Economy: The role of the central banks, put simply

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06/06/2018 | 05:16 pm
The easiest way to understand the functioning of the economy - broadly speaking - is to imagine a machine with two engines: the first engine consists of the money supply, in other words, the amount of cash in circulation and the credit; the second engine consists of the production of goods and services.
These two engines are naturally connected and depending on each other; the currency is used to finance and/or buy the production, while the added value of the production is used to - among other things - determine the value of the currency.

This is why, when the money supply increases proportionally faster than the production, the purchase competition becomes too intense: there’s more and more money for fewer goods or services, with as an immediate consequence an increase of the prices - in others words inflation - and a return of risky behaviour from the various economic players who engage in what we call a speculative mania...

As such, the recent so-called accommodative monetary policies of the central banks are being pointed at by certain people: the central banks are being accused of boosting the prices of all asset classes.

Contrary to this first phenomenon, and still broadly resuming, when the money supply increases proportionally slower than the production, it’s the purchase competition that overtakes: followed by a dynamic of declining prices - meaning deflation - while the economic players suspend their investment projects.

The central banks are thus forced to play a strategic role in regulating the economy : they can choose to increase the money supply when the economy goes down in order to stimulate investments or consumption ; or  they can decide to decrease the money supply when the engine overheats and the prices go up - in which case the central banks find themselves right in the middle of their initial mandate to ‘control the inflation’.

Naturally, no excess in the inflation or deflation situation is desirable. But every coin has two sides, and as for every complex recipe, the success or failure is above all the result of the right dose and…. luck.  

For example - abundance obliges - inflation leads to a decrease in value of the currency, and thus a decline in the purchasing power of the domestic economic players. However, a currency that weakens compared to other currencies boosts the export - because the purchasing power of foreign companies increases. It also reduces the government debt since the refunded capital will be worth less tomorrow than it is today. 

A controlled inflation certainly has its benefits, for example when a sovereign state borrows long-term against 2% interest, with an inflation target between 1 and 1,5%…

Deflation presents the same ambivalence: a decrease of the money supply leads to a decline of the prices that’s too strong and creates a risk for the production - for example, that it won’t be able to find the necessary capital for its development anymore. However, during a period of an overheated economy, reducing the money supply allows for the speculative fevers to cool off and to rebalance the system - for example by purging it of its inefficient players that survive only because of the easy credit.

Naturally, all these classic economic concepts are.. purely theoretical. Practice has proved that economy is a discipline that is mainly behavioural, where the animal instinct plays an essential role, and where it’s difficult to establish systemic relations able to predict the future with precision - like for example with the weather, where the technique is mastered and the phenomenon is understood, but the projection for more than a couple of days ahead is risky.

In this imbroglio, even more so than with the control of the money supply, the principal role of the central banks is to inspire confidence in the various economic players - so that they know that the monetary policy serves their best interests and that they can rely on it to plan their investments.

Translated from the original article

Neelie Verlinden
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