In Lesson 18, we talked about the flow of money and how an investor can take advantage of rotating the same dollar over and over to compound returns. This principle mimics the actual circulation of money within an economy which affects inflation, interest rates, and policy makers decisions. Money circulation is driven by consumer spending, the issuance of government bonds by the treasury and purchase of those bonds by financial institutions and the central bank, and the printing of money by the central bank. Where exactly does money come from and how is it regulated?
Let's start simple: the definition of money.
Money in an economic sense is defined as the combination of "currency" and "liquid deposits", liquid deposits being the biggest portion of this equation. Money is a unit of account, a storage of value, and is universally accepted as a means of transaction to eliminate the need to barter. Of course there are many currencies that exist around the world, but broadly speaking it is used for the same purpose every around the world: to transact.
In an open market operation such as the Canadian economy, there are four major players at the table:
1) Central Bank, or Bank of Canada
2) Treasury (Government)
3) Banks or other financial institutions
4) The People
The Treasury issues government bonds and sells them to banks or financial institutions at an auction. In exchange, the institution lends money to the Treasury for this bond. The banks will now sell these borrowed bonds to the Bank of Canada. The Bank of Canada will buy these bonds, which results in a liquidity injection, or money creation, or "New Money". Financial institutions also sell government bonds to The People, which is a form of private economic activity. However, a central bank may loan the government or treasury money in exchange for government bonds. In other words, the central bank will print money. Money is printed to replace old notes, and to sustain the cash flow needed for a growing economy. A common misconception is that money creation is the result of a central bank printing money. Printing money is totally different (and is bad!) which actually devalues a currency and results in hyperinflation. Money creation is the New Money injected into the economy through the purchase of bonds by a central bank from a financial institution as mentioned earlier. The figure below summarizes open market operations in Canada:
Figure 1: Open Market Operations - Cycle of Money
In recessionary times, to inject money into the economy, the central bank will purchase government bonds from financial institutions to create New Money. This is a form of Quantitative Easing, or QE. During slower economic times, the central bank will put downward pressure on interest rates, which increases money supply. When interest rates are low, demand for deposits is higher. Going back to the money equation, assuming currency value stays the same, an increase in demand deposits will increase money supply. The opposite is true in increasing interest rate environments when economies are in inflationary periods. Central banks will raise interest rates to curb inflation and decrease money supply to stabilize currency inflation. More information around changes in currency valuation is described in Lesson 18.
Having an idea of how money flows through an economy will hopefully give a better understanding of why inflation occurs and why central banks regulate interest rates in a particular direction. Making sense of and anticipating rate movements, currency valuations, and resulting economic decisions can prepare oneself for his or her own future investing decisions, and the timeliness surrounding such decisions to ensure optimal returns.
Don't be a stranger to the cycle of money considering you are already a part of it.