I’m thinking about inflation, a situation in which prices increase, causing each unit of currency to have less purchasing power. I have always believed that one cause of inflation is the influx of money into the system. That actually makes sense in that if people had a lot more money, merchants would raise prices in response to heavier sales. But how does the money supply actually increase? If the government prints, for example, twice as much money this year, how exactly does that extra money get into the hands of people, to ultimately cause prices to rise?
Inflation doesn’t happen because there’s more money, it happens because there is too much money for a given supply of goods. If the supply of goods and services available increases at the same rate as the supply of money then there is no inflation even though the supply of money is increasing. Likewise, you could have the same amount of money but if the supply of goods and services decreases you could have inflation.
The best way to think of inflation and deflation is not to think about prices for goods increasing or decreasing. Instead remember that money is a particular type of good that is subject to the same laws of supply and demand as other goods. Increase supply or decrease demand for money and the value of money decreases and you have inflation. Decrease supply or increase demand for money and the value of money increases and you have deflation.
The fraction of money in the economy represented by paper bills is actually very small. Think about how modern banking works. I get my paycheck directly deposited, I pay my bills online or by credit card. I only pay cash for a few incidentals. So most money in the economy is not represented by paper bills, but by accounting entries in bank computers.
Even if “money” doesn’t only mean currency, but also includes electronic transactions, how does the increased money supply get into the “hands” of people? I still don’t get that. This, from the Wiki article on Inflation: “Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.”
They mean the growth of the money supply relative to the underlying value of the property, goods, and services that the money is supposed to be based on.
Your question concerns aggregate demand and the physical bills. They are linked but not synonymous. I can only help with the first part.
Aggregate demand = Gov’t spending + private consumption + private investment + (exports-imports).
When we see AD rise, it’s usually not because there are more bills (mass) but because they’re spent at a higher frequency (velocity) . People hang on to their money less and it goes from one person to the other faster.
A lot of currency creation occurs through fractional reserve banking. Since banks only need to keep a fraction of the money from savers and can lend the rest, the amount of money gets multiplied and the more banks lend, the more AD (though not physical bills) there is.
A central bank will also use financial instruments to increase the amount of money available to banks.
As for the second part, I don’t know through what path physical bills go from the printing press to the wallet. I found this but I’m not sure it goes into enough details: How Currency Gets into Circulation - FEDERAL RESERVE BANK of NEW YORK
I just realized that there’s something about fractional reserve banking in the electronic age that I don’t quite understand, so I’ll ask about it here:
- When I get paid, it’s an electronic transfer of money from my employer’s bank account to my chequing account. That’s good so far.
- When the bank gets that money, they credit my chequing account with the amount of the paycheque. Under fractional reserve, they’re also able to turn around and lend most of it to somebody else, as long as they’re able to cover the specified fraction of all the chequing accounts they have open.
- What happens if they don’t have enough physical bills to cover the fraction? Do they need to ‘buy’ bills with the electronic funds? How does that happen?
Please feel free to correct if any of the above is based on mistaken assumptions.
The central bank has an amount it charges banks to borrow money. By raising and lowering that amount it can control the demand banks have for money. The central bank can also buy bonds from banks with newly created money. The banks will then lend this new money out where it will find its way to consumers.
Ok, so have I missed seeing the answer to my question? I’m still confused. If the amount of money is somehow increased, say, by printing more or by making it easier for banks to borrow or lend, how does a consumer wind up with more of it -to create greater demand and to cause prices to rise, i.e inflation?
CC,
You seem to conflate the creation of physical bills with increased aggregate demand. Even if no bill or coined were ever produced, you could still have currency and aggregate demand. It would just be less convenient for a lot of exchanges.
AD isn’t increased by the gov’t printing physical money, it’s increased by the gov’t reducing fractional reserve requirements, lowering interest rates, gov’t spending, private consumption and private investment and some other means I may not know.
If the Fed reduces interest rates, it’s cheaper for banks to borrow from the Fed and banks have less incentive to buy gov’t bonds with their money, so they have greater incentive to lend to consumers (e.g.: car and home loans) and investors. Consumers and investors then spend more money.
The cheaper it is for banks to get money, the more they want to lend it out. Consumers can then get loans for less interest, so they take out more loans and more money goes into the system.
This only works up to a point though. Currently the interest rate charged by the Fed is effectively zero. And yet people are still slow to take out loans. The end result is that even though the Fed is happily shovelling money out the door, most of it just sits in banks and doesn’t add to the circulating money supply.
ok, so then are credit card rates a significant part of the equation? It seems that there aren’t that many people borrowing to buy cars or houses, but almost everyone seems to use credit cards and apparently most of them are also willing to carry a balance. If the credit card rates go down, I imagine more people will spend more.
Worse still, from my understanding at least, is that the banks have borrowed a tonne of money from central banks (be it UK or US) at an effective zero interest rate and then used these free loans to buy government bonds/guilts (again, US and UK), which essentially gives the banks a positive return, thus free money. At the same time banks are still not lending to the public at the rates that would encourage growth (and the public is increasingly feeling insecure in their jobs and so aren’t taking out loans or spending).
