But why would a country not print more money to purchase from other countries (e.g. to repay debt or to purchase raw materials). Wouldn’t the extra money then simply be dumped into the other country, leading to higher inflation in that country and not your own? Or perhaps is the answer that in dumping the extra money overseas, you are indirectly creating more money in your own territory?

Firstly, it is not inevitable that printing money will lead to increased inflation. It is more complicated than that (e.g. money supply and inflation in US)

Printing money will cause inflation if:

• Velocity of circulation is stable
• Money supply increases faster than real output

However, if you do increase money supply faster than real GDP growth, then ceteris paribus, you would expect inflation and a decrease in the value of money.

If you print money to buy goods oversees, you are effectively devaluing your currency, reducing the purchasing power of Sterling.

If the government increased the supply of pounds (by printing money), the Pound would be worth less on the foreign exchanges so you would be able to buy less foreign goods / debts with Pound Sterling. So printing money would not solve the problem of our foreign debt.

It reminds me of the experience of Weimar Germany in 1923. Part of the problem was that they were trying to pay external debts (war reparations to the Allies). One reason for printing money was to pay of their foreign debts, but this lead to a depreciation in the German Mark and domestic inflation as well.

If the UK wanted to pay off debts to Japan, I guess we could start trying to print Japanese Yen, but, I guess the Japanese would think that a bit cheeky

At least, that’s my understanding as to what would happen. I guess there’s no such thing as a free meal and printing money doesn’t have any effect on increasing real output / real income.

• Problem of Printing Money

What is Money?

Money is an object used as a medium of exchange between two parties. It can have intrinsic value like gold or it can be a universally accepted instrument such as notes and coins printed by a Central Bank.

Functions of Money

1. Medium of Exchange (can be widely accepted for payment of debt / goods)
2. Unit of Account (measure of relative worth of goods / debt)
3. Store of Value (inflation means cash tends to reduce value over a period of time)
4. Standard of deferred payment (money is used to payback debt. Closely related to unit of account.

Types of Money

• Narrow Money = cash, notes and coins. This is what springs to mind when people think of money.
• Broad Money = notes and coins + bank + building society deposits. This is often known as paper money, because it exists in accounts but banks don’t actually keep the total value of bank deposits as cash (they keep a very small %)

More Money Links

• Problem with Printing Money
• Printing Money and the value of Savings
• How to Increase the Money Supply
• Link between Money Supply and Inflation
• Money Supply and Inflation in US
• History of Money
• Broad Money
• The Ascent of Money at Amazon.co.uk
• Preview of Ascent of Money at PBS

Governments or central banks “print new money” apparently only rarely, but given the fact of almost persistent inflation throughout decades, the total volume of money in the economy must grow persistently and significantly anyway.

If a central bank lends money, does it (in normal circumstances) always only turn the central bank’s cash into central bank’s (loan) debtors? Is it really absolutely unusual that by giving a new loan a central bank at the same time also increases its assets and capital (i.e. makes a capital injection into its cash, increasing that way its cash rather than using only its old cash to give a new loan)?

Also, when we are talking about “printing new money”, does it only mean issuing new money for the government expenses rather than only for the central bank’s loans, new money being issued in that or other way anyway?

The money supply measures the stock of money in the economy.

• A narrow definition of money (M0) includes the stock of notes / coins and operational deposits at Bank of England
• A broad definition of money (M4) is notes and coins + deposits in bank accounts+ other liquid assets.

There are 3 ways to increase the money supply

1. Print more notes – usually by Central Banks
2. Increase lending of money by Banks – If banks hold a small % of bank deposits as cash, they can lend out more cash and this increases the money Supply
3. Central Bank buying government securities. i.e. Central Bank pay people in return for bonds. If the Central Bank buy Government securities (or corporate bonds) People who were holding the bonds have more money to spend.

In recent decades the money supply has been increasing because:

• Reduction in reserve ratio by banks
• Creation of new types of liquid assets which
• Increased velocity of circulation. – The number of times cash changes hands.

