Money isn't really money

Yesterdays’ headline financial news was that the U.S. Federal Reserve Bank raised interest rates because of concerns about inflation. Higher interest rates will affect us here in the Commonwealth just as much as it affects the mainland United States.

What do interest rates have to do with inflation? The answer is simple: Money isn’t really money. See?

What is money, anyway? Surely economists–who can’t seem to agree on anything–will agree what money is, right? Sorry. A few definitions of money have been cooked up.

“M1,” for example, is the “tightest” measure of money. This includes money the way we usually think of it (coins and bills, collectively known as currency), plus deposits in checking accounts. “M2” is M1 plus deposits in savings accounts. M3 is M2 plus heavy institutional deposits and time deposits. (There are other elements involved in these measures but you get the point).

So far, so good. We don’t even know what money is. Not a comforting thought.

Moving from the what to the how, how is money related to inflation? When you increase the supply of money, it causes prices to rise. Think of it this way: if the tax rebate computer hiccuped and sent everyone in Saipan a check for $1 million, we’d all be lined up at the car dealer the next day wanting new cars. But there are only so many cars on the lot, and the prices would be bid up.

You can see, then, that if you can control the amount of money in an economy, is gives you a good degree of control over price levels, the change in which we call inflation (or “deflation” if the prices are going down). And this brings us back to the issue of what money really is.

As you can see from M1, M2, etc., a lot of money is really balances sitting in bank accounts. Here’s something to keep you awake at night: your bank does not have enough cash in the vault to cover everyone’s deposits. So does the bank’s headquarters somehow have all that money stashed away safely somewhere? No. So where is it? It’s nowhere. It doesn’t really exist; your money is simply a digit in a computer, mere ink on your monthly statement.

Which means that banks can create money out of thin air by making someone a loan, simply by putting more digits in someone’s account. And that’s exactly what they do. There are all sorts of rules about how they do it, but why trouble our minds with such esoteric matters right now.

When you think of your smiling banker making a loan, you know why he’s grinning: he’s charging you interest. Interest is the price of money, or at least the price of borrowing it. Like anything else in life, if you raise the price, you’ll reduce the amount sold. So if you raise the interest rate–the price of money–you’ll reduce the amount of money borrowed. Which means that less money will be created by the loan process.

Which brings us full circle to the interest rate thing. By raising rates, the Federal Reserve will reduce the amount of money created by banks making loans, which will reduce the supply of money (from what it would have been if interest rates weren’t increased), which will reduce inflationary pressures.

So if you’re trying to get a car loan or a bank loan now and you’ve noticed that it’s going to cost you more, relax. Just think about how you are playing an important role in this magical economic process, and why worry about money anyway? After all, we still haven’t figured out exactly what it is.