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Thursday, April 12, 2012

Inflation (part 2)

A few weeks ago, I explained a little bit about the mechanics of an increase in the money supply in an economy, and the inflation associated with it.  In today's post, I'll talk about why a government would want to increase the number of bills in circulation.

            There are two types of "inflation."  Price inflation and monetary inflation.

            Price inflation occurs when producers slowly creep prices of their wares up and up overtime. 

            Its not a good thing in of itself - no inflation is - but price inflation is usually seen as a sign of a strong economy.  Producers only raise prices in environments where customers have more to spend, lest they drive away customers and lose business.  So if producers are slowly increasing their prices, that's usually a good indicator that business is doing well.

            So price inflation just sort of happens naturally in growing economies.  And aside from setting price controls, there's little a government can do about it.

            In the last post, I spelled out a scenario where the supply of currency increases in an economy in the absence of any actual economic growth. 

            Because incomes and prices both increase together in this case, no one's income actually really changes.  All entities in that economy are just as poor or wealthier as they were before the extra currency was pumped into the system. 

            This type of inflation is called monetary inflation.

            So what causes a government to print money in the absence of growth, like in the scenario I detailed last time?  What would motivate them in inflate their own money supply?

            Adjusting the money supply is one of the very few ways a government can try to steer its economy.  Honestly, it can be a pretty clumsily way of doing it.  There's not a lot of guarantees that it will work exactly as we want it to.

            But because a government otherwise has incredibly little direct control over its own economy, monetary policy/central banking is practiced by just about every country on the planet.  Its become so ubiquitous simply because its one of the very few ways mankind has found for which a government can play an active role in its own economy.

             The Federal Reserve - the US's Central Bank - was formed in 1913, when Congress passed the Federal Reserve ActWhile the role of the Fed has changed over time, today it states its principal objectives as "maximum employment, stable prices, and moderate long-term interest rates."

             Now, how effectively you can achieve these objectives though tweaking the money supply is up for debate.  Its not like there's a little dial at the Fed labeled "employment rate" that people just turn up or down.
The Fed plays with the supply of cash out there to try to pave the way for these outcomes, not to cause them directly.  

            And of all these objectives, influencing interest rates is usually the modern Fed's number one concern.
            OK, so how does increasing the money supply lower interest rates in an economy?  

           Well, the more cash there is floating around, the harder it is for any individual, business, government, etc. to spend it all.  Everyone ends up with a lot of money set aside.  So increasing the money supply inadvertently increases savings.

            BUT! - if savers just let their money sit around, they lose opportunities to make additional money by lending it out and charging interest.  So there's always an incentive for savers to lend out their savings...they can make money from doing so! 
            So with everyone in the economy just stockpiling cash, and sweating to find someone to lend it to, a borrower would suddenly find himself in quite the "buyer's market!"  He can negotiate very low interest rates, since he can always tell a potential lender that he thinks is charging too much interest: "the heck with your offer, I can go elsewhere for a loan!"

            As people, businesses, governments, etc. become more and more desperate to lend out their savings, they'll have to ask for less and less in interest to find a taker.  They'll take any price, as long as it's more than zero! 

            And that's how - in a very round about way - increasing the money supply decreases interest rates!  More cash means more savings, more savings mean lower interest rates.

            I like to think of it like this: imagine a country where no citizen is homeless.  Some rent, some own, but everyone has a place to crash. 

            Now picture, all of a sudden, its government gifts everyone in that country a new house.  Doesn't matter if you own zero, one or a dozen places already.  Everyone gets one free house.  And the houses are identical and homogenous.

            So what does everyone do with their new digs? 

            Well, if they just let the place sit empty, they forgo potential new incomes from renting the place out!  Since most people won't want to miss the opportunity to make a little extra cash, we should anticipate that overnight, everyone in that country would become a landlord on the side, right?

            But imagine how hard it would be to find a tenant!  The only way to convince tenants to rent from you is to lower your price!  There's no other front to compete on, since the houses are all identical.  (OK, yes, they can compete on location, but let's leave that out for now so the parable works, cool?) 

            Of course, in a country where there's such a plethora of rental houses, rents will be very low.  No landlord gets a monopoly, and every renter has tons of other options.  So there's some hot competition.  We get a huge new supply of housing, but demand for housing isn't changing, and so the price of rent falls. 

            How does this example tie into to a jump in the money supply?  Remember, interest payments and rents are the same thing.  Interest is just the money we pay to rent someone else's savings.

            So if we just pump a bunch of dollars into the economy, let them circulate and percolate, viola!  Lenders are going to have to step up their game and compete over borrowers.

            And since a US dollar is the same, whether I borrow it from Visa or MasterCard or a mortgage broker or a car loan guy or a student loans guy or whoever, the only way all those lenders can compete, is on the price of borrowing - aka "interest rates"!

            When the Federal Reserve, in their ultimate wisdom, squeezes a little extra cash into the economy, the goal is to drive down interest rates.  That gives a short term boost to lending and the credit markets.  But we pay for it with inflation.  There is no free lunch.

            Economists disagree over how much affect tweaking the money supply can really have on economies.  Even Austan Goolsbee, an Obama econ adviser (whose worked with Obama since he was a Senator) once stated "probably 98% of the economy has nothing to do with Washington at all."  He goes on to say that the other 2% hinges on Washington, but given his position, you'd think he'd say "the economy is totally in control of the White House," right?

            So if the money supply has such a marginal affect on the economy, why worry about monetary policy and the money supply at all?  The retort is typically something along the lines of "Hey, what would you have us do?  Just sit around and let whatever happen happen?  At least we're trying something!"

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