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[ 31 January 2004: Message edited by: C. Haught ]

The policy proposal is to increase the reserve ratio to 50% or so. If the total money supply is supposed to stay the same in order to avoid inflation, the only way that banks could meet this ratio is to call in half of the loans they hold.

To make thing simple, let's limit ourselves to the narrow definition of the money supply: M1 = currency plus demand deposits (i.e., chequing). For the purposes of the policy experiment, this number is supposed to be fixed throughout. People choose a mix of cash holdings and deposits depending on the frequency of their transactions and things like the rate of inflation and the interest rate. If M1 is supposed to be fixed to avoid inflation, none of these can change.

A more practical way to flood the country with money is to spend it into existence by employing people on whatever projects need social utility. As a result, those newly employed people will need to deposit their money into banks. This swells the dollar value of deposits, and indirectly swells the dollar base of reserves, assuming loans don't change.

Little wonder the pseudo-science of economics is in such disrepute.

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There are much less disruptive ways of getting an extra $15b in revenue.

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[LECTURE

The power to print money provides purchasing power for the government: it creates pieces of paper that can be exchanged for goods.

The revenue power is known as seigneurage. In the most recent annual report on the BoC's website, they made a profit (which was transferred to the federal govt) of just under $2b without even trying. I don't know where the $15b number came from, but it certainly seems plausible that they could make that kind of money without too much effort.

But this increased purchasing is not coming out of thin air. Since we have more money chasing the same number of goods, the purchasing power of the existing money supply goes down. This reduction in purchasing power works in exactly the same way as a tax, since it amounts to the transfer of purchasing power from the people to the government.

It's been established that the inflation tax is strongly regressive. The rich are able to protect themselves fairly easily against inflation, but anyone whose salaries are fixed by multi-year contracts, or who are living on incomes that are not continually indexed to inflation will see the purchasing power of their salaries decline.

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Originally posted by Oliver Cromwell:
Doc: The thought experiment was based on pp 9-10. The point that prices depend on the total money supply and not its composition is correct. Since the policy proposal is to change the composition and not the total stock of the money supply, that's all I changed.

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Sure, but you used M1. M2, though, includes savings accounts and some more monetary instruments. M3 (or M2+ in Canada) is the broadest measure and I suspect if you used this in your thought experiment, you would find the results to be less clear-cut.

Incidentally, on reading Paul Hellyer's books, I don't recall that he ever suggests instantly going from 0% reserve requirement to 50%.

Inflation's effects are not necessarily as clear-cut as you put them. The majority of government benefits are indexed except for welfare and EI, while the minimum wage sets the floor income for workers.

Furthermore, high employment is somewhat more important to the majority of the population than stable prices, especially if stable prices happen to be achieved in the context of high persistent unemployment (for example, Europe; the only reason they haven't faced revolution by now is because governments there substitute a good safety net for full-employment policies).

Unanticipated inflation, in particular, does a funny thing: It drives down the value of assets and changes the distribution of wealth. In the mid-1970s, for example, the richest 1% in the USA held only 26% of the total wealth of that nation. This trend reversed itself by the 1980s, of course, as low inflation and speculative excess drove that percentage back up.

Further, the "inflation tax" is not as regressive as you make it out to be, because of the differential impact on workers and businesses; manufacturing tends to benefit well from inflationary increases in prices of their final products because of the ability to take advantage of productivity growth as well, while minimum wage workers are less protected than workers under a union agreement.

My macro text pointed out that the effects are somewhat randomly distributed and so the overall impact can be rather uneven.

[ 01 February 2004: Message edited by: DrConway ]

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Let's look at a chartered bank's balance sheet. Assets = reserves held at the central bank + loans, and liabilities = deposits. Assets have to equal liabilities (another accounting identity).

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I think you are simply accounting for this incorrectly. Loans are assets and deposits are liabilities. "Reserves" are simply owner's equity.

The equations is Assets = Liabilities + Owner's Equity. If you look at the math then what the bank does is run a deficit on the owner's equity side. But it is a deceptive deficit because it masks the return on investment. Using the age old "hank" principle all the bank has to do to account for its deposits is show that it has sufficient assets to match them. As banking regulations have relaxed (as this comic so interestingly illustrates) owner's equity accomodates for the imbalance. These assets can also take the form of ownership loans so that the amount of cash can actualy greatly excede what is required to be held on deposit even with the deposit/reserves ratio is 1!

You can imagine in days gone by when some unscrupulous banker convinced some regulator that he was just allowed 6 months at a .99:1 ratio he would quickly make up the difference through interest earned on the "missing" cash.

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If M1 is to stay unchanged, the deposits have to stay constant. So if the bank has to increase reserves, the only way that can happen is by reducing loans.

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...or decreasing owner's equity like this:

100,000,000 (loans)= 50,000,000 (costs+deposits) + 50,000,000 (owner's equity)

Now to increase loans by 100,000,000.00 you have to increase owner's equity by 100,000,000. How do you do that? You simply prorate the equity to accomodate or you "borrow" the money. So the accounting equation really becomes something like this:

Assets = Deposits + (Owner's Equity)*f, where f is some function or ratio that balances the equation - the "fudge factor". All the better if it is approved by regulators...

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Originally posted by Oliver Cromwell:
It's been established that the inflation tax is strongly regressive. The rich are able to protect themselves fairly easily against inflation, but anyone whose salaries are fixed by multi-year contracts, or who are living on incomes that are not continually indexed to inflation will see the purchasing power of their salaries decline.

