Inflation, interest, and the supply of money.

Inflation, interest, broad money, base money, foreign exchange.


In Jane Austen’s novels (written nearly 200 years ago) it seems to be a truth universally acknowledged that annual income is equal to 4% of capital. For example in Pride and Prejudice, Lydia’s marriage settlement of one thousand pounds “in the 4 per cents.” is equivalent to forty pounds a year. The implication is that this is real income, and the inflation part of interest is zero.

According to a graph in Robert Beckman’s book The Downwave, the long-term trend of wheat prices in England was flat between 1260 and 1510, and between 1590 and 1940. The 20th century exception was probably due to Keynesian policies, and the Tudor one to the influx of Spanish-American silver and gold. The two other outstandingly long deviations from the mean were the high prices from about 1790 to 1820 (the time of the Napoleonic wars), and low prices about 1880 to 1910. The repeal of the Corn Laws in the middle of the 19th century didn’t seem to make much difference. There were lots of other short-term fluctuations, between about half and twice the long-term mean, but the mean price in the first half of the twentieth century was about the same as the mean in the first half of the 17th century.

The creation of too much M4L money by irresponsible banks seems to me like the influx of Spanish-American silver and gold when money was related to the gold standard. It’s self-defeating for the banks because it causes high inflation and/or low interest rates. We may now be returning to the norm of zero long-term inflation but non-zero real interest rates. At present the main cause of inflation is the reductions in interest rates because of the fear of recession, which enable higher mortgages, which cause higher land prices.

(Alison Marshall, November 2001).

Although monetary aggregates are no longer officially targeted for monetary policy purposes, analysis of these quantities plays an important role in the Bank’s regular assessment of the outlook for inflation. In its regular monetary policy analysis, the Bank primarily examines the banking sector’s sterling liabilities and assets with the UK private sector. These quantities, known as M4 deposits (M4) and M4 lending (M4L) respectively, constitute a sub-section of the banking sector’s overall balance sheet. . . .

M4 comprises sterling notes and coin and sterling deposits at, and money market paper issued by, UK monetary financial institutions (MFIs) and held by the UK non-bank private sector (known as the M4 private sector-M4PS). The MFI sector is made up of the Bank of England and other banks and building societies. Transactions that affect M4 must therefore involve an MFI and an agent in the M4 private sector. . . .

(, accessed November 2001).

Inflation followed the 1967 devaluation of the pound. Most economists thought that this would be temporary, and it was a shock when it failed to reverse.

( Brittan on Britain, The Financial Times, 28 March 2014, )

The stagflation of the 1970s, including Richard Nixon’s imposition of wage and price controls in 1971, and in 1972 unilaterally cancelling the Bretton Woods system and ceasing the direct convertibility of the United States dollar to gold, as well as the 1973 oil crisis and the recession that followed, called into question Keynesian macroeconomic policy making and the effectiveness of government intervention in the economy.

(–09_Keynesian_resurgence , accessed March 2015.)


Usury, the charging of interest, has like the Jewish people had a long history of being a scapegoat for financial and other problems. Like prostitution and alcohol, it has proved to be difficult to suppress. It was forbidden by the Christian religion in medieval times, which was why Jews were moneylenders. It is still forbidden by the Islamic religion, I think. It has been going on for hundreds of years in England, which with 2 exceptions has not experienced long-term inflation, and has been very successful and perhaps no more unjust and oppressive than most other nations. The injustice and oppression have been due to population growth and Selfish Genes, rather than usury.

I don’t see why paying a capitalist for lending his money is considered different from paying a farmer for growing food, a nurse for nursing, a musician for entertaining, etc. The amount of money that can be spent is not fixed, even if there is a gold standard and a fixed quantity of gold. Total spending equals the amount of money multiplied by the velocity of circulation. The moral justification for usury in the absence of inflation is that it is an incentive for lenders and a way of deciding who gets to be a borrower. Real interest rates are only immoral if lending and borrowing are immoral.

