We Have An Elastic Money System. There Is No Fixed Quantity Of Money

Professor Perry Mehrling discussing the difference between disciplined and elastic monetary systems. A fixed quantity system imposes a lot of discipline on the economy, and potentially prevents mutually advantageous trades from happening. Elasticity helps the system expand and contract with demand, so that when money is needed to facilitate business, it is created from thin air, and when it is no longer needed, it disappears.

In the modern economy, this especially takes the form of bank money. The money in your account at a bank was not created by the government, but is an IOU of your bank to you (which is convertible on demand into government money). These are created when the banks make loans or when the government spends, and destroyed when loans are paid back or the government collects taxes.

There are many believers in the "Quantity Theory Of Money," who look at the equation PT = MV (P - Prices, T - Transactions, M- Money supply, V - Velocity of money), and think that the quantity of money determines the prices and number of transactions. This might be close to true in a pure discipline system with no credit, but that isn't the system we have (and one might argue that such a system is not possible). In an elastic money system, the causation goes the other way: the prices and number of transactions determine the amount of money in the economy, which can expand and contract as needed.

This is true both for the bank money created by banks, and government money. In order to keep a fixed relationship between the two, so that $1 in your bank account is actually worth $1 of government money, and to maintain a stable interest rate, the government (more specifically the central bank) must accommodate the needs of the public for money. When the banks create a lot of money they require more government money to facilitate their payments. And, when banks are contracting their own money they require less government money and prefer higher returning assets. The actions of the central bank cause the supply of government money to expand or contract along with the banks', though not necessarily at a fixed ratio.

(If you think this through, it should tell you something about how hyperinflations happen: it's not the case that relentless money printing by the government forces up prices. Rather, prices are forced up due to economic conditions, such as destruction of fertile farmland leading to a fall in the supply of food, and then the money supply expands elastically to meet the needs of the public for more money to pay ever-rising prices.)

If you aren't sure how balance sheets work, here's an intro:    • What is a Balance Sheet?  

Watch this to learn more about endogenous money:    • Minsky: Banks Create Money Endogenously, M...  

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