan is paid back. I don’t see that.

You borrow 10,000 and pay back 11,000 to the bank they are going to take that and loan it out again. Nothing is destroyed, in fact it is created. Additionally you have the object you borrowed money for be it a house, or car, or improvement to your business.

btw…the above does not take into account the bank’s cost of doing business.

6

No. Never heard of it. But I’ll look at it.

7

I didn’t get to the Fed yet, because the Fed deserves a post of its own, and what I wrote was already too long.

But to answer your question, Federal Reserve money is directly a liability of the Fed. Indirectly, it is the debt of whoever the Fed has lent money to. Most of the debt the Fed owns is debt of the U.S. government. Therefore it represents - or, is backed by - the U.S. Government. The Fed, in this sense, works like other banks: it creates money by lending (or buying bonds, which are loans) and destroys money by selling bonds.

Currency and bank deposits can be converted back and forth. But what you have to understand is that if you deposit currency at a bank, the currency does not become (or transform into) a bank deposit. The currency remains currency, and the bank does whatever it does with it: keep it in a vault, for example, or give it to someone else, who wants to currency in exchange for a bank deposit. The bank will credit your accoumt by the amount of cash you deposit. It does not, however, put your cash in a special box with your name on it. The transaction, from the bank’s POV, looks like this: (assuming you deposit $100 cash) Liabilties $100 (the increase in your bank account) Assets: $100 currency. Anyway, the point is it’s an exchange, not a transformation. The currency does not become a bank deposit.

It is a lot like telling people not to have children. Not having children may be great advice for a particular person or couple: after all, children cost a lot, require time and attention, and there’s no guarantee it’ll work out. But if everybody followed that advice, not only would the human race go extinct (which may or may not be a good thing, depending on your perspective), but there would be nobody to take care of people when they got too old to take care of themselves: no one to make wheelchairs, no one to push them, no one to make medicines or food. Your life, as a retiree, would be brutish, short, and miserable.

It comes from the fact that the total amount of debt (the amount you have to pay back, when you take out a loan) is more than the amount of money created by the loan itself (the amount you get when you borrow). To put it differently, the total amount owed to banks is more than the amount of money there is.

8

But you are forgetting something and that something is the value of whatever the loan was used to buy.

For example. If I borrow 200,000 to buy a house, get a loan and pay it off the total system has now the loan amount, the amount I paid for the loan and the house.

In other words, assests have value.

Slee

9

I’m not expert on this stuff, but even in the executive summary portion there seems to be some issues:

This simply isn’t true. There are assets and liabilities as well as reserves. Not EVERY dollar is debt since banks can’t make loans of every dollar having to keep back (I think) something like 10% in those reserves.

So? They aren’t left to their own devices. They are highly regulated, in fact, and can’t simply create as much money as they like whenever they like and however they like to do it.

True, as far as I understand the process, which is pretty nebulous since it’s a complex subject and to the uninitiated seems a bit like magical thinking.

I’m unsure what you want to debate, but I don’t see anything majorly wrong with your explanation of how banks determine what’s an asset and what’s a liability or how they use that to create money. You don’t seem to have gone into the checks and balances on how much they are allowed to make or how the Fed regulates how much ‘money’ is in circulation or how they determine how much can be made, but I don’t know what you are getting at so it might not be important to whatever it is you want to discuss. There is also the fact that modern currencies are also commodities that are traded in international markets of course, but again not sure what you are looking for here, and it might be well beyond me in any case.

10

Thank you. Comparing central bank money to artificial gold is a good analogy.

Yes. You said it better than I did.

Thank you for pointing that out. In my defense, the post was about money and inflation, not “savings”. But you are correct. There is more than one way to create savings. Putting money under the mattress might be an example, or keeping money in a savings account. But those aren’t the only ways to create savings.

Anything that lasts a long time and is likely to be useful, helpful, or productive in the future is also a kind of savings. Houses, for example, provide shelter. Roads allow for transportation. Telephone networks allow for communication. Education creates savings in the form of human capital.

You could, if you wanted to, divide “savings” into “financial savings” (like money saved for the future) and “real savings” (like houses or roads, for example). Not everything fits neatly into those two categories, though. Stocks, for example, are technically shares of ownership of companies. Those companies, in turn, own “real savings” like factories and buildings. Stocks themselves, on the other hand, are financial instruments. And they function more like financial savings (a way for people to set aside money for the future); rather than real savings (something that is useful in and of itself.) So if I were to put stocks into one of the two categories, I’m not sure which they’d belong to.

I am aware there’s a difference between what I’m provisionally calling “financial savings” and “real savings”. So If that’s the idea you’re hoping will sink in, it has.

I’m curious to know if there are better words to distinguish between them, than the words I’m using: “financial savings” vs. “real savings”.

