Posted on by Art Powell

The future of money has been getting a little attention lately. It could go one of three ways – inflation, deflation or part of it could disappear into thin air. Concerns about money probably reflect concerns and uncertainty about where the economy is going. Frequently behind these concerns lurk people who want a fixed money supply such as gold or bit coin.

This blogger figures money should be defined as a tool to facilitate the exchange of goods and services. I do not like definitions that make it a store of wealth or a measure of value because these give money an intrinsic value which it does or should not have. Money should only have value as a tool.

One of the most important features of money should be the amount available in the economy needs to be flexible. It should be able go to up or down with changes in the quantity of goods and services we want to exchange. If the money supply is not flexible then as we change the quantity of goods and services then either prices must go up or down or the velocity, the rate at which money changes hands will change. It is dangerous to assume there will be only growth.

Inflation happens when the money supply increases faster than the rate of economic growth and deflation happens when the money supply goes not keep up with the rate of growth. Inflation is good for borrowers as the can repay their loans with money which has less real value. This is one reason governments and their agents want to see mild inflation. Deflation is good for lenders as they will be repaid with money which has more value. The ideal should be price stability so nobody loses.

Our understanding of inflation and deflation has been distorted by the long period of economic growth we have just experienced. Most inflation has happened along with growth and most deflation has resulted from banking authorities trying to restrict the amount of money available. This happened in the 1930s and todays central bankers have sworn to never again let that happen.

There is some evidence that our time of economic growth has terminated. It is unclear how this will affect prices. Quantitative easing which is an attempt to increase the money supply has not led to high inflation. Past hyperinflations have occurred when governments have increased to money supply faster than the economy was capable of growing. It appears the money created by quantitative easing has led to inflation in the financial markets rather than consumer markets.

Economists generally understand how fractional reserve banking works to increase the money supply but I am not aware of anyone who has thought out the opposite process. Money that can be created out of thin air can just as easily disappear into thin air.

In fractional reserve banking banks are required to keep a portion of their deposits as reserves for protection against runs. The rest is loaned out and redeposited with the new deposits subject to the same fractional reserve. The result is that a large proportion of our money supply is somewhat precarious. This blogger and many other people on the internet have explained the process. Just search “fractional reserve banking.”

Central banks can add money to the system by purchasing financial instruments or by changing the reserve requirements. The could also reduce the money supply by selling financial instruments or by changing the money supply although it is unlikely they will do either under current conditions.

Another way the money supply could be reduced is if the banks suffer large losses. Any loans the banks have to write off will directly decrease their available reserves. (The technical term is high powered money.) This means they will have to decrease their outstanding loans with the same multiplier effect as the money supply was increased. We will hear about it as a contraction of credit.

So if the banks experience unusually large losses there could be a drastic decrease in the money supply which could have dire consequences. ( I have read that a number of Canadian and British banks are highly exposed to the energy industry with unsecured loans.)

If a large part of the money supply were to disappear into thin air in the short term a lot of economic activity would come to a screeching halt. People have in the past used playing cards or candies as a substitute for money. In the long term the level of activity would depend upon the physical resources available.

People who talk up monetary reform often want a return to a gold standard or facsimile (bit coin). It is not clear that either of these would correct the problems inherent in the fractional reserve way of creating money. Nor would they provide the flexibility that is needed in the total amount of money available.

We all think we know everything there is to know about money. That is a part of what our parents teach us. However, it is a complex subject which few people understand and there are a lot of unknowns, especially if we have to deal with an extended period of low or negative growth.

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Filed under: Economics | Tagged: banking, bit coin, central banks, deflation, economic growth, Economics, fractional reserve banking, gold standard, inflation, money, money supply |