There are two main schools of thought on this forum on the role of cash in inflation outcomes.
1. The Count du Monet's theory is that the quantity of cash (bank notes and coins) in circulation is the only criteria determining the rate of inflation and that the quantity of cash and inflation are positively linearly related.
2. The mainstream theory on this forum is that the quantity of cash is irrelevant for inflation outcomes. This theory takes it that the quantity of cash results from peoples choices of the form in which they wish to hold their money - cash or bank deposits and it doesn't matter which they choose.
However, the role of cash does appear to have direct influence on the level of bank reserves.
Consider cash expansion. Suppose I and others decide that we want more cash. We go to our banks and demand cash in exchange for our bank deposits. To maintain their cash reserve level those banks will then need to obtain more cash, typically from their CB. The CB will debit those banks' reserve accounts (ESAs in Oz).
There is no change to the spending ability of the bank customers. Their capacity to spend the new cash they have is the same as their capacity to spend the previous bank deposits (the accounts must have been on-demand accounts to obtain the cash).
But there is a material change for the banks. The banks' deposit liability has been reduced but their reserves have been reduced by the same amount. A reduction in reserves can surely have no positive effect on a bank's ability to lend and potentially increase money supply and/or velocity.
Wouldn't the effect of cash expansion on inflation be neutral to negative?
Applying similar thoughts with cash reduction, from the depositing of cash to banks, bank customers will have no change to their spending ability, but the effect will be to increase banks' reserves with their CB. Wouldn't this increase the propensity of banks to lend and increase the money supply and thus potentially increase inflation?
The above suggests that the rate of inflation is inversely proportional to the quantity of cash in circulation. This seems plausible. If everyone had cash and no bank deposits there could be no money growth and there would surely be zero or negative inflation. Cash increase by withdrawal from banks removes money from banks which therefore reduces their capacity to create money and inflation.
Say you EFT 1,000,000 from Wespac to NAB then the number 1,000,000 goes through the RBA computer (to keep it simple) from Wespac to NAB.
Because it goes through the RBA computer it is called money, and is given the same status as money that the coins and notes the RBA gets minted and printed has.
If you EFT 1,000,000 to me (and of course feel free to) and we are both Wespac then no money has come into or out of Wespac.
If Wespac customers EFT NAB customers 100,000,000 and NAB customers EFT Wespac customers 100,000,000 on the same day then the banks just Net It Off. No money changes hands.
In fact the banks know during the day what they will owe each other and start negotiating with each other for intra bank loans, so the overnight loan facility of the Reserve Bank is a back up and no bank would pay more off another bank which is why it sets interest. In the financial crisis no one was taking anyone phones calls. That's why the Reserve had to say borrow of us then.
If loans today are say $100 billion then all the banks could write loans for $100 billion dollars more with no "money" as long as the amounts that got netted off in the RBA system to zero. NAB lends you 1 million. Wespac lends me a million. I pay another NAB customer 1 million to buy something. You pay another wespac customer to buy something. The banks debt owed each other is zero. You and I owe the banks 1 million each.
What stops all that in Australia (and this is what the Basel thing is all about) is that the banks have to have loans no more than particular ratios on deposits. (to keep it simple).
Digest all that and see if you head with inflation.
And before we get a spill of ill will towards banks saying that make money out of thin air, you have to have some way to manufacture money, and this is the best one we have come up with.
Alternatives are things like having to have someone in government decide who gets new money if you make it free, for example.
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