Money.
Money is:
A unit of account—it allows us to “add up” the values of many otherwise dissimilar things.
A medium of exchange—it facilitates trade by providing a common medium which everyone will accept in payment.
A store of value—we can hold our wealth in the form of money, though doing so forces us to lose interest earnings and subjects our wealth to the withering effects of inflation.
Many things have been used as money throughout history—cattle, beads, stones, various metals, cigarettes, paper, the list is long. Over much of modern (from the Greeks onward) history, money has been metal coins, most recently gold and silver. Gold and silver have properties that make them particularly useful as a money medium. Both are relatively scarce, they are durable (don’t rust, for example), and are fairly easy to work. Because they are scarce, they have significant value—so that one doesn’t need to carry a lot of coins to bring a lot of wealth.
The use of gold and silver coins meant that money was essentially the same everywhere. Whatever name a coin might have, Pound Sterling, Mark, Frank or Dollar, each was made of the same thing: gold, and as such could be spend interchangeably, taking note only of the quality and quantity of gold contained in each coin. If a Pound Sterling had 5 times the gold or silver than a silver dollar, then one pound would exchange for 5 dollars. The use of a material for money that has intrinsic worth in and of itself gives rise to what economists call “Commodity Money”, that is, money of a sort that the monetary value is related directly to the material that it’s made of. Gold and silver coins are commodity money.
The United States used commodity money up until about 1933, when the US officially “went off the gold standard”. I put this in quotes, because it isn’t, technically, true. What the US did was to bar US citizens from holding monetary gold, forcing them, instead, to use paper currency. Only coin collectors, jewelers, dentists and industrial users were allowed to hold gold. All of the monetary gold was transferred to the government and put in storage as a “backing” for the paper currency that was issued. The dollar was still “defined” in terms of gold. Gold was pegged at $33 an ounce. Thus one dollar was reckoned to have (be backed by) 1/33 of an ounce of gold. While Americans couldn’t claim the gold that “backed” the dollar, foreign dollar holders could. All of the worlds “hard” currencies (those with commodity “backing”) were defined in terms of gold. Thus, the Pound Sterling would have had 5/33 of an ounce of gold “backing” it, since during the 1930’s the Pound was worth $5 US. This is how the value of currencies were pegged for foreign trade—by the amount of gold backing them. This worked reasonably well until the 1970’s. By the time the 1960’s were working to a close, the US trade deficit was significantly negative (we were buying more than we were selling overseas), and showed no sign of turning around. This meant that more and more foreigners were holding onto US dollars that they had no intention of using to buy US goods. It became clear that should foreigners decided that dollars were not a good thing to hold, the US would be unable to meet their demand for the gold that theoretically “backed” the dollar. As a result, in about 1973, the US really did leave the gold standard. The dollar officially became worth whatever foreigners would bid for it. US citizens were allowed to own as much gold as they might want. Nothing “backs up” the US dollar any more, other than peoples’ willingness to accept it in payment. Money of this sort is called “Fiat Money”, or money which has value because it is “proclaimed” to have value—it is stated to be legal tender for all debts public and private.
As the twentieth century progressed, money has become, increasingly, checking accounts, with currency taking a secondary role. These days, many people don’t even see much cash. Paychecks tend to be automatically deposited in checking accounts by the employer, and the advent of computers and cheap, high-speed electronic communications has facilitated the rise of debit cards with which almost anything can be purchased. Some cash, or currency, is needed to undertake particular transactions (paying your bus fare, for example), so currency is still around and probably always will be. For most of us, though, checks and our debit cards will become more and more important.
The thing that differentiates money from other assets is it’s unique and high level of liquidity. Liquidity is the ability to convert from one asset form to another. Obviously, the asset “money” is supremely able to be converted into other assets of all sorts—take $60,000 and buy a Porsche, and you’ve converted assets in the form of money into assets in the form a car. The Porsche, however, is not a particularly liquid asset. It can be converted into something else—that’s what the classified ads are about—but it won’t be nearly as easy a transition as converting from money to the Porsche was. Thus, anything that you own can be looked at as an asset: your house, car, savings account, stock and bond holdings, stamp and coin collections, jewelry and so on. These things constitute your wealth. Money is simply the most liquid of your asset holdings—the most easily convertible component of your wealth.
The line that divides money assets from non-money assets is a bit arbitrary. The most common definition of what constitutes money is M1, which includes currency and checking accounts (demand deposits). M2 includes currency and demand deposits but adds savings accounts (time deposits) as well. For our purposes, we’ll be using M1.
