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April 29, 2007 8:13 PM   Subscribe

So, governments control inflation (and their economy in general) by limiting how much money they print and put into circulation. But now that most transacations (and virtually all 'major' transactions) are done electronically, and that most countries aren't tied to gold anymore, how can the amount of physical cash have any effect?
posted by Kololo to Law & Government (13 answers total) 1 user marked this as a favorite
The physical printing of money isn't really relevant. When the government prints new money, it doesn't just give it to someone, it spends on things. It's the spending without corresponding revenue (a.k.a. deficit) that causes more money to be in the economy.
posted by 0xFCAF at 8:18 PM on April 29, 2007

And the expansion of the money supply, if I understand the critiques of Heinlein's "For Us, The Living" correctly, comes from banks and non-100% reserve requirements.

See also: Social Credit.

posted by baylink at 8:22 PM on April 29, 2007

It's not about physical cash, or what the government itself puts into circulation. "Printing" money is a misnomer. The government can control the money supply through interest rates which affect how much money people want to borrow. Money is created mainly by banks giving loans. When interest rates increase the price of borrowing money goes up, which makes it less attractive. People and businesses borrow less (for instance, they are more reluctant to take out mortgages), so there's less money to spend. There is therefore a drop in aggregate demand in the economy, which means there's less pressure on prices (price being a function of supply and demand, of course). This therefore lessens inflation (the increase in prices every year).

You're quite right that most transactions are electronic - physical money is less than 2% of the money supply in the economy, IIRC. That's probably diminishing. But physical or not, if it costs you more to borrow money, you'll do it less, and spend it less, therefore, voila, less inflationary pressure.

Aren't macroeconomics magical?
posted by Dasein at 8:24 PM on April 29, 2007

I'm sure more advance economists than I can expound on this, but basically, the government does not control the money supply by printing or not printing money, but by changing the amount of cash reserves it requires banks to hold against the amount they can loan out. Lower requirements = more loans = more "money" in circulation.
posted by Rock Steady at 8:26 PM on April 29, 2007

Response by poster: Baylink, uh... what does a science fiction book have to do with this question? (I haven't read the book or the critiques, but this seems odd...)
posted by Kololo at 8:30 PM on April 29, 2007

The Fed does control interest rates but it also creates new money. The primary way it injects new money into the system is by buying T-bills, using money that it creates out of thin air. That money isn't physical currency, it's electronic.

The Fed can also inject new money into the system by loaning money (that it creates out of thin air) to major banks, but I believe they prefer to buy T-bills so that they aren't accused of having sweetheart deals with particular banks.

The Fed actually holds a large portion of the national debt.
posted by Steven C. Den Beste at 8:37 PM on April 29, 2007

Rock Steady is correct that the Fed does have the ability to control how much reserve money banks are required to hold, but that is not how the Fed controls the money supply.

Dasein is correct that the Fed has the ability to control interest rates, but again that is separate from the Fed's control of the money supply.
posted by Steven C. Den Beste at 8:39 PM on April 29, 2007

As others have said... it was never about the physical money supply.

Credit creation through lending occurs regardless of the electronic (or otherwise) nature of the transactions.
posted by pompomtom at 8:43 PM on April 29, 2007

posted by Steven C. Den Beste at 8:44 PM on April 29, 2007

You could also look at the numerous previous questions on AskMe about this subject (try searching on 'Federal Reserve'), in particular this one.
posted by Chrysostom at 9:34 PM on April 29, 2007

Steven is mostly correct, except that the way the Fed controls the money supply and the way the Fed controls interest rates are the same. When the Fed buys bonds on the open market, it increases demand for bonds, thus raising the price, thus making the interest rate on those bonds lower. However, in the course of doing this, they create money out of thin air, which is what causes monetary inflation. Inflation per se is monetary inflation - change in productivity. Normally productivity goes up, so the fed can print some new money without making goods much more expensive.
posted by cameldrv at 10:16 PM on April 29, 2007

To piggyback— Anyone know how this works in countries where interest is illegal (primarily Muslim countries)? How is monetary policy regulated?
posted by klangklangston at 11:41 PM on April 29, 2007

pompomtom has the answer, cameldrv is right but isn't directly answering the question.

Where money comes from: Printing money doesn't increase the currency in circulation as much as loaning money does. Credit increases the money in circulation more than anything else.

How money is controlled: The fed influences the rates at which loans can be given, and tells banks how much of their credit they have to hold in the bank in cash.

Remember that this is an oversimplification of one side of a three sided equation... but the question is an oversimplification so I guess it's okay.
posted by ewkpates at 10:42 AM on April 30, 2007

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