Increasing money supply = inflation?

Economics Economics Questions
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21

Agreed on your final point.

The Open Market Operation is the primary tool the Federal Reserve has at its disposal when implementing its chosen monetary policies. In short, it buys or sells assets (theoretically any asset it wants) on the open market. If it is decided, for example, that the money supply needs to be increased, the federal reserve board, through its Federal Open Market Committee (FOMC) will go buy assets with money that literally did not exist the day before. The purchased assets could be anything, from nails to toothpicks to tractors, but they almost always are Treasury Bonds (if they’re going to make new money, who better to use it, right?) That’s why, incidentally, when people talk about the government’s being in debt to China, that’s mostly overblown; by far the largest creditor to the federal government is the federal reserve.

Anyway, on the other hand, if the federal reserve wishes to shrink the money supply, it can use Open Market Ops to sell the assets it has on its balance sheet on the open market. The money earned in the transaction then disappears whence it originally came.

You may have heard in the past the criticism of the USD that it is literally debt. This is where that comes into play. A gold coin is an asset in its own right, and the holder of that asset is not somehow holding debt. However, being that the federal reserve is the originator of the dollar, every single note you hav e in your possession was first loaned to the US treasury by the fed. Each dollar is debt as soon as it is created.

22

Mises: “In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.”

We know that banks create money too. This is just one reason why monkeying with interest rates is a bad idea.

23

What, in your opinion is the purpose of interest in a) our present economic system and b) under a gold standard? What I’m looking for is a justification for charging interest where a typical 30 year home loan will cost a buyer 2x the value of the home which goes to the bank as pure profit. I understand time value of money but there really is no one putting up funds that have been earned in our present system where the banks temporarily expand and over time contract the funds being loaned for the purpose of purchasing the home. Any thoughts?

24

If you understand the time value of money then where is the problem?

To me, the question of “What is the purpose of interest?” is exactly analogous to “What is the purpose of prices?” Interest, like prices in general, arises out of people bidding for scarce resources. Where prices, loosely speaking, deal with that bidding process within a given time period, interest rates come from a desire to secure resources across time periods.

The fact that the current monetary system is broken and unjust is not an indictment of interest, as interest is a reflection of scarcity and, to use Mises’ parlance, “time preference,” which is to say, the fact that people prefer the satisfaction of their desires sooner rather than later. In fact, I would say the major problem regarding interest rates under the current system is that they are not free to accurately reflect the time preferences of the individuals in society, and are rather suppressed by the government, meaning that in a free society they would probably be higher.

25

But can’t you see the injustice in paying the bank (who did nothing more than enter a few numbers on a keyboard) and then take our payments each month, pocket the interest and retire the principal back out of circulation?

A home developer for example performs labor to bring into existence the home and the buyer gives up his labor over time to pay for it. What lawfull consideration equal to the value of the home does the bank give up? Simply for being in a position of power over the issuance of money then, the banks collect the equivilent value of (depending on the interest rate) up to two homes of commensurable value. I would say that they are getting away with the crime of the century!

The time value of money works under a capitalistic system where individuals and groups save their money to have it invested by banks where the incentive factor comes into play. You need to collect interest or you would never save but would rather consume. But this system we have now needs no savings for the fact that they simply temporarily expand the money supply to pay for the asset and then contract it as it’s paid down. This is my question. Can anyone justify the charging of interest under our present system? This just doesn’t make sense to me.

26

Well, maybe you do have a point (that it is unfair for banks to profit off of interest in our current system). But rather, the more unfair or immoral thing is that

a) banks have a monopoly on the creation of money (and specifically the FED)

b) government provides a moral hazard of bailing out banks when they make poor risks (through the FED)

This is why free markets are advocated. Banks would likely become of two types: investment and savings banks. Investment banks would loan out depositors savings at interest and pay the depositors interest for their deposits. Savings banks would not loan out money but instead would only store money for a fee paid by depositors. Some banks may still do both, and they would likely keep much higher reserves than they currently do, because their would no longer be a safety net by the government to bail them out when they make mistakes, and this would likely strengthen stability in the financial sector. But depositors of investment banks would understand that their money is not guaranteed by some FDIC or any other form of government intervention; they would be taking a risk for a chance to earn interest. Of course, there could be other options available, such as direct investing through services similar to kickstarter, eliminating the need for some investment banks. The free market is the way to go, hands down, if one wishes to eliminate legalized plunder, moral hazard, and government-forced inefficiency. (;

27

I hear what your saying. What I’m getting at though is to fundamentally rethink the purpose of a monetary system in the first place and then to form a set of sound principles based off of this.