People will only spend or borrow money when they are secure in employment, and that is not the case, so although it appears that people are spending on credit cards, they aren’t spending enough. Hence the need for the government(s) deploying QE trying to kickstart the economy (by giving banks funds to loan)… Which isn’t working because they’re funnelling that money into banks and not people’s pockets (and it needs to be people who spend money not save or invest, therefore it would be better to give it to poorer households who are more likely to use it rather than bank it). Although you don’t want people paying off debts at the moment either.
In the US, gov’t bond rates are below expected inflation, so the amount of money to be made this way is somewhere south of zero.
But in any case, banks buying bonds from the gov’t means the gov’t spends more. From an economic point of view, there isn’t any difference between the gov’t taking out a loan to buy a tank or Joe Schmoe consumer taking out a loan to buy a house. The mechanism works as well in either case.
True, who’s buying the Italian and Spanish bonds though?
The recent money making scheme called “Quantitative Easing” (QE) is designed to free up non-cash assets by turning them into cash created out of thin air.
Once banks unload Treasuries and get cash, scheme design suggests, bank will invest that money into economy by lending.
Now, for an individual, that does not really create any cash as the cash individual is interested in is the so called “unencumbered” cash; i.e. credit card debt or loan debt is cash that is encumbered by the fact that you have to pay it off.
So, to answer your question, the only way for an individual to get a hold of unencumbered cash is to get a job if they don’t have one or get a wage increase if they already have a job.
The grand design of QE is that once economy picks up people will get jobs or wage increases. And that’s how you benefit from money printing operation such as QE.
The risks of a scheme like this are many but people generally don’t want to hear about it.
The basic idea:
The monetary base, M0, is central bank money. This money is created when people at the central bank hit buttons on their computers. This money gets into bank possession when the central bank buys assets (in common situations, short term government debt) from banks. They’ll say, “Hey banks! Give us 10 cool bil in bonds!” And the banks’ll be all like, “ah-ight”. The banks will ship those bonds on over to the central bank, and the people at the central bank will hit buttons on the computers that say the banks have 10 billion more cash (M0, base money) than they had yesterday.
This computer cash is the same stuff as paper banknotes as far as accounting goes. No special difference. Banks can exchange central bank computer money for paper money at will.
Once it’s in bank possession, they can do what they want with it, like loan it out or buy things with it or set it all on fire like Joker did in that Batman movie. Whatever they want. It’s their cash. Sometimes they just sit on the cash like a chicken sits on eggs, and there’s not really any inflation. It’s like printing a trillion dollars, and then digging a cave and putting the trillion in the cave and burying it. It can’t do anything if it’s not moving.
What matters is not just the existence of new money, but how fast it moves. This isn’t really a problem, though, if there’s a central bank that is determined to make more and more money. If the central bank keeps making more, eventually that money will move. Banks will make more loans, they will buy more things, the new money (and the old money, too) will eventually be passed back and forth faster and faster in the real economy, and with enough money moving, you’ll end up with inflation. How does it get in people’s hands? Bank loans and bank purchases. That’s pretty much it. (This tends to be bank deposit money, not base money, but the underlying dynamic here should be clear.)
That’s the basic idea. Private banking is its own weird little world with its own complexities, but a central bank can get an inflationary process started if it makes enough new money by buying stuff from banks.
A bank’s own bills in its vault, and its electronic reserves on central bank computers, are treated as the same thing. They’re not two different things, they’re just both central bank money that the bank owns. They can convert one into the other at will.
If a bank doesn’t have enough base money (central bank money) to cover the legally mandated fraction to back their deposits, then they would potentially get in trouble with their banking regulators. But really? Ordinarily, they’d just borrow from other banks to make up the shortage. This can be seen as an intentional loophole. Deposit liabilities, like your checking account, have to be backed by a fraction of cash (whatever form that “cash” takes). Interbank liabilities, however, are most often exempt from a fractional backing requirement. That means that if they don’t have enough cash on hand to meet their legally mandated deposit reserve requirement, they just borrow from other banks.
This allows the common situation where banks can lend money first and then find reserves later. This is most often the case: the loan is made first, and only after the loan is made does the bank search for more cash to safely back its fractional requirement once again.
But if other banks for some reason won’t lend them the money, they’re hosed. The banking regulators will eventually see that they’re under the legal requirement, and the hammer will presumably come down. (Pretty sure the US Fed checks reserves every other Wednesday. Dunno about other central banks.)
Well, there’s one more thing to add.
Aside from the fact that it is a huge assumption that banks will lend newly obtained cash, inflation will be small in scale only if economy increases output in a somewhat proportional degree to the amount of new cash obtained. That economy will actually produce such an output is even a bigger risk than having banks lend the money in the first place.
The government prints currency. Banks create money. When you put 100 in your bank, the bank sets aside some portion, (10%?) and loans the rest. Thus you still “have” your $100, and somebody else has a new $90.
When people talk about the government “printing money”, they are usually talking about taking measures to increase lending.
I am guessing that the op wanted a more basic answer than the ones given so far.
Yes, banks create money via fractional reserve banking and the money multiplier but the fed also creates money via the mechanism Hellestal described.
However it is, as they say, pushing on a string if, when the fed purchases securities from banks, the banks simply let that money sit in excess reserves.