Currency, credit, confidence and bubbles

Abstract

The popular media suggest that the Federal Reserve is ‘all powerful’ in determining things like interest rates and inflation, but this is not true. The Fed controls currency and reserves – imperfectly – but the money supply is determined by the numerous decisions of borrowers and lenders to expand credit. Thus, the Fed can try to pump reserves into the financial system, but it will not result in an expansion of any monetary aggregates. Monetary policy can also lead to price bubbles. When people think of money and inflation, they usually think about inflation in goods prices. This stems from the quantity theory of money that treated the number of transactions taking place as being proportional to goods and services produced. That may have been appropriate for a society in which most transactions were indeed for goods and services, but today, the transactions for real estate and securities dwarf the transactions for goods and services. This means that the quantity theory of money needs to be rethought, and this rethinking illuminates how excess money supply growth can cause price bubbles in securities, real estate and commodities as well as traditional inflation.