Sunday, September 16, 2012

Money....

The reason there's no inflation is because those of us that understand actual macroeconomic theory know that increasing the supply of money isn't DIRECTLY correlated with a rise in prices.

I'll explain. Basically, let's start by saying that everyone has $100 dollars on hand in a community, and the stock of money for each person is equal to the desired stock of money (That is, everyone wants to hold $100). Then, we say that the central bank of that community decides to print $100 dollars to raise the money supply, and they give it to someone - banks, for example. So now, the actual stock of money held is higher than the desired stock of money.

That person doesn't refuse the money - of course, he can always get more assets instead of the money even if he doesn't want the money itself. That person doesn't actually want to hold that money - he wants to spend it, invest it, save it, etc. So he goes and spends it. So that money plays "hot potato," and goes around the country bidding up prices until the stock of money equals the desired stock of money again. This is how increases in the money supply Indirectly cause inflation.

So every time the money supply is increased in a good time, it INDIRECTLY raises prices by giving consumers and investors more liquidity to bid up prices.

So every time the money supply is increased in a good time, it INDIRECTLY raises prices by giving consumers and investors more liquidity to bid up prices.

Now, in a depression, there's depressed demand and output, so when the central bank creates money, it no longer immediately gets spent. In effect, for every 100 dollars it creates, only a fraction of that actually gets spent or invested. Because the velocity of money is so low, quantitative easing is a way to increase expectations of inflation and therefore increase demand, which is what as seen as what's not high enough to bring us back to full employment.

So right now there's a huge supply of liquidity sitting around that's waiting to go back into the economy to bid up prices.

However, the Fed can create AND destroy money - when the economy recovers, the Fed stops QE, and starts raising interest rates, it starts selling bonds instead of buying them, and then destroys the money it gets for them by reducing the liabilities side of it's balance sheet as well. So, when we get back into the boom cycle, the Fed will (hopefully) remove money fast enough to avoid any high level of inflation. It's certainly possible for them to do, anyway.