Dwarf Printing

I know its hard for people without an economic back ground to understand why printing money may not devalue the
dollar or increase inflation. Applying micro economic examples that is how you run your house hold accounts to macro economics just doesnt work

The US economy is very weak. Gross domestic product fell heavily in the December quarter and is likely to have fallen further in the present quarter.

This week the US Federal Reserve’s open market committee met and decided it wanted to ease monetary policy further so as to stimulate borrowing and spending (demand).

There was just one problem. It had already reduced its official interest rate (the federal funds rate) essentially to zero. And once interest rates are at zero they can’t go any lower.

So the Fed announced its intention to buy up to $US300 billion (0 billion) worth of longer-term US Treasury bonds over the next six months. It would buy bonds that had already been issued and it would pay for them simply by depositing money in the accounts of the banks from which it bought the bonds (or, if the seller wasn’t a bank, it would credit the seller’s bank’s account with the central bank, and then the bank would credit its customer’s bank account).

In other words, it would pay for the bonds by creating money out of thin air - something only a central bank can do. It would be the modern equivalent of printing $US300 billion worth of bank notes.

Early this month the Bank of England’s monetary policy committee decided to cut its official interest rate to just 0.5 per cent, but also to purchase £75 billion (0 billion) worth of government bonds over the next three months.

The purchase would be covered by "the creation of central bank reserves" (no prize for guessing what that means).

.The Fed’s big purchases of long-term government bonds will put upward pressure on the prices of those bonds, thus automatically forcing down their yield (interest rate).

in America and some other countries, most home loans are at rates fixed over the 25 or 30-year life of the loan. This means the interest rate charged on home loans tends to vary in line with long-term government bond rates.

This, in turn, means that mortgage interest rates haven’t fallen all that much in the US, even though the Fed has slashed its official interest rate to zero. So people with home loans haven’t had much relief (which they get by renegotiating their existing home loans, something they can do without penalty) and home loans haven’t become much more affordable to new borrowers.

But now, you see, the Fed’s purchase of long-term bonds will, by forcing down the yields on such bonds, have the effect of lowering mortgage interest rates.

This will be the main stimulatory effect of the quantitative easing, and that’s exactly why it was done.

This week the Fed also announced its intention to purchase up to $US100 billion worth of the bonds issued by Freddie Mac and Fanny Mae and up to $US750 billion worth of mortgage-backed securities that had been guaranteed by those two government agencies.

These purchases will "increase the size of the Federal Reserve’s balance sheet" - that is, they too will involve the equivalent of printing money. And their objective is the same: "to provide greater support to mortgage lending and housing markets".

But why won’t all this extra money in circulation add to inflation? Well, in normal times it would. Extra money should add to nominal demand and when the demand for goods and services isn’t far apart from the supply of goods and services that should put upward pressure on the prices of goods and services.

But these are far from normal times. America, Britain and the world are in a severe recession, one so bad the International Monetary Fund has dubbed it the Great Recession.

So demand in these countries is very weak and falling far short of supply - which is why unemployment is shooting up and factories have much spare capacity - meaning the risk of price rises is low.

Indeed, the big worry in these countries at present is the very opposite of inflation, the risk of deflation. Deflation means widespread and continuing falls in prices. Why would you get prices falling across the board? Because demand is so weak relative to supply.

Falling prices may sound nice, but in reality are very bad. It means the economy gets locked in reverse. When people get used to falling prices they become even more reluctant to spend because everything will be cheaper next month.

When firms have to keep cutting their prices to match the competition they stop investing in new equipment or expansion. If they can’t cut their employees’ wages they lay them off.

And while all this is happening the real value of people’s debts is rising (not falling as normally happens) thus increasing the burden.

If all the money created adds to demand (and Japan’s experience in the 1990s suggests it may not) the effect will be to reduce th
the effect will be to reduce the risk of deflation, not to increase the risk of inflation.

That’s why those countries’ central bankers are prepared to do it, and why most economists have applauded, rather than decried, their actions.