Inflation has been around since antiquity. The Roman Empire was particularly known for debasing its currency (by minting their coins with increasingly impure precious metals) to cover state expenditures, especially in times of war. The increasing nominal money supply and pressure from imports paid for with silver resulted in steady inflation of prices and wages.
The invention of paper money only made it easier for governments to cause out-of-control inflation by creating too much money. This occurred most famously in the Weimar Republic (prices doubling about every two days) and in Zimbabwe (prices doubling about every day). The most extreme example in recorded history was the Hungarian pengő (prices doubling about every 15 hours): “…by the time the pengo was replaced by the forint in August 1946 the dollar value of all Hungarian banknotes in circulation was just one-thousandth of one [US] cent.”
Some small level of inflation is seen by present-day central banks as desirable for various reasons. Most obviously, it discourages hoarding of capital and therefore fuels economic growth. The ability to freely print money also gives central banks a greater level of control over the economy through setting monetary policy. The Federal Open Market Committee (FOMC) in the United Stats aims for 2% annual inflation.
The equation of exchange states:
where M represents the supply of money, V represents the velocity of money, P represents prices, and Q represents the real value of transactions. This equation relates the “real” economic factors V and Q with the “nominal” factors M and P particular to the monetary system. Because V and Q are determined by the “real economy,” according to the monetarist school of thought, inflation in prices P is best managed by controlling the increase in the money supply M. So how does the money supply expand under our current system, and what controls are in place to control this expansion?
The conventional view is that banks take money from depositors (in exchange for safety and account services) and lend some of that money out to borrowers (in exchange for interest). The original depositors still have their money on paper (as long as not too many people try to withdraw their money at once), and the borrowers now also have money to spend. The money supply has therefore increased. This is compounded by borrowers depositing their borrowed money back into the banking system, where it can be loaned out again. The main obstacle said to prevent this lending cycle from going on forever and producing infinite money is the reserve requirement imposed on banks by regulators to ensure that sufficient reserves (say, 10% of deposits) are on hand at all times to satisfy withdrawals of demand deposits. The inverse of the reserve requirement is called the money multiplier; a 10x money multiplier means that a deposit of ten dollars results in nine of them being lent out to borrowers, with one dollar held in reserve. By adjusting reserve requirements, a central bank can adjust how quickly the money supply grows.
Numerous economists and financial commentators have pointed out that this conventional textbook view bears little resemblance to how banks lend in the real world. Banks do not and can not lend out their reserves. Instead, when a loan is disbursed, a new asset (the value of the loan to the bank) and a new deposit liability (the money placed in the borrower’s account) are added ex nihilo to the bank’s balance sheet. This newly-created “commercial bank money” does require corresponding “reserve money” (bank notes in the vault or money on deposit with the central bank) in case the borrower wants to withdraw cash, but any solvent bank has no difficulty in acquiring sufficient reserves by borrowing them from other banks or, in an emergency, the central bank. Reserve requirements mostly serve to ensure that sufficient liquidity is present to settle transactions between banks at the end of each business day. Reserve requirements play little role in limiting lending and the United States Federal Reserve seldom changes reserve requirements to effect monetary policy. Some countries, including Canada, the United Kingdom, New Zealand, Australia, Sweden, and Hong Kong have no reserve requirements at all. The factor primarily responsible for limiting lending is a bank’s capital requirement: a minimum ratio of equity to debt meant to ensure that the bank can remain solvent if some of its loans fail. The capitalization of a commercial bank is at best only distantly connected to its deposits or its reserve requirements.
Given adequate equity, a bank can create new money as it pleases, and the central bank will ultimately provide it with whatever reserves it needs. So how does the central bank control the money supply in order to hit its inflation target? It does this by controlling the interest rates of loans throughout the banking system. In a low interest rate environment, money for investment is easily obtained and the economy “heats up,” increasing inflation. By raising rates, the central bank makes loans less attractive for borrowers and the economy “cools down,” decreasing inflation.
In order to influence commercial lending rates, the Federal Reserve manipulates the federal funds rate, the average interest rate that banks charge each other for overnight loans to cover their reserve requirements. This rate perhaps doesn’t seem particularly significant, but the short maturity of the loan (overnight) and extreme creditworthiness of the borrowers makes the federal funds rate an essential indicator for the theoretical interest rate of an asset with zero financial risk. This risk free interest rate is used throughout the financial system as a base for determining rates on all kinds of debt instruments. For example, the prime rate used for home loans, student loans, credit cards, and other lines of credit runs about 3% above the federal funds rate.
Individual banks determine amongst themselves the rates that they charge each other for overnight loans, but the Fed can constrain and influence these rates. It sets a ceiling on the federal funds rate by offering at all times to lend to member banks at the discount rate, which is set higher than the target federal funds rate, in exchange for suitable collateral. Banks with excess reserves can’t charge other banks much more than the discount rate because they’re competing with the discount window at the Fed. Similarly, the Fed sets a floor on the federal funds rate by paying interest on excess reserves. Banks won’t loan reserves to each other at less than the IOER rate because they would make more money by simply depositing the reserves with the Fed.
Within these bounds, the Fed has various tools for pressuring the federal funds rate in one direction or the other, though it mainly engages in open market operations, wherein the Fed trades securities (especially short-term Treasury debt, but also including longer-term government debt and even equities since the financial crisis) with its member banks in exchange for reserves, at market prices. Banks with excess or insufficient reserves are often happy to take such a deal, particularly with T-bills because they compete directly with reserve lending in the short-term risk-free money market. When the Fed buys Treasurys from the banks in exchange for reserves, the amount of excess reserves in the system goes up, driving down the cost of borrowing reserves. Conveniently, buying large quantities of Treasurys also creates a scarcity in the market for government debt, allowing the Treasury to lower rates on new debt. Conversely, when the Fed sells Treasurys to banks in exchange for reserves, the amount of excess reserves in the system decreases and the cost of borrowing reserves goes up. The extra Treasurys on the market make it harder for the government to sell new debt, and they have to raise rates to attract buyers.
The process by which a central bank’s monetary policy affects the “real economy” is called the monetary transmission mechanism. If you’re interested in learning more, this Creative Commons textbook has more details. There are also numerous reports on monetary policy at federalreserve.gov.