I see a monetary system that has as it’s only purpose, money created = wealth created and equal representation of each other’s labor as determined by the free market. This, in my opinion is the only goal in mind for a true and just economic representation. Would you agree?

Now lets explore the process logically. If new wealth is created (a home, a car, whatever) and we have new money created to represent it, what would have to happen in order to make any transaction a true representation of this monetary system?

Would it not be… (1) new money = wealth created and (2) market determined value of the buyers labor = market determined value of the sellers labor?

In the case of buying a car then, the seller of a car manufactures a car worth $20,000 on the market. The buyer cannot come up with this amount now but he can over a period of time. He needs $20,000 to be issued into circulation. Once this happens the transaction can take place. At this point you need to ask where’s the incentive for the issuer of money? So you pay him for his services. Now the buyer must pay back over time, what amount? And over what period of time? 5 years? 2 years?

Isn’t the objective here to have the money in circulation = what the car is worth? (no deflation, no inflation). So how long do cars last? 10 years on average? Why not pay back not over 5 years but at the rate of depreciation of 10 years. Then at any given time that car is worth was is owed on it. Once the car is paid off then the car is worthless and all the money has been paid back. The issuer of the $20,000 also has the job of retiring the payments back out of circulation. Bingo! You’ve got the ideal economic system!

28

Too lazy/preoccupied to address each of your points, but I would say that I feel you are unduly assuming the obviousness of the point that money is “created” in order to “represent” wealth, as though money itself is theoretically something that is imposed upon the market and not an organic development from within the market. While it is true that money and wealth are not the same thing, it isn’t true that a new monetary unit must be created for every instance of wealth creation. As practically anybody here would argue, any quantity of money is equally sufficient to service the needs of the economy, and those needs specifically entail facilitating exchange and acting as a basis for objective profit/loss accounting, without which economic calculation and the resulting rational allocation of resources would be impossible.

As far as your example goes, I don’t think the goal is to somehow equalize monetary units and aggregate economic value, being that the former should be determined by supply and demand forces, while the latter is subjective and therefore impossible to calculate. I don’t see any justification for overriding the voluntary preferences of the individuals in the market in favor of some arbitrary monetary target set by the individuals who somehow hold monetary monopoly privilege.

Which brings me to my point. If the money commodity were truly open to market competition, you would be free to test the validity of your theory directly. Because what do I know? But as it stands of course, competition is outlawed. So the “ideal economic system” may or may not incorporate your great idea, but it would certainly not prevent you from offering your “exchange medium” services on the market.

29

I think Stephen Adkins basically covered it, but to add to what he is saying:

Your proposed system seems to attempt price stability. That is, you want a, for example, new Ford to always cost the same as what it always has by creating money simultaneously with the car. This would really just be a type of intervention in the market (an specifically with the natural price mechanisms). When a new car is created, it likely isn’t worth what a new car (with exactly the same features) was worth two years ago. As the supply of cars increases, the value tends to decrease. By issuing new money with new products to maintain this sort of “price stability,” you’d really just be stealing value from all other currency holders.

Money isn’t really an invention; and a monetary system isn’t either. They are naturally occurring phenomena of the market. Remember, money is just another commodity to be exchange for something else. A system designed to force things like price stability is nothing more than a type of central planning.

P.S. - At the end of the 10 years, the car is not worthless. Far from it. It might be worth LESS, but it still has value.

30

@Rick, I wanted to reply to some of your statements.

I disagree wholeheartedly with your understanding of the “purpose” of a monetary system. The purpose is one of convenience. Indirect exchange reduces the friction in an economy. I no longer have to find someone who has a good I wants AND simultaneously wants a good I have. In addition, I don’t have to continue looking even further to find someone who not only fits that condition, but also is willing to exchange with me for quantities I’m willing to exchange for.