11

I’m not sure I can explain it better than I already have.

The important thing is to realize that commercial bank deposits have mirror and opposite values, depending on whether you’re a bank, or a customer. If you’re a bank, a deposit is a liability: it’s money the bank owes somebody (the owner of the deposit account). If you’re a customer, a deposit is an asset: it’s money owed to you by the bank.

Similarly, loans have equal and opposite values, depending on whether you’re a bank or a customer. If you’re a customer, a loan is a liability: it’s money you owe someone else (in this case, a bank). To the bank, on the other hand, it’s an asset: money owed to the bank.

When you pay back a bank, you extinguish your liability: the loan is gone. It disappears. You no longer are under an obligation to pay the bank anything. Similarly, when you use money that is in a bank account to pay back the loan, the deposit disappears. The bank is no longer under any obligation to pay you that money.

As far as the extra $1000 is concerned, that $1000 had to come from somewhere. It may have passed through many hands before it got to you, but originally it was created by a bank. The $1000 isn’t money added to the economy by the act of you paying it to a bank. It was already there (somewhere) before you handed it over. The $1000 is the bank’s profit for successfully making and collecting on a loan.

And you’re absolutely right: I have not taken into account the bank’s cost of doing business. It pays those costs out of the profits it makes, primarily from interest and fees on loans (though, of course, banks can make money in other ways, such as overdraft charges or transaction charges or as interest from - for example - excess reserves).

When a bank pays out money (say, as paychecks to employees) it losses that money. Like any business, a commercial bank must make sure its costs are less than its profits. Otherwise, it will eventually go bust.

12

I don’t think this analogy works, since currency was backed by gold, but was not readily transferable: e.g. I couldn’t walk into a bank and swap my pound of gold for a fixed quantity of currency.

Nevertheless, I accept that two things which can readily be interchanged are not “really” one thing, so I’ll concede the point.

Yes, but there’s a bait-and-switch there that you are not acknowledging.

You said that saying that Americans should borrow less was “literally speaking nonsense” because if everyone borrowed nothing it would be disastrous. But recommending someone do less of X is not the same as telling them completely eliminate X. “Reduce your salt intake” doesn’t mean eliminate all salt and die.

But, trying to interpret what you meant to say, economies can flourish even with a culture of individuals saving relatively more than the US e.g. Germany, Norway.

13

You’re absolutely right: assets have value. Money, of course, facilitates transactions, which is why it’s so important. Money, however, does not build houses: people do.

What I mean by this is (and I’m sorry if I’m going off on a tangent): the wealth of a country is not based on the amount of money in the country, or held by the government; but on the skills and knowledge of its citizens, and how many of those citizens are using their skills and knowledge to perform productive work. That’s why unemployment, and underemployment are such important problems. They directly and inevitably make a nation poorer. Money, from a national perspective is a means to an end, not an end in itself. It is a powerful tool, that can and does affect employment and the production of real assets. But it’s still a means to an end, not and end in and of itself.

I don’t know if that sounds socialist or not. However, it comes directly from The Wealth of Nations, by Adam Smith. In his time, the dominant economic theory was called mercantilism, which held that a country’s wealth was the amount of money (gold) it accumulated. Smith wrote The Wealth of Nations partly to debunk that particular economic theory (mercantilism). Unfortunately, imo, an only slightly altered version of it has come back to haunt us.

14

I didn’t read your whole post, because you are fundamentally wrong about a key concept, so any conclusions you may draw are probably wrong.

Commercial Banks (as you call them) do not just create or destroy money. To explain it in simple terms;
In order to provide a loan, a Bank must already have that money in hand to give to you, they don’t just ‘create’ it. The two main sources of that money for a bank are
A) deposits received from it’s customers,
B) Loans from other parties (usually sourced through international debt markets also called bond markets/capital markets)

When you then repay your loan to your bank, that money is again not destroyed. Depending upon the source of the money it is either paid back to the bond markets, or held by the banks ready to be paid back to the banks depositors if and when they want their money back.

A bank makes profits by borrowing money at x% interest rate (either from depositors or the bond market) and loaning it out at (x+2)%.

This is a gross oversimplification of the system but hopefully it clearly illustrates that at the ‘commercial’ banking level there is absolutely no money being created or destroyed.

15

Well, plus other factors such as what natural resources are available.

Not necessarily because there are other factors such as productivity.
It’s quite possible for a nation’s economy to grow at the same time as unemployment increases, contrary to the rule you are making here.

This is the main problem with this thread IMO: you keep making absolute statements from rules of thumb or general observations.

16

Greedysmurf hit the money destroyed/created by loans issue.

