Why does printing more money cause inflation?

[Beej]

QE is printing [currency] money. It is not credit creation, which is a separate form of money creation.

Simply observe M1

Yes but M1 is likely to increase in response to the "new money" being injected into the system via the QE, low interest rates (increased demand/supply of credit) etc. But it is not increasing because the Fed has physically printed the cash (or directly asked Treasury to) and handed it over to someone. Also, in the US, M1 includes both physical cash/notes in circulation and central bank deposits, so have to remember that when looking at M1 graphs etc.

As Macquack points out, notes in circulation only ever represents a small percentage of the amount of "money" in existence. Cash is "printed" as required based on what people demand (via withdrawals from banks, cash payrolls etc etc).

At the end of the day the point is moot anyway, regardless of the actual mechanism, the result in an increase in the amount of money that exists in that economic system. That creates the *potential* for inflation, both in the short term and the longer term, depending on what else is going on, how the economy reacts to the increased money supply etc etc. Clearly how much and what the risk is can be debated!

Cheers,

Beej

 

[Beej]

There is deflation in some assets and inflation in others but overall there is slight inflation (every asset doesn't go up by the inflation rate).

The best way to understand creation and destruction of money is this. Suppose you go to your corner store and start up a tab and buy some bread and milk. You buy it and put it on the tab. You havent paid for the bread and milk yet (because you havent handed over any money) all you have done is create credit (which spends exactly like money). The storekeeper hasnt received any money but they think (rightly so) they have an asset (they think you will repay them at some point in the future).

In a recession what happens is that the money supply decreases - there are a whole lot of storekeepers out there that realise that the debts that are owed to them arent able to be paid. What do they do? They write the debts off. So the asset is now gone. It hasnt gone anywhere - the money supply has just decreased.

That's actually not a bad analogy. I would extend it though - in the shopkeeper example, they don't actually extend the credit, usually a bank does (via a credit card, other loan etc). So the bank takes on the default risk, but in return they get the interest margin "premium" from everyone they extend the credit to. This is in fact the key mechanism normally used to increase the money supply in the economy.

So the shop-keeper get's the money regardless, and keeps it - either spends it again, or banks it, or invests it, or a combination - and remember this is in effect "new" money that is being used now. If the consumer defaults on their loan, the bank carries the "loss" or destruction of money, as they know will not get back the money they lent. However, as long as this doesn't become systemic (and send the bank under, or worse ALL the banks under) it's basically OK, as they have made enough of a buffer through the interest charged on all their loans to handle the loss.

The banks responsibility is to manage this risk properly, but to "help" them do this properly, we have a central bank that can influence what retail banks do via monetary policy, + prudential regulation which sets broad parameters within which the banks must operate by law. The US banks clearly needed more "help" on this front than they got.....

BUT, (and this is the key), as a result of increased defaults the bank may now charge more to lend, or else lend less, ie credit tightens, so the next time the consumer cannot use credit at the shop at all, they need cash - but the money supply is now not growing. This causes a sharp drop off in economic demand, a lowing in the velocity of money and the growth of the money supply, and this can bring on a recession (as you point out in the first example). The shopkeeper sells less so has to lay off one assistant, unemployment increases and so on and so on. It starts a negative feedback loop. This is also why in response the central banks try to pump more money into the system in order kick start demand again, however they risk creating inflation if it is over-done.

Cheers,

Beej

 

[ducati916]

Beej

Also, in the US, M1 includes both physical cash/notes in circulation and central bank deposits, so have to remember that when looking at M1 graphs etc.

I specifically showed the currency component of M1.

Here is the currency + demand deposits. You can see it is circa $1.3 Trillion compared to currency of $800 Billion

 

[Beej]

Beej



I specifically showed the currency component of M1.

Here is the currency + demand deposits. You can see it is circa $1.3 Trillion compared to currency of $800 Billion

Oh yes so you did - apologies; good graphs!

Cheers,

Beej

 

[ducati916]

Beej

At the end of the day the point is moot anyway, regardless of the actual mechanism, the result in an increase in the amount of money that exists in that economic system. That creates the *potential* for inflation, both in the short term and the longer term, depending on what else is going on, how the economy reacts to the increased money supply etc etc. Clearly how much and what the risk is can be debated!

