Stanislaus on monetary hydraulics — guest post

Tom here: Stanilaus has been working on figuring out MMT for some time and has come up with the following post as a comment at Modern Monetary Mechanics hosted by Senexx. I offered to put it up here to introduce him and get some feedback. Please encourage him with constructive criticism. He has been working hard to figure all this out. His background is in psychology.

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As an amateur MMTer, I’ve arrived at the stage where I regard the economy somewhat from a holistic point of view.

 Briefly (heh, heh) I focus on an equation that concerns the level of money in circulation (not ‘existence’, folks), that is, money readily available and being used in exchange transactions of goods and services for money. It’s not the ultimate equation of everything economic, but it gives us a perspicuous view of an important part of the economy.

ΔC = INF – EXF

where
C – quantity of money in circulation
ΔC – change in quantity of money in circulation
INF – quantity of money flowing into circulation
EXF – quantity of money flowing out of circulation

We can expand INF and EXF somewhat along lines of equations for GDP, but not the same as these equations.

INF = [X + G + I + L]

X – quantity of export money coming into circulation
G – quantity of money entering circulation from government
I – quantity of money entering circulation as investments
L – quantity of money entering circulation from bank loans

EXF = [M + T + S + P]

M – quantity of money leaving circulation in buying imports
T – quantity of money leaving circulation as taxes
S – quantity of money leaving circulation as saving
P – quantity of money leaving circulation in payback of bank loans

In other words,

ΔC = [X + G + I + L] – [M + T + S + L]

This equation is inspired by a basic equation in hydrology concerning the change in level of water in a reservoir as a function of the difference between inputs and outputs of water into and out of the reservoir. Or you can think of swimming pools and beautiful girls…. and various sources of
water coming into the pool and draining water from the pool.

If ΔC is positive, the quantity of money in circulation is increasing.

 If ΔC is negative it is decreasing.

Note that because money is fungible we can substitute different amounts of different sources of money flowing in and flowing out of circulation and get the same change in the quantity of money in circulation.

 For example an economy may be heavily deficit spending (beyond taxes taken in) and
one could counter that imbalanced effect on the level of money in circulation by liberalizing importing with low or no tariffs so that M = D where D is the deficit component of G, i.e. D = G – T.

Anyone we know did this? What about Dick Cheney’s remark that deficits don’t matter. He was saying this in the context of heavy deficit spending on the war in Iraq while people were being encouraged to buy inexpensive imported goods from China at WalMart. No need to balance the budget fiscally, i.e. G = T.; what we need to balance is inflows against outflows from circulation.

But when? We don’t want to force inflows of money to always be equal to outflows of money to and from circulation.

It would be folly to seek the balance when the economy is in deflation.

When that is the case INF should be greater than EXF, and INF > EXF held for some time until C rises to the level C’ where there is full production and employment at stable prices. At that point we should seek to make INF = EXF.

But there may be many ways to achieve this with different mixes of the quantities in these expressions. So, this equation allows a government using it to have considerable flexibility in its policy on spending.

The equation also shows what must be done to to avoid inflation once we reach full production and employment at stable prices. Essentially, we will have inflation when C > C’, that is, more money is circulating than needed to maintain full production and employment at stable prices. Prices will begin to rise as excess money is used by those who acquire it to outbid others for goods and services, which cannot be increased by more INF.

Once we arrive at full employment and production and prices start to rise generally across the board, that is the time we must make INF < EXF so as to lower the level of money in circulation C. The goal then is to get back to C'. Increase buying imports (sending money out of circulation in the nation).

Encourage savings and discourage investment by raising interest rates.

Clamp down on bank lending and encourage borrowers to pay up.

 Have the Central Bank or Treasury sell more bonds to take money out of circulation into time deposit saving accounts known as bonds or securities. These can be the same kind of bonds or securities used to acquire money for deficit spending. But deficit money is going to increase money in circulation if spent back into circulation, while sequestered money from sale of govt. bonds and securities drains money out of circulation.

So, this equation shows us that hyperinflation is not inevitable. No more is it than a reservoir not flooding when inflows are managed by adjusting outflows to keep the reservoir full but not overflowing.

 The CB does not have to always "print more money". There is a time and place for everything. And the equation shows us what must be done in each circumstance.