News

How exactly does a central bank use their monetary instruments to increase and decrease money supply?

There are two ways to increase or decrease a money supply. The first way is to print or destroy currency. We have seen that it is the intention of the CBI to destroy currency. I cannot imagine that there is anyone on the forum who will miss thispoint: destroying bills lowers the amount of currency in circulation, thereby lowering the total money supply. This is very basic.

The second way to affect money supply is through what is called monetary policy. This policy affects the deposits in the banks. If the reserve bank (CBI) has a liberal monetary policy it makes it possible for the banks to lend against the deposits of its clients for a minimal cost (interest rate). Another way to affect the amount of depositors money that gets invested by banks is by placing higher “reserve requirements” on the banks. I have already noted that most countries in the world use what is called a “fractional reserve requirement” system. This means that if, for example,a bank holds $1 million in deposits and has a 10% reserve requirement, they can lend out another $9 million on those deposits for investments. The affect of this is to increase the“electronic” component of a money supply. Currently Iraq has a very restrictive policy on this and requires either 100% reserves (thanks to Chaper 7) or nearly that amount. This has a severe dampening affect on investment lending and also limits the total supply of money in the country.

In the case of Iraq, then, the money supply is controlled by the amount of actual currency, and the amount of electronic currency. We have seen that the intention of the reserve is to eliminate all large denominated notes. Since that consists of nearly ALL notes in existence, the reduction will approach 25 trillion dinars before the end of this year.

At the same time, however, the CBI will introduce smaller denominated notes to allow commerce to continue. Using the CBI’s own numbers we will expect them to produce 1/1000th the amount in small notes as existed in large notes [they have actually been printed since 2004]. Therefore, by the end of the year the money supply of physical currency should be around 25 billion dinars (1/1000th of 25 trillion). This is consistent with what would occur in a LOP but it is not a LOP in this case. Furthermore, this amount, according to his calculations, is consistent with a revalued value of the currency at $2.60 per dinar or greater, even up to $4.00 or more.

As the economy completes the adjustment from a “physical currency” situation and enters into a more “electronic currency” situation through banking and investment by the banks in various projects we should see the “hidden” money supply increase. I am confident that theCBI is not only aware that this is necessary but that it also will welcome this growth in the money supply.

In short, after the large denom notes are withdrawn, the money supply will fall precipitously to 25 billion from 25 trillion dinars. Then as fractional reserve banking begins it will rise in proportion to the growth of the economy through electronic banking.

We know that this process is already taking place. The CBI announced last week that 70% of the large notes had already been drawn in and destroyed, so the current money supply is now only about 7.5 trillion dinars.

Historically, how quickly can a money supply be expanded or reduced, while still maintaining a stable economy?

I am not familiar with the history of banking or revaluations enough to give other than one specific example on this issue. That example is Germany after WWI. The currency was so hyperinflated that people would cash their payroll check and then take a wheelbarrow of money to the market to buy groceries. The solution was to LOP the value dramatically while at the same time increase the ability of the reserve banking system to handle this. This was an extreme situation. The same has occurred in some African nations recently, where the money supply was dropped by up to10 zeros in a matter of months in order to bring stability.

None of these situations, however, is similar to what we will see in Iraq. Iraq is in complete control of its money supply. Furthermore it has told the press exactly what it intends to do and how long it will take to do it (about 9 months, as of now). I see no reason, given the control that the CBI has had on the currency for the last 5 years, to believe that they will lose control for the next 9 months. In other words, I expect that they will do what they say they will do and have no reason to believe otherwise.

Steve