Debt Leads to Growth – How Monetary Policies Work

How Money is Created

For a country’s GDP to grow there needs to be economic expansion, which means people must earn and spend more money. But in order for additional money to exist somebody has to create it first. That’s where you and I come in. 🙂 Money is created whenever we borrow money from a bank. When we take out a $1,000 loan, for example, $1,000 of bank credit is instantly created which we can cash out and spend, which adds $1,000 into the existing currency supply in the economy. This $1,000 did not exist in the world yesterday, but it does now because we created the money by borrowing it into existence. This increases the country’s nominal economic output. Nice. 🙂  Most of the world’s money today is created this way. Even though we are now $1,000 in debt, the nation overall is better off because our extra spending just becomes income for other people.

The opposite phenomenon can also happen. If we pay off our $1,000 loan then that money would cease to circulate in the economy and be destroyed forever through debt cancellation. This is deflationary and is what every Central Banker in the world wants to avoid. 😕

Monetary Policies

Generally if the money supply is growing then the economy is seen as healthy. More currency flowing around means more economic activities, which means more jobs, higher disposable incomes, positive inflation, and more money for everyone to save. But if the money supply is shrinking then the economy is slowing down. Too much of one or the other can have negative consequences on people’s lives so most central bankers use monetary policy to find a happy balance between inflationary and deflationary pressures by controlling the supply of money in circulation. 🙂

Interest Rates

The most common way to control the supply of money is through interest rate policies. At lower rates people are inclined to assume more debt because the cost of borrowing is cheap. The more money people borrow the more currency will be created which increases the overall money supply. On the other hand higher interest rates will stall economic growth and inflation. So if borrowing gets out of hand then making it more costly to borrow will encourage people to pay down their debts rather than borrow more money.

Printing Money

When interest rates are at zero however and can’t drop any lower central banks will often introduce newly created money into the economy. Both the U.S. and Japan have done this already, and Europe is planning to do the same soon. When consumers in the U.S. prioritize paying down their debts rather than borrowing more money they are destroying the currency supply. This increases the value of the currency and makes the country less globally competitive. The Fed desperately wants to deter a drop in the money supply so it has printed its own money several times since 2009. The U.S. dollar is just like any other commodity. The less of it there is the more desirable it becomes.

Since the last recession Americans are trying to get out of debt while Canadians continue to pile on more. The Fed, in the U.S. has injected trillions of dollars into the economy to combat the immense deflationary force of money supply reduction caused by average Americans paying down their debts.

However, the Bank of Canada doesn’t need to print money. Canadians are already borrowing and creating enough new money to grow the economy organically. And the large commercial banks are more than happy to facilitate our appetite for debt. Canadians now owe over a trillion dollars just in residential mortgages. No wonder our banks are more profitable than ever. 😐 With so much dough already being created there is no need for the Steve Po to print any mo! 😉

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Random Useless Fact:

Although known as a classic French dish, the quiche originated in Germany.