Saturday, 6 October 2012

The Demand and Supply of Money

Economists love the idea of demand and supply.  It is one of the basic concepts we use to describe almost everything.  Yet, thinking about demand and supply with regard to money may seem strange.  Money is something that everyone wants more of and there is never enough of the stuff.  But with central banks across the globe printing more money but banks and companies being cautious about using the bundles of money they have, there is plenty of it around but no one wants to spend it.

The supply of money has been on the rise due to the policies of quantitative easing which central banks have used to try to revive sluggish economies.  The central banks have been creating money from nothing to buy bonds in an attempt to push down interest rates so as to prompt firms and households to borrow more. 

Typically, an increase in the money supply will result in inflation as more money chasing the same number of goods pushes up prices.  But much of the extra cash is being hoarded by banks and companies who are too scared to put it to use.  On the other hand, consumers are being squeezed with downward pressure on wages for those that manage to hold onto their jobs.  Any extra money for households is typically being used to pay off debt after a borrowing binge in the build up to the global financial crisis. 

Central banks have tried to boost the demand for money by lowering interest rates.  It may sound like a bizarre concept but the interest rate is the price of money as it is the cost involved in obtaining cash that is not yours.  The interest rate is determined by the demand and supply for money in a market environment.  That is, an abundance of savings (excess supply) will push down the interest rate while lots of borrowing (excess demand) will have the opposite effect.  In practice, interest rates are also influenced by central banks that set the interest rate, which acts as a base rate for the interest rates on different types of debt, to keep inflation within a target range – typically inflation of around 2.0%. 

The global financial crisis in 2008 and 2009 can be seen as the result of interest rates deviating from what would have been appropriate.  There were massive inflows of savings from China in the banking system in the United States as the Chinese government built up foreign currency reserves which were in US dollars and invested in US government bonds.  This kept interest rates artificially low and resulted in increasing levels of debt as companies, households, and even the government took advantage of cheap borrowing.  Fingers have also been pointed at the US central bank, the Federal Reserve, for not acting faster to clamp down on the excessive borrowing by increasing the interest rate.  But it proved difficult for even the Federal Reserve to end the debt fuelled party – the results of which have only become obvious with hindsight. 

But now interest rates cannot be low enough.  The central banks have set the interest rate close to zero but this is still too high to prompt companies to borrow considering that it is unclear whether investments will generate profits given the uncertainty that clouds the global economy.  Central banks have tried printing more money through quantitative easing which is another way of pushing down interest rates which firms actually pay when borrowing.  While this new cash has helped somewhat in this regard, much of the money has gone elsewhere – some to stocks which has helped to boost the share market but some of the funds have headed overseas with undesirable effects (but more on this in my next posting).

The nitty gritty of economic is not for everyone, and while it may not be that interesting (Your Neighbourhood Economist cannot work miracles), hopefully the workings of the economy will make a little bit more sense (and please comment or email if you would like to know more).

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