Note: I wrote this article during the beginning of 2009 when central banks first mulled the idea of creating money to put into the economies they serve. The original publishing date has been lost due to the conversion of JournalXtra from a forum into a blog. I’m sure the Internet Archive will have a record of the original publishing date.
This isn’t intended to be a fully involved, complete delving into the complexities into the way money is given value and how that value is manipulated for economic benefit. I’ve kept it simple and basic to lay the ground work for the more complex intricacies to be garnered at a later date.
In recent months we’ve all heard about a measure that Central Banks may use to encourage economic growth after interest rates have hit zero. For those who haven’t heard, it’s called Quantitative Easing. You’re probably wondering what it is and how it works.
I could give you the short answer here but I’m not going to do that. First I’m going to explain the basics of how money is valued, and then you’ll understand what Quantitative Easing is and how it works to improve trade. For those who want instant satisfaction, the short answer is written in bold at the bottom of this article (be warned that it isn’t the nice measure that it’s being made out to be).
We’re going to miss out the origins of money as the transition from bartering one item or more for another item of equal value. We’re going to jump in at the deep end and start from the equating of precious metals with coins, paper notes, cheques (checks for our U.S friends) and digital money. From this point onwards, when I refer to money I mean any form of cash, dosh, wanga – or whatever you want to call it – and any other form of centrally issued product that is used to facilitate the purchase and hire of tangible and non-tangible goods and products from one entity (human, group, business…) by another.
Different parts of the world have different forms of officially issued and usable money with which to trade products: one place might use Dollars, another Stirling yet others still the Yen or Rupee… Each place that uses a particular official money type is known as a Currency Zone, for example the Euro Zone or the Dollar Zone. Some places permit the use of several currencies for day-to-day trade by their citizens although usually a single currency is used within any one zone.
Most currencies are regulated by their zone’s Central Bank which stores the precious metals (usually gold) that back that currency and give it tradable value. To keep this explanation simple, we’re going to assume that gold is the sole precious metal used to back money and stored by central banks.
The amount of money issued by a Central Bank to represent its currency is called its Money Stock, for example all the US Dollars issued by the US Federal Reserve also constitute the total money stock of the United State’s Federal Reserve; it doesn’t matter where those US Dollars are in the Universe, each Dollar, Quart, Cent represents part of the Federal Reserve’s gold store and is a part of the Fed’s money stock.
Neglecting artistic value, any two bars of gold with equal size and purity hence density (mass divided by volume) hold equal value so it follows that when two Central Banks have an equal number of gold bars and an equal amount of money to represent those gold bars then both currencies hold equal comparative value i.e one bar of pure gold that occupies 100cm3 of space has the same value as another bar of pure gold that occupies 100cm3 of space.
- Central Bank A holds 100 gold bars,
- Central Bank B holds 100 gold bars.
The money we use is a representation of a fraction of our currency zone’s central bank’s gold stores. When we earn money, we effectively earn a stake in that gold. I’m not saying any one of us will ever be able to walk into a central bank and trade our money (notes and coins) for the value of gold they represent but what you can do is trade your time and skills for a greater stake or trade your stake (partly or wholly) with someone else for their goods. Money is a store of wealth – it represents a stake in its issuing central bank’s gold store.
- A stake in a central bank’s metal store can be traded:
- that trade can be for money issued by another bank (currency exchange),
- that trade can be for someone else’s time and skills (employment),
- that trade can be for someone else’s belongings (a purchase).
Money issued by a central bank only has tradable value because it represents a denomination of the issuing central bank’s gold store. That denomination is determined by how much money is created to represent that store.
- Central Bank A creates 100 Currency A coins to represent its 100 gold bars.
- Central Bank B creates 100 Currency B coins to represent its 100 gold bars.
- For both Bank A and Bank B, 1 coin represents 1 gold bar.
- Neither has a currency unit smaller or greater than 1 coin.
When money is traded within a central bank’s zone i.e traded only where that currency is used, then that central bank’s gold stores neither increase nor decrease in consequence of that trade. The result of internal trade is that the currency neither loses nor gains value.
When money is traded between different currency zones, i.e one currency is traded for goods somewhere another currency is used, then the gold stores of those central banks either increase or decrease dependent upon the direction of that trade.
- Central Bank A’s currency is used in Zone A.
- Central Bank B’s currency is used in Zone B.
- When Currency A is traded for goods in Zone B then Central Bank B gains gold from Central Bank A.
- When Zone B takes gold from Central Bank A then Central Bank A loses gold from its stores to Central Bank B.
- Region A and Region B can trade with each other by moving gold between their Central Banks.
The more gold a central bank has to back its currency the more that currency is worth relative to other currencies with less gold backing them. The opposite is also true, central banks with a currency backed by less gold have lower valued currencies than those with currencies backed by more gold.
- If Central Bank A has 100 coins against 100 gold bars then each coin is worth 1 gold bar (100 bars divided by 100 coins).
- If Central Bank B has 100 coins against 100 gold bars then each coin is worth 1 gold bar.
- Currency A is in parity with currency B only when 1 coin A and 1 coin B each represent 1 gold bar (1 Coin A is worth 1 coin B).
Before I show how currency values change I’d like to ask you a question: what will happen to Central Bank A’s currency when people in zone A trade coins with people in Central Bank B’s zone (Zone B)?
