Money Supply

theEnd

mwpt wrote: »

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?

Normal day to day inflation/deflation come from demand for debt.

Longer term inflation comes from 2 factors.
1) Lowering the capital reserve ratio of the banks (provided the demand for debt also increases)
2) Printing money, which I believe the BOE do constantly in small amounts.

Let's assume there's always full demand for the available debt and there's £100bn narrow money supply and the capital reserve ratio is 10%. You'd end up with £1tr of broad money.

If a couple of decades later you'd printed a bit and extended the narrow supply to £150bn, whilst dropping the reserve ratio to 4%, you'd then have nearly £4tr of broad money.

princeofpounds

How do we get inflation if the system is in fact truly closed and all loans must net out at the end?

Thanks for the clarification. It's often hard to track where people are in their thinking when they are trying to describe concepts they are in the process of grasping.

I'll deal with this in another post shortly...

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.

Yes and no. There can be an entity that sits behind a specific type of money. And that entity can try to control the money supply. It can control narrow money very easily - simply print more notes or less notes (this isn't what happens in practice, but it will do for the purpose of explanation).


But it cannot control broader types of money easily.


Let's go back to the pub. The original printer of the £10 note you have could have printed £5, or £15. So they have total control over M0.


But the original printer of the note cannot control whether you lend it to your friend or not (unless they resort to a communist-style command economy where everything is controlled, including friends lending their mates some cash). So they don't control the M2.


To control all money supply of all types would mean to control all creation (or destruction) of credit.


The 'loans that need to be paid off' ARE money.


Now, central authorities can influence money supply of all types in a couple of different ways.


They can change how the creators of credit (principally banks) are allowed to lend under the regulations, although they can't actually make the decision for them. This is done through things like the 'reserve requirement' Generali mentions. (It is the equivalent of someone sayinf even if you have £10 in your pocket, you can only lend £9 to your mate).


They can also change the interest rate on money, which makes people more or less willing to borrow/lend. And whilst they can't control the interest rate you charge your mate directly, you are going to be influenced by the central bank's rate (after all, why lend £10 to your mate to get £11 next week, if the central bank will give you £12 AND you have 100% confidence it can pay you back)


Finally, if the central bank starts doing really stupid things, people can stop using the money and just adopt different types of money. Let's say the Bank of England uses helicopters to drop billion pound notes on the streets. No-one will trade in pounds any more, and we'll probably fall back on trading lumps of gold (or more realistically, use dollars or euros). This kind of thing happens all the time in emerging markets that fail, it's called 'dollarisation'. So you only have control over the currency, but not necessarily the fact that the population actually use it as their main currency.

mwpt

theEnd wrote: »

Normal day to day inflation/deflation come from demand for debt.

Longer term inflation comes from 2 factors.
1) Lowering the capital reserve ratio of the banks (provided the demand for debt also increases)
2) Printing money, which I believe the BOE do constantly in small amounts.

Thank you. Both yourself and clapton have now answered with the same thing (point 2 bolded). I don't profess to have nearly a full understanding of the monetary system but I have read a bit. It just didn't feel intuitively correct that in a closed system we could get long term inflation solely by fractional reserve banking.

CLAPTON

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?

the system isn't closed as the BoE can create unlimited money

There is a general relationship that says
for a period of time where T goods and service are sold:
PT=MV
where P is the generialised price level (i.e related to inflation)
T is the goods and service (things being bought and sold over the period)
M is money supply during the perio
V is the velocity that the money changes hands

so inflation (basically how P changes) can be caused by more money or by money changing hands more quickly

princeofpounds

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

Yes, unwinding all credit would result in only M0 money existing.


But it's not 'just' an extra transaction. That is the process of money creation. It's the 'magic' that allows you to own £10, and a friend to spend £10, and the publican to own £10, and the bank to lend £10. All with one note in existence.


The note itself is relatively unimportant to how much people in the economy spend and how much cash they think they own; what matters is how many times it flows (The V in the PT=MV equation) and how many times it is used in credit (the M in the PT=MT equation).

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?

Yes, it can do. But this is really not an important process at all these days, apart from helping to make sure that there are enough £5 and £10 notes and we aren't all walking around with £50 notes no-one will accept just because we can't break them easily.


What is actually much more important is the indirect influence on the broader forms of money - reserve requirements, interest rates, repo operations etc. That is the same thing as saying the impact upon the ability of banks (and mates in pubs) to lend, either positively or negatively.

the system isn't closed as the BoE can create unlimited money

This is basically correct. But it's not just that the BoE can print lots of notes. But what is important is how much credit (and therefore money) the BoE 'allows' the whole economy to make using all these tools of influence it has.

It doesn't have to sit there with a printing press burning away, when it can just lower interest rates 0.25% and every mortgage-borrower in the land gears up to buy a new car. To put it in your terms from earlier: 'just' introducing [a hell of a lot more credit] transactions'.


Hopefully now I don't need to find a way of explaining inflation in a pub analogy, now you know that a) narrow money can be introduced or removed from a closed system and more importantly b) broader money can be generated or lost within a system just by people making or calling-in loans - it doesn't require an external 'injection'.

mwpt

princeofpounds wrote: »

Yes, unwinding all credit would result in only M0 money existing.


But it's not 'just' an extra transaction. That is the process of money creation. It's the 'magic' that allows you to own £10, and a friend to spend £10, and the publican to own £10, and the bank to lend £10. All with one note in existence.

The note itself is relatively unimportant to how much people in the economy spend and how much cash they think they own; what matters is how many times it flows (The V in the PT=MV equation) and how many times it is used in credit (the M in the PT=MT equation).

