Unit 11: Monetary Policy

Jim’s Guide for Unit 11

What is Money?

Money is obviously an important part of economics. In fact, many people mistakenly think economics is just the study of money — of course, by this point in the course you know that’s not true. Economics is about how people, individually and as a society, cope with scarcity by producing, exchanging, and consuming. Nonetheless, money does play an important role in economics, particularly in macro-economics.

But before we can examine the role money plays in the economy, we need to define money first. In other words, we need to answer the question: What is money?  You may think the answer is obvious: money is that stuff in your pocket that you use to buy things (granted some of you might suggest that money is exactly what you don’t have in your pocket and that’s why you’re broke). It’s also known as currency, cash, moolah, chickenfeed, scratch, dead presidents, etc. Well, you’re right. But is the paper currency and coins in your pocket all there is to money? Think about it a little deeper. Why are the paper dollar bills in your pocket considered money, but the piece of paper in my pocket with a grocery shopping list scratched on it isn’t considered money? They’re both paper. Why is a quarter “money”, but a prize token from Chucky Cheese isn’t? They’re both shiny tokens of metal. What is it about money that makes it, well, money?

Simply put, money is a token of purchasing power – it’s evidence that its holder is owed something or entitled to purchase something. In the absence of money, people have to trade with each other by exchanging goods directly, a process called barter. An example of barter is two kids sitting in school lunch room and each deciding the other’s lunch looks more appetizing. They negotiate an exchange: “I’ll give you my ham & pickle sandwich in exchange for your cheese, crackers, and cookies.” The problem with barter is that it breaks down when when the number of goods and people gets large. It’s dependent on finding two traders who each want what the other has (a condition called double coincidence of wants). Large-scale barter simply isn’t feasible.

An even greater problem with barter involves time. In a barter exchange, not only do we need to have a double-coincidence of wants (you must need what I have, and I must need what you have), we need to have a coincidence in time.  We must both want to make the same exchange at the same time. But that isn’t desirable. Let’s take an example. Suppose you are going to exchange your labor for food to eat.  Let’s further suppose your employer, let’s call him pointy-haired boss, actually has food and wishes to use your labor. Under a barter system, you work only when you’re hungry. But pointy-haired boss might need you to work all day on some days and not at all on other days.  Do you just starve on the other days?  You might say, well the pointy-haired boss could give me a promise that he will feed me on my days off if I work all day today. Ok, but do you trust the pointy-haired boss?  Besides, if he gives you a promise to feed you next Saturday, what do you if he reneges? So you say, “well let’s write the promise on paper and make it a legally enforceable contract where he owes me so much valuable food”.  This is better, but you’re still dependent on the boss living up to the contract.  What if the pointy-haired boss gets hit by a truck on Friday and can’t deliver on his promise?  It would be better if the paper promise of future value was usable somewhere else besides the pointy-haired boss.  If it was, we would have “money”: little promises (credits) of economic value that can be redeemed in the future for real things.

So, there we have it.  Societies have invented “money”.  Money is credit. It’s promises to deliver real economic value that are universally redeemable within that society/nation.  Typically money is measured or denominated in little somewhat standardized units of value.  In the U.S. the unit of money is a “U.S. dollar”.  In Japan, it’s a “yen”. In the U.K. it’s called “a pound sterling”.

In our modern society, the use of money has evolved significantly. With modern technology, we no longer need to use some actual, physical commodity as the token of purchasing power. Instead, we now carry pieces of paper that are themselves tokens of the purchasing power we possess. We can use these pieces of paper to buy and sell. Computer and network advances of the last 40 years have taken us to to the point where we don’t need any physical tokens at all. Instead a record of our purchasing power is kept simply as a number on a computer at some bank. When we buy something, we simply tell the bank to reduce the number that represents our purchasing power (your bank balance) and to increase the seller’s record of purchasing power (the seller’s bank balance). It’s still useful, though, to think of those numbers at the bank as representing some amount of actual money tokens.

History of Money

Money is what economists call a “social contrivance” – a  practice or institution that society has defined and created and isn’t naturally occurring.  Since societies have evolved throughout history, so has money and the tokens used. Like many concepts in macroeconomics, there are two different stories of how money came to be in society.

One commonly offered explanation of the history of money emphasizes money’s role in overcoming the double-coincidence of wants problem of barter.  This story  or version of the history of money (the private evolution of livestock-to-precious metals-to-gold-to-paper, not the video), has been relatively popular among economists, particularly Classical-oriented economists, for a long time.  It’s origins come from some speculation by Adam Smith that societies at one time were barter-based and searched for a better way.  The story is popular because it suggests there’s little room or need for government in the history of money.  In fact, government is often cast as a “bad guy” for having debased money by diluting the gold content of coins.

Unfortunately, the story hasn’t held up well in the light of historical, anthropological, and archaeological evidence.  (never underestimate the ability of some theoretical economists to ignore factual evidence!). The story of gold-was-the-original money is simply false. The historical and archaeological evidence suggest a different story for the history of money, a story called the “chartalist” view.  What we find historically is that money only exists where and when a strong or credible government exists. And, we find that markets and a widespread market economy typically only exist where a stable money exists created by government.