Actually I would argue that the mechanism, if you are an active participant in the financial markets is important. The reason that it is important is that inflation in the initial stages favours some sectors/industries preferentially. If you know the mechanism, you know the sectors in which to concentrate your search and analysis.

A bank system mediated inflation or credit expansion, which is a monetary policy expansion, is a very different beast to a fiscal credit expansion. The end result is also likely to be somewhat different.

Currently, the credit expansion, being a fiscal expansion is supporting consumer goods, the lower the stage, the greater the margin, and the more likely the expansion of the P/E multiple awarded.

jog on
duc

 

[TabJockey]

lots of good information on this thread.

for a great addition check out the Zeitgeist:Addendum movie, released for last year. it's anot for profit production designed to illustrate the immoral functioning of the central banjing system and covers myths of inflation.

I'm pretty sure you can watch it on you tube, as it was released free online last year

www.youtube.com/watch?v=5r6-o1lpJHU

check it out. worth the time if you have a geuine interest.

Ive watched those movies, they are incredibly well done and entertaining, however they are almost entirely made up. Not many people have an indepth understanding about the way that credit creation works within the economy but it works pretty well most of the time especially here in Aus (US is a little dodgier as always). Allot of lay-people dont know that when banks lend money they create money, and its something that those zietgiest movies have really preyed upon painting it as evil, but there isnt anything wrong with it.

There are stacks of those nutjub conspiracy theory movies all over the internet, and they are highly persuasive if you dont know the ins and outs of the content material, but they are all the same. They dont do any REAL scientific research with a scientific method that gives you facts that stand up under a bright light and the only people they reference are other conspiracy theorists.

A really good website to read if you watch one of these movies and are suddenly engulfed by a burning desire to strike out at the oppressive social construct is http://conspiracyscience.com/.

So yeah not recommended to watch Zietgiest if you want any credible learning on inflation

 

[ducati916]

TJ

Allot of lay-people dont know that when banks lend money they create money, and its something that those zietgiest movies have really preyed upon painting it as evil, but there isnt anything wrong with it.

Actually there's plenty wrong with it.

The irregular demand deposit, the obligation to guard and protect the goods deposited is the fundamental element in all deposits.

In the first instance we have an ethical failure on behalf of government who have perverted the law to allow the following.

In an Irregular deposit, the fungability of money in no way mitigates the obligation of having 100% of the tantundem available, on demand. Banks in complicity with government, have, essentially committed theft when through fractional reserve banking they create money from nothing - using demand deposits as the initial [and continuing] reserve.

In the second, inflation is simply theft by government, from the people. Inflation is a debasement of the money. When the money is debased, all economic decisions become distorted, leading to periodic crisis.

jog on
duc

 

[Macquack]

Actually I would argue that the mechanism, if you are an active participant in the financial markets is important. The reason that it is important is that inflation in the initial stages favours some sectors/industries preferentially. duc

This reality is what really annoys me about government 'controlled inflation'.

Obviously the private banks are the first cab off the rank in profiting from inflation, that is understandable as they create the inflation in the first place!

Other early bird recipients of inflationary gains would include real estate agents (increased commissions on inflated real estate sales), insurance companies (increased commissions on inflated policy values), fund managers (increased commissions on inflated portfolios).

Better to take those gains early in the cycle while they have some value and are not eroded by "inflation."

Anyone interested in starting up a bank? If you cant beat them, join them.

 

[TabJockey]

The ethics of fractual reserve banking are debatable, just like the ethics of just about anything. Yeah its sort of **** that your deposit may or may not be there if lots of people try to withdraw at the same time, but without it the supply of credit for entrepreneurial progress is really limited isnt it? Not sure if economic growth is possible at rates we are used to without the credit creation process? Im no expert so correct me if im wrong.

 

[ducati916]

The ethics of fractual reserve banking are debatable, just like the ethics of just about anything. Yeah its sort of **** that your deposit may or may not be there if lots of people try to withdraw at the same time, but without it the supply of credit for entrepreneurial progress is really limited isnt it? Not sure if economic growth is possible at rates we are used to without the credit creation process? Im no expert so correct me if im wrong.

