Money:What it Does
Money is 1. a unit of account. Everything in economic life can be measured by money. Things as diverse as a ton of coal and a billet of pig iron have values delimited in dollars. As such, we can sum the value of a wide range of items to a dollar total. An example of this is a persons "net worth". Net worth is the sum of the dollar values of all of a person's assets and liabilities. We add up you money holdings, savings, stocks and bonds, coin collections, etc.. To this we add the value of your house and car, for example. Against these assets we must subtract your liabilities, you mortgage, car loan, student loans, credit card balances, gambling debts, etc. The result can be either positive or negative. In any event, money has served to "account" for your worth. Money is a unit of account.
Money is 2. a store of value. You can hold your wealth as money. If you do, however, you'll miss out on interest earnings, and suffer the eroding effect of inflation on you money holdings. Still, holding your wealth as money is better than holding it in the form of, say, cantaloupes. After a few weeks, your cantaloupe wealth would be worthless.
Money is 3. a medium of exchange. Money allows us to carry on purchasing transactions. It allows us to escape the bonds of barter. Barter, where we directly exchange one good for another, is limited because for every transaction we have to find someone who wants exactly what we have and who has exactly what we want. Then we need to work out the terms of trade. With money, we have something everyone wants. Purchases are much simpler. We simply need to find what we want at a price we like. Without money's role as a medium of exchange, the modern economy would not be possible.
Money:What it Is
Many things have been money over the centuries: cattle, stones, beads, iron, copper, zinc, cigarettes, silver and gold, for example. Things that are money because they have an intrinsic value are considred commodity money. Of these items, gold and silver hold a place of special importance. They have qualities which are important for any useful commodity money. They are relatively scarce, have a high value for unit of mass, are easily divisible, are durable and easily worked. They are, furthermore, considered rather valuable in and of themselves. Up until quite recently, gold was money. In 1933, the United States went off the domestic gold standard. Gold was stored in government vaults (Fort Knox is the most famous of these), and in it's place people were issued paper money which, purportedly, was "backed" by gold or silver on a one for one basis (actually, the enabling law allowed Congress to reduce the "backing" to 1/4 to one under "emergency" conditions--numerous "emergencies" occured). Finally, in 1973, the U.S. went of the international gold standard. This meant that gold and silver no longer had any monetary role whatever. They became (and remain) industrial commodities. If money is no longer gold or silver--or even "backed" by gold or silver, what is it?
There are several definitions of money, depending on what level of liquidity is being considered. Liquidity is the easy with which an asset can be converted into another asset. Currency (paper bills and coins)is obviously the most liquid of all assets. You simply spend it. Currency is money in any definition. Checking accounts are nearly as liquid as currency. With the advent of debit (or check) cards, it is simple to spend from the balances in you checking account. Checking accounts are money (along with currency) in the most common definition of money (known as M1) which we will use in this course. There are more definitions, M2 for example, which includes savings accounts along with currency and checking accounts (AKA demand deposits). For this course, once again, we shall be using M1.
How the Banking System Creates Money
When we deposit money into our checking accounts, we're pretty much aware of the fact that the banks don't keep our money "one hand": they lend it out--that's how they make their profits. Banks lend to borrowers, folks who, universally, want to buy something. They borrow the money, and spend it. The recipients of these expenditures probably take the payment and deposit it their checking account. That act increases the size of the money supply because these deposits are now money where, before, there was none. The banks receiving these checking deposits increase their loans (often keeping on hand only the minimum reserves required by law). When they lend, the recipients of the resulting expenditures will likely deposit those receipts into their checking accounts creating yet more money. This process continues until the remaining amount available for lending becomes insignificant. At the end of the process, the total money supply supported by the original deposit (see above) can be as much as 1/RR time the original deposit (where the RR equals the reserve requirement--the fraction of deposits banks must hold close at hand to meet depositors withdrawal requests).