The Money Supply
At any given time, there is a definable stock or supply of money in the economy. Most of this money consists of checking accounts, with a sprinkling of cash thrown in for consumer convenience. Checking accounts exist in banks, and banks are where we put our money assets for safe keeping. Once your money is in the bank, you can write checks against it (or use your debit card) to make purchases. You can write a check for any amount up to the total you have on deposit. As far as you’re concerned, your money is available at any time—and, in effect, it really is. Still, we all know that our money isn’t really in the bank, the bank has lent it to someone else, and is earning interest on it. How can our money be “in two places at once”: both in our checking account at the bank and out at loan to someone else? The answer is found in simple probability. Bankers learned long, long ago that only a small fraction of the total deposited with them is ever called for at any given time. This being the case, bankers discovered that they could safely lend out a significant fraction of total deposits, earn on the loans, and still have plenty of cash around to meet depositors demands. All the bankers had to do was keep a reasonable fraction of deposits on hand as “reserves” to meet depositors needs. With this discovery, what we now call fractional reserve banking was born.
Modern banks keep a portion of deposits on hand—or close at hand—to meet customer requirements, and lend the balance to borrowers. For members of the Federal Reserve System, reserves can be deposited with the Fed. There is a required level of reserves that banks must hold. The fraction required differs for various types of accounts—higher, obviously, for checking accounts were withdrawals are common and unannounced, lower for certificates of deposit which cannot be withdrawn before a specified date. For our classroom analyses, we will assume one reserve requirement for all bank accounts, and we will use figures like 20%, 25%, 10% in order to keep the arithmetic simple. Let detail how this works.
Assume you’ve deposited $10,000 in your checking account. We’re going to assume only one mega-bank in the economy—a move that simplifies, but does not change the outcome. The bank sees a deposit of $10,000 as $2,000 in reserve requirement, and $8,000 in loans. The loan is made. When someone borrows the $8,000, they do so to buy something. The folks from whom the purchase is made now have $8,000 to put in their checking account. The bank sees a new deposit of $8,000, and proceeds to put $1,600 in reserves and lends the remaining $6,400. . The $6,400 loan is spent and turns up as a new checking account deposit. Note, in passing, that the money supply resulting from your deposit now equals $24,400 (your $10,000 plus the deposits arising from the $8,000 and $6,400 loans) The bank will keep $1,280 of the $6,400 (20% of $6,400) as reserves and lend out the remaining $5,120. This will return as a new checking deposit, and the process will continue until the banks reserves have grown by $10,000 and support $50,000 in total deposits. Your deposit of $10,000 will have allowed the bank to create $40,000 (presumably your initial deposit already was money) in new money, and will have afforded the bank $10,000 in additional reserves which support the expanded deposits.
Each depositor is assured that he can have all his money on demand, and yet each depositor’s money has been lent and that loan has provided the source of some other depositors checking account balance. It all works because, as depositors, we simply do not, all of us, ask for all of our money at once. This being the case, the bank can meet nor normal demands, and has the Fed standing by to lend to it should it be caught short.
It should be clear what a powerful role the reserve requirement plays in this process. Were the reserve requirement to have been, say, 10% rather than 20% in the above example, then your initial deposit of $10,000 would have supported $100,000 in deposits rather than the $50,000 specified above. Raise the reserve requirement to 50%, and the initial $10,000 deposit would only carry $20,000 in total deposits. Change the reserve requirement, and you exert a powerful leverage on the money supply. It is probably for this reason that the Fed rarely changes the reserve requirement. The Fed does change the discount rate fairly commonly, however. The discount rate is the rate the Fed charges member banks when they borrow from the Fed. The reason the Fed changes the discount rate is either to bring it in line with other similar market rates, and, more importantly, to signal member banks about the Feds monetary policies. If the Fed raises the discount rate it is telling member banks that it is trying to discourage borrowing, and that the member banks would be wise to limit their lending in order to be less likely to be caught short of reserves--so that they don’t need to borrow from the Fed. This suggests the Fed is pursuing a tight money policy. If the Fed lowers the discount rate, it is suggesting that banks can liberalized their lending policies, and that the Fed’s policy is one of monetary expansion.
If the Federal Reserve wants to increase the supply of money, they could simply print more currency—but they don’t. Instead, the Fed tries to increase the money supply by aiding in the creation of more checking accounts. The Fed does this by giving banks more reserves, so that the banks can increase their lending. More lending means more spending, and new deposits to the checking accounts in the banking system. To give the banks more reserves, the Fed buys government bonds on the open market. When the Fed buys bonds, it is giving out money to bond holder in order to buy their bonds. The former bondholders take the money they’ve received and put it in the bank. As a result, the banks have more reserves in the form of new deposits, and can increase their lending. Increased lending means lower interest rates, more borrowing and spending and an expanding economy.
