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Now that governments have to inject billions into world banks, do you think monetary policy should be adjusted to better maintain a balance between currency in circulation and bank funds?

Name: Mick Tarel
City & State: El Cajon, Calif.

Question/Comment: The ratio between commercial bank money and currency in circulation has been widening for decades. While the Federal Reserve's monetary policy has protected our economy from runaway inflation, it may have been starving the market for currency. Now that governments have to inject billions into world banks, do you think monetary policy should be adjusted to better maintain a balance between currency in circulation and bank funds?

Paul Solman: The Fed has NOT been protecting us from inflation by "starving the market for currency." The Fed will print and coin as much currency as we, the public, demands. Remember, currency is a small fraction of the total money supply. At the moment, there is about $800 billion dollars in U.S. currency sloshing around out there. Checking and savings accounts in banks alone add up to more than seven times that number.

If "Mad Money" Jim Cramer got on television this morning and urged his viewers to go to their banks and withdraw all their deposits as currency - as he urged them, several weeks ago, to sell all their stocks - it might take quite awhile for the Fed to provide enough bills and coins to effect the move but theoretically, it could be done.

But - and this is the big conceptual "but" here - that WOULDN'T increase the money supply, or in any way stoke inflation by itself. Think about it: You take all your money out of the bank. Are you now more likely to spend it, or less? No more credit card use, unless you intend to send cash to cover your balance at the end of the month. No check writing. All cash, all the time.

The key takeaway here is that inflation isn't caused by cash, or even by how much total money there is, if you add in bank accounts and the like. It's the amount of money MULTIPLIED by how often it's used, or what's known as the "velocity" of money. In short, if there were a gazillion dollars out there, and we put it all under our mattresses, there would be massive deflation, since no one would be spending and prices (and wages) would therefore plummet.

My finance professor Zvi Bodie puts it more tersely: "The mix of currency vs. demand deposits has no economic significance."

-- Posted October 27, 2008 | Comments ( ) | Permalink