In the real history of money, money is created when a government or ruler finds itself in need to purchasing or obtaining real goods and services. For example, an early ruler needs food and weapons to feed and equip soldiers. The government or ruler, having nothing to trade for these goods creates or defines some token and calls it money. The token has no inherent economic value on it’s own. The sovereign, the ruler, offers to pay for goods by paying with the tokens.  Obviously, it’s not much of a deal for the farmers or blacksmiths.  What are they going to do with these useless tokens?  To provide and define value for the tokens, the sovereign levies a tax on the people and declares that the tax can only be paid using tokens.  But how do the people get the tokens to pay the tax?  The farmers and smiths are now willing to sell real goods to the sovereign ruler in return for the tokens since other citizens are willing to sell real goods to the farmers and smiths so the citizens can get their hands on tokens so they can pay taxes.  The tokens now have an accepted economic value and begin circulating as money and as a medium of exchange. As long as there is confidence that the sovereign will continue to rule, people are even willing to accumulate and a store of tokens for future spending (savings). If enough money begins to circulate and gets accumulated, then wealthy people can create banks and make loans of money using paper certificates that promise they can be converted into tokens.

This chartalist account of the history and evolution fits well with historical and archaeological evidence.  The most common tokens of money issued by governments throughout history have been coins based on some kind of precious metal alloy.  But contrary to some myths, coins have never contained enough precious metal to define their value.  In other words, there’s never been enough gold in a gold coin to justify it’s circulating face value. Even gold coins have only ever been tokens, not actual bits of the commodity. At times governments have used tokens other than metal-alloy coins as their tokens of money. Obviously, today we use pieces of paper with pictures of dead presidents on them as tokens.  In ancient Mesopotamia, little pieces of fired clay were accepted as tokens and money.  For a long time throughout the middle ages and even later, wooden sticks with distinctive marks, called “tally sticks”, were accepted in England as money and as payment for taxes.

A reminder of this history of money as a credit token to be used to pay taxes is engraved on our coins and paper dollars today.  On the U.S. one dollar bill, just under the “THE UNITED…” part in the upper left, you’ll see this inscription:  “This note is legal tender for all debts, public and private.”  That’s what separates that one dollar bill in your hand from any other approximately 2 1/2′ x 6″ piece of paper.

One implication of this analysis of money is that government does not have to tax or borrow first before the government can spend.  Instead, government spending (deficit spending) actually creates the money in circulation that the economy needs.  The government can tax to bring the money back into the government but that is only necessary to create a demand for the money in the first place.

Banks have been integral to market capitalism and industrialization. While the story of the trade revolution (1600′s) and industrial revolution  (1700′s-to present) have gotten the most attention in history books, these revolutions went hand-in-hand with the invention and evolution of banking.  Today we live in a world of “fiat money” dominated by “fractional-reserve banking”.  We have fiat money, which means what we think is money (dollars in the US, euros in Europe, etc), only has value because some government says it has value and will accept it as payment for taxes. There is no gold backing it up. There is no gold or other commodity backing the money.

Jim’s Observation:  Warning! Thinking about money, banking, and credit, particularly at the macroeconomic level, is not easy.  It’s also often somewhat uncomfortable for people.  We grow up since we were little kids just knowing that money is a valuable asset or commodity.  It’s a convenient good thing that we carry around and exchange for other things.  It’s’ “real” we think.  Think again.  It’s not “real” in the economic sense and it’s not natural. Money is purely a social invention. Money isn’t really a valuable commodity.  Instead, money is just credit. It’s a promise to deliver real economic value sometime in the future. That’s it. It’s just promises. One suggestion: think about how money is treated in science-fiction movies like Star Wars.  In those movies, people buy things by exchanging digital “credits”.
Also, we grow up thinking banks are safe places that store our valuable money for us.  They don’t. Banks actually create the money they lend to us, and they lend out the money we deposit with them, all in an effort to make profits for themselves. Their ability to do this depends on the confidence we have in the banks.  Banking is quite definitely, as you will see, a “confidence game”.

If, at some point in thinking about money and banking,  you don’t feel like you’ve fallen down the rabbit hole like Alice in Wonderland, then you’re probably not thinking about it clearly enough. Even some of the greatest monetary economists have said that same.  I will help you through this, but I’m just warning that a lot of long-held assumptions about what money is might be disturbed.

Money changes everything it is said. That is certainly true in macroeconomics.

Why We Need Central Banks (or something like them)

The invention and evolution of money is one of the most important (and powerful) developments in all economic history. Money enables trade and specialization, which raise living standards. But the existence of money creates new problems, such as safe-keeping it and borrowing. Banks evolved over the past several hundred years as a solution to these problems. One of the problems a growing economy faces is having enough money in circulation to facilitate trade.  Part of the problem is that some people accumulate money as wealth and “store it away”.  That takes the money out of circulation. If enough rich people save enough money, then the economy is deprived, starved even, of money so people can buy and sell. One solution is for banks to safe-keep the savings of wealthier people and then loan it out to those who need it for transactions.  The growth of banking was most dramatic in the 18th and 19th century. But while banks solve some economic problems for customers, the banks themselves can run into problems. But banks learned a long time ago that they could loan out more money than had originally been deposited. This is called fractional-reserve banking. The greatest problem a fractional-reserve bank can encounter is a bank run. If deposit customers panic and attempt to withdraw an unexpectedly large amount of funds suddenly, the bank won’t have enough cash reserves to make good on the withdrawal