However there is a school of thought due to Schumpeter, that there can only be profits if there is innovation. Schumpeterian innovation theories are one of the groups of theories for explaining long-wave Kondratieff economic cycles. Others are based on investment, price, Marxism, and social structure. There isn’t a consensus about which is the right explanation, or even whether long-wave economic cycles really exist.

High interest rates may make the rich richer and the poor poorer, and ideas for preventing extremes of wealth and poverty include low or no interest rates, progressive taxation, land tax and other resource taxes, citizens incomes, and economic growth. Economic growth is not always bad, although clearly there is a lot of non-Green economic activity which we would like to disappear. If there is population growth or a depression, then there should be economic growth. But it shouldn’t be used as the solution if the rich have cornered most of the money and aren’t recycling it, or to create jobs for people who would rather be students, artists, full-time mothers, or just idle like some of the rich, but haven’t got citizens incomes or any other income to live on. Taxes on resources, and if necessary on real interest and other income, can be used to stop the rich getting too rich and to pay for citizens incomes.

(Alison Marshall, November 2001).

. . . as well as receiving interest on loans, banks pay interest on deposits. So really they are just transferring interest from borrowers to savers, though they make a profit from this service.

(Alison Marshall, February 2008).

All the clearing banks keep accounts at the Bank of England. When the banks settle daily differences between themselves in the clearing system – that is, in the exchange of cheques written by each other’s customers, or of credits moving from one bank to another – they do it using their accounts at the Bank of England. . . .

Because the Bank is the final provider of cash to the system it can choose the interest rate at which it will provide funds each day. The interest rates at which the Bank supplies funds are quickly passed throughout the financial system, influencing interest rates for the whole economy. . . . Changes in short-term interest rates are the principal instruments of UK monetary policy. Other techniques have been used in the past . . . .

(, accessed November 2001)

The new Bank of England interest rate, 0.5%, announced this week, is the lowest in 315 years. The highest was 17% in 1979. Before the 1970s the interest rate always stayed within the range 2 to 10%.

(Alison Marshall, March 2009. Data from the Financial Times, 6 March 2009).

The multiplier. (Creation of broad money).

. . . A required reserve ratio is the fraction of deposits in savers’ accounts which must be kept immediately available and not lent to borrowers. In fractional reserve banking there are two limits on bank lending. The first is the reserve ratio. The second is a limit on the total expansion of the money supply, the money multiplier, which follows automatically as a result of the reserve ratio.

If the reserve ratio is 1/10, the money available for lending is 9/10 of the deposits. Back in circulation some of this money may be used to pay back bank loans, and some may be deposited back in banks as further savings. These new deposits allow further lending of an amount which cannot exceed 9/10 of the new deposits, or 9/10 x 9/10 of the original deposits. That’s 81/100 of the original deposits. The total of all the deposits that could be generated from one unit of an original deposit by many cycles of lending, spending, and saving is 9/10 + 81/100 + 729/1000 + 6561/10000 etc.

If the required reserve ratio is 1/5, this total is 4/5 + 16/25 + 64/125 + 256 / 625 etc.
If the required reserve ratio is 1/3, it is 2/3 + 4/9 + 8/27 + 16/81 + 32/243 etc.

In general, if the required reserve ratio is R, the fraction of a deposit which is available for lending is 1-R, and the total of all the new money generated from one unit of an original deposit by all the cycles of lending, spending and saving is less than or equal to (1-R) + (1-R) x (1-R) + (1-R) x (1-R) x (1-R) etc. It can be shown mathematically that the total of this infinite series plus the original unit is 1/R. The expansion of the money supply from 1 to 1/R is the multiplier effect and 1/R is the multiplier.

So if the required reserve ratio is 1/3, 1/5, or 1/10, the fraction of each deposit which is available for lending is 2/3, 4/5, or 9/10, the multiplier is 3, 5, or 10, and a deposit of $1000 cannot be expanded beyond $3000, $5000 or $10,000 by any number of cycles of lending, spending and depositing.

