Setar wrote:The topic that always seems to get me is the money supply. I don't know at all how to deal with neoliberal arguments about having to get money from somewhere, or why governments have to be subject to the same sort of rules as a private household or enterprise in terms of spending...And from the other side, I've seen claims that since the 1970s there has been meddling at the international level that's effectively rigged the game and forced neoliberalism. It was something about governments somehow being convinced to take loans from private banks at their interest, rather than directly from their central bank (at least, in Canada this is claimed to be the case) at low/no interest because um something something creating new money inflation (I think, though I haven't heard a neoliberal argument about the money supply that doesn't boil down to that).
I have a 487 page book which discusses this topic. Basically you're asking how does the government print more money without suffering massive inflation? I'm going to explain this using the US as an example (because I'm very familiar with the American system) but the rest of the First and Second Worlds work in basically the same way.
Governments print money. The central bank, i.e, Federal Reserve, Bank of Canada, Bank of England, etc., determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The Treasury does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.
Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”.* To increase the nation’s money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some households’ savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will buy government bonds if the interest on them rises and will sell those bonds when the interest rate falls.
If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed’s open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!
Remember, the money printed at the Treasury and held at the Fed was not part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks’ excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.
Now, commercial banks have sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do not earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed’s bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.
So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.
Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.
Additionally, the lower rate on US government bonds resulting from the Fed’s open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.
Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation’s output puts upward pressure on prices as the nation’s producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption.
Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contradictory monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.
I’ll leave you with one question to ponder (the answer to which would require a much longer post than this one). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That’s right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America’s unprecedented monetary growth over the last few years.
*I say traditionally, because in the last few years the Fed has devised numerous new ways to inject liquidity into the economy, which I will not get into now.