Could Someone Please Explain the Money Supply?

[Mempho]

How is our currency created (not physically)? In all of the discussion on economics, I have not yet seen anyone clearly explain how our money supply works. A few things I do know is that:

1) Our currency is not backed by anything; it's just paper
2) Is inflation a byproduct of printing too much money?
3) The Federal Reserve controls a lot of this process

Do we:

1) Consistently print more money than we destroy (on a federal level)
2) If so, who gets the benefit of this extra money printed?
3) How do we keep track of the amount of digital money since most money now is not kept in hard currency?
4) How do we find out how much money was created, either through printing or other creation, in the past year? Further, how do we know how much has been destroyed?
5) Why is our money not backed by something of value? Why did we decide to get off gold and silver standards? Doesn't this make more sense?
6) What is it that is currently backing our currency?

I feel completely ignorant as an American citizen as I know none of this. It really struck me because last night because I went to sleep watching CSPAN coverage of Bernake's testimony. Paul's opening comments were disturbing...every fiat currency system in history is failed. Why is he wrong? If he's not, why is this not a major political issue. I'm not trying to push Paul in 2008, I just really figured out that I have no idea what I'm talking about when I talk about economics, which is sad because I have a post-graduate degree from a business school.

[tolbiny]

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2) If so, who gets the benefit of this extra money printed?

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People who receive loans.

[BCPVP]

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1) Consistently print more money than we destroy (on a federal level)

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Yes

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2) If so, who gets the benefit of this extra money printed?

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The first users who receive the money before prices increase

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3) How do we keep track of the amount of digital money since most money now is not kept in hard currency?

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Not sure

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4) How do we find out how much money was created, either through printing or other creation, in the past year? Further, how do we know how much has been destroyed?

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Not sure. Mints might know.

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5) Why is our money not backed by something of value? Why did we decide to get off gold and silver standards? Doesn't this make more sense?

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This is going to get you a variety of answers. Many believe that a fiat currency facilitates government spending, since they are not limited to a fixed amount of money. A video from the Austrian perspective on the topic.

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6) What is it that is currently backing our currency?

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The government's word that "we're good for it".

[Skoob]

I think it has something to do with the federal gold reserve - Fort Knox. That and the government's word that they're good for it.

[Mempho]

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2) If so, who gets the benefit of this extra money printed?

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People who receive loans.

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What do you mean? If I could print money and you needed to borrow $10,000 to enter the WSOP ME, I could give you the $10,000 loan at little risk (actually, just the cost of my time and materials used to print the money) and it wouldn't effectively matter if you paid me back. If you pay me back the $10,000 with interest, then I, the lender, end up gaining. Sure, you get the benefit of capital financing (dictated by the time value of money), but I get the principal and it's time value, so, once I'm repaid, I get to spend the principal and the juice and every bit of what I get is gain (save the materials and time of printing).

Better stated, you ask me for $10,000, and you agree to pay me $10,000 in one year's time plus 20% juice. Let's say it costs me $200 in labor/supplies/equipment to print the $10,000.

My risk is only $200. When you repay me in full, I gain $11,800. If I threaten to start breaking things and only am able to suck $1,500 out of you, I still gain $1,300. If this "business" was legally sanctioned, why wouldn't I want to be in this line of work. It's still free money...for the lender. I was more than willing to give a gambler a below-market interest rate because my risk is almost nil and, effectively, my EV is extremely high on every such loan I make. Even if 80% of my customers never pay me a dime, I get filthy rich just by getting business. Don't you mean to say, then, that the lender gets the benefit?

Sure, maybe the borrower gets a below-market interest rate, but that's only a very small part of the benefit. Most of it goes to the lender in this situation.

It's entirely possible that I've completely misinterpreted your reply, though and that it has to do with some other effect.

[Mempho]

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[ QUOTE ]
1) Consistently print more money than we destroy (on a federal level)

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Yes

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2) If so, who gets the benefit of this extra money printed?

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The first users who receive the money before prices increase

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Wouldn't this dilute the money supply? Isn't money a relative instrument since, if I could go back in time with all of my cash, I could be one of the wealthier people in the my area? Since this would dilute the money supply, wouldn't it be akin to a hidden tax since it eventually increases the price of things? Is the government the one that is getting the benefit of this?

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3) How do we keep track of the amount of digital money since most money now is not kept in hard currency?

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Not sure

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This would be nice to know, though.

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4) How do we find out how much money was created, either through printing or other creation, in the past year? Further, how do we know how much has been destroyed?

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Not sure. Mints might know.

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I would think this would be in a financial report somewhere but I have never found it when scouring the federal financial statements audited by the GAO.

EDIT: I must add that i find it deeply disturbing that we can talk about taxes and spending without an understanding of what money actually is.

[pvn]

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Sure, maybe the borrower gets a below-market interest rate, but that's only a very small part of the benefit. Most of it goes to the lender in this situation.

It's entirely possible that I've completely misinterpreted your reply, though and that it has to do with some other effect.

[/ QUOTE ]

You've got a pretty good handle on it; one thing you're missing, though, is that as the new money circulates, it devalues all other money (by dillution). The guy getting the loan gets to spend the money first, before it gets devalued.

[tolbiny]

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It's still free money...for the lender.