Link Between Money Supply and Inflation MV=PY

In theory an increase in the Money supply causes inflation (if money supply increases faster than real GDP)

However, in practise the link between money supply and inflation is weak.

One reason is that the velocity of circulation (number of times cash changes hands) is volatile – it tends to follow the business cycle. For example, in 2008, a recession in the US caused the velocity of circulation to fall and therefore money supply grew slower despite increases in the monetary base.

• Link between Money Supply and inflation
• Money Supply and inflation in US
• Questions on Money Supply

It is true, that banks can effectively increase the money supply, by lending out say 97% of all deposits.

If you deposit £1,000. The bank may keep only a reserve of 3% (£30).

This means they can lend out £970 to other people. However, this means that banks will have additional deposits in the future. Therefore, when this £970 gets deposite they can again lend out 97% of the value.

There is a fuller explanation at Wikipedia on Money Creation

In practise the money multiplier is less than the inverse of the reserve ratio – Money multiplier and reserve ratio

Effect on Inflation of Money Supply

If there is an increase in the Money supply, it could cause inflation. If money supply rises much faster than the long run trend rate of real output, then inflation is likely to occur.

see: Inflation and Money Supply

What happens if I take a £10 to the Bank of England?

If you look at a British £10 note, it says “I promise to pay the bearer on demand the sum of ten pounds”

Therefore, if the Bank of England is true to its word, you should be able to go to Threadneedle street and demand the value of ten pounds in Gold.

Of course, a ten pound note, has no intrinsic value. It is used to merely act as a medium of exchange. There was a time when the economy operated along the lines of a barter economy. – You give me six chickens and I’ll give you 2oz of gold. However, as economies developed it became a bit awkward to carry all these gold coins around. How do you barter six chickens for 3/4 of a horse? Therefore, some banks started to issue notes in lieu of actual gold. These notes meant that you could take it to the bank and exchange it for actual gold. Now, because people trusted these banks consumers were increasingly willing to use notes rather than money with intrinsic value. It was easier and more convenient. This is how notes and coins started to replace gold. The promise on a £10 note is a relic from the beginning of early notes, when it was necessary to explain what it meant. So in theory, the Bank should redeem its value for gold. In practise, I think, they would probably give you some technical reason why they couldn’t.

Might be worth a trip just to see what they say.

Readers Question: Why is the money multiplier in the under states smaller then the inverse of the required reserve ratio? Help (note: not on UK A Levels – my British readers may be relieved to know)

• The Money Multiplier refers to the amount that commercial banks can increase the supply of money in an economy. This is calculated by:
•  Increase in money Supply / Increase in monetary base that caused it

For example, if the commercial banks gain deposits of £1 million and this leads to a final money supply of £10 million. The Money multiplier is 10.

• The Reserve Ratio is the % of deposits that banks  keep in liquid reserves. (Central banks used to set a minimum reserve ratio as a way to control the supply of money)

• If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 = 20
• This is because if you have deposits of £1million and a reserve ratio of 5%. You can effectively lend out £20 million.
• However, it is possible that if you have a reserve ratio of 5%, the money multiplier may be smaller than 20. This could be due to a number of reasons:

1. Currency Drain Ratio. This is the % of banknotes that individual consumers keep in cash, rather than depositing in banks. If consumers deposited all their cash in banks, there would be a bigger money multiplier. But, if people keep funds in cash then the banks cannot lend more
2. Safety reserve ratio. This is the % of deposits a bank may like to keep above the statutory reserver ratio. i.e. the required reserver ratio may be 5%, but banks may like to keep 5.2%.
3. It might not be possible to lend more money out. Just because banks could lend 95% of their deposits doesn’t mean they can, even if they wanted to. In a recession, people may not want to borrow, but they prefer to save. Therefore, the banks end up with a higher reserve ratio than is the profit maximizing point.

Therefore, due to these and other factors, the reserve ratio is often just theoretical. Banks may not lend out as much as is theoretically possible. Therefore, the money multiplier is less than the theoretical prediction.

(disclaimer: It is a while since I studied this topic, I had to look up some textbooks. It is not taught for UK A Levels)