How Monetary Policy Works
The Fed controls the money supply by increasing and decreasing the amount of reserves the banking system has to work with. The Federal Reserve "Open Market Committee" buys and sells government bonds on the open market. When the Fed buys bonds on the open market, it's sending out checks to holders of US bonds. Those bond holders, upon selling their bonds, take the check from the Fed and deposit in in their checking accounts. This very act increases the money supply by an amount equal to the Fed's bond purchases. The banks see that they now have excess reserves in an amount equal to the new deposits less the reserve requirements on those deposits. Let's say the Feb bought $5 billion in bonds. This would increase deposits in the banking system by $5 billion--and it would also increase the money supply by the same amount, because the Fed will have funded their checks by simply adding digits to the accounts upon which the Fed checks were drawn--the Fed will have "invented" the money. It had to happen somewhere. Would you have preferred a printing press and the destruction of the requisite trees to accompany the "fantisized" or "fiat" money? With the new deposits, the banks have $4 billion in excess reserves (assuming a reserve requirement of 20%--left as an exercise for the reader to verify). Armed with these excess reserves, the banking system can begin an orgy of lending. In the first round, banks can lend $4 billion, this, if redeposited as checking accounts, will increase the money supply a further $4 billion. These deposits will provide a further $3.2 billion in excess reserves after 20% is deducted. The banks lend this $3.2 billion and upon redeposit in various checking accounts, the money supply goes up by a further $3.2 billion. At this point, a further 20% is removed leaving $2.56 billion to lend--and the process goes on until the remaining amount to lend is effectively zero. At that point, the money supply will have increased by $25 billion (1/0.2) times $5 billion in original bond purchases. Clearly, if the money is ever hid in a matress or put in a savings account, the results will be somewhat different. Note, also, that in order to increase lending by $25 billion, banks will have to have lowered the interest rate to coax out that much more borrowing. Efforts by the Fed to increase the money supply provide banks with more reserves, encourage increased lending, reduced interest rates in increased spending and aggregate demand. The economy is, as a result, stimulated. Should the Fed sell bonds on the open market this will put bonds in the publics' hands. They will probably pay for the bonds by writing checks on their various checking accounts, drawing down the money supply and draining the banking systems available reserves. As a result of paying out, say $5 billion for new bonds, checking accounts holders will have made "withdrawals" on their checking accounts equal to that amount which the banks will have to meet out of available reserves. This reserve reduction will mean that banks will be short of reserves and will have to stop lending, call in loans that can be called (call loans--is the term) and will let loans that expire do so without re-lending the proceeds. Interest rates will go up, borrowing and spending will go down and the economy will be slowed down. That (above) is how monetary policy works.
Monetarism
In the late 1950's and on through the 1960's a school of economic thought emerged from the University of Chicago unter the guidance of Milton Friedman. They called themselves Monetarists. They believed that monetary policy was highly effective and fiscal policy (see lecture six) was useless. They accused Keynesians of ignoring the importance of money. Keynesian economists hadn't paid much attention to monetary policy because it was felt that, since all that monetary policy did was add or subtract reserves from the banking system, it couldn't do much to stimulate an economy that was mired in a true depression. You can give the bankers money, but you can't make them lend--and if they can't expand lending, there is no economic stimulus. While this is probably true during a depression, it's also true that monetary policy can really slow down an overheated economy. If the banks don't have adequate reserves (because the Fed has "sapped" them through bond sales), then the banks can't lend and aggregate demand will go down. By the mid-1970's the US was mired in serious "Stagflation" (high unemployment and high inflation simultaneously). Congress was paralyzed. The only way to deal with the inflation was to have a recession-depression, and no one in Congress wanted responsibility for that outcome. It became clear that we needed to address the inflation without worrying about the resulting increased unemployment, and only the Fed had the political independence to create a serious recession without facing the political firestorm. Jimmy Carter brought on Paul Volker as Chairman of the Federal Reserve Board in 1979, and Volker cut the growth of the money supply dramatically, plunding the economy into as severe a recession as it had faced since 1929 (though not as severe as that historic collapse). It is probable that Volker, or at least many of his staffers, were Monetarists. Monetarists, under the guidance of Milton Friedmand, argued that fiscal policy was pointless since any effort on the govenment's part to borrow money would inevitably simply bid funds out of the hands of private borrowers. The result of the government "crowding out" private borrowing in an amount equal to it's own borrowing would be no net stimulus to the economy. After all, the gain in govement spending financed through borrowing would come at the cost of an equal reduction in private borrowing. Result, no change in total spending or aggregate demand. Not only was fiscal policy useless, monetary policy was powerful and unpredictable. Friedman wrote a book called the Monetary History of the United States in which he argued that all economic disasters experience by the United States were the result of ill advised monetary policy actions. It is as though, Friedman might say, we're driving down an winding mountain road in a car with a random delay steering mechanism. We know if we turn right that we'll turn right eventually--we just don't know exactly when and by how much. Trying to guide the economy using monetary policy is just that uncertain. We will, unavoidably, run off the road. The correct procedure is to simply increase the money supply by a constant percent (3-4%) per year, effectively forever. In this way, there will be no unfortunate monetary shocks, and the economy, Friedman argues, will gravitate to full employment and remain there with stable prices. Since output can be expeced to increase (in real terms) at about 3 to 4% a year, increasing the money supply apace will keep prices constant. Friedman is akin to Adam Smith. He wants a policy of minimal government regulation and control. With Friedman, the new-classical economists were back in control. It's clear, now, that the Fed is not pursuing anything like a monetarist economic policy. They are using active monetary policy to attempt to achieve stable prices and something like full employment. Obviously, the jury is not yet in on their succcess.