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I don't think it's been established at all. There's truth to some of what you say. But let's not forget that the poor tend to be debtors, these days quite heavy debtors. Inflation reduces the value of debts. Rich people tend to be creditors and/or heavy depositors. Inflation erodes the value of those holdings. Inflation is particularly bad for banks, not among the poorest institutions in the world.
And I've noticed that in practise, it seems to be more workable for the salaries of the poorer classes to be held to zero or near-zero raises when inflation is low, producing an erosion of paychecks that's too slow to really notice. My union in specific has been victimized by this phenomenon for the past fifteen years plus, and it's something that I've seen all over. The erosion of the buying power of minimum wage is a result of this effect--in any given year, inflation hasn't changed anything by very much, so any pressure to increase the minimum wage is weak. And governments are constantly lobbied by corporations *not* to increase the minimum wage, so they are unlikely ever to do so unless pressure is very strong. When inflation is higher, it's pretty much impossible to refuse to give any raise at all--the amount being lost isn't below that threshold of perception.

Meanwhile, it's been pretty clear over the last couple decades that huge raises for the rich don't require inflation.

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But this increased purchasing is not coming out of thin air. Since we have more money chasing the same number of goods, the purchasing power of the existing money supply goes down.

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I may be missing nuances, but it seems to me that the increased money supply does not have to be chasing the same number of goods, depending on how the govt spends the new cash. If it is used to create new services that the public can purchase, then you have expanded your economy along with your money supply, and it need not have a detrimental effect.

I'm going to have to look up some studies about the redistributive effects of inflation. My original claim was based on comments by people whose opinions I respect, but I'm going to double-check. Several good points have been made, but I'd like to add a couple more to the stew:

- Most indexing is done once a year, so aside from the actual month when the indexing is done, the real value of an indexed income declines over the year. The higher the inflation rate, the steeper the decline.

- Inflation does erode real debt burdens, but the rich gain even more than the poor do there. For one thing, the poor don't have much debt to erode, since no-one will lend them very much (another reason why I don't see why increasing reserve ratios is a good idea). On the other hand, people who have multi-hundred-million-dollar mortgages to finance their property holdings end up becoming very wealthy indeed, since the inflation-fueled value of their assets goes up, while the debt stays the same. (My own personal hate figure is Donald Trump. He got wealthy by having the amazingly good luck of inheriting real estate just before the inflationary period of the 70's and 80's.)

A couple of other posts made reference to the tradeoff between inflation and unemployment, otherwise known as the Phillips curve. That tradeoff does exist, although it's only a short-run effect that lasts for about 18 months or so.

I'm generally bemused by the fact that left-leaning commentators will advocate a looser monetary policy in order to increase employment. The reason why increasing inflation increases employment is that increased inflation reduces real wages. Firms react to those lower wages by hiring more workers. The reason why the effect is only a temporary one is that when workers get a chance to renegociate their contracts, they will insist on recovering their lost buying power. And when real wages go back up to their original level, employment goes back down. Since the inflation-unemployment tradeoff is based on tricking workers into accepting decreases in their real wages that they wouldn't have freely agreed to, I have a hard time understanding why anyone who cares for the welfare of workers would advocate using such a policy instrument.

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Originally posted by Oliver Cromwell:
- Inflation does erode real debt burdens, but the rich gain even more than the poor do there. For one thing, the poor don't have much debt to erode, since no-one will lend them very much (another reason why I don't see why increasing reserve ratios is a good idea).

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Well, the middle class stands to gain a fair bit even so, if one considers that the single biggest debt incurred by working-age people tends to be their house.

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Since the inflation-unemployment tradeoff is based on tricking workers into accepting decreases in their real wages that they wouldn't have freely agreed to, I have a hard time understanding why anyone who cares for the welfare of workers would advocate using such a policy instrument.

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Although you attribute this to Keynes, it reads a bit suspiciously like Robert Lucas's "rational expectations" model.

Further, I might ask why, in the low-inflation era of the 1990s, it took forever for unemployment to come down, if you believe in the idea that a "credible" monetary policy and all the other bafflegab I get off the BoC's website will somehow magically spur production and employment, even though such aspects are investment-sensitive, which in turn happens to be interest-rate-sensitive, and with real rates higher than they have been since the 1960s and 1970s, it is not surprising that the BoC is basically blowing so much hot air.

[ 02 February 2004: Message edited by: DrConway ]

But more subtle in the suggestion is the idea that it is within the public's power to do that or anything else for that matter that would improve our general welfare, without violence or appropriation. But the economic othodoxy says that it all must be done throught the market mechanism guided by the profit motive.

This is held up as not only the best way to do things but the only "intelligent" way to do things.

[ 05 February 2004: Message edited by: DonnyBGood ]

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Originally posted by DonnyBGood:
The point is if lending large amounts of money doesn't create inflation why would printing it?

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The only real discretionary power lies with the authority to print money, so ultimately, the supply of money in Canada is determined by the Bank of Canada. Their control is not absolutely precise, but if they want to engineer an increase or a decrease in the money supply, they can do it.

This proposal does not make everyone better off; it's the equivalent of a tax on
loans. Existing spending power is shuffled around; nothing new is created.

[ 05 February 2004: Message edited by: Oliver Cromwell ]