But never forget that both sides of any exchange are value for value. Value is subjectively determined. It’s based on what use I see for the good or service I’m getting in exchange for my good or service. In a voluntary exchange, I necessarily prefer what I’m getting over what I’m giving.

Indirect exchange, involves getting a good I don’t intend to use directly, but which I expect to be able to exchange for another good or service.

Wealth is hard to quantify, but it’s “things that have value”. Creating a new good creates wealth. Money isn’t used to “represent it”. Though we may represent it in an accounting book by current expected market “prices”. In this case money is used as an accounting tool, it’s used to quantify the assets one has, as a means of comparing it to other value.

But the “money” is it’s own product in the market with it’s own value. In your car example, you completely misunderstand that the price, which you say as “worth $20,000 on the market” is based on what it might sell for if you sold it. There’s no guarantee of that value. Nor is there a guarantee you’ll get that value in the future.

“Isn’t the objective to have the money in circulation = what the car is worth?” NO! What’s the car worth? You’ve stated it, but you’ve ignored how it gets a value that’s quantifiable. It’s the expected use by someone who’s willing to pay for it. That is a dynamic, subjectively determined quantity of money. Supply and Demand determine what the price is.

Stable prices are not a goal, stable prices tell us nothing. Unless they tell us something ;). Prices are information. They represent all the various pressures on supply and demand in the global economy that get rolled up into one number that’s convenient for calculation.

Now increasing the money supply (without changing the demand for money) will increase prices across the board. But an increase in prices for a specific good would normally mean that there’s an increase in demand for the product. The problem therefore with increasing the money supply is that it sends confusing and distorted signals to the market, making economic calculation even more difficult than it already is.

Now, let’s focus in on money supply directly. Lets say that there are 200,000 tons of Gold in the world. Now let’s also say that there are 150,000 tons being held as a store of value (Saved). This means that only 50k tons of gold are actively participating in the formation of prices. HOWEVER, as prices drop, the desire to store gold will drop and the desire to get cheaper goods and services in return will rise. This will draw more gold out of savings and into the market to compete for goods. Thus driving prices back down. That’s the natural that prices have on the “money supply”. As prices fall for goods, and more so as technology advances, it will become more and more “profitable” to engage in productive efforts that “create gold”, i.e. mining. This will contribute a relatively stable inflation of the money supply ALSO. But “creating gold” will always require capital investment of time, energy, and goods. It cannot be done in a vacuum.

In the above example, let’s talk about interest rates. Some people will save money to spend on their immediate consumption, think of this like your checking account. This type of savings would actually incur a penalty (think of as negative interest) because storing, auditing, and transfering gold, as you engage in your daily transactions would be a service which would be charged for.

However, interest rates operating on market principles would have the effect of drawing gold from savings into longer term investments. If I were running an investment bank as detailed above, I would have two rates. One that I loan at (12%) and one that I pay at (10%). I would use the 2% difference to cover my storage, auditing, collection and accounting fees, and to pay for insurance to cover the inevitable losses. There would be a ton of interesting ways to structure this type of investment banking. In fact our markets show us how these things play out.

But the mistake is to forget that money is it’s own commodity, NOT a trick of accounting that represents value, but a commodity that has it’s own inherent value AS WELL AS value in it’s use for indirect exchange.

31

I think you may have misunderstood or I wasn’t clear enough in my statement. The system I’m talking about is not a replacement for the free market enterprise system but rather a complement to it. For example, the free market is in operation when individuals make what they determine to be the correct price in which to buy and sell. Once this has been established, the monetary system comes into play.

Based upon their agreed upon price, money is issued to pay the seller with a promissory note and collateral backing it. There is no central planning whatsoever, it is the free market in operation with a monetary system that prevents deflation / inflation from occuring without the added injustice of dispossessing us of our just reward for our labor by interest. Surely anyone can see the logic behind this.

By the way the car in the example I gave is not a fixed number of years but depends upon it’s depreciation value. The point is to equalize as close as possible the money in circulation with the market value of the asset.

32

Maybe I do not understand what it is you are proposing.

Who issues the money?

