Money Supply

mwpt

Instead of hijacking padington's thread I thought I'd move my next reply here. Just recapping with some quotes:

I asked:

mwpt wrote: »

To be fair, it's easy to see why people get confused, with the following direct quote from their document:

This is a topic I actually don't know a lot about. I just tried to spend 5 minutes reading that document in my typical style, which is to skim over and see if I can spot the key points and understand it. I could not. I was pondering, how do we get inflation in a system where, if you get right down to the base of it skipping all fancy terminology and cruft, money isn't "created out of thin air". I tried to google but it appears there isn't a simple explanation for lazy people.

Can one of you just tell us who don't know, If all debts were settled completely tomorrow and everyone went to the banks to withdraw every GBP as notes (which in our hypothetical question would be made available), would this physical cash total be greater than the total if our hypothetical situation occurred 20 years ago? If so, where did the extra money come from? Does the central bank slowly print money?

Generali answered:

Generali wrote: »

Physical cash is a tiny fraction of bank deposits and TBH is pretty meaningless in the C21st.

If you set up a new bank and everyone tried to withdraw their money physically or electronically to put it there then all the other banks would be bust. Banks only hold a small proportion of the deposits that people have hence the phrase fractional reserve banking.

The way it works is thusly.

A bank receives a deposit of £100. It has a reserve requirement of 10% so it needs to put £10 in its vaults (not literally but it's simpler to explain if we use the old ways) and can lend out £90.

That £90 is lent to someone to do up their house and is paid to a builder who puts it in his bank account.

That bank has £90 in new deposits and so can lend £81 to the builder who uses that money to buy a nice bottle of English not-Champagne........

And so it goes on. Ultimately (because maths) that £100 becomes almost £1,000. That is how money is created via fractional reserve banking.

If anyone says money is pulled out of thin air then they are either stupid or being disingenuous.

Which is explaining how money is created using fractional reserve system. But this is stuff I already knew, and I was interested to understand if you wound back all of those loans, would you be left with the exact same amount of original deposit money.

I asked:

mwpt wrote: »

Please accept that my original question is a hypothetical one invented in order to understand something else. I knew as I pushed submit I'd probably made a mistake because someone would focus on the rather irrelevant concept of cash that I'd mentioned, but can you understand why I tried to frame it this way? The physical representation of cash was just a way to frame it so I could get the answer to "is there more money in existence today than 20 years ago".

To which some answers were: "Yes"

But I'm still curious, what is the mechanism for introducing the extra money. Does the central bank just push a button and create new money in it's own "vault" which it then loans out to commercial banks? Is this the mechanism underlying everything else including fractional reserve banking? Or am I still not understanding it?

cells

If you have a billion pounds and set up a bank the bank is permitted to create a ledger with debt and credit to a certain figure depending on regulations in that country. If the regulations is 30x then such a bank can create £30 billion of debt and credit

People can not really withdraw credit all they can do is move it within the banking system. So if someone withdraws a million from your bank and deposits it in my bank. My bank will then lend your bank a million via interbank lending. Even if your bank had £30 billion in deposits and £30 billion in loans and all the depositors withdraw their cash and put it into my bank, my bank would lend it to your bank via interbank lending so you would be fine. If I refuse to lend to your bank for whatever reason then I have to lend it to the BOE who will then lend it to your bank.

The £1 billion you used to start your bank with is a buffer for you being a crap bank. That is to say if you made too many bad loans then you would have to either call upon your shareholders to pony up more dosh or dip into that £1 billion as a last resort. One of the problems with the banks i think is that if you did dip into that £1 billion the regs then require you to shrink your loan book which may or may not be that eassy. a proposal is to have that £1 billion vary depending on the economic cycle.


How can banks as a whole lend out more dosh. Well they need more capital to be able to meet the regs. So they ask their shareholders. or they retain profits. or they convince the government to reduce the regs


thats my understanding of it

cells

the debt to credit in the system can shrink if people pay off their loans or increase if people want to take on more loans. The only limit to how high it can go is regs vs capital.

