Introduction
According to the New Keynesian view Money does not matter in the long run, but it does matter in the short run. This refers to the idea that printing money cannot lead to long-term economic growth, but it can lead to short-term economic growth.
Put another way, in the long- run printing money as a stimulus to the economy won’t produce jobs, just inflation. But is this theory correct?
Table of Contents
What is money and Who Makes it?
We use Fiat money; this means our money has no intrinsic value other than the fact that we as a society agree to believe it holds value. In the New Keynesian view of the world there are two paths to the creation of money. First the government ‘prints’ money which it injects into the economy either by directly funding new infrastructure projects or by using it instead of tax revenue to pay for civil servants, social security benefits and other ongoing daily government expenditures.
The second is done by the banks and is called ‘fractional reserve banking’. The idea is traditionally explained with a simple example. Imagine a bank starts trading for the first time and it gets its first depositor. They deposit £100 in the bank. The bank knows that on any given day they will never want to draw down on more than 5% of their savings and so lends out the other £95. The £95 of lent money will then be spent and finds its way back into the bank’s deposit system (assume it is the only bank in this make-believe world). The bank now has another £95 in deposits which it can lend out 95% of to new borrowers.
The cycle repeats itself until by the end the banks have ‘created’ a huge amount of money via debt (in our example there would be twenty times the original amount deposited if banks only had to hold a 5% reserve). This is an important pillar of New Keynesian Economics, but is again completely wrong and unrelated to how real-world banking occurs.
The Fractional Reserve Banking Fairy Tale
Fractional Reserve Banking sounds nice in principle, but banking is more sophisticated than this. Banks do not need deposits from customers to lend money. Banks are part of the banking system, and they can borrow money from the central bank at will. The central bank will charge them interest on the money lent, but this will normally be less than the interest the bank charges the customer. That means that a bank could have no deposits and still make a loan to a customer. Once it has made the loan it would then borrow money from the central bank if it failed to meet its minimum reserve deposit requirements. This all happens automatically and is how the banking system is designed to operate. The key point to understand is that banks do not need customer deposits to make loans. This conceptual error seriously undermines New Keynesian Economics.
Core New Keynesian Belief – Money Does Not Matter in the Long-run
What do I mean by the idea that money does not matter? Well what we really care about in macroeconomics is the standard of living that people have. So, we judge the prosperity of a society based on the quality of material goods and services people can buy. These are called ‘real’ variables, so talking about a new Ford Fiesta is a real variable. Talking about a £20,000 car is a ‘nominal’ variable because it’s expressed in terms of money. Why does that matter? Well real variables do not change in value, but money does. If there is severe inflation, or even hyperinflation, then £20,000 may not buy a Ford Fiesta, it may only buy you a toy car.
New Keynesian’s believe that in the long-run, if the government prints money it will just increase the price of everything. So, if the government doubles the money supply, in the long run the prices of everything will double and there will be no change to the real variables that determine people’s standard of living. Hence, Money does not matter in the long-run when it comes to trying to figure out how to improve the standard of living in society. However in the short-run it takes time for people to realise the money supply has doubled and for prices to rise, which is why printing money can effect economic activity (and hence standards of living) in the short-run. New Keynesian’s can make this claim in the long-run because they assume the economy is at full capacity. This assumption plus some algebra leads to a proof that printing money leads directly to inflation.
Boring Math – Quantity Theory of Money
Money neutrality is the official name given to the idea that printing money can’t produce real economic benefits in the long-run, and instead just leads to inflation. The idea is formerly underpinned by an equation called the Quantity Theory of Money, written below:
Money (M) x Velocity (V) = Price (P) x Output (Y)
First let’s understand the terms:
- Money – this is the amount of money in circulation, and is usually the sum of hard cash and current account deposits
- Velocity – this is the amount of times on average that an individual pound gets spent in a year. For example, if GDP is £300 and there are only £100 in existence, then each pound will have a velocity of 3 (i.e. it gets used 3 times in the given period)
- Price – This is the average price of a good.
- Output – Is the number of Transactions that take place in a given period
So, if the economy heats up and people start spending more money, the quantity theory of money tells us what variables might change. For instance, if there are more transactions (i.e. output is bigger) then either the amount of money or it’s velocity will need to change to allow the equation to balance (assuming prices don’t change). However New Keynesian Economists add some key assumptions to this equation in the long-run:
Key Long-run assumptions:
- Velocity is fixed in the long-run. This is a major simplification as velocity fluctuates quite a bit in the real world
- Output is fixed. Remember that key assumption made throughout the long-run, that the economy is at full capacity? Well it leads to major implications and this is one of the most critical. The factors of production determine the level of economic output and they are always at full capacity, so we know what economic output will be for a period
Putting it All Together
Two of the four variables (velocity and Output) in the Quantity Theory of Money Equation are now fixed by the above assumptions. Note a horizontal line over a letter denotes that it is fixed.
M x \bar{V} = P x \bar{Y}
This leaves just Money and Price as variables that can change value. So, an increase in the money supply must lead to an increase in Price once these assumptions have been made. And as increasing prices lead to inflation, we see how New Keynesian’s reach the view that printing money will cause nothing but inflation in the long run and bring no economic benefit.
Closing Thoughts
I hope it’s clear that the ‘mathematical proof’ that underpins the strongly held belief that printing money leads to inflation is built on assumptions that are mostly not applicable to the real world. Velocity of money is not fixed, and more importantly the economy is almost never at full capacity. If we remove the assumption that the economy is at full capacity and output fixed, then an increase in the money supply could lead to either higher prices or higher output, or some combination of both.