Is there such a thing as too much money?
by Fred E. Foldvary, Senior EditorWhat is inflation? There are two economic meanings of inflation. The first meaning is monetary inflation, having to do with the money supply. To understand that, we need to understand that the impact of money on the economy depends not just on the amount of money but also on its rate of turnover.
We all know that money circulates. How fast it circulates is called its velocity. For example, suppose you get paid $4000 every four weeks. You are circulating $4000 13 times per year. Then suppose you instead get paid $1000 each week. Your total spending is the same, but now you are circulating $1000 52 times per year. The velocity of the money is 52, but the money you hold has been reduced to one fourth its previous amount, although the money held times the velocity is the same. The effect on the economy is the money supply times the velocity.
Monetary inflation is an increase in the money supply, times the velocity, which is greater than the increase in the amount of transactions measured in constant dollars. Simply put, if velocity does not change, monetary inflation is an increase in money that is greater than the increase in goods.
Price inflation is an on-going increase in the price level. The level of prices is measured by a price index, such as the consumer price index (CPI). Usually, price inflation is caused by monetary inflation. So let’s take a look at recent monetary inflation.
The broadest measure of money is MZM, which stands for money zero maturity, funds which can be readily spent. The Federal Reserve Bank of St. Louis keeps track of various measurements of money. Its data show that on an annual basis, MZM increased by 13 percent in January 2008, 36 percent in February, and 23 percent in March. These are huge increases, since gross domestic product, the total production of goods, increased at an annual rate of only .6 percent during these months. In 2006, MZM grew at an annual rate of only 4 percent.
High monetary inflation results in high price inflation. Indeed, in May 2008 the consumer price index rose by 4.2 percent from the level of May 2007. For the month, the increase for May was .6 percent, an annual rate of 7.2 percent. The “Consumer Price Index for All Urban Consumers” (CPI-U) increased 0.8 percent in May, before seasonal adjustment, for an annualized increase of 9.6 percent. The “Consumer Price Index for Urban Wage Earners and Clerical Workers” (CPI-W) increased 1.0 percent in May, prior to seasonal adjustment, for a whopping annual increase of 12 percent.
The rapid rise in oil prices fueled the increase in the price of gasoline, while the greater demand for grains made food prices rise, but beneath these rises is the monetary inflation that creates a higher demand for goods in general. The government reports that “core inflation,” not counting gasoline and food, is lower, but what counts for people is everything they buy, including food and fuel. If you have to pay much more for food and gasoline, there is less money for other things, so of course these will not rise in price as much.
In making monetary policy, the Federal Reserve targets the federal funds interest rate, which banks pay when they borrow funds from one another. During the financial troubles during the first few months of 2008, the Fed aggressively lowered the federal funds rate to 2 percent and also indicated that it would supply limitless credit to banks that borrowed directly from the Federal Reserve.
The Fed lowers the interest rate by increasing the supply of money that banks have to lend; to unload it, banks charge borrowers less interest. To start, the Fed buys U.S. Treasury bonds from the public. The Fed pays for the bonds not by using old money it has lying around but by increasing the reserves held by the banks in their accounts at their local Federal Reserve Bank then using that new money.
This increase in reserves or bank funds is a creation of money out of nothing. Actually, this does not violate the law of conservation, because this creation of money is at the expense of the value of all other money holdings. Every extra dollar created by the Fed decreases the value of the dollars you hold by a tiny amount.
Most monetary reformers stop there, but that is not enough. The current financial instability is also caused by the real estate boom-bust cycle, since even with sound money, an economic expansion would spark a speculative boom in land values. In a competitive market, when produced goods rise in price, producers usually supply more, bringing the price back down or limiting the rise. But land is not produced, so with increased demand, the price has nowhere to go but up. Speculators drive the price of land based on expectations of even higher future prices, but at the peak of the boom, the price becomes too high for those who want to use the land.
Real estate stops rising and then falls, and that brings the financial system down with it, as we have witnessed during the past year. To prevent the inflation in land prices, we need to remove the subsidy, the pumping up of land value from the civic benefits paid by returns on labor and capital goods. We can remove the land subsidy by tapping the land value or land rent for public revenue. Land-value tapping or taxation plus free-market money and banking would provide price and financial stability.
Only the free market can know the right money supply. Some people think the government could just print money and spend it. That is what is happening in Zimbabwe, which has an inflation rate of one hundred thousand percent. Much of the population has fled the country. Once government can create money at will, there is really no way to limit it, and if there is some limiting rule, then the money supply becomes too rigid. Only free market competition and production can combine price stability with money-supply flexibility.
-- Fred Foldvary
Copyright 2008 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
Part III, The Trouble With Money and its Cure
A Better Way to Pay for Railways?
How Economic Systems Really Work
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