Title: The Production and Cost of Currency: Who Creates the Ultimate Demand? - Huxiu.com
This article explores the production and cost of currency, starting from the perspective of partial equilibrium analysis and focusing on the monetary policy of the Federal Reserve. It analyzes the relationship between the supply and demand curves of debt currency and the impact of fiscal stimulus on the economy.
- The Federal Reserve determines the global ultimate demand and plays a guiding role in the economy.
- The essence of fiscal stimulus is to inject demand deposits into the real economy through the issuance of debt currency.
- Changes in the ten-year Treasury yield have a significant impact on the economy, and fiscal stimulus needs to be timed appropriately.
Diversity of Analytical Sequences
The field of economics is always filled with various confusing analyses, making it difficult to find a clear direction.
For example, some attribute the current economic downturn to the slump in the real estate industry. But why is the real estate industry in a slump? They say it's because of low household income. And why is household income low? Because of the economic downturn.
If we don't reflect on our analytical approach, we can easily fall into a cycle of A->B->C->D->A.
In fact, every single-arrow supply and demand analysis is a partial equilibrium analysis. Theoretically, there are many such analyses, but most of them are worthless.
So, what kind of partial equilibrium analysis is valuable? Starting from the outer layer of supply and demand analysis and gradually moving inward - achieving consistency until all variables are covered - achieving completeness.
In fact, the following two things are essentially equivalent:
- General equilibrium analysis - including analysis of all variables.
- Partial equilibrium analysis that progresses in a specific order and layer by layer.
In other words, although we cannot create a general equilibrium model that encompasses all variables at once, we can construct a hierarchical series of partial equilibrium analyses that include all variables as an approximation of a general equilibrium model.
It is not difficult to see that only a few valuable partial equilibrium analysis sequences exist, while most sequences are worthless. For any analysis sequence, its core characteristics are:
- The starting point of the analysis.
- The direction of progression.
Who Creates the Ultimate Demand?
Now we can finally get to the point: what is the source of ultimate demand? Or in other words, who creates the ultimate demand?
My answer is the Federal Reserve, which means that the starting point of my analysis sequence is the monetary policy of the Federal Reserve.
As shown in the graph, we have obtained a demand curve, but we don't know what it represents yet.
However, this is already deviating from the traditional IS-LM model in economics textbooks, where the money supply appears on the supply side.
By taking the monetary policy of the Federal Reserve as the starting point, the asset supply of any country becomes its counterpart, forming its supply curve. Let's label it as the supply curve of debt currency.
Why is it called debt currency? Because any asset is a form of debt, and these debts can generate a certain amount of currency - demand deposits.
Supply and Demand Curves of Debt Currency
When we put the demand curve and supply curve of debt currency together, we can see the following graph:
Now we can conduct a simple supply and demand curve analysis. What happens when a country increases the supply of debt currency?
As shown in the graph, if a country increases the issuance of its national debt while keeping D1 unchanged, we will see that the price of debt will decrease from P1 to P2.
Here, it is important to note that P represents the net price of long-term national debt denominated in US dollars.
In other words, aggressive fiscal stimulus will have two consequences: 1. Increase in domestic government bond yields; 2. Depreciation of the exchange rate.
The Production of Currency and Its Cost
The increase in government bond yields and depreciation of the exchange rate are negative effects and costs. In this process, what do we gain? An incremental amount of currency, dQ.
Although the Federal Reserve is not a central counterparty and not the source of global currency, it is a guide and commander. It does not participate directly but influences every transaction that generates currency.
In monetary derivative transactions, the person receiving the money needs to pay a certain cost, and the Federal Reserve influences the level of this cost.
This cost can be divided into two parts: interest cost and depreciation cost of the exchange rate.
As the supply curve of debt currency continues to shift outward, the price of debt currency continues to decline, and the initial creators of currency have to pay higher costs.
Of course, different economies will balance the interest cost and depreciation cost based on their own circumstances. Greece and Japan are two extremes: Greece relies solely on interest costs as it does not have an independent currency, while Japan relies on depreciation of the exchange rate to reduce interest costs.
China is in a middle ground between Greece and Japan, with a moderate depreciation of the exchange rate and a moderate increase in interest rates.