If the dealership is selling a car for a promissory note backed by collateral, you understand that the car is being traded for the collateral? That’s what money is; it’s a commodity that is used in indirect exchange. And that collateral belongs to some depositor, right? So…

Why or how is it unjust for some depositor to earn a reward (interest) for not consuming when he has the means to in order for some debtor to consume when he has not the means? Do you think it the duty of the depositor to save so others can consume?

i guess you need to explain your proposition more.

33

OK lets back up a few steps. The money creation process is “sold” to us as follows:

An individual saves money, depositing it into the bank. He needs incentive to do so…thus the charging of interest is justified under this system. The bank also needs incentive so they charge a higher rate of interest to their customers as their profit.

The way money creation actually works is like this. A buyer and seller get together and agree on a price for a sale. If the buyer doesn’t have the money up front, a promissory obligation (a promise to pay over time) is issued. The bank intervenes between the buyer and seller, legally stealing our promissory note as if it was theirs and simply issues money into circulation to the amount of the agreed upon price. By doing this they launder the principal into their possession.

Bank deposits are not what is being lent out! This is all smoke and mirrors. The banks then charge us interest on the principal that was just stolen from us. When we pay the loan back, the principal is retired back out of circulation and the interest charged is a steady stream of unearned profit flowing into the coffers of the banking cartel. This is the actual money creation process.

34

Hmmm… Either the (savers’) deposits are not being lent out or the principal is stolen from the savers. It cannot be both ways, can it?

I still am not clear on what you are saying is the solution, regardless, or I am not sure you are clear on what it happening when fraction reserve policies are employed to create money (money multiplier effect).

How would the elimination of legal tender laws and the monopoly on the issuance of currency not solve the problem?

35

I disagree wholeheartedly with your understanding of the “purpose” of a monetary system. The purpose is one of convenience. Indirect exchange reduces the friction in an economy. I no longer have to find someone who has a good I wants AND simultaneously wants a good I have. In addition, I don’t have to continue looking even further to find someone who not only fits that condition, but also is willing to exchange with me for quantities I’m willing to exchange for.

I stand corrected. Those are also very important to a monetary system. Thanks for pointing that out.

36

When you pay back a loan, who do you pay it back to? The bank. It’s actually you, the buyer that has signed a promissory obligation to give up consideration, and the seller who gives up consideration in the asset being sold. The banks give up nothing of equivilent value. They provide the service of issuing “new” money into circulation to pay the seller and taking payments from the buyer and retiring this money back out of circulation. This is what’s termed the elasticity of money. The principal does not rightfully belong to the banks. How could it! Unless it gives up lawful consideration commensurable to the value given up by another party it is unlawful consideration.

Think of money elasticity as a balloon which is temporarily inflated and then over time deflated back to its original condition. This is actually the best system ever devised to fill the gap between what an individual needs “up front” to make a big purchase without creating inflation in the final analysis.

The issue I have with it is the charging of interest is totally unjustified and the process of paying back the principal over an arbitrary schedule creates circulatory deflation (the amount of money available to be earned). The payments should be paid back at the rate of depreciation of the related asset. If you combine these two aspects (erradication of interest and paying back over time at the rate of depreciation) you have a viable economic system (keeping in mind it’s complementary cousin, the free enterprise system).

37

In a truly free market, there could be no lender of last resort, such as the FED. And there would be no legal tender laws that empowers a central bank with a monopoly on the creation of money. It is because of this, that banks fear little of their creation of money. In abensce of these policies, enforced by the government on the backs of its subjects, the atmosphere would be quite different. Banks would be more weary of making loans, especially if it was creating new money to do so. This is because with the creation of new money comes a decrease in value of all money. Should banks inflate enough, more people tend to pull money out of savings and consume in the present. There would be a run on banks. Banks that loaned out too much would suffer, likely resulting in failure. Banks that did not, and had the cash or commodity in reserve would not, as they would be able to satisfy the claims of depositors that came calling. As such, in a free market devoid of government intervention, the banks with the wisest policies on savings and loans would be rewarded with the ability for future business, while the banks that commuted what could be considered fraud would fail, have their assets liquidated, and be much less likely to do business in the future. Consumers are the ones that benefit. Not only does the whole of the population not have to suffer a decrease in the value of their money as a result of a lender of last resort bailing out banks with inflation, but the banks that serve themselves more than the consumer will be thinned out. Additionally, consumers will educate themselves more on the nature of coin, credit, and circulation and demand to know more about different banks’ business practices and records before doing business with them. It is only through regulation and coercion and special privileges granted by the State to special interests in the form of legal tender laws, monopoly on money creation, and stealing from the public to pay for private institutions’ blunders (either through taxation or inflation) that any immorality in this sector of the market, the financial sector, not only continues, but thrives.