The BOE rate tends to try and manipulate this balance and keep this credit growth at a level where it does good rather than bad.

princeofpounds

Actually it's a pretty fair question.


The point is to understand that credit/debt is a form of money in itself. Whether the money is physical or not is actually not all that relevant.


Picture this scenario.


You have £10 in your pocket and you are in the pub with a friend.


Your friend asks to borrow £10 to pay for the next round, and gives it to the publican.


The publican puts it in the bank that evening.


The next day, you go to the bank and ask for a loan of £10 because you want to buy a TV. The bank hand you the very same £10 note.


So you now own £10 x 2 of cash. One note in your hand, and one that you lent to your friend. Yet this has been achieved by only having one £10 note, and still having only one £10 note.


The creation of money happens as an inevitable result of the creation of credit.


(It is indirectly one of the reasons there is a phrase on bank notes saying 'I promise to pay the bearer the sum of £ on demand', which doesn't make much sense with the modern use of cash)

princeofpounds

How can banks as a whole lend out more dosh. Well they need more capital to be able to meet the regs. So they ask their shareholders. or they retain profits. or they convince the government to reduce the regs


thats my understanding of it

Hi cells.


Whilst you haven't said much wrong, you are confusing bank equity (or capital) with bank liquidity (which is the ability to pay out cash on depositor demand).


They are related topics, because it is impossible to pay back all cash when you don't have enough assets to cover it. But they aren't the same thing.

mwpt

princeofpounds wrote: »

Actually it's a pretty fair question.


The point is to understand that credit/debt is a form of money in itself. Whether the money is physical or not is actually not all that relevant.


Picture this scenario.


You have £10 in your pocket and you are in the pub with a friend.


Your friend asks to borrow £10 to pay for the next round, and gives it to the publican.


The publican puts it in the bank that evening.


The next day, you go to the bank and ask for a loan of £10 because you want to buy a TV. The bank hand you the very same £10 note.


So you now own £10 x 2 of cash. One note in your hand, and one that you lent to your friend. Yet this has been achieved by only having one £10 note, and still having only one £10 note.


The creation of money happens as an inevitable result of the creation of credit.


(It is indirectly one of the reasons there is a phrase on bank notes saying 'I promise to pay the bearer the sum of £ on demand', which doesn't make much sense with the modern use of cash)

Yeah thanks, that’s a scenario and information I’m comfortable with. But in the above scenario, it nets out because your friend still owes you the £10, which you then can go pay back the loan from the bank, the bank can give back to the publican. And just to add on to that, the publican pays your friend £10 for the rent of the pub, so that’s where your friend got the money to pay you. A closed system.

Unless I’m missing something, I get all this. My question is more subtle. How do we get inflation if the system is in fact truly closed and all loans must net out at the end?

I’m asking if there is an entity that sits behind it all (e.g. central bank) and actually pushes a button to create new money. Not in the form of loans that will eventually be paid off, but actual new money.

Does that make sense?

cells

princeofpounds wrote: »

Hi cells.


Whilst you haven't said much wrong, you are confusing bank equity (or capital) with bank liquidity (which is the ability to pay out cash on depositor demand).


They are related topics, because it is impossible to pay back all cash when you don't have enough assets to cover it. But they aren't the same thing.

you cant really take out credit from the banking system just move it around.

If people wanted to physically withdraw cash in too high a quantity then most likely the system would just print the cash and allow the banks to hold an equivalent entry on their books. So physicall cash would just become an extension of credit

If a bank has 30 billion in loans and 30 billion in credit and there were 10 such banks in the country and only £1 billion in actual cash. If for whatever crazy reason the population wanted to withdrw the whole 300 billion as cash they would just print it and hand it to the people with the central bank holding the counterparty. At some stage the people would hand it back and the central bank would burn them

Of course there really isnt a time when people want to withdraw the whole system of credit as cash. And maybe at some stage cash itself will go

princeofpounds

As a further follow-up...