The appeal to authority in the subject line is complete and utter BS. This is not mainstream economic thought. Defining money supply in this way is not something you can expect to hear in a Macroeconomics 101 class. It’s decidedly a niche theory that challenges mainstream definitions of money supply that you’d actually hear in those classes. Some smart economist might be able to show why this theory better explains issues in actual historical data as a way to demonstrate that the theory makes sense. That’s a career and world changer if they do. Have one to cite?

17

You absolutely could. In places with safe banking systems (which was not everywhere), most people who came into possession of gold would immediately exchange the metal for paper currency at their bank.

Back in the day, convertibility in both directions was the whole point of the classical gold standard.

This is just basic bookkeeping. Using a debt from the banking system to resolve a debt to the banking system will dissolve both debts. By definition, one of those debts being dissolved is money.

Have you had any accounting? I can walk you through the debits and credits if you like.

Not necessarily true.

Not a whole lot of new loans were being extended to private nonfinancial borrowers in 2008-9, even as old loans were paid off. Further, any interest revenues might be used to pay expenses or even dividends to owners, rather than helping to finance new loans.

Excellent point.

Every dollar is, at least technically, a debt. Every dollar in existence is represented by a credit to liabilities on some bank’s ledgers. No exceptions.

Central bank monetary liabilities don’t quite represent a legitimate debt in any real financial sense, but the accountants call it a liability anyway. It’s sort of a fictional debt but technically it’s on the books, so it still sort of counts.

“Financial savings” doesn’t quite work, in my opinion. I normally consider my S&P mutual fund holdings to be financial savings, but they’re obviously equity and not debt.

“Monetary savings” would work fine. But it still wouldn’t salvage your statement:

I think Americans should borrow less and save more. Not nonsense. A reasonable statement.

You could specify money. “Americans should borrow less and save more money” is a fairly ridiculous statement, taken literally. But even then, it’s not literal nonsense. Well, not inherently. There is a sensible literal interpretation of that statement I could find, if I wanted to be cantankerous.

They absolutely do.

There is no point at issue here. This is not controversial. Private banks create and destroy “money”, broadly defined, literally every working day. Your subsequent explanation conflates the monetary base with broader forms of money.

You guys are simply mistaken.

LinusK is an advocate of a weird heterodox economics school, but there is nothing controversial or non-mainstream about the statement that private banks create and destroy money. This is plain boring fact. It isn’t even economics, per se. It’s just bank accounting.

As I said above, I can walk through the debits and credits if there is some confusion on this.

I can promise you that, yes, it is. I don’t like that link but it’s fairly clear, or I can provide additional cites as needed.

Some instructors might use slightly different words but they’re talking about the same thing. The broad money supply is created and destroyed by private banks. There is simply no question about this.

18

And my assets: $100
Thus one could easily argue that it is depositing money into a bank that increases the money supply. Every time I put money into a checking account, I just doubled the money supply, since both I and the bank pretend to own the same bank note.

This all gets into different types of money (M0, M1, etc.). The fractional reserve banking system takes cash and multiplies it by creating different classes of money with different liquidity. Arguing which exact part of the banking system is responsible seems like splitting hairs.

19

That’s a fair statement. It’s a legitimate way of looking at things.

But let’s be clear that it’s not how things are conventionally defined. Broader aggregates of the money supply like the M1, as measured by the central bank, exclude any currency in bank vaults. Depositing a hundred bucks in cash into your checking account will not affect the official M1. There will be one hundred dollars more of checkable deposits, and one hundred dollars less of currency outside of bank vaults, and the net change will be zero.

But a new loan? Created by a bank? A new loan generally will expand the stock of broad money as conventionally measured. Paying back the loan will tend to collapse broad money.

I agree with this to a certain extent.

But it seems legitimate to split hairs if one is doing it in the official way.

20

Reserves are liabilities of the Fed. The Fed’s a special bank, but in this aspect it works like other banks: it has assets and liabilities. Its assets are loans, and its liabilities are reserves (and currency). It creates reserves by lending (usually by purchasing US debt.) it decreases reserves by collecting on its loans (for example, by selling US debt).

This is true. Banks are regulated, and there are constraints on their ability to lend - both practical, and regulatory. This is a good thing, and although it’s not specifically relevant to this thread, more and better regulation of the banking system would, imo, would be a good thing. If there are banks that are “too big to fail”, for example, they ought to be divided into banks that are small enough to fail.

The most recent financial panic was a result of a failure of regulatory oversight over the banks - especially the “too big to fail” banks of Wall Street.

It’s not magical thinking though; it’s just how the banking system works.

Actually, I just want to discuss everything I’ve said. I’m hoping that by discussing it, I’ll improve my own understanding, or someone else’s, or both.

That’s why il explicitly asking criticism, if you think I’ve got something wrong.
Sorry for not using quotes within quotes, but I’m working from my iPad.