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Its not risk free for the lender as your money only has value if someone else wants it. I can print up $10,000 in tolbiny dollars and try to buy my way into the ME but they aren't going to take it, so no one is going to come and borrow the $10,000t from me (and i have lost whatever it took to print it up). On a larger scale, lets say Zimbabwe since there is a thread going on them right now, if i print to much money no one will accept it and it becomes devalued heavily. When you try to pay people with it they rebel, go on strike, refuse to accept it, use other mediums of exchange (if you travel to zimbabwe everyone there will accept US $ or South African Rand (sp?), but no one wants the Zimbabwe dollar. So now the government (supplier of Z$) is losing power/influence and gerneally sucking all around. The supplier does not benefit without risk, but the wider the power he has (ie the more in demand his currency is) the more he can print without exposing himself to these risks.

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Even if 80% of my customers never pay me a dime, I get filthy rich just by getting business.

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If you are just printing money whenever someone asks then why would they ever accept it as payment? YOur dollars are worthless

[Mempho]

[ QUOTE ]
[ QUOTE ]
It's still free money...for the lender.

[/ QUOTE ]

Its not risk free for the lender as your money only has value if someone else wants it. I can print up $10,000 in tolbiny dollars and try to buy my way into the ME but they aren't going to take it, so no one is going to come and borrow the $10,000t from me (and i have lost whatever it took to print it up). On a larger scale, lets say Zimbabwe since there is a thread going on them right now, if i print to much money no one will accept it and it becomes devalued heavily. When you try to pay people with it they rebel, go on strike, refuse to accept it, use other mediums of exchange (if you travel to zimbabwe everyone there will accept US $ or South African Rand (sp?), but no one wants the Zimbabwe dollar. So now the government (supplier of Z$) is losing power/influence and gerneally sucking all around. The supplier does not benefit without risk, but the wider the power he has (ie the more in demand his currency is) the more he can print without exposing himself to these risks.

[ QUOTE ]
Even if 80% of my customers never pay me a dime, I get filthy rich just by getting business.

[/ QUOTE ]

If you are just printing money whenever someone asks then why would they ever accept it as payment? YOur dollars are worthless

[/ QUOTE ]

I was talking about American dollars, of course. I was just making an example (as if I were the mint). That said, shouldn't we know exactly how much dilution is occuring on a daily basis? Would that not affect our beliefs in regards to rate of return on investments and such. After all, if inflation is 3% and your savings account is a no-fee 2.5%, aren't you going in the hole by having the money there?

Also, if our money is getting diluted at the benefit of others, isn't that a type of theft from people that are holding American currency? I mean, everything is subject to supply and demand, even supposed inflation hedges, like gold. If a company finds a new gold mine that will increase the world gold supply by 10%, then, in a vacuum, that 10% should eventually be reflected in gold prices (relative to the dollar, of course).

Money is, of course, the same way. I would think that it would be far better to benchmark the currency against something of relatively constant value, however. For instance, if all science indicates that 95% of the world's platinum has been found, why not back the currency with platinum since it figures to be a better benchmark than a fiat system.

However, if we're going to have a fiat system, is it not better to have a constant amount of currency (or a constant amount per capita) in the system rather than a fluctuating amount?

I had heard on a talk radio show just a few days ago that there was an $800B difference between money created and money destroyed over the past two years. I have absolutely zero idea of the source of that information or if it is factually correct, but I do realize that this would be the equivalent of $2,666.67 for every man, woman, and child in America. That would be a heck of a lot of dilution for just two years.

[ScottieK]

If the money supply grows by more than real GDP growth, inflation is likely (taken from wiki). Inflation almost naturally occurs with the interaction of money and interest rates. Prices and wages always tend to rise, not fall, in a healthy economy. Workers usually demand more pay, and businesses usually increase the price of their goods, both for profit and for paying their workers. The money supply has to be adjusted to compensate for this...otherwise, there won't be any money to pay for additional goods and services that come from GDP growth. However, as you said, inflation is like a "hidden tax" because it diminishes the purchasing power of the money you have now. But remember, inflation applies to prices and wages. So a little inflation is a good thing, but too much is a very bad thing.

The Fed tracks M0 (all hard currency in circulation) and M1 (M0 + highly liquid electronic accounts that consumers use, like checking accounts) as well as other liquidity classes of money that make up the total money supply. They try to keep it on pace with GDP growth. I'm pretty sure that banks are required to report their total deposits and electronic deposits to the Fed on a regular basis. The Fed controls the money supply by adjusting interest rates and buying/selling government securities on the open market. They don't just give money away to banks. Lower rates make borrowing more attractive, and loans increase the money supply. Banks can "create" money because of fractional reserve requirements. They can effectively loan out more than what they have in hard currency deposits. When the government buys securities, it pumps money into the economy for lending, and this increases the money supply.

If the money supply is growing too fast (which could lead to inflation), the Fed increases the prime rate and the federal funds rate, and borrowing slows down. When the govt. sells securities, they take money out of the economy that could be loaned out by banks. They can also print money, either to put new money into the economy (via buying securities) or to replace old currency. The Fed can also mess around with the depository requirements, but that's a heavy-handed measure that isn't used too often.

Wiki has a pretty good article on it:

http://en.wikipedia.org/wiki/Money_supply

WRT business school....one of my econ professors said that the business school just takes economics and keeps all the sexy parts, so they can make money doing it. My business school alma mater did away with some of its econ requirements not too long ago, which is very sad IMO. Lucky for me, I took enough econ credits to unofficially minor in it....FWIW.

ScottieK