I stumbled across a great article this morning which explains very well how Central banks (the Fed, the Bank of England, etc) operate on the money markets to inject liquidity into the system in order to stabilise it. This prompted me to consider the bigger question why money and credit is important in an economy.

Central banks and monetary policy: Typically Central banks aspire to maintain a certain target interest rate, and tighten credit (reduce it) when rates are too low, or increase the money supply when the rate is too high when rates are too high. This does not mean printing money: purely issuing notes and coins without reference to economic conditions can and does lead to inflation which, when excessive, is very damaging to the economy (it is outside the scope of this note to consider what is deemed “excessive” or what drives inflation in the first place, although some degree of inflation seems inevitable and healthy). Instead Central banks buy or sell short term Treasury bonds to primary banks (the likes of Goldman Sachs) to manipulate liquidity.

Central banks thus influence available credit through its dealings with primary banks and not small regional banks. If primary banks ceased to exist, e.g. if they went bust, Central banks would lose this existing tool of influencing available total money in the economy.  

Money in circulation: Through their borrowing and lending activities, banks actually create money in circulation. The faster money changes hands in financial markets (gets borrowed and re-lent on), the more money effectively exists. “Total” or “broad” money is the sum of physical cash in circulation, plus all the on-demand deposits, savings accounts, long term deposits, etc, created through financial activities. A high velocity of money changing hands  is a sign of advanced financial markets. 

If money changes hands slowly or various types of advanced deposits do not exist, there is less total money overall. It also means, however, that such less financially advanced economies are insulated from the impacts of liquidity issues.

If total money in circulation shrank in a country used to a particular level of available credit and money available, this should cause deflation. Deflation due to this factor is actually bad for the economy – think about the 1930ies Great Depression.

Great Depression: As the amount of available money reduced, economies contracted and unemployment rose; this became a downward spiral. The Great Depression occured mainly as the Fed did not act as Lender of last resort in rescuing failing banks at an acceptable rate of interest. Money was too expensive to borrow for everyone at that time.

Bailout Bill passed: Now that the Bailout Bill has been adopted, it looks like we are safe from an exact repeat of the 1930ies scenario where the Fed would not step in.

New danger ahead: However we now have a new risk, that of the US government not physically having enough money to rescue everyone who needs rescue. US Government debt is currently standing very high – it has not been reduced during the recent economic growth period as it should have been. A remote possibility lurks that maybe, just maybe, if things go particularly bad, the US Government could in itself default. This happened to in the past to countries (think Russia in the nineties) and it is a catastrophe for a government and the country’s economy.  

And I cannot even begin to comprehend the consequences of this happening in the US.

By the way  today I heard today that the economy of Iceland is de facto bankrupt. We’ll watch with interest and trepidation as to what happens next and what steps their Central bank will undertake in response.

Link to  article  which prompted this post.


I welcome people’s feedback and comments on the above


Copyright 2008 by CuriouslyInspired