You seem to postulate that more (albeit different) regulations on what businesses and individuals may or may not do is a solution to a problem that I understand to be caused by regulation and coercion, or simply put, restrictions on liberty and disrespect for property rights and liberty.

38

3 points:

  1. Interest is not an invention of banks. Interest is conceptually anterior to banking, as interest is a natural manifestation of scarcity, and the interest rate is the aggregation of individuals’ various degrees of time preference. You could outlaw banks, or interest if you wanted, and it wouldn’t change the fact that some people will demand satisfaction of their desires sooner rather than later, nor would it change the fact that some people will be willing to supply funds to service that demand at a premium. That premium, the interest rate, is the outflow of this emergent, aggregate rate of time preference, and would simply develop, as it did historically where interest was outlawed, in the “black” market (or, as i like to call it, “the market”).

  2. You forget another important, useful function of banks - providing intermediary services. In your examples above, the person who doesn’t have enough funds to complete a transaction up front pays a promissory note to the seller, while the bank siphons off unearned income in the form of interest. The question is, though, without the bank, how can you be sure willing borrowers will find willing lenders? These individuals don’t just materialize next to each other. Without a bank, many eager borrowers would be left to ask their friends, family, and neighbors for liquidity. Of course this does happen, and where it does, a bank is indeed superfluous. If people always felt that way, certainly many banks would go out of business. The fact that they stay in business seems to indicate that they provide a useful function.

  3. Related to my previous point. If you don’t like banks don’t use them.

39

Rick, I’d recommend reading some Austrian Economics. Human Action by Mises or Man, Economy and State by Rothbard are both available in electronic form on mises.org and would give you a great foundation in Austrian Economics. I don’t find these situations so mysterious when viewed through the Austrian School’s explanations.

What you described above is true in so far as it goes. But… when one goes back to money as value, gold (or some other medium of indirect exchange) is what’s saved. Banks are a safe place to store it, in this scenario one would expect to be charged a fee for storage and security, and to pay for the insurance the bank would pay to protect itself from theft and fraud, and the auditing/accounting/transfer services. Savings is money you put off using, in order to use it to satisfy wants at a later date.

Investment is a different activity. Investment banks are a differnt type of entity. They would be a place to put your savings, they would pay you interest, and would in turn loan out the money at a higher interest rate, the difference in the two rates would be their profit. They would bear a certain amount of risk and would have to cover that risk. In this business you have the potential for loss of the value loaned out, and those losses would hit both the investment banker and the investor.

Making these profits is a proper function for the investment banker. Just as a savings bank should also make profits. And when I say should, I simply mean without the profits, the business wouldn’t exist, as there’s no incentive to offer the service. More importantly the service wouldn’t be purchased or used if it didn’t provide value back to the purchaser.

Now you are accurately describing a very corrupt and warped caricature of the systems which arise naturally in the market. But my issue with your proposed solution is that to me it represents a lack of understanding of the origin and value provided by these services in the first place. In this case, savings, investment, and money itself. If these are properly defined and clearly understood, the current system is seen clearly as the corrupt entity it is, but also the solutions become obvious. Allow competing currencies, allow competing financial institutions, without bailing them out. Disconnect savings institutions from investment institutions.

The classic 3 purposes of money are in it’s use as a) a store of value, b) a medium of exchange, and c) a unit of accounts. The fiat nature of modern currencies means that the inflation of the money supply erodes the confidence in all 3 uses, and the recent (late 90s) reconnection of investment banks and savings banks means that they are able to engage in the very shenanigans you described above.

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Weird forum issues here