Money and credit

Readers Question: In simple terms what is the difference between credit and money?

Credit

Credit is any form of deferred payment. For example, if you purchase on a credit card – a bank effectively pays on your behalf – anticipating you will pay back the amount to the credit card company in six weeks time.

If a bank lends money to a consumer, this is a form of credit. The consumer is given money, which it later has to pay back to the bank.

Money

Money is any item or electronic record that can be used for the purchase of goods,  provide a store of account, and can be used as a medium of exchange.

If you buy on a debit card, you are using actual money in your bank account. You have a certain amount, and once your bank account is depleted, you can’t spend any more money. People will accept your money as legal tender in that country.

difference-money-credit

Example of difference between money and credit

If you buy on a credit card, the amount you can spend depends on the generosity of your credit card company. For example, you may spend £3,000 on credit (money you may or not have). However, the credit card company may decide to increase the amount of credit that it gives you, it can increase your credit card limit to £5,000 and more credit is created. But, you have to pay this back. This credit is not negotiable; you can’t go to a shop and directly offer them some of your credit card limit.

You can’t increase the amount of money you have (without earning it), but you can increase the amount of credit you receive – if banks are willing to lend it to you. In this sense, you could think of money as more tangible, and credit is more intangible.

As a youngster, you will be told ‘money doesn’t grow on trees’. You can’t personally create money out of thin air.

But credit in a way can be created out of thin air. If a bank decides to lend you more.

Read moreMoney and credit

Velocity of circulation and inflation

Readers Question: When does velocity of money pick up and why will it? Clearly, the reason US inflation worriers have been wrong so far (NB). Is it confidence or policy?

The velocity of circulation / velocity of money refers to how frequently the money stock in an economy is used in a given period.

In the basic money supply equation, we have MV=PY

  • M= Money supply
  • V = Velocity of circulation
  • P = Price Level
  • Y = Income (in other versions, T also used for transactions)

If there is £1,000bn of money in the economy, and the total value of transactions in a year is £1,000bn, then the velocity of circulation is just 1.

If the total value of transactions rises to £3,000bn, this means the £1,000bn of money stock is being used three times in an economy. This gives a velocity of circulation of 3.

Quantitative easing and a fall in the velocity of circulation

monetary-base-cpi

Blue line is the monetary base (one form of money supply). This surge in the monetary base has had no effect on inflation.

During the period of quantitative easing, we saw a big rise in the monetary base, but, inflation didn’t increase. The reason for this is that people didn’t want to spend this extra money. To be more precise, banks didn’t want to lend this extra increase in the money supply, they just kept bigger bank reserves. Therefore, the money supply didn’t filter through to the wider economy.

Velocity of circulation

m1-velocity

The Green line shows a fall in the M1 velocity of circulation at the start of 2009 (wiki)

This is to be expected in a recession. Banks reduce lending, consumers reduce spending, and there is a rise in saving. Therefore, the velocity of circulation falls. This explains why a rise in the money supply doesn’t cause inflation (which it might if the economy was at full capacity)

Read moreVelocity of circulation and inflation

Why did printing dollars not cause a fall in value of the dollar?

Readers Question: Economic theory says that when Quantity (Q.S) increases Price (P) should ordinarily fall. After the 2007 crisis in the USA, the FED pumped billions of Dollars into the economy through QE. However the price of dollars, interest rate has not only fallen lower, but is closer to zero as of today ( 2016). How do you explain this?

It is true that since 2007, the Fed has increased the money supply, but there has been no collapse in the dollar, and inflation has stayed very low.

You might expect increasing the money supply would cause a lower value of the dollar. A simple supply and demand diagram.

increase-supply

Traditional economic theory states that ceteris paribus increasing the money supply will lead to inflation and a fall in the value of the currency. However, this makes assumption about the state of the economy.

Why has the dollar not fallen during this period of low interest rates and quantitative easing?

1. Dollar relatively stronger than other currencies.

In normal economic circumstances, low interest rates in US and Q.E. would cause  a fall in the Dollar. However, most other major economies are seeing a similar situation of ultra low interest rates and quantitative easing. In the case of Europe, there are great concerns about the state of the Euro, and Eurozone economy, making Euro weak. A currency will fall if interest rates are relatively lower than elsewhere.

Trade weighted dollar index

Even the prospect of a rise in interest rates from 0.5% to 1.0% have been a factor behind strong rally in dollar since 2014.

In recent months, many oil exporting countries have seen oil prices plummet and therefore their currencies have struggled. The dollar if anything, benefits from weak oil prices.

2. The increase in the monetary base has not led to same increase in broad money supply

Money supply

The sharp increase in the monetary base, caused by the action of the Fed.

Read moreWhy did printing dollars not cause a fall in value of the dollar?

Money Supply in the credit crunch and recession

Question: re: article on the great recession. How did the money supply affect the credit crunch and recession?

Firstly, we can look at the statistics for the money supply growth rate in the UK.

m3-m4

Source: Bank of England

This shows strong growth in the broad money supply in the years leading up to the credit crunch. – An annual growth rate of 10%. By 2010, broad money supply growth had become negative. This is a result of the fall in bank lending we saw in the recession, and the corresponding effect on broad money supply growth.

Did money supply growth play a role in the credit boom? The main issue was the rise in bank lending, and the type of unsustainable bank lending. The growth of the broad money supply didn’t give a clear sign of an underlying boom. If you look at the money supply from a historical perspective, it has always been difficult to see an easy link between the money supply and the rest of the economy.

Broad money supply over past 100 years.

UK broad money supply

source: Bank of England

 

Money Supply in the credit crunch

This first graph suggests that at the heigh of the credit crunch 2008 to May 2009, the money supply was rising at a fast rate, which you wouldn’t expect. This is true, but it only tells half of the story.

Money supply and velocity of circulation

The money supply is the stock of money in the economy. However, it is also very important to know the velocity of circulation of money. The velocity refers to the amount of times this money changes hands in a year. The velocity of circulation has been in long-run decline because of various changes to financial sector. But, in the credit crunch, the velocity fell sharply.

Read moreMoney Supply in the credit crunch and recession

Money Supply, Bank Lending and Quantitative Easing

Since 2009, the Bank of England has been authorized to create £375bn of assets by the creation of central bank reserves. This new money has been used to purchase government gilts.

Bank of England Holding gilts
The Bank of England’s holding of gilts. More on Bank of England’s asset purchase scheme at B of E

The theory is that by creating extra money and buying gilts from financial institutions, there would be an increase in the money supply and increase economic activity.

Read moreMoney Supply, Bank Lending and Quantitative Easing

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