Inflation and the Money Supply

Yesterday, I discussed the effect of continued inflation, especially when it outpaces wage increases. When the two are in balance, you will get a steady rate of growth. This is the goal of our central bank, the Federal Reserve. They attempt to control the money supply available to banks and ultimately to the consumers by raising or lowering the discount rate (interest rate). This rate is the interest rate that banks can borrow from the federal reserve to keep their deposit requirements, usually 1/10th of their outstanding loans. The federal funds rate is closely tied to this and is set at the Federal Open Market Committee (FOMC) meetings. This rate is the interest rate private banking institutions lend federal funds to other depository institutions overnight to keep their deposit requirements. The FOMC usually follows whatever the Federal Reserve does.

What this all means, is that if the banks do not have money it can loan to consumers and businesses, there is less money that can be spent. This is called constricting the money supply. When less is spent, the economy slows. Conversely, when more is spent, the economy or speed at which money is spent increases. Available credit and cash is what businesses need to keep open and to draw customers.

When the sub-prime loan issue started happening in August, adjustable rate mortgages were going up and people who couldn't afford the increases started defaulting on their payments. The decrease of incoming funds to the banks started restricting what they could lend out. Private banks had to bail out smaller banks by lending federal funds to keep them open. Then the loans started going into foreclosure, and more money had to be loaned to keep the banks open. Still, thousands of people lost their homes.

This was really bad for our economy, but it was leading to something far worse. The Federal Reserve, dropped the discount rate by 1/2 of percent in their September meeting, a big drop. They had to create more credit to keep the money moving. They again lowered the discount rate another 1/4 percent in October. They were willing to risk inflation to keep the economy from completely stalling. The sudden influx of cash and credit spurred on inflation. With the increasing cost of gas and now consumer goods, everything started going up. As mentioned yesterday, when costs rise and wages don't keep up, the overall economic situation for the consumer decreases each year.

How long will you be able to keep your head above water? Can you do something about it?

My gifts are better than gold, even the purest gold,
my wages better than sterling silver! Proverbs 8:19 (NIV)

We will discuss inflation more and alternative solutions. Stay tuned ...