Yes, it can do. But this is really not an important process at all these days, apart from helping to make sure that there are enough £5 and £10 notes and we aren't all walking around with £50 notes no-one will accept just because we can't break them easily.

What is actually much more important is the indirect influence on the broader forms of money - reserve requirements, interest rates, repo operations etc. That is the same thing as saying the impact upon the ability of banks (and mates in pubs) to lend, either positively or negatively.

This is basically correct. But it's not just that the BoE can print lots of notes. But what is important is how much credit (and therefore money) the BoE 'allows' the whole economy to make using all these tools of influence it has.
It doesn't have to sit there with a printing press burning away, when it can just lower interest rates 0.25% and every mortgage-borrower in the land gears up to buy a new car. To put it in your terms from earlier: 'just' introducing [a hell of a lot more credit] transactions'.

Surely in a fractional reserve system there is an upper limit on how much money we can actually create, because, well, maths. If you have to retain a fraction of the original money, you converge on an upper limit.

But over the long term, as we go through credit easing and credit tightening, wouldn't we just cycle around a stable broad money base? We don't seem to. Broad money seems to increase over the long term and we cycle around this increasing trend line. (EDIT: I may be using the incorrect term here, broad money, apologies, but hopefully you get my point).

Doesn't that imply that underlying it all is a slow printing of completely new money as a separate notion to money as debt? (Clapton and theEnd posters seem to believe so).

theEnd

mwpt wrote: »

Surely in a fractional reserve system there is an upper limit on how much money we can actually create, because, well, maths. If you have to retain a fraction of the original money, you converge on an upper limit.

But over the long term, as we go through credit easing and credit tightening, wouldn't we just cycle around a stable broad money base? We don't seem to. Broad money seems to increase over the long term and we cycle around this increasing trend line. (EDIT: I may be using the incorrect term here, broad money, apologies, but hopefully you get my point).

Doesn't that imply that underlying it all is a slow printing of completely new money as a separate notion to money as debt? (Clapton and theEnd posters seem to believe so).

I think in reality it's just really complicated and not transparent. I feel the BoE print steadily to 'maintain the money supply' or something like that.

But, the banking system itself has led to a lot of the inflation of the broad money supply we saw in the 2000s. The basket of goods, stayed steady as all the money went into property.

There's also the complication of what is narrow money or how much of it there is. To an extent government debt and various other bonds, although seem like they should be broad money, actually act as narrow money as they can be included in the capital reserve of banks.

I can't pretend to fully understand, but in a full system, all the narrow money should be in the banks current accounts in the BoE and all the broad money is the rest. If the govt issue more debt then allow this debt to be used as narrow money, even more broad money can be created.

Generali

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?

The Central Bank creates money as GDP grows usually in a fiat money system otherwise all growth would be deflationary as there would be the same amount of money available to buy more goods so the price of those goods would have to be lower.

In a specie money system that growth in the money supply comes from more gold or silver or whatever being dug out of the ground. In a fiat money system it comes from the central bank creating more money.

As we now have fiat money across the world, all central banks are Government owned as the profits from seigniorage are significant.

Izabella Kaminska writes well on this stuff. It does require a bit of perseverance to understand her though!

princeofpounds

Surely in a fractional reserve system there is an upper limit on how much money we can actually create, because, well, maths. If you have to retain a fraction of the original money, you converge on an upper limit.

Sort of. If the system all consisted of regulated banks, yes. But you can't wipe out all lending by blokes in pubs. But let's put that aside for now.

But over the long term, as we go through credit easing and credit tightening, wouldn't we just cycle around a stable broad money base? We don't seem to. Broad money seems to increase over the long term and we cycle around this increasing trend line.

Yes, ignoring the trickle of 'blokes in pub' lending (I mention that just because often shadow banking is absolutely not ignorable, but let's put it aside for now).


But the consensus is that would not be good at all. Because if money supply is constant, but we are producing more goods every year, then the price of goods has to fall (as per PT = MV, assuming V is roughly constant, which is simplistically fair).


That is deflation, and we think it is bad because people stop being incentivised to spend and invest, as waiting on cash generates a return risk-free, and you end up with a Great Depression situation.


So Central Banks do tend to want to grow the money supply given the sort of growing economies that exist on the planet.


Typically to produce an environment that is inflationary, but only slightly-so, because high inflation has its own problems. Note that this is a simplified description of Central Bank policy. Not all institutions think the same, but most think along similar lines these days.


But the important operation to do this is not physical money printing. That's mostly concerned with making sure the right physical notes are in circulation to help cash machines and corners shops work ok.


What they do instead is that they internally create a bit of money that they lend out to banks - at rates based on the Base Rate we hear about all the time. Some days they create, some days they withdraw. And it is not given out for free - in fact often it won't be lent out at all unless some collateral (typically a government bond) is provided by the bank.


(Note they have other tools to do different things, but this is just a simplified example).


But again, although this operation has great significance, Central Bankers are not thinking 'we need to provide £X' for the economy to work. They are mostly thinking about supplying or withdrawing enough overnight lending - a type of liquidity - to keep interests rates around the target levels. The banks and the whole economy do the rest.


And I strongly suggest you read the wiki article on this:


"A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is - asides from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks - to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply"


https://en.wikipedia.org/wiki/Open_market_operation

princeofpounds

I think in reality it's just really complicated and not transparent

Actually although it is complicated, it's really transparent. Most Central Banks publish most of what they are doing in terms of financial operations, and also a lot of their thinking on the various subjects. If you delve into any Central Bank website you'll see all sort of incomprehensible, but very much published, things.