I don't think there's any debate at all. The contract that covers time deposits [mutuum] provides for the legal transference of the deposit [tantundem] for the specified period. Thus demand deposit contracts are violated when they are used to create money via fractional reserves.

Economic growth is enhanced when savings, or, time deposits are used to fund the requirement for loans [credit] This has been demonstrated many times, yet, because government overspend, they require constant inflation to mitigate their profilgate spending and debt.

jog on
duc

 

[GumbyLearner]

QE is printing [currency] money. It is not credit creation, which is a separate form of money creation.

Simply observe M1

What about MZM?

http://en.wikipedia.org/wiki/Money_with_zero_maturity

 

[ducati916]

What about MZM?

http://en.wikipedia.org/wiki/Money_with_zero_maturity

Not as useful as it includes demand deposits. Demand deposits are [were] the way banks created credit. With QE we are looking for evidence of money being printed

jog on
duc

 

[Uncle Festivus]

So when the banks 'make' money, what do they do with it? Lend it out of course creating price inflation and booms, or getting a little shy of the commercial loan business? A sustainable parabolic trend, or what is the end game? Is this just 'normal'??

 

[Beej]

So when the banks 'make' money, what do they do with it? Lend it out of course creating price inflation and booms, or getting a little shy of the commercial loan business? A sustainable parabolic trend, or what is the end game? Is this just 'normal'??

Looks more exponential than parabolic to me UF A parabola looks like this:



Anyway, try plotting your graph with a log scale and it might make more sense

PS: You know that the human population has grown exponentially for the past several thousand years don't you??

Cheers,

Beej

 

[Macquack]

For a good example of "Why does printing more money cause inflation?", look no further than Indonesia.

The exchange rate determined upon Indonesia's independence in 1949 was 3.8 rupiah to 1 US dollar. Today the exchange rate is close enough to 10,000 rupiah to 1 US dollar.

The Central Bank just keeps pumping up the numbers. Their political aim is to make the people feel better off because they have more money (in terms of the numbers printed on the currency). In reality, the people become worse off in real terms because of the reduced purchasing power of the 'inflated' money.

 

[GumbyLearner]

There is also one example where the distribution of gold to the poor has caused rising inflation. Unlike today though the IMF will sell a chunk of it's gold, usurp 3rd world balance sheets with it and it will be quickly purchased by excessive net US dollar holders.

http://ezinearticles.com/?Gold-And-Mansa-Musa&id=1189523

In the Mali Empire all gold nuggets belonged exclusively to the king. It was required that all gold nuggets be turned into the imperial treasury in return for an equal amount of gold dust. The value of the gold dust varied throughout the region, but was used all over as a form of currency. While there was no set currency, gold was usually measured in units called mithqals. A mithqal is about 4.5 grams of gold and the term dinar was often also used. It is not clear as to whether coined currency was used in this time though.

By the time Mansa Musa took control of the Mali Empire it was an extremely wealthy and very powerful nation. They had firm control of most of the trade routes in Africa. On his pilgrimage to Mecca he was accompanied by 60,000 men. He took with him more than 2 tons of gold. This gold was distributed to the poor along his way, which drew attention to the great wealth of the Mali Empire and also cemented his respect among the Arab world. Mansa Musa distributed so much gold that it caused inflation in Cairo. The value of gold dropped and did not recover for many years.

 

[Uncle Festivus]

Looks more exponential than parabolic to me UF A parabola looks like this:

Anyway, try plotting your graph with a log scale and it might make more sense

PS: You know that the human population has grown exponentially for the past several thousand years don't you??

Cheers,

Beej

Half a parabola then?

Whatever the scale used, the data shows that residential lending increased from $50B in 1989 to $860B in 2009.

Now if you want to link that to population growth then it doesn't compute as Australias population has not increased at the same rate over 20 years (16.8m to 22m) .

Which means to me that money supply inflation via fractional reserve banking has been a large factor in asset price appreciation, probably more so than supply/demand fundamentals?

Imbalances get corrected eventually over time...even if they are artificially sustained in the short term?

Now someone who's smarter than me and knows a bit about the banking system might be able to explain to me if having $170Billion more in loans (assets) than deposits (liabilities) in the banking system is a good thing? (As well as bumping up their impaired charges to $32B from $4B 2 years ago??)