If the Fed wants to decrease the money supply, it sells bonds on the open market. These bond sales involve buyers writing checks on their accounts to pay for the bonds. The banks see their deposits shrinking as bond buyers send money off to the Fed in payment. These checks must be paid out of reserves, so the banks will need to curtail lending and call in loans in order to replace the reserves they’ve lost. As a result, interest rates will rise, and lending and spending will diminish.
The ability to change the money supply is a potentially potent tool for controlling the level of economic activity. If the economy needs speeding up, the Fed can buy bonds on the open market which gives the banking system extra reserves. This encourages new lending and spending thus stimulating the economy. To slow an overheated economy down, the Fed need only sell bonds which soaks up reserves, tightens banking lending practices, raises interest rates, lowers borrowing and spending which reduces the level of economic activity.
Monetary Policy
Given that the Fed can change the size of the money supply by buying and selling bonds on the open market, what should it’s course of action be? Should the ability to increase and decrease the money supply cause the Fed to try and influence the operation of the economy; and if so, how? The answers to these questions constitute monetary policy. Over much of it’s history, the Fed did not attempt to influence the level of output and employment. Instead, the Fed clung to it’s role as stabilizer of the banking system and lender of last resort to member banks. The Fed, for a time, also adopted the goal of stabilizing interest rates. With the great depression, and the rise of Keynesian economics, the Fed’s role as a macroeconomic actor became increasingly prominent. Keynes, who was one of the most accomplished monetary economists of his century (his most famous work, after all, is entitled “The General Theory of Employment, Interest and Money”) didn’t feel that monetary actions could do much to help during a severe depression. The Fed’s efforts to increase the money supply are only enabling because while banks get increased reserves when the fed buys bonds, whether they lend these increased reserves is up to the banks themselves and their potential borrowers. In a severe depression, the banks are more likely to simply hold the extra reserves, and not increase their lending. When businesses are failing in large numbers, and the economic climate is dismal, banks have little incentive to put deposits at risk through reckless lending. As such, the Fed, Keynes argued, had little it could do to help bring the country out of the depression. Fiscal measures, direct government spending, were called for instead.
Because Keynes downplayed the role of the Fed in depressed times, and because economists worried more about depression than they did about inflation during the period from 1929 through to 1965, the role of monetary policy in stabilizing economic activity was not emphasized during these years. Gradually, Keynesian economists came to be criticized for not recognizing the potential importance of monetary actions in regulating the level of economic activity. The charge was somewhat unfair. Keynesians knew of the potential for monetary policy, but felt that the most likely economic problems—recession or depression—were not the sort of situation that monetary actions could best address.
As the 1960’s progressed, a shift occurred in the way economists looked at monetary and fiscal policy. Fiscal policy came to be look upon as unwieldy and hard to apply. Large government spending programs tend to be hard to apply on a timely basis (they have to be passed by Congress, for example, a time consuming process), tend to be “lumpy” (if you build a dam, you’ve got quite a chunk of spending going on, and you can’t just “turn it off”), and are hard to eliminate once started (we actually had official government tea tasters until at least the 1960’s—an office begun at the inception of the nation). Changes in taxation suffer from similar problems. Taxes are set by Congress which is reluctant to raise taxes at all, much less for purposes of macroeconomic stabilization. This is not a criticism of Congress. Taxation and spending are not, primarily, macroeconomic tools, they are actions undertaken to provide for the common good. Congress needs to respond to the voters, not to panels of economists. Increasingly, even Keynesian economists came to view fiscal policy as a tool of desperation. Were the economy to pitch into a severe recession, one that monetary policy simply couldn’t handle, then government spending would be available to pull the economy out of the abyss. For day-to-day macroeconomic purposes, however, fiscal policy was increasingly viewed as inappropriate.
As fiscal policy receded in the estimation of economists, a curious thing happened to their view of monetary policy. One would expect that monetary policy would be seen as the primary tool of discretionary macroeconomic policy. For a growing number of economists, however, exactly the opposite was the case. These economists, called Monetarists, believe that the Fed should do nothing except increase the money supply by 3-4% per year, year in year out, forever. Monetarists believe, further, that fiscal policy is ineffective.
According to the monetarists, government deficit spending has no effect on total demand. This is because, the monetarists claim, any money the government borrows to fund deficit spending would have been borrowed and spent by private borrowers anyway. The net effect is simply to bid money away from private parties, and devote it to government spending. There is no net change in aggregate demand. For this to be the case, there must be no idle money balances in private hands for the government to borrow. All the available money holdings must already be lent out to people, or actively in the process of being lent. In other words, people aren’t holding idle money, they’re holding interest earning assets instead. The willingness to hold money is what we call the demand for money.
