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Monetary Expansion

Ok I have received the question: “why is expansionary monetary policy contractionary in the long run?”  This is the most natural question that arises from what I have written here and indeed it is the main point that most people (including economists) miss in my view.  The short answer to this is that when money is created as debt, it is loaned with interest.  What this means is that the nominal, long-run liability which is created along with it is larger than the nominal amount of money that is created. 

To see what I mean consider an economy with a money supply that is constant and just circulating around.  There is no money coming in or going out.  And for simplicity’s sake assume that the velocity of money is also constant for everything we do here (this is not a realistic assumption but it allows me to make the point in question much more clearly).  In this situation, real output and the price level will be inversely related.  This means that if output is growing the price level will be falling (in other words, you would have deflation).  But everyone would expect the deflation so it would not be disruptive in any way.  I will probably write more about exactly what this would look like and why later but for now just notice that the money supply is constant, output is increasing, and the price level is falling. 

In this economy there is a nominal interest rate which makes the quantity of money that people are willing to lend equal to the amount people are willing to borrow at that rate.  Now imagine that a central bank comes along and offers to lend money at a rate lower than what prevails in the market.  This will cause the quantity of lending supplied to become lower than the quantity demanded or in other words a shortage of money.   The bank then fills this shortage by printing more money.  The people borrowing this money will then bid up the price of goods.  In other words, this policy will cause inflation. 

To see the important point here, consider what would happen if the central bank, after doing this for one year, suspended all lending (and therefore all printing of additional money).  Would the money supply and prices just remain stationary at the new inflated level?  Would they go back to what they were before the central bank came into existence?  The answer is no on both counts.  In fact, once all the loans the central bank had made in the process of inflating the money supply are paid off, there will be less money in circulation than there was originally.  This is because all of those loans will be paid back with interest. 

We can create a simple numerical example.  imagine the money supply was $10,000 to begin with and the central bank’s expansionary policy creates $1,000 of loans at interest rate 5% with a term of 1 year.  Then in a year, when these loans become due, people will have to pay back $1,050.  This means, if the bank suspends lending at that point the money supply will be $9,950 or $50 less than before the bank came along.  But of course, the central bank doesn’t do this.  They try to convince us that the inflation they are causing is normal and beneficial and that they can maintain it at a stable level indefinitely.  So let’s see what they have to do in order to maintain that belief.

Assuming, as I said, that velocity is constant and, again to keep things simple, assuming that output is constant, the ten percent increase in the money supply will cause a ten percent increase in the price level.  So let’s imagine that this is the magic inflation target (in reality it is more like 2-3 percent).  In order to maintain this rate of inflation they will have to keep the money supply growing at 10% per year.  This means that in the second year they will have to create $1,100 of new money.  And this means that they will have to create $2,150 worth of loans–$1,050 being required to replace the retired loans from the year before.  In the third year they will have to create $3,467 worth of loans.  $4,971 in the fourth year, and $6,685 in the fifth year.   So you see the amount of borrowing required to maintain the inflation grows exponentially (note that it would have to grow even faster if output is increasing).

Now in the fifth year the price level will be 61% higher than it was before the central bank.  What’s more, if the central bank suspended lending at this point the money supply would fall to $9,085 in year 6,  a sudden decrease of 44% leaving the money supply about 9% lower than what it had been before the central bank.  This would be catastrophic to the economy because unlike the natural deflation that we imagined in our free money economy, this deflation would be unexpected.  This means that people would not be able to pay back all of those loans and would have to default on many of them.  This is what happens in a modern recession.  The longer the expansion goes on this way, the larger the gap between the total money supply and what I will call the “hard money supply”–meaning money not attached to a central bank debt–gets.  If it goes on long enough, all the money that was in the economy to begin with will be absorbed by the central bank and the total outstanding debt will actually become larger than the total money supply.

Of course, recessions do not occur because the central bank suddenly suspends borrowing, but remember that the creation of debt requires a voluntary transaction between the bank and a willing borrower.  As the necessary quantity of loans required to keep the price level growing at the desired rate gets bigger and bigger, it gets more difficult to find people willing to borrow.  The main way they try to generate additional borrowing is by lowering the interest rate but eventually this cannot be done any longer because rates cannot go below zero.  When this happens they have to get more creative to get the money out into the economy.  They can start buying up other assets like longer term debt (quantitative easing), or they can have the government expand the public debt.  People often refer to this as “inflating their way out of debt” but it’s actually the opposite.  What people have in mind when they say things like this is a government who owns a printing press and just prints money to pay its bills.  But in reality, in order to create inflation a debt must be created as well since the printing press is owned by the Fed.  This means, to get more inflation you have to expand the debt.  Conversely, contraction of the debt will cause a contraction of the money supply and deflation.

  1. little fish
    March 19, 2011 at 3:21 pm

    This makes me see the whole Fannie and Freddie thing in a new light. Maybe the government wasn’t worried about helping people buy homes at all – they just wanted to maximize borrowing. So the central bank has been kicking this can down the road for a long time. How and when does it end; or does it have to end? Can they just keep kicking?

  2. Free Radical
    March 19, 2011 at 7:17 pm

    Yeah exactly. Every time there is a wave of defaults it relieves some pressure because some loans get retired without the cash beign sucked back into the bank so some money leaks out. Interestingly, it could theoretically go on forever if the Fed is willing to lend endlessly to the federal government without being paid back. If this is the case though it exactly replicates a system when there government does own the printing press, which raises all the issues normally associated with that arrangement.

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