Money in the Economy

1 The money supply

The money supply is the total value of money in the economy. It can be measured in various ways, for example:

Narrow money comprises currency and readily spendable deposits. Broad money includes a wider range of deposits and other monetary liabilities. The precise statistical definitions differ between countries.

M4 is a UK broad-money measure of sterling holdings of the private sector, principally cash and deposits. A monetary aggregate is a measure of money held, not a measure of the economy’s total wealth.

However, for our purposes, the precise definitions are not very important but it is important to appreciate why the money supply is important in economics.

You will understand, on a personal basis, that if you do not have much money and you are unable to access any more then you will not be able to spend much whether on day-to-day living or the purchase of major assets. It is the same for all participants in the economy, including businesses. If the economy has a very restricted supply of money then economic expansion is difficult. Furthermore, there will be competition for whatever money is available and this will push up interest rates and this makes borrowing to invest more expensive and less attractive.

In contrast, if the money supply is very loose, expenditure is easy and there will be greater competition for the purchase of goods and services. This is likely to increase prices and the economy is likely to suffer from inflation

2 Monetary and fiscal policy

Among other considerations most governments aim to control economies so that:

• Unemployment is maintained at relatively low levels. Unemployment represents a waste of human resources in addition to the human misery it can cause. High unemployment can also lead to civil unrest.
  

• Inflation is held at moderate levels. High inflation means huge and distracting effort has to be spent on negotiating pay deals. It also means that planning for the future is difficult and is a dis-incentive to save because the spending power of savings is eroded.
  

Governments have two main ways in which to control or regulate their economies:

• Monetary policy, and
  

• Fiscal policy.

2.1 Fiscal policy

The word “fisc” is an old word which referred to the king’s purse. Where does the state get the money from? Where does it spend it? If the state wants to spend money it either has to raise income through taxes or borrow money. If it wants to reduce taxes it either has to reduce expenditure or borrow money. The three - expenditure, borrowing and tax - have to be in balance.

In the Covid 19 recession governments sought to spend more money to support businesses which were unable to trade because of lock-down rules. This is a way of putting money into the economy to try to stimulate it. To finance the expenditure governments increased their borrowing (there was no point in trying to increase taxes if businesses were not functioning). So, borrow money, spend it, once it’s spent it will be earned by people who will spend it again. And that’s the way in which governments hope the recession will be brought to an end.

2.2 Monetary policy

The second way in which governments attempt to control their economies is by their monetary policy: managing the supply of money in the economy. The more money in the economy the more the economy is likely to be stimulated. This creates demand for goods and labour and boost employment. However, too much fast expansion of an economy can cause prices to rise (demand pull inflation as explained below). If the money supply is reduced, then economic growth slows down and a country might even have a recession (economic contraction). This can increase unemployment and is likely to reduce inflation.

There are two main techniques in monetary policy:

• Interest rates. If interest rates are very high people will tend not to want to borrow money. If you don’t borrow money you can’t spend it, and if you can’t spend it then, for example, inflation will be relatively low because of low demand for goods. If however you greatly reduce the interest rates more people will be encouraged to borrow. They spend that borrowed money on televisions, cars, houses, whatever. And once it’s spent the money is in the economy, other people earn it, demand goes up, and the economy is stimulated. In most countries interest rates are controlled by the central bank such as the Bank of England in the UK and the Federal Reserve in the USA
  

• Credit controls. Limits on lending, and capital or liquidity requirements, can affect the availability of credit. A fixed reserve-percentage example is a simplified historical model, not the mechanism by which the Bank of England normally controls UK lending today. Banks create deposits when they lend; lending is constrained by profitability, risk, regulation and monetary policy.

Monetary policy influences demand through interest rates and financial conditions. Quantitative easing (QE) involves central-bank purchases of assets financed by creating central-bank reserves. Quantitative tightening (QT) reduces those asset holdings. QE is not simply the printing of banknotes.

3 Inflation

Inflation is the year-to-year (or in cases of hyper-inflation, the day -to-day) increases in prices.

High inflation is undesirable because:

• Huge amounts of time and effort are expended negotiating wages, salaries and prices. This effort is entirely non-productive.
  

• Planning becomes very difficult as future cash flows are made much less predictable.
  

• Savers lose out because the purchasing power of their savings is eroded.
  

• Pensioners often lose out if they are on a fixed pension because each year it will buy less.
  

The causes of inflation are:

• Demand pull. This is where there is a lot of money in the economy, lots of people who want to spend money, and because demand is therefore high, prices are pulled upward.
  

• Cost push. An example of cost push inflation is where people in the manufacturing industry, let’s say coal mining, have a large wage rise. Inevitably that wage rise is passed on and will find itself reflected in the cost, say, of electricity. The cost of electricity goes up and that’s an example of cost push inflation.
  

• Import-cost inflation. Higher prices for imported energy or materials, or a weaker domestic currency, increase input costs. Businesses may raise prices, causing cost-push inflation.

• Expectation. This is where people expect there to be inflation and because they expect inflation, they make higher wage demands and the higher wage demands inevitably push up the price of goods that are going to be sold.
  

• Increase in the money supply. An increase in the money supply will stimulate demand. More people have money to buy goods and this will cause demand pull inflation.
  

4 Interest rates and inflation

Central banks can attempt to reduce inflation by increasing interest rates: if it costs more to borrow, fewer people will do so and fewer goods will be bought. However, inflation also has an effect on the interest rates that banks and other institutions need to pay to attract funds.

For example, assume that there is no inflation in an economy and to persuade investors to put money in a bank for a year, the bank has to pay 3% interest. If $1,000 is deposited now then in 1 year $1,030 is available to spend and, because there is no inflation, $30 (ie 3%) more goods can be purchased. The investor is really richer by $3% and this is known as the real return or real interest rate. The 3% is what the investor requires to defer the enjoyment and utility of expenditure by a year.

Now let's say that inflation is running at 5%. Just to be able to buy the same goods in a year as could be bought now by $1,000 will take $1,050 (ie a 5% increase to allow expenditure to keep up with inflation. However, that has not increased the investor's wealth in terms of goods that could be purchased and presumably to defer expenditure the investor still needs a real 3% increase in purchasing ability.

Therefore, the investor needs the deposit to grow by 5% to stay level with inflation and then an additional 3% to generate an increase in wealth.

These rates are combined as follows:

  1 + Money (or nominal) Rate = (1 + Inflation rate) x (1 + Real rate)

Here:

  1 + Money rate = (1 + 0.05) x (1 + 0.03) = 1.0815

  Money rate = 0.0815 or 8.15%

8.15% is the interest rate that banks would need to offer to persuade investors to deposit cash with them

It is called a 'money rate' because this is the amount by which the investor's money must increase by to cover both required returns. It is called the 'nominal rate' because it is a headline rate. The investor is not 8.15% richer and therefore 8.15% is certainly not a measure of the real rate of return (which remains at 3%).

The rates advertised by banks and other institutions are the money or nominal rates available.

5 Chapter 10 questions

Question 1

If the real interest rate is 4% and inflation is 7% what is the nominal (money) interest rate?

Question 2

What are the two groups of mechanisms (policies) that the government can use to control the economy?

Question 3

What is demand pull inflation?

Question 4

What are the three variables in fiscal policy?