Sunday, December 18, 2011

Inflation and the Optimal Money Supply

In recent months, I have learned much about fractional reserve banking, central banks, inflation, interest rates and money supply. In this blog post, I'd like to explain some aspects of inflation, its relation to the money supply, the gold standard, and some considerations on the optimal size of the money supply. In order to accomplish the goal of a discussion on these topics, some background information is necessary.

To begin, I will give a brief overview of fractional reserve banking. To my knowledge, all banks in Canada today are fractional reserve banks. In the early days of banking, customers of a bank could deposit their gold at the bank for safekeeping. To facilitate easy economic exchange between parties, banks began to issue promissory notes representing a certain amount of gold, so that two parties wishing to exchange gold between themselves would not need to withdraw, transport and deposit physical gold. An individual could exchange the note at the bank for the corresponding amount of gold at any time. This is called full-reserve banking with money tied to a gold standard. The promissory notes issued by the banks functioned as currency because their validity was universally recognized within the community, and because the holder of a note equated to the owner of the gold it represented. As people began to use these promissory notes more and more often, the banks noticed that not many people actually came and exchanged their notes for physical gold. As a result, the banks issued more loans to people by distributing more promissory notes for the gold they had just sitting in their vaults. This is called fractional reserve banking, where the bank "loans out" the gold sitting in their vaults. Eventually, banks began to loan out more money than the total gold they had, in effect loaning out more than 100% of their gold deposits. In modern day, money is no longer exchangeable for gold, instead fiat money is used. Fiat money means that the government has declared the bank notes legal tender, and the government's central bank can print more money if they so choose. Most of the money in circulation today comes from loans issued by banks, which is characterized as money creation through lending of credit (since only the central bank can truly "print" money). An astute reader might also notice that this means that interest must be paid on all money created through lending of credit. The total of these two amounts of money issued is called the money supply.

Inflation is defined as a rise in prices of consumer goods. There are many aspects to inflation, however the generally accepted cause of inflation is growth of the money supply. When more money is created, each new dollar represents a smaller fraction of the real wealth in the economy, and so more dollars are needed to pay for the same item than before the increase in the money supply. When the initial new money is created, there is an increase in spending as the money changes hands repeatedly. Entrepreneurs see this increase in spending and increase prices accordingly, in order to make a higher profit. According to the previous paragraph, there are two sources of money creation: printing of money by the central bank, and bank-created money by lending of credit. This may seem the case, but the real cause is only one of the above. Firstly, it may seem in the interest of fractional reserve banks to issue as many loans as possible to make more profit. This is not the case for two reasons. Firstly, fractional reserve banks are required to maintain an asset-to-capital multiple. Loans issued by banks are called assets, because they produce interest (income) for the bank. Capital is the amount of cash or easily-convertible-into-cash securities. Banks must maintain a certain amount of cash so that if everyone wants to withdraw their deposits at once, there won't be a run on the bank. (For an amusing example of a bank run, watch this YouTube video). Secondly, the central bank has the power to set the interest rate (called the key interest rate) at which banks lend money to each other. If this interest rate rises, it becomes more costly for banks to borrow money, and so they raise the interest rates on their consumer loans, which in turn discourages further borrowing and encourages paying back loans by consumers. If the key interest rate is lower, it becomes cheaper for banks to borrow money, and so they can issue more loans at lower interest rates, which encourages consumers to borrow and spend money. The central bank uses this key interest rate to control the money supply indirectly and speed up or slow down the creation of credit and the functioning of the economy.

So in essence, the central bank of a country controls the creation of the entire money supply, either directly or indirectly. But, there is a key difference between government-created money and bank-created money. When money is created through credit, the money can be paid back and consequently cease to exist. When money is "printed" by the central bank, it stays in existence. In addition, if the central bank keeps interest rates low, more loans and bank-created money are added to the system. For these reasons, one can blame the central bank for consistently increasing the money supply over the years, and consequently perpetuating inflation.

One might draw the conclusion that the money supply is "too big" and ask the question, what would be an optimal money supply? As it turns out, there is no "optimal" amount of money to have at the scale of today's economy. If central banks were to stop targeting interest rates and printing money when they deem prudent, the free market would determine the amount of money in circulation via supply and demand for money (or cash holdings). Similarly, supply and demand for credit would determine the market interest rates for loans. Inflation is not caused by a single increase in the money supply over the long term, it is caused by the fact that new money is not propagated across the economy instantly. When new money is created, those that hold it benefit by being able to spend the newly created money according to existing prices. Once the money propagates through the economy over time, prices tend to rise to adjust to the new total money supply. At some point, prices will reach a new range and tend to stay in that range according to the business cycle and other factors, provided no new increase in the money supply occurs. Due to central banks, the money supply changes constantly and rapidly, and so the new adjusted price range is never attained before the money supply increases again. The result is a constant increase in prices over the years.

Taken from

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