(RBA Tables B02 & B03)

 

[Beej]

Whatever the scale used, the data shows that residential lending increased from $50B in 1989 to $860B in 2009.

Now if you want to link that to population growth then it doesn't compute as Australias population has not increased at the same rate over 20 years (16.8m to 22m) .

Which means to me that money supply inflation via fractional reserve banking has been a large factor in asset price appreciation, probably more so than supply/demand fundamentals?

Imbalances get corrected eventually over time...even if they are artificially sustained in the short term?

OK I like this post, you have made me think! It's an interesting set of numbers. The current figures can also be found here (http://www.apra.gov.au/Statistics/Monthly-Banking-Statistics.cfm) and seem to match up pretty well. Let's look at it like this:

First, over the last 20 years, we would expect money supply growth generally to at least increase with GDP growth + CPI inflation right? The average of those 2 would be somewhere around 10% for the past 20 years (remember we had double digit inflation alone for the first few years of this period).

OK now let's scale up the initial $50B by the population growth (as we would expect lending to increase with population growth at least, even though this is kind of accounted for in GDP growth as well). That gives us a base of $65B. Compound it by 10% for 20 years and we get to about $500B.

So that still leaves "pure monetary inflation" of $390B. A part of this may be accounted for by the rise in the amount of property investment loans as a proportion of total investment loans since 1989, due to the deliberate policy of not building public housing, and relying on private investors to provide growth in rental accommodation (with NG incentives etc etc). This has resulted in a shift in the balance sheet of public to private debt. Also add to that figure the systemic lowering of interest rates (meaning of course people can afford to borrow more), plus the increased use of equity manager loans, redraw facilities etc etc that probably adds some more credit growth in there as well.

Still probably still leaves some pure monetary supply growth (and you could argue the last 2 factors above are the cause of this anyway), so yes I would agree this would still be a factor in asset price growth seen over the period. But I am also not sure you can divorce that factor from the supply/demand argument? At the end of the day, nobody forces people to borrow - they do it because they want/need the money for whatever reason, (ie demand). The price of what they want may grow due to lack of supply and too many people chasing it (because we haven't built enough houses where people want to live or haven't provided jobs where houses can be built cheaply etc etc).

So I would argue the "inflationary" credit growth component can still be seen to have been driven by demand. But above I also think I demonstrate that this component of credit growth may not be as large as the raw numbers when presented on their own with no other context suggest.

Now someone who's smarter than me and knows a bit about the banking system might be able to explain to me if having $170Billion more in loans (assets) than deposits (liabilities) in the banking system is a good thing? (As well as bumping up their impaired charges to $32B from $4B 2 years ago??)

(RBA Tables B02 & B03)

I don't claim to be an expert, but I'll have a go:

Again the APRA tables also seem to confirm this situation (Total loans $1,483B, total deposits $1.243B). But if you download the spreadsheet at the link I posted, you will see that "Total Resident Assets" of all banks in Australia is $2.324B, which includes cash and liquid assets held, trading securities, investments (+ all loans) and so on. Ie, if you take the loans out, there are still another $900M of other non loan assets held in the system. So by that measure the banks appear to be well capitalised relative to the size of their loan/deposit books to me?

Cheers,

Beej

 

[Macquack]

Which means to me that money supply inflation via fractional reserve banking has been a large factor in asset price appreciation, probably more so than supply/demand fundamentals?

If the money supply was not continuously increased by the private banks there would be a saturation point in terms of asset values.

I think there is a misconceived belief that people are competing against each other for a limited pool of money available for loans.

Now someone who's smarter than me and knows a bit about the banking system might be able to explain to me if having $170Billion more in loans (assets) than deposits (liabilities) in the banking system is a good thing?

How can there be more loans than deposits in the banking system as a whole?

When a loan is issued, a deposit is created somewhere in the system.

Bad loans reduce a banks assets, however the corresponding deposit in the system does not disappear.

 

[alter1217]

How can there be more loans than deposits in the banking system as a whole?

In a country with no bank, there is $1 mill of currency. you and a group of entrepreneurs pool your money together and start up a bank with $100k of capital.

Your first customer takes out a loan of $10k with 10% interest per annum.

Total Loans are greater than total deposits by $100,000, unless you count the 100k of capital as deposit.