If there is no required reserve ratio, R is zero and 1/R is infinite, but banks can still lend no more than the total of all the deposits in all the cycles of depositing, lending, and spending. The opposite extreme is full reserve banking, in which the required reserve ratio is 1, and banks can’t lend any of the deposits at all.

(Alison Marshall, February 2008).

Quantitative Easing. (Creation of base money).

If a central bank is to maintain a target interest rate, then it must necessarily buy and sell government bonds on the open market in order to maintain the correct amount of reserves in the system. . . the central bank buys bonds by simply creating money — it is not financed in any way.

(, accessed 8 August 2015).

The Bank of Japan . . . adopted quantitative easing . . . on 19 March 2001 . . . by buying more government bonds than would be required to set the interest rate to zero. It later also bought asset-backed securities and equities . . . The BOJ increased the commercial bank current account balance from 5 trillion to 35 trillion yen . . . over a four-year period starting in March 2001.

(, accessed 12 August 2015.)

. . . the combination of fiscal authorities and commercial banks can create all the money required by the economy. Indeed it can create far too much, potentially triggering inflation.

. . . increasing bank reserves does not force banks to lend. . . Quantitative easing . . . cannot adequately replicate the . . . effects of direct government spending.

. . . why not end bond issuance completely, and fund government borrowing requirements entirely from bank lending, as Richard Werner of Southampton University has suggested?

( )

Foreign exchange.

Fred Bethune described three examples of sectoral balances in the USA:

Clinton Era (1992-2000): The trade deficit results in the foreign sector saving. The government also saves by reducing its deficit and eventually establishing a fiscal surplus. The private sector picks up the slack by increasing its borrowing, encouraged by Greenspan’s low interest rates.
Trend: private dissaving, public saving, foreign saving.

Bush Era (2000-2008): The trade deficit is still widening, and the foreign sector is saving even more (Bernanke’s “savings glut”). The drag from the trade deficit is so bad that Bush’s large fiscal deficits and Greenspan’s low interest rates are necessary to keep the economy afloat. Trend: private dissaving, public dissaving, foreign saving.

Obama Era (2008-2010): The trade deficit is still an issue, but now the private savings rate has gone up while private borrowing has collapsed. The private sector can’t be convinced to increase its borrowing, even with interest rates at 0%. Now the public sector has to pick up the slack for two sectors, necessitating huge deficits. Trend: private saving, public dissaving, foreign saving.

( )

In the UK in the quarter-century from 1987 to 2012, the trade balance, exports minus imports, was nearly always negative, and the government balance, government spending minus tax receipts, was mostly positive.

The domestic private sector balance, private savings minus private investment spending, was also mostly positive, with two three-year exceptions, from 1987, when the sharemarket crashed, and around 2000, when the dot-com crash happened.

(Alison Marshall, May 2015. Data from Neil Wilson, ).

Richard C. Koo wrote in 2009 that under ideal conditions, a country’s economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero.

( ).

There have been four foreign exchange crises in the UK in the last 50 years: the devaluation in 1967, the IMF rescue in 1976, the exit from the European Exchange Rate Mechanism in 1992, and the current account deficit in 2014.

The current account deficit is a relatively small difference between two very large numbers. In 2014, as a percentage of national income, it was the largest in postwar history.

(Financial Times, 3 November 2015)

To improve the current account, consumption should be reduced and production encouraged. A relevant policy. . . which shifts the tax burden from labour to resource consumption . . . was favoured by the FoE in the European election campaign in 2014. ( ). Citizens incomes could be used to make resource taxes progressive. (“Red and blue reasons for a Green tax switch”,

(“Westminster election”, Alison Marshall, May 2015).

Further reading.

The crash of 2008.
Cheap money, deregulation, more cheap money, re-regulation.

Monetary sects.
Positive Money, full reserve banking, Modern Monetary Theory.

The search for a stable economy.
Land tax, protectionism, demography, Green taxes, citizens incomes.