Money and Monetary Policy

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Money and Monetary Policy

Economists use the word money to mean whatever is accepted as payment for goods and services. Today in the United States, one measure of the money supply is the sum of coins and currency in circulation plus funds in checking accounts (this is roughly the definition of M1).

Using money is more convenient than the alternative, which is barter. In barter exchange, goods trade for goods. Barter makes it necessary to find someone who not only has what you want, but also wants what you have. This double coincidence of wants necessitates more search and hence higher costs of completing a trade than monetary exchange. In monetary exchange, money is always on one side of the transaction. Once people have money, they only need to find someone who wants to trade what they want, because they know money will be accepted as payment. Money also serves as a means of storing value over time (although typically this is not the most efficient means of doing so) and as a unit of account in which prices of goods and services are expressed.

THE QUANTITY EQUATION

The quantity equation is a useful framework for understanding how changes in the money supply (M) influence both the price level (P), which is the average money price of goods and services, and the quantity of goods and services produced per year (Y). The quantity equation is: M x V = P x Y. If the currency unit is the dollar, then the price level (P) is measured in units of dollars per good. Since Y is the physical quantity of goods and services produced per year, the product P x Y on the right side of the equation is ($/good) x (goods/year) = $/year. Another name for P x Y is nominal Gross Domestic Product, which for the United States in 2004 was about $11 trillion. If M equals $1 trillion and P x Y = $11 trillion/year then V, which is called velocity, has to equal 11/year. Hence velocity is the number of times per year that a unit of money (e.g., a dollar) is spent. The quantity equation says that, if velocity is constant, an increase in the money supply (M) means that P x Y has to increase.

Economists have discovered that increases in M will temporarily increase Y, since typically firms are slow to adjust prices to changes in the money supply. For longer intervals of time or for large increases in M, increases in the money supply cause inflation, that is, a growing price level. The question that naturally arises is, what determines the quantity of money?

VARIOUS FORMS OF MONEY

Since 1450, exactly what form money takes has varied by region and historical period. In Europe circa 1450, gold, silver, and copper coins were used as money. These coins were minted by governments, and when a government was not under financial stress, they contained fixed quantities of silver or gold. Unlike the token coins of today, these gold, silver, or copper coins were "full bodied coins" which means they had metal content equal to their monetary value. In 1450 few countries used paper money. In fact around 1450, China stopped using paper money, after having used it for five hundred years.

Paper money began to be used in Europe around 1660, when goldsmiths in London issued notes (i.e., paper money) that could be exchanged for gold. This is an example of representative commodity money. Goldsmiths and later bankers discovered that since most of their paper notes circulated, and only some were returned for redemption in gold, more paper notes could be issued than there was gold to back them. This was the beginning of fractional reserve banking, where banks hold only a fraction of their bank deposits in the form of reserves—gold coins in the gold standard period, for example, or today as central bank currency or funds held in central bank accounts.

Central banks are a bank to private banks. Central banks lend reserves to banks, clear checks, and issue currency. Currently in the United States money consists of token coins, fiat currency, and funds in checking accounts that can be redeemed in token coins and fiat currency. Token coins are coins whose metal content is worth less than the monetary value of the coins. "Fiat money" is paper money issued by the government that is not redeemable in terms of any fixed amount of a commodity, such as gold or silver, but has value by government fiat. That is, the government states that money is legal tender, in other words legally used for payment of all debts, public (e.g., taxes) and private.

A CHANGING MONEY SUPPLY

Historically one important influence on the amount of money in an economy is a government's need for revenue. When governments have needed or wanted to spend more than they could collect in tax revenue or borrow, they resorted to printing money. In the period where coins were the main form of money, governments (kings and queens) when wanting to spend more than they could collect in taxes or borrow resorted to currency debasement. That is, they decreased the metal content of coins to create more coins, to pay for the shortfall of tax revenue over government spending.

After the use of paper money redeemable in silver or gold became widespread, printing paper money to finance a government budget deficit was only possible if a country was not on a commodity standard. Under a commodity standard, a country's currency is redeemable in the commodity. This means that the amount of money that can be created is constrained by the amount of the commodity owned by the government. For example, with a gold standard the money supply equals the currency price of gold (e.g. $21/ounce) times roughly the quantity of gold in the country. In times of large budget deficits, governments sometimes suspended payment, no longer redeeming their currency in terms of gold or silver. This meant that a government could print fiat paper money that was not backed by gold or silver.

In the late seventeenth century and eighteenth century, various American colonies issued fiat paper money both to finance government spending and to deal with the problem of a lack of coins. Without the constraint of backing paper money with a commodity and faced with a need for revenue, colonial governments, such as Rhode Island in 1770, printed large quantities of paper money. The result, as predicted by the quantity equation, was inflation, which in the case of Rhode Island was sufficiently high to make its currency worthless.

The American Continental Congress, in financing the Revolutionary War of 1775–1783, resorted to printing fiat money, called continental dollars. This resulted in high inflation that made the continental dollar worthless. In 1797, Britain suspended convertibility of its currency to gold and printed fiat money to finance the Napoleonic Wars. After Napoleon was defeated, the British pound resumed convertibility to gold in 1821. In the early 1920s, Germany financed its budget deficits by printing so much fiat money that hyperinflation occurred, with prices increasing by a factor of 100 billion in a period of fifteen months.

Under a commodity standard, increases in the world supply of the commodity itself were a major external determinant of the quantity of money. These increases occurred both due to discoveries of ore deposits and the development of new technologies for extracting and processing ore. For example in the first half of the sixteenth century, gold and silver from Spanish colonies in South America resulted in an increase in the European money supply, resulting in a rising price level in Europe into the middle of the seventeenth century. Other examples of increases in the supply of commodity include gold discoveries in the middle of the nineteenth century in California and Australia, as well in Canada in the late nineteenth century, and the development of new technologies for extracting and processing ore.