When economist look at the money supply, they use different levels.


M0 is physical cash, for example. Note that 'broader' money, such as M4, include bank deposits. Of course those bank deposits can be lent out to other individuals in the economy, even though you still 'own' them.


http://lexicon.ft.com/Term?term=m0,-m1,-m2,-m3,-m4


In the example I gave you just now, we started off with £10 of M0, and ended with £10 of M0 and £20 of M2.


If you want to take the mental exercise further, and understand how the concept of money arose from IOUs, imagine a different scenario where your friend 'Adam' wrote you an IOU note when you lent him the money in the pub.


You then go home and realise that you have forgotten to pay a mutual friend of the two of you - 'Bert' - for paving your driveway. So you pop round to his house, apologise for being late and having nothing to pay him with.


Then you realise that you have the IOU note from 'Adam' in your pocket. So you give it to 'Bert', as you know he is seeing Adam in a couple of days and can cash in the IOU before you can.


Because you, Bert and Adam all know and trust each other, he is happy and considers himself paid.


That's basically how note money started. IOU notes got traded around between people.

cells

mwpt wrote: »

Yeah thanks, that’s a scenario and information I’m comfortable with. But in the above scenario, it nets out because your friend still owes you the £10, which you then can go pay back the loan from the bank, the bank can give back to the publican. And just to add on to that, the publican pays your friend £10 for the rent of the pub, so that’s where your friend got the money to pay you. A closed system.

Unless I’m missing something, I get all this. My question is more subtle. How do we get inflation if the system is in fact truly closed and all loans must net out at the end?

I’m asking if there is an entity that sits behind it all (e.g. central bank) and actually pushes a button to create new money. Not in the form of loans that will eventually be paid off, but actual new money.

Does that make sense?

They could but they generally dont

You dont need to print cash to cause inflation.

If there was a comet coming to earth and it was 100% going to hit in a months time and wipe out 90% of the planet guess what inflation would be? Probably something like 200% a day if not more. within days money/credit(IOUs) would be worthless within two weeks a £1 loaf of bread would cost over £5 million.

mwpt

princeofpounds wrote: »

As a further follow-up...


When economist look at the money supply, they use different levels.


M0 is physical cash, for example. Note that 'broader' money, such as M4, include bank deposits. Of course those bank deposits can be lent out to other individuals in the economy, even though you still 'own' them.


http://lexicon.ft.com/Term?term=m0,-m1,-m2,-m3,-m4


In the example I gave you just now, we started off with £10 of M0, and ended with £10 of M0 and £20 of M2.


If you want to take the mental exercise further, and understand how the concept of money arose from IOUs, imagine a different scenario where your friend 'Adam' wrote you an IOU note when you lent him the money in the pub.


You then go home and realise that you have forgotten to pay a mutual friend of the two of you - 'Bert' - for paving your driveway. So you pop round to his house, apologise for being late and having nothing to pay him with.


Then you realise that you have the IOU note from 'Adam' in your pocket. So you give it to 'Bert', as you know he is seeing Adam in a couple of days and can cash in the IOU before you can.


Because you, Bert and Adam all know and trust each other, he is happy and considers himself paid.


That's basically how note money started. IOU notes got traded around between people.

Sure, but again, you've just introduced an extra transaction into the system but unwinding everything still results in £10.

My question still stands, does the BOE press a button to create more money such that if we unwind everything we're left with £12 instead of £10?

mwpt

cells wrote: »

They could but they generally dont

You dont need to print cash to cause inflation.

If there was a comet coming to earth and it was 100% going to hit in a months time and wipe out 90% of the planet guess what inflation would be? Probably something like 200% a day if not more. within days money/credit(IOUs) would be worthless within two weeks a £1 loaf of bread would cost over £5 million.

I'll answer this shortly, I don't want to lose track of the thread by cross posting across tangents. Thanks.