Could Someone Please Explain the Money Supply?

[Arnfinn Madsen]

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:

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1) Our currency is not backed by anything; it's just paper

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I see what you mean, but it is backed by something, it is backed by people's perception of it and also that it will i.e. be accepted for paying your taxes etc. to the government. A diamond or a share in a company that will go bankrupt tomorrow has a value today mainly due to people's perception of its value, and this perception is real. It is however important that it is dependant upon this perception, when people stop trusting the money as happens in different economies from time to time the consequences are very negative.
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2) Is inflation a byproduct of printing too much money?

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Yes, it can be put that way. Although too much is a disputable term, less would have to be printed in order to stabilize prices. But as above also part of inflation is due to people's expetance of inflation, prices rise partly due to the fact that you expect something to be more expensive than yesterday. But much of this expectancy is due to the constant norm of printing "too much" money, so at the basis of it all is the constant inflating of the money supply.
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3) The Federal Reserve controls a lot of this process

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In the US it is very powerful and can influence it a lot. However it is very hard to predict the exact effects of an action, so it could i.e. decide that it want inflation in 2 years time to be 20% and it would end up somewhere between 15% and 25%.

Do we:

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

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Not consistently, sometimes the demand for money drops, so that the Federal Reserve will destroy more money than it prints, however the underlying trend is toward a constantly rising money supply.
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2) If so, who gets the benefit of this extra money printed?

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This is very complex, since the market can factor in a lot of this effects and thus minimize/eliminate them. I.e. if you borrow money in a time of high expected inflation you will be charged a high interest rate for that (in which the expected inflation is part of your interest rate). If the increase is unexpected everyone who has a loan benefits, so the government could print a lot of money to make it's own loans smaller in terms of real value. Also there are a lot of others who benefit, i.e. banks do it since a 50% increase in property value means the banks have 50% more security for its real estate loans in which the clients have mortgages.
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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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By putting in a computer that bank A has $2 trillion deposited at the Federal Reserve, that bank B has a claim of $5 trillion towards the Federal Reserve in government bonds. It is very simple. The Federal Reserve can basically make money by hitting a button.
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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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They keep detailed statistics of both, down to every cent.
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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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Why does it have to? There isn't any need for it other than protecting money owners against the government. And history has shown us that that really isn't necessary, hasn't it? [img]/images/graemlins/grin.gif[/img]. Seriously, it is very convenient for the government to get rid of it as it has much more opportunities to influence the economy, and in countries like the US where the population trusts the government in this regard and the government keeps it actions within some reasonable standard it works well. If we should move to it being backed by something? I think in reality this is not doable in i.e. the US now.
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6) What is it that is currently backing our currency?

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See earlier answer.

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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.

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Nobody benefits from you knowing. It is very convenient that people in general do not know, since then people do not start to question it, and if too many people question it too much it actually collapses.

[ojc02]

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But remember, inflation applies to prices and wages. So a little inflation is a good thing, but too much is a very bad thing.

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No amount of inflation is ever a good thing. Inflation only doesn't affect you if you spend your wages immediately, or get paid with some other good (kinda the same thing).

If, however, you want to save some money (which is perfectly rational), then any amount of inflation is a bad thing.

[Arnfinn Madsen]

To clarify on the loan part, let's say you borrow $20k of me to buy a car. The the government quickly push up inflation and the car suddenly gets worth $40k, then you have a $40k car with only $20k in loans. However, if I knew the government would make so much mess in one month I would simply charge you 100% montly interest for the first month.

So in political terms, let's say you become president and you see that your country has x$ in loans and the market hasn't factored in high inflation. Isn't it tempting to just print money and suddenly half of the national debt disappears? It is and it works, but then comes the next president who is responsible and tries to renew the government bonds that expire and says "Borrow us money for 5% interest, I promise to keep inflation stabile" to which the market responds "LOL @ your country, we want minimum 30%". So you gain short term but lose long term.

[Arnfinn Madsen]

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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?

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You are onto something, it is a sort of theft. Every note or coin you have in your pocket loses value all the time, but you are told this. If you ask Bernanke if he can promise you you will get the same for 1k as you get today in 5 years time he will tell you that his aim is to make it so that you get less. So nobody cheats you unless they do something to pump up inflation above what they have signalled.

[ScottieK]

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But remember, inflation applies to prices and wages. So a little inflation is a good thing, but too much is a very bad thing.

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No amount of inflation is ever a good thing. Inflation only doesn't affect you if you spend your wages immediately, or get paid with some other good (kinda the same thing).

If, however, you want to save some money (which is perfectly rational), then any amount of inflation is a bad thing.

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Let me put it another way...inflation is a byproduct of a healthy economy where people are trading money for goods and services, and they are receiving interest payments for their deposits. It indicates that people are, on average, making more money, and businesses are getting more money for their goods. They have faith in the economy, and prices and wages rise accordingly. A credit-based economy (like the U.S.) should have an inflationary bias.

Contrast that to deflation. Businesses are getting less money for their goods. As a result, they have to pay their workers less. Those businesses and workers have less access to money because they cannot afford to take on additional debt. They know that their debt payments right now may be manageable, but may become unmanageable in the future when their income levels drop and their payments remain constant.

As for banks, the real cost of funds (difference between interest rate and inflation rate) increases during a deflationary period. If the interest rate was 8%, and the inflation rate was - 3% (deflationary) then the real cost of funds would be 11%. Interest rates can only drop so much to compensate, and they can't go below zero.

ScottieK

[Arnfinn Madsen]

Whether inflation is a good thing or not is debateable, it is also a value question wrt to whose needs are more important than whose. What is clear is that our current economies benefits from inflation in many ways, it makes the financial system more stable and also makes the clearing of the labor market more smooth (especially in many European countries where nominal wages are relatively static). Also that people spend and invest money instead of putting it in a cupboard is good for the economy as a whole and inflation contributes to triggering that. If the expected inflation however becomes very high the economy is damaged due to the inefficiencies it creates in transactions, note that expected high inflation is a problem even when the real inflation is low, so the government constantly tries to ensure the private sector that future inflation will not be high.

[tolbiny]

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I was talking about American dollars, of course. I was just making an example (as if I were the mint).

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Recall though that at one point the US dollar was backed by something use full, ie. gold (or tangible if you want) and so there was a demand for it already. The process of separating the dollar from gold took ~60 years, so there was already a demand for dollars. This demand has maintained largely because oil is generally traded in dollars making it a very usable currency, hence the continued demand.
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That said, shouldn't we know exactly how much dilution is occurring on a daily basis?

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Uhhh probably. I am not sure precisely how the fed works somedays. They can manipulate the money supply by printing money straight out or they can lower interest rates, encouraging more people to take out loans and its the banks that are "printing" the money via FRL. This is (my impression) how the fed generally manages the curency rates, which is less precise than literally printing the cash.
Secondly inflation is generally measured by the CPI which is not a direct measure of the money supply. The CPI adjusts because of the money supply, but also because of new technologies and better production methods. A 3% increase in the CPI could mean a 6% increase in the money supply but a 3% decrease in prices due to increased efficiency. Hard again to peg perfectly. (This is all assuming my minimal understanding of the CPI is correct).

[tolbiny]

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A credit-based economy (like the U.S.) should have an inflationary bias

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This is bogus, there is no such thing as a "credit based" economy. All economies are production based as you can only consume what you produce. Terms like credit based are supposed to make people feel that its acceptable to pile on debt since as long as everyone does it (this includes the next generation) the growth will pay for their debt. In reality all that production has to be turned out in reality or else the economy comes crashing down.

[Arnfinn Madsen]

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That said, shouldn't we know exactly how much dilution is occurring on a daily basis?

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Uhhh probably. I am not sure precisely how the fed works somedays.

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A lot of information about their activities they make public I assume (at least this is normal in modern economies in democracies). If you search through their website, publications etc. I assume you will find everything that is relevant. However, how much your money will dillute during i.e. the next month is a function of a lot of factors in which the Federal Reserve's influence is only a part, so nobody can tell you how much your money is going to dillute during the next month. Note again that how much your dollar will be worth in one month time depends on the perceived value of one dollar in one month time, it is not a simple mathematic formula in which the Federal Reserve puts something in and know what comes out.

[jogsxyz]

http://app.ny.frb.org/markets/omo/dm...?SHOWMORE=TRUE

Here's the link the FED Reserve open market operations.
The FED just created another $10B today.