Another external determinant of the money supply under commodity standards was the balance of payments in international trade. Countries exporting more goods than they were importing, that is running a balance of payments surplus, experienced an inflow of gold or silver that foreigners used to pay for the excess of goods purchased over goods sold. The result was an increase in the domestic money supply and an increase in the price level. Conversely, balance of payments deficit countries experienced a decrease in their money supplies and a decrease in their price level. The rising prices in balance of payments surplus countries made their goods more expensive, and the falling prices in deficit countries made their goods cheaper, thereby bringing the surplus and deficit countries into trade balance with each other.

The type of money used in a country can change over time. For example in colonial America tobacco and wampum (seashells) were used along with various European coins as money. From 1792 to 1832, the United States was on a de facto silver standard, and then from 1832 to the Civil War in 1862 it was on gold. From 1862 to 1879 the United States printed fiat money, called "greenbacks," to help finance the Civil War (1862–1865). Then from 1879 to 1933 the United States was back on a gold standard.

THE EVOLUTION TO FIAT MONEY

The evolution of the world economy, from a gold standard to fiat money, took place in a series of steps from the 1930s to 1971. The period 1870–1914 is known as the classical gold standard period, during which the core economies of the world were on the gold standard. World War I (1914–1918) destroyed the classical gold standard, as countries printed fiat money to finance military spending. After World War I, in the 1920s, Germany, France, and the United Kingdom returned to the gold standard. Britain chose to return to gold at its prewar pound price of gold. This required that the central bank of England decrease the money supply, which caused an economic slump and deflation in Britain in the 1920s. In 1928 the U.S. central bank, concerned with stock market speculation, decreased the growth of the money supply. Other countries on gold had to follow U.S. monetary policy to maintain convertibility to gold.

The consequence was a recession that began in 1929, which through a series of monetary and fiscal policy mistakes evolved into the Great Depression. Countries that left the gold standard and increased their money supplies, such as the United Kingdom and Japan in 1931, suffered less than the United States, which remained on gold. In 1933 the United States raised the dollar price of gold, which along with gold inflows from Europe in response to expectations of another world war, resulted in an increase in the U.S. money supply. This caused the economy to expand after 1933, and along with the increased military spending beginning in 1940 put an end to the Great Depression in the United States.

After World War II, the goals of monetary policy became oriented toward low unemployment and low inflation. However, an attempt was made to return partially to a gold standard with the Bretton Woods System. Under Bretton Woods (which lasted from the 1950s to 1971), member countries used monetary policy to maintain a fixed price of their currency in terms of the U.S. dollar. The United States was supposed to convert the dollar to gold if asked to do so by member countries.

The Bretton Woods System broke down when the United States followed an inflationary monetary policy in the 1960s. This resulted in the United States running balance of payment deficits, which meant that other countries accumulated U.S. dollars. In the late 1960s the United States came under pressure to redeem dollars for gold. With insufficient gold to do so and not being willing to reduce the U.S. money supply, the United States announced in 1971 that it would no longer redeem dollars for gold. This ended the Bretton Woods System and any link between money and gold. Since the collapse of Bretton Woods in 1971, every country has used fiat money.

CENTRAL BANKS

The fiat money supply is controlled by the central bank of a country or common currency area. In the United States this is the Federal Reserve System. In the euro area, the central bank is the European Central Bank. A central bank controls its money supply by controlling the supply of bank reserves. If a central bank wants to increase the money supply, it buys a bond and pays for the bond by writing a check. Unlike every other checking account, a central bank check is unique in that whenever a central bank writes a check, the action of writing the check creates funds equal to the account of the check. When the seller of a bond deposits the check from the central bank into its private bank, the central bank increases that bank's reserves by the amount of the check. Since bank deposits have increased, the result is an increase in the money supply. Conversely whenever a central bank sells bonds and accepts a check in payment, a central removes funds equal to the amount of the check from the reserve account of the bank on which the check was written. This results in a decrease in the money supply.

Part of the reason for the collapse of Bretton Woods was the rising inflation in the United States from 1965 to 1979. This was caused by an attempt to permanently lower the unemployment rate by making the money supply grow faster. Unemployment was lowered only temporarily, and inflation increased. This higher inflation was spread to the rest of the world via the fixed exchanged rates of Bretton Woods. By 1979 high inflation was politically unpopular, and there was a political consensus to decrease inflation. From 1980 to 1985, inflation fell in the world as central banks reduced the growth rate of the money supply. This resulted in a severe recession in the early 1980s and then in low inflation for the twenty years from 1985 to 2004. In the last twenty years of the twentieth century, the focus of monetary policies has shifted to maintaining low inflation.

The quantity equation shows how controlling the amount of money in the economy can influence the price level and hence inflation. Recall that over long periods of time, changes in the money supply primarily influence the price level (P). To obtain a desired price level or growth rate of the price level (i.e. inflation), central banks make bank reserves grow and hence make the money supply grow at a rate consistent with the desired rate of inflation.

In summary, from 1450 to the end of World War II, money was backed by gold or silver. Except in times of war, the primary goal of monetary policy was to maintain convertibility of paper money (once it was invented) to gold or silver. After World War II the focus of monetary policy switched to having central banks control the supply of fiat money to achieve low unemployment and low inflation.

SEE ALSO Banking; Bullion (Specie); Commodity Money; Gold Standard; Gresham, Sir Thomas;Quantity Theory of Money.