If you don’t know the answer don’t worry, you soon will and I suspect you’ll kick yourself for not voicing what you actually thought the answer to be because your unvoiced answer is probably correct. If you do know the answer then well done, smile and get someone to pat your back.
When people in Zone A use Central Bank A’s coins to buy goods from Zone B they are effectively instructing Bank A to send gold bars to the value of the spent coins over to Central Bank B. The effect of this trade is to lower the value of Central Bank A’s coins whilst increasing the value of Central Bank B’s coins. For example,
- 50 Zone A coins are spent in Zone B hence,
- Zone A now has 50 gold bars represented by 100 coins,
- Zone B now has 100 plus 50 gold bars represented by 100 coins.
- Central Bank A’s coins are now worth 0.50 gold bars each (50 gold bars divided by 100 coins),
- Central Bank B’s coins are now worth 1.50 gold bars each (150 gold bars divided by 100 coins),
- A single coin B is now worth 3 C coins.
The trade between Zone A and Zone B is a good thing for Zone A because it makes it an attractive place for people in Zone B to trade due to each coin from Zone B being now worth 3 coins from Zone A.
As Zone B trades more with Zone A, Zone A’s currency will increase in value as the number of gold bars flowing into Zone A’s central Bank increase. This reflects the balance of trade. When trade takes stores from a zone then that zone has a trade deficit with any zone that takes more from it than it returns to it. In our premises, Zone A has a trade deficit with Zone B whilst Zone B has a trade surplus with Zone A.
Trade between currency zones can boost overall trade between those zones:
- A trade deficit decreases trade flow from a zone in deficit (that loses stores) toward a gaining zone (due to the surplus zone’s currency’s relatively increased value).
- A trade deficit increases trade flow to a zone in deficit (that loses its reserves) from a zone in surplus (due to the deficient zone’s currency’s relatively lowered value),
When a currency’s value is considered to be too high a central bank might increase the amount of currency that represents its gold stores. That process is termed Quantitative Easing.
Increasing the amount of currency in circulation serves to lower its value relative to other currencies by decreasing the currency unit’s stake in that central bank’s stores.
Increasing the amount of currency available in a zone has one direct effect and two possible consequences: it lowers the currency’s value relative to other currencies; this
- increases trade to the devalued currency’s zone from zones with more highly valued currencies, and,
- decreases trade from the devalued currency’s zone to zones with more equal or higher valued currencies.
- Devaluing a currency increases the flow of gold from other zone’s central bank’s stores with more highly valued currencies.
- Devaluing a currency decreases the flow of metals from the devalued currency’s central bank’s stores to other regions with higher value currencies.
Central banks can increase the value of their currency by decreasing the amount of money that represents that currency. For example,
Central Bank A increases the value of its currency by removing 50 coins from circulation, and Central Bank B decreases the value of its currency by producing another 50 coins, therefore
- Coin A is now worth 1 gold bar (50 gold bars divided by (100 minus 50 coins),
- Coin B is now worth 1 gold bar (150 gold bars divided by (100 plus 50 coins),
- Consequently, Coin A again has the same value as Coin B (they are at parity)
Although we’ve used gold to represent a central banks stores, those stores might also be silver or copper etc.. but usually will be gold.
The process of trade between central banks used to involve precious metals being housed in different vaults within a complex at each central bank. Each vault represented a currency. At the end of each trade day, the balance of trade would be calculated and metals would be moved from one vault to another. Some vaults would gain, some would lose. The system in use now is a little different.
Quantitative Easing is another way of saying devaluation.
The explanation I’ve given above is basic compared to the more complex real world but the principles remain the same: the direction of trade (along with other events that increase a central bank’s metal stores) and the amount of money created by a central bank determine the value of the money issued by a central bank.
My opinion is that devaluation of a currency is similar to theft from a currency’s money holders (you and I). When currency is devalued it stores less of a stake in its issuing central bank’s metal stores.
Quantitative Easing could be likened to a central bank borrowing from its currency’s money holders because, in the long term, a devalued currency’s value could be increased by removal of the additional money created during the devaluation (increased trade from zones with more highly valued currency’s spurred by a devalued currency brings more metals to the devalued currency’s central bank’s stores. Destroying some currency increases the value of the remaining currency because the metals that back it are spread less thinly by it).
The downside to devaluation and quantitative easing is that the currency’s money holders at the time of devaluation lose some of their financial worth – money held as that currency is worth less, assets (homes, cars, other property, time, skills etc…) become worth less when traded outside that currency’s zone. Assets held outside of, and traded outside of, the devalued currency’s zone remain unaffected by the value of the devalued currency relative to their own zone’s currency; but being worth more of the devalued currency, assets outside of the devalued currency’s zone could be traded for the devalued currency (of which more would be obtained) in holding for that currency’s increased value at some future time (possibly through revaluation) (i.e a currency trade).
In the real world, a currency’s value is affected by other factors too. One of those factors is an increase in a central banks gold stores through gold mining which effects inflation; the current global average inflationary increase through gold mining is 2% i.e gold stores increase in quantity by 2% each year. If you want to know about other factors then I recommend you do a little research into currency, money, central banks, gold reserves and inflation. It isn’t difficult to research – I worked it out through introspection followed by research to validate and refute my reckoning. If you do do some research, then I bid you good look.
For those who just wanted the quick answer:
Quantitative Easing is another way of saying devaluation. The reason is explained above.