Money is one means of holding one’s wealth. The amount of one’s wealth that one holds in money form constitutes a person’s demand for money. According to economists, people have various motives for holding a portion of their wealth in money form. These motives are:
The transactions demand for money: People need a certain amount of money to carry on their basic purchasing and payment activities. Without money, you can’t buy things (remember, checks are money—and so’s your debit card).
The precautionary demand for money: It’s good to have a certain amount of money around to handle emergencies.
Most economists agree on these motives for holding money. The monetarists and Keynesians differ on the following motive. The Keynesians accept it, the monetarists do not.
The speculative demand for money: Keynes argued that people hold money for speculative reasons. If the interest rate is low, people tend to hold money rather than putting their wealth out at interest. They will wait for interest rates to rise. On the other hand, if interest rates are quite high, people will actively put their wealth in interest earning form rather than allowing the opportunity to get these extraordinary returns to slip by.
To the extent that people hold speculative “idle” money balances, then there are funds out there (at least sometimes) that the government can borrow without bidding away or crowding out private borrowing. Given that, during recessionary periods, interest rates tend to be low, this suggests that there will be significant idle, speculative money balances just when the government is most likely to want to borrow them.
The monetarists argue, on the other hand, that there is no speculative demand for money. People hold a minimal amount of money for transactions and precautionary purposes, but tend to hold as much of their wealth in non-money forms as possible. If the monetarists are right, there are no idle balances for the government to borrow. Any government borrowing simply crowds out and equal amount of private borrowing. There is no resulting increase in aggregate demand. The government’s spending increase is exactly offset by a simultaneous and equal decrease in private spending and borrowing. If you expect that this means the monetarists support and active use of monetary policy, you’d be wrong.
Milton Friedman, a Nobel laureate from the University of Chicago, is the father of monetarism. Friedman did a study of monetary policy in the United States and concluded that the great depression, indeed all major instances of macro instability, could be traced to bad monetary policy. (Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960) Rather than suggesting, however, that what was needed was “good” monetary policy, Friedman argued for no monetary policy at all. Instead, the Fed should simply increase the money supply by 3-4% a year, forever. Friedman calls for this monetary rule because he believes that economic stability is achieved by regularizing monetary behavior. By increasing at this constant rate, economic “shocks” due to monetary swings are eliminated, and sufficient additional money is provided to allow for normal economic growth (which ought to be about 3-4% a year).
Friedman and the monetarists adhere to the quantity theory of money. The quantity theory can be described by the following equation:
MV = PQ
Where:
M = quantity of money
V = velocity or rate of circulation of money (which the monetarists assume is fixed)
P = the price level
Q = quantity of output
PQ, effectively, equal GDP
The quantity of money times the rate at which it circulates (changes hands) equals nominal GDP. If we assume that the economy gravitates to full employment (as the monetarists do) then Q is relatively fixed in the immediate short term, and will increase gradually at about 3-4% a year as the economy grows. If we increase M at 3-4% a year, we should have stable prices and full employment along with normal economic growth. The monetarists believe that one shouldn’t arbitrarily change the money supply to try and “fine tune” the economy, since chaos will result. Trying to tune the economy using monetary policy is like trying to drive a car equipped with a random delay steering mechanism down a twisting mountain road. Given that you don’t know when the car will respond to your steering signal, nor exactly by how much, you are destined to crash. Similarly, given that we don’t know by when or by how much the economy will respond to a change in the money supply, an economic crash—the monetarists claim—is the inevitable result of discretionary monetary policy.
The monetarists’, monetary rule is only part of the picture, however. Milton Friedman envisioned an economy operating on a laissez faire model. Like the classical economists, Friedman has great faith in the powers of the market economy, and believes that government should back off from most of it’s current economic activities. All the regulatory bodies such as the Food and Drug Administration (FDA), the Securities and Exchange Commission (SEC), Consumer Product Safety Commission, Social Security Administration, the Post Office, to name a few, should be eliminated. The government should content itself with conducting foreign policy, providing for the national defense and enforcing contracts, and very little else. Obviously none of these changes has been put in place. Monetarism is, finally, the rebirth of the classical economic vision in a modern context.
Most economists these days are probably a bit of both monetarist and Keynesian. When the economy is booming, for example, it is probable that government borrowing does crowd out a fair amount of private borrowing and spending. Still, when the economy is booming, there is little need for government induced fiscal stimulus. As we sink into depression, on the other hand, governments will have plenty of funds to borrow without sacrificing private borrowing. It is at this time, too, that deficit spending’s stimulating effects are needed most.