In other words, there is only one currency in the world - the US dollar - and other currencies are just US dollars with an additional layer of flexible outerwear.
Who Pays the Bill?
So, who plays the role of Prometheus? Generally, when the economy is doing well, the real economy can play this role, and their initial cost of liquidity is not too high.
However, when the economy is not doing well or when the Federal Reserve raises interest rates too aggressively, the real economy cannot play this role.
This situation is evident in the current economic contraction.
As shown in the graph, the ten-year Treasury yield is on the right axis in reverse order, and the sales area of commercial housing is on the left axis in positive order. They have a strong positive correlation. The chain of causality is clear: as the ten-year Treasury yield continues to rise, real estate sales decline, and domestic currency generation weakens.
In other words, when the ten-year Treasury yield reaches a certain level, there is no one in the real economy to play the role of Prometheus, and everyone is short of cash, leading to a vicious cycle in the economy.
This is when fiscal stimulus is needed. As shown in the graph, in this situation, fiscal policy plays the role of Prometheus, shifting the supply curve of debt currency to the right and generating dQ for everyone to use.
Once we understand this level, we can understand that unless the central bank engages in PSL (Primary Dealer Credit Facility), injecting more base currency into the system will not increase the currency because there is no one to pay the cost of being Prometheus.
There is no confidence without currency.
The Shape of the Demand Curve and Escape Velocity
Due to the Federal Reserve's framework of expectation-guided monetary policy, the tail of the demand curve is a horizontal line.
This means that as the supply curve continues to shift outward, P will not decrease indefinitely, and the comprehensive cost of increasing debt currency will not increase indefinitely.
In other words, when the supply curve is on the left side of the inflection point, increasing government debt will quickly lower P and increase the borrowing cost for the real economy. Once it crosses the inflection point, increasing government debt will not affect P, and the borrowing cost for the real economy will remain stable. Therefore, we do not need to worry too much about the crowding-out effect of government debt.
In addition, once fiscal stimulus pushes the endogenous momentum of the economy beyond the "escape velocity," the supply curve S will gain inertia and continue to shift outward.
As shown in the graph, when the supply curve moves to S3, the corresponding currency supply increases to Q3, providing more momentum to the real economy. This momentum will further push the supply curve to the right, creating a positive feedback loop.
The special shape of the demand curve implies that fiscal stimulus must be strong enough to at least push the supply curve beyond the inflection point and ideally beyond the "escape velocity." In doing so, the economy will spontaneously move towards a positive feedback loop.
The Movement of the Demand Curve
During fiscal stimulus, it is crucial for the Federal Reserve to guide the decrease in the ten-year Treasury yield. Therefore, fiscal stimulus often needs to be timed appropriately.
As shown in the graph, from the perspective of fiscal policy, during the process of the ten-year Treasury yield falling, stimulus is the most cost-effective. The supply curve S1 remains unchanged, but the demand curve moves from D1 to D2.
As a result, the net price of ten-year national debt increases from P1 to P2, and the currency supply increases from Q1 to Q2. If at this time, the government issues more debt, the effect will be even better.
As shown in the graph, the currency supply will increase significantly, but the net price of ten-year national debt denominated in US dollars will increase.
It is not difficult to see that fiscal stimulus is important for boosting the domestic economy, and the decrease in the ten-year Treasury yield is even more critical.
In summary, we have clarified the outer layer of partial equilibrium analysis, and the important conclusions are as follows:
- The Federal Reserve determines the global ultimate demand.
- Without enough demand deposits, there is no animal spirit.
- When analyzing economic momentum, we should focus on M1, which is the fuel itself, and other indicators are not as important.
- The essence of fiscal stimulus is to bravely play the role of Prometheus and inject demand deposits into the real economy at a certain cost. The finance departments of various countries can compete with the Federal Reserve.
- The role of central banks is to balance interest rates and exchange rates, without truly affecting M1.
- As long as demand deposits increase to a certain extent, the economy will re-enter the expansion phase.
- Everything is a monetary phenomenon, but we need to analyze it along the correct path.
- Incorrect analytical paths are not only confusing but also worthless.
- Many analyses are ineffective because we think too narrowly and overlook many key factors.
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