By manybanking.com Staff
One of the main responsibilities of the nation’s central bank, The Federal Reserve, is to manage the country’s money supply. The current recession has led to a major contraction of the money supply, which (among other things) is preventing a recovery.
In order to get banks lending, people borrowing and overall spending to increase, the Fed has tried to increase the money supply by lowering interest rates. Currently, interest rates are close to zero and the economy is still lagging.
So, what’s left to do when The Fed cannot possibly lower interest rates any further? Print money! The concept of “printing money” is a colloquial term for quantitative easing. Quantitative easing is a mechanism by which The Fed can inject more money into the economy, virtually out of thin air.
Printing money is not done literally by firing up the printing presses. Of course though, the government does print physical money to replace old currency it removes from circulation, however. These days the central bank prints money electronically by buying up securities in the open market, lending new money to private banks and/or buying assets from banks. The money is then credited to private banks. Theoretically, the private banks then use this money to create more money through lending. That process then adds more money into the economy.
The main problem with printing money is the danger of inflation. Inflation occurs when money in the system increases and the supply of goods and services does not increase at the same rate. For example, take a simple system in which there are one million goods. If there were $1 million in that system, then the goods would even out to each be worth $1. If, however, suddenly the money supply doubled to $2 million without the number of goods increasing, then the price of each good would double to $2 as well. Each dollar will have lost 50% of its purchasing power.
In order to mitigate the threat of inflation, when printing money, the government must attempt to strike a balance. This is extremely difficult because so many factors affect inflation and the value of the dollar. Critics of quantitative easing warn that inflationary effects can occur years down the road in the form of double-digit inflation. Broad inflation and devaluation of the U.S. dollar can have massive implications on the U.S and world economy and seriously threaten the U.S. dollar’s role as the reserve currency.
Proponents, however, stress that deflation is the current danger. Because of the credit crunch, the value of the dollar has increased as prices have fallen. Wide distrust among lenders has caused the money supply to dwindle. Lowering the cost of borrowing money has been ineffectual and consumers are afraid to spend money for fear that the economy will get worse. The danger of deflation is in the cycle it creates. As prices fall, bankruptcies and unemployment increases, which ultimately contributes to more deflation. Many believe there is no other option but for the Fed to “print money” and hope it spurs spending. Most agree, however, that there are no guarantees.