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Strictly Monetary Part II: The Mechanics of Money

In Financial, Strictly Monetary: A Series on January 26, 2011 at 11:59 AM

The global system of money is going through some drastic changes. This piece explains the tools our governments have to control the money supply and the price of money. After this, we’ll be ready to talk intelligently about some of the heavier global issues.

There is no clearer sign that interest rates in Canada are going to go up than this, an announcement by the Bank of Canada Governer, Mark Carney, flat out warning Canadians to reduce their debts. Within a country, the price of money is the interest rate. For the last fifteen years, we have lived in an anomalous era where money has been incredibly cheap, abundant and accessible. The result of this has been to push asset prices up, such as real estate. As interest rates increase slowly over the next decade, it will put downward pressures on asset prices because there won’t be as much money and it will cost more to borrow it.

Higher interest rates obviously make money more expensive, but how does it reduce the amount of money circulating in the economy? Mechanically, monetary policy works in a very roundabout way.

The Bank of Canada increases the rate at which all Canadian banks borrow money. In turn, those banks will lend that money to each other and to you at higher rates. Both the personal and commercial borrowers are less likely to take loans, because the cost of borrowing has gone up. The result is that less debt is extended overall, shrinking the money supply.

That is how a free nation controls the price of its money, internally. However, raising interest rates also affects the price of the Canadian dollar externally, which is known as the exchange rate.

Foreign capital is often attracted to high interest rates. It is especially attractive if Canada raises its rates and other nations do not. This is similar to you switching banks when the new bank in town offers a savings rate of 3% while your existing bank offers 0.25%. In order to do this, foreigners must purchase Canadian dollars, which pushes the value of the dollar up globally.

A stronger dollar has yet another ripple. Because the dollar is worth more relative to other currencies, those countries will purchase less Canadian products. Raising interest rates internally makes the goods and services we sell more expensive to the rest of the world, decreasing exports. Less exports means less business, and less business ultimately means less loans because Canadian businesses don’t need additional money to finance their operations. All of this reduces the money supply in the most indirect way possible, through the reactions of the free and global markets.

The relationship between interest rates and unemployment is also evident. A hike in rates strengthens the dollar, reducing exports and the expansion of business internally, potentially leading to unemployment.

Then there’s China. Its government has full control over each component of the monetary system (quantity of money, interest rates and foreign exchange rate).  Its money supply is actually quite sheltered from free markets, despite all the trade it does with the rest of the world. When China wants to control inflation, which it has been doing for the past several months, it destroys the money directly.

For example, recently China increased the banking reserve requirements. Recall your $100 deposit and the $10 that the bank had set aside in the vault. Chinese financial institutions wake up to learn that $15 should have been put into the vault, and now they can only lend $85 rather than $90, literally destroying $5 the moment their reserve requirement was adjusted.

What about interest rates (the price of money internally)? Or exchange rates (the price of money externally)? Those too are controlled separately. China has mentioned it might raise interest rates, but unlike free market money systems, that does not affect the exchange rate unless China wants it to.

China has kept its exchange rate low against the American dollar in order to ensure that the demand for the goods it produces was sustained. The effect of that has been tremendous around the world as other countries struggle to compete against the mighty Chinese manufacturing machine. Indeed, while other countries struggle to create jobs, China has the opposite problem, trying to slow down an overheating economy.

But the global monetary system is reaching its limits. The world’s reserve currency, the American dollar, is being called into question.

When America overtook Great Britain as the world’s largest economy roughly 100 years ago, the American Dollar also supplanted the Pound as the world’s reserve currency. A switch to China’s currency seems intuitive and imminent, but of course, it’s more complicated than that.

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