Inflation and the Money Supply

Central governments create and destroy money, thereby affecting its supply. However, if the supply of money is not carefully controlled, it can hamper economic growth. Optimally, the money supply should grow with the economy, but no more.

Deflation

If the economy grows faster than the money supply, then deflation occurs where the prices of goods and services decline. This might seem like a good thing, especially for the consumer, but it isn't, because as prices fall, people hold onto their money since it will be more valuable in the future. But modern economies depend on consumer spending. Without consumer spending, goods and services can't be sold and businesses have to lay off people, causing a downward spiral where people attempt to hold on to their money even more, causing more layoffs. Furthermore, governments receive less revenue through taxes which causes them to cut services.

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Another serious economic problem with deflation is that it makes borrowing prohibitive for businesses and other organizations because their income is dropping, but loan payments remain the same, requiring a larger proportion of income to service the debt. This causes businesses to curtail spending and investing, which causes more unemployment, and even more deflation.

Let's look at this problem in terms of real interest rates. If the annual deflation rate is 2% and a business takes out a loan at 6%, then the real interest rate on the loan will be 8%. In contrast, if prices are rising by 2% instead of falling, then the real interest rate is 4%. A business will only borrow money for capital projects if their projected return is greater than the real rate of interest. Hence, fewer projects will be undertaken during deflation than during inflation.

Not only do existing loans become more expensive, but businesses have difficulty getting new loans because their net worth—assets minus liabilities—declines because the value of their assets are declining. High net worth, like collateral, helps to ensure that the borrowers will pay back the loans. Hence, with lower net worth, lending becomes riskier, causing banks to either not lend or to charge a higher interest rate. This reduces the amount of money that businesses can invest, which causes even more unemployment and deflation.

Inflation

If the money supply grows much faster than the economy, then rapid inflation ensues. People lose faith in the money. Money cannot be used as a store of value because it continually loses value, and neither is it effective as a unit of account, since prices are increasing continually. People start buying as soon as they receive the money before it loses more value. Businesses have difficulty in planning for the future without knowing what future prices will be. Higher interest rates will be charged for loans and credit to compensate lenders for the declining value of money, which limits investment and spending.

Since economies do usually grow, the money supply must grow with it to prevent deflation. The ideal situation is to have the money supply grow a little bit faster than the economy. Since it is difficult to measure the amount of money that the economy needs at a given time, supplying a little bit more than it needs helps to ensure that the need for money is being met. Another advantage is that the central government can benefit from seigniorage, which is the difference between what the value of the money is and what it cost to produce.

Not only should there be some inflation, but the inflation rate, which is the rate at which inflation increases, should be steady. Why? Because without knowing future inflation rates, it would be difficult for lenders to price loans, which would limit credit and investments, which would have a negative impact on the economy. This is why the Federal Reserve (aka Fed), which is in charge of monetary policy in the United States seeks to maintain an inflation rate of about 1 – 2%.

In the past, certain economies have printed excess amounts of money to try to solve fiscal problems, only to create much larger economic problems. Many politicians, especially those without an understanding of economics, are prone to see the printing of more money as an easy solution to paying for the government without raising taxes. Hence, in most modern economies, the money supply is determined by the central banks, which operate largely outside of political influence. The decisions that the central banks make in regard to the money supply is called monetary policy.

Below are the words of a sign, presumably, in a restroom somewhere in Zimbabwe, where hyperinflation was rampant. Although the sign may be a hoax, it would certainly be a reasonable prohibition, given the worthlessness of the Zim dollar. According to this article posted in August 2008, Zimbabwe inflation reach 42,000,000% as the government printed Zim dollars with abandon! The people of Zimbabwe have since turned to foreign currency, as is often done, when the domestic currency becomes worthless — as money anyway. In July 2010, the inflation rate was 5.3%, which was probably the result of more people bringing in more foreign currency over time.
TOILET PAPER ONLY
TO BE USED IN THIS TOILET
NO CARDBOARD
NO CLOTH
NO ZIM DOLLARS
NO NEWSPAPER
Source: Inflation in Zimbabwe: What can you do with a Zimbabwean dollar? | The Economist

How much money should be available? For more effective control of the money supply, it is necessary to know how much money is circulating in the economy and what the inflation rate is. In the United States, the Federal Reserve, as the central bank of the United States, is in the best position to measure the amount of money in circulation, since it creates and destroys money, and oversees the banking system of the United States. It also sets a key interest rate that affects all other interest rates charged in the United States.

To determine the amount of money that is already circulating, it is first necessary to determine what exactly is money, which is not as simple as it sounds, because money is more than just currency. The concept of money has evolved over time as new services provided by banks can effectively serve as money. The different forms of money are quantified according to their type and the total quantities according to types are called the monetary aggregates.

The Monetary Aggregates M1 and M2

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The monetary aggregates have been classified into different components over the years, including M1, M2, M3, M4, M5, and L and MZM. Currently only M1 and M2 are considered useful by the Federal Reserve; just recently they have stopped reporting M3 since they thought that it didn't convey useful information about the economy.

So currently, the money supply is componentized into the monetary aggregates M1 and M2. M1 is all assets that can be immediately used as a means of payment, which includes not only currency held by the public, but also traveler's checks and bank accounts that have checking privileges.

M1 = Currency held by the public + Traveler's Checks + Demand Deposits + Other Checkable Deposits

Traveler's checks are issued by travel companies and banks. Travelers buy them because they can be used as a means of payment and they can be replaced if lost or stolen. Demand deposits are checking accounts that pay no interest and other checkable deposits include checking accounts that do pay interest.

M2 includes M1 plus all assets in accounts at financial institutions that allow the withdrawal of cash, either immediately or after a certain amount of time.

M2 = M1 + Small-Denomination Time Deposits + Savings Deposits + Money Market Deposit Accounts + Retail Money Market Mutual Fund Shares

Small-denomination time deposits are savings deposits of $100,000 or less where advance notice is required to withdraw any money. Savings deposits, money market deposit accounts, and retail money market mutual fund shares are accounts that have check writing privileges and where money can easily be withdrawn. Non-M1 M2 is distinguished from M1 in that M1 is usually used as money while non-M1 M2 is not. Most people use these accounts as a store of value and to earn income and although the accounts have check-writing privileges, the privileges are limited by the number of checks that can be written on the account per month. Most of these accounts are retail accounts held by individuals.

M2 is considered the better indicator of money supply, especially since M2 is much larger than M1 as the following table shows.

M1M2
September 2017 3.5532* 13.7034*

* In trillions of dollars, seasonally adjusted.

Source: http://www.federalreserve.gov/releases/h6/Current/

Note that liquid assets, such as stocks and bonds, are not counted as money because they cannot be used as a means of payment. They can easily be converted into a means of payment by selling them, but that just transfers money from the buyer to the seller. The aggregate money supply remains the same.

Since it is difficult to determine how much money an economy needs at any given time, knowing the quantity of the monetary aggregates is not enough to set effective monetary policy. However, the inflation rate is determined by the economy's need for money and by the supply of money, so knowing the inflation rate can help to gauge whether the money supply is great enough to meet the needs of the economy and to monitor the effectiveness of monetary policy. The most common measure of inflation is the Consumer Price Index.