In a recent post, I pointed out that government spending is limited by inflation, not revenue. You might ask, “so what? don’t federal budget deficits and inflation rise together?” Well, not necessarily. There are times when other conditions can affect inflation other than the federal budget.
Currency Destruction: If physical currency is destroyed or lost, that means it can no longer be used. That results in less money in circulation. Since there is less of it, it means the value of it rises. If money is more valuable, then prices drop which means deflation. Therefore, if someone just burned a whole pile of cash it would cause deflation. Since only 6 to 7 percent of our money is physical currency, I doubt this would ever happen in a large enough amount to have a measurable effect. However, some of the following items will.
Personal Savings: People hoarding cash has the same deflating effect as destroying cash. The only difference is that eventually the cash will eventually be brought back into circulation. However, until it is brought back into circulation the effect is deflation. Whether or not the cash is hoarded by putting it in a cookie jar at home, or by putting it in the bank, it can cause deflation.
Confident consumers can have an effect on inflation. If a lot of loans are taken out it creates a lot of bank money. This can have an inflating effect completely independent of any federal budget deficits.
A financial bubble or a bubble in any other sector of the economy becoming overly inflated can have an effect on the over all inflation rate. While the bubble is forming a lot of extra bank money is pumped into the economy, inflating the supply of money. Then, when the bubble bursts a lot of people default on their loans and that bank money disappears which causes deflation. Both of these things can happen independently of any budget deficit or surplus.
Notice that all of these are things are results of decisions by consumers and decisions and cannot be directly controlled by federal spending decisions. In other words, to keep inflation low and steady requires government policies to react to the private market. Right now that mostly happens with the fed controlling the interest rates, but that doesn’t mean there aren’t other inflation regulating options out there.
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I do not know if I would say that putting money in the bank necessarily causes deflation as that money is used actively on the market. Although banks offer services other then lending to make money, but to make things simple: If you take out a loan at a bank that I have money in, part of my money is used to cover the loan. This means that some of my money is not just arbitrarily sitting in a bank collecting dust. I am not saying that what gets put in and taken out is the same; I am just weary on it causing deflation.
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True, part of your money would be used to make that loan, but your money being there is not a requirement for that loan being made. Thanks to the Fed always acting as the lender of last resort, banks don’t need to rely on it’s deposits to make loans. The bank may use your money because it’s slightly(very slightly) cheaper than borrowing from the Fed, but whether or not your money was there, new money is going to be created from the new loan.
You can look at it two ways. One: your money sits in the bank collecting dust. Two: your money prevents the federal reserve from creating new money. In both cases, as long as you aren’t spending it for an extended period of time, you are temporarily taking money out of circulation.
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You bring up good points, but aren’t banks required to keep a certain amount of assets on hand, and wouldn’t they rather borrow from other banks to meet such demands so they are not in debt to the Feds.
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Banks are required to hold 10% dollar reserves for all demand accounts, such as checking accounts.(Assets are another issue)
Banks would rather borrow from each other. Every night banks try to put all their money that they aren’t required to hold in reserve into an interest bearing account. Banks with excess reserves offer dollars to banks who need reserves in exchange for interest. However, that doesn’t mean that banks don’t still borrow from the fed. If no banks are willing to part with their reserves, but there’s still more banks that need dollars for their reserve balance, the fed will loan it to them as long as they have the assets to back it up(i.e. your loan).
That paragraph, at least, is the simplistic way of looking at it. All of this actually happens via the U.S. bond market. The reality is that banks usually spend all day everyday buying and selling U.S. treasury securities to and from each other, and to and from the federal reserve. The federal reserve controls the overnight interest rate by buying treasuries when the interest rate is too high(which puts more dollars into the banks), and sells treasuries when the interest rate is too low(and takes money out of the system).
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Good to know, thanks!