I received the following email today, which gave me a great excuse to write a blog post about monetary policy! My reply to the teacher is below.

Jason,

I hate to bug you, but I have a question. I am a first year AP Econ teacher and I know something is going to come up right away and I want to explain it in the simplest way. “Why can’t the govt. just print more money?” I know the inflation part of it, but when I am reading to look for quality ways of explaining it, I see plenty of information about it, but I can’t grasp it. Principle 9 in Mankiw text states “Prices rise when the govt. prints too much money.” I feel like a dumb kid and I am supposed to teach this!!!!

If you can help, great, if not, I will figure it out.

Thanks,
Teacher

Dear Teacher,

I love your question! It is definitely one of those issues that gets glossed over in most economics textbooks. Or it is assumed that the money supply diagram makes it obvious why excessive monetary growth leads to inflation. But I agree, this is one of those things that for the first couple of years I taught economics, I probably didn’t really understand all that well either! So let me try to break it down in plain English for you. This will be good for me too, cause I always understand things more clearly myself after writing them (which is why writing a textbook is about the best PD I’ve every undertaken!)

So, here it goes:

Printing money and its effect on inflation is a bit more complicated than it sounds. In fact, it is the US treasury that prints money, but it is the Federal Reserve that determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The treasury and the government of which it is a part does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.

Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”. (I say traditionally, because in the last three years the Fed has devised numerous new ways to “inject liquidity” into the economy, which I will not get into now). To increase the nation’s money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some of American households’ savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will want to buy government bonds if the interest on them rises and will want to sell those bonds when the interest rate falls.

If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed’s open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!

Remember, the money printed at the Treasury and held at the Fed was NOT part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks’ excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.

Now, commercial banks have just sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Picture the money market diagram and you will see the money supply increasing.

So the next question is, why does this lead to inflation?

Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do NOT earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed’s bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.

So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.

Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.

Additionally, the lower rate on US government bonds resulting from the Fed’s open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.

Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation’s output puts upward pressure on prices as the nation’s producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption. Firms see price rises in the future and increase their investment now to meet the expected rises in demand tomorrow.

It does not take much for inflation to accelerate in such an environment. If the the government and the Fed do not slow down the increase in the money supply (STOP THE PRINTING PRESSES!) then soon enough workers will begin demanding higher wages and resource costs will start to increase in all sectors of the economy, causing the nation’s aggregate supply to decline as firms find it harder to cover their rising costs. Now we have both demand-pull AND cost push inflation! The weaker currency also makes imported raw materials more costly to firms, further adding to the inflationary environment. An inflationary spiral is now underway!

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contractionary monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.

I’ll leave you with one question to ponder (the answer to which would require a much longer article than this one!). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That’s right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 right before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America’s unprecedented monetary growth over the last three years!

Infographics are a great way for students to dig a bit deeper and explore an issue. They are typically a combination of graphs, maps, visuals, charts and texts that can be explored through the internet. The New York Times has produced a wealth of these resources over the past few years and this week they are showcasing their best exhibits. It is important for students of Economics to be able to read and interpret visual information, to learn about the world around them. Some of my favourites from the NY Times website are here. Click on the images to explore

For an overview of infographics

For a full list of relevant infographics for Economics, Social Studies and History – NY Times

Click on the images to explore

Can a President Tame the Business Cycle?

How Different Groups Spend Their Day

#4a

All of Inflation’s Little Parts

#5a

Debt Rising in Europe

#6a

What Your Global Neighbors Are Buying

#7a

Over a year has gone by since the 2009 American Recovery and Reinvestment Act (ARRA) was passed and put into action by the Obama Administration. Supporters of the program say that it has been successful, arguing that the economy would be in much worse shape if no stimulus had been introduced at all. In fact, some are arguing that government spending has not been sufficient for a full economic recovery and that more direct government spending is necessary. Economists on the other side argue that the stimulus package has done little for the economy except to delay the inevitable, self correcting forces of the economy needed to pave the road back to recovery. Some actually say that we are in a worse situation now due to the massive increase in government debt which will eventually have to be paid back.

So the question is, are we better off as an economy a year after the stimulus package was introduced? With growth still sluggish and unemployment at 9.5%, many people have begun to question the success of the ARRA. Again, some say the $784 billion was insufficient while others say less regulation and more tax cuts should have been utilized.

In a recent Washington Post article, Neil Irwin argues that the obstacles towards economic growth may not be solved by more stimulus, lower interest rates or tax cuts for corporations. The problem, he claims, is not a lack of funds for investment, but in the uncertainty businesses have in future conditions. He writes:

Corporate profits are soaring. Companies are sitting on billions of dollars of cash. And still, they’ve yet to amp up hiring or make major investments — the missing ingredients for a strong economic recovery. Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side’s assessment fits.

They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of almost unbroken prosperity of the quarter-century that preceded the financial crisis.

With consumers choosing to save or pay off their debts now rather than spend, many businesses find it in their interest to hold off on investments into new capital until consumers begin spending again. With no planned investment and no incentive to hire workers, unemployment stays high and economic growth remains stagnant. With inflation rates low and economists predicting deflation, it makes more sense to hold onto money as it is not losing its value.

So is there a solution? In this situation, expansionary monetary policy through lower interest rates will not have the desired effect as demand for loanable funds is low. As stated in the article:

For large companies such as Illinois Tool Works, the price of borrowed money isn’t the problem. The company had $1.3 billion in cash on its balance sheet at the end of June, up from $743 million at the end of 2008. Lower interest rates wouldn’t make much of a difference, either.

“I could borrow $2 billion tomorrow for 3 1/2 percent,” said Speer. “But what am I going to do with it?””

Other executives claim that an increase in government spending would only provide a temporary fix but have no effect on long term consumer spending.

David Speer is chief executive of the company, which has 60,000 employees worldwide in more than 800 business units and $14 billion in sales. He said an additional burst of fiscal stimulus from Washington might help boost economic growth for a period of months. But that is unlikely to affect his decisions about hiring and expansion, which Speer said are based on expectations for sales over years to come, not just the immediate future. As long as U.S. consumers remain deeply strained, he is unlikely to undertake aggressive expansion.

More fiscal stimulus “might help make things a little better for a couple of quarters, but I’m not sure it would get at the underlying economic issue,” Speer said. “The core question is: How do you get consumers back on their feet. We need growth in a sustainable way, not another Band-Aid.”

Another solution would be for the government to implement supply side measures such as less market regulation and lower corporate taxes. Again, without the much needed consumer spending and confidence, its difficult to say whether or not this will materialize into increased investment and employment.

The rest of the Washington Post article can be read here. Once you’ve read the article, answer discuss the questions below and share your thoughts in a comment on this post.

Discussion Questions:

In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 - Krugman argues for continued stimulus:

Discussion Questions:

1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
2. What are three characteristics of an economy in a “depression” according to Krugman?
3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
4. Why is deflation dangerous according to Krugman?
5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

Video 2 - Ferguson argues for austerity and “fiscal regime change”:

Discussion Questions:

1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
2. Why would fiscal tightening “choke off the recovery”?
3. How is the financial crisis in Europe a warning to the US?
4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

Dear year 2 IB Economics students,

Welcome back and I hope you enjoyed your time off. Before breaking for summer we were in the midst of our unit on Macroeconomics, just beginning our debate on whether or not government intervention in the economy in order to kick start activity during a deep recession was a good or bad idea. In other words, would the economy correct itself or would government stimulus be necessary to get our economy moving again.

As you all know, exactly a year and a half ago, the US government decided that in order to a avoid a recession as potentially devastating as the Great Depression of the 1930’s, government interaction into the economy was necessary. 787 billion dollars was put aside for government sponsored projects, transfer payments and decreases in taxes. The hope was that this spending would not only help people maintain their current jobs but also create jobs for those who had recently become unemployed. A year and a half later, proponents of the stimulus package, Keynsians if you will, believe that this great experiment has been a success and that if nothing had been done the economy would be in much worse shape. Opponents of the spending believe that the bill has simply postponed the self correcting forces in the economy and has instead created what economists call a double dip recession where the increase in government spending only creates a temporary, unsustainable increase in economic activity. In fact many of these opponents say that we are worse off now as the government is now further in debt due to the spending.

Has the great experiment thought up by John Maynard Keynes over half a century ago been a success or was it a solution that has caused more harm than good, potentially making the recession worse than it would have been? The radio show Plant Money recently dedicated a show to addressing this very issue. In order to get a balanced look, they interviewed two prominent economists, Tyler Cowen, a Professor of Economics at George Mason University and Mark Zandi, Chief Economist at Moody’s Analytics. Cowen, a skeptic of Keynesian spending, believes that we would now be better off if the government had not intervened in the economy. Zandi, on the other hand, is adamant that the US economy would be much worse off if the government had done nothing. Two economists analyzing similar data and coming up with very different conclusions. This is where economics becomes both complex and fascinating.

Click play on the podcast player below, listen to the whole podcast, and then answer the following questions.

The Great Stimulus Experiment - NPR Planet Money [ 0:01 ] Play Now | Play in Popup | Download (61)

Discussion Questions:

1. How does an economy “self correct” itself once it has entered a recession?
2. What are the arguments put forth by Tyler Cowen and Mark Zandy about the effectiveness of government stimulus? Is one more convincing than the other? Why?
3. What are automatic stabilizers and why does Tyler Cowen believe they are better solutions than the government creating new jobs?
4. According to Tyler Cowen, why is it dangerous for economists to become “wed to only one theory”?
5. What does this podcast teach you about the importance of being able to evaluate economic theory and its effectiveness? Can we ever have an economic theory that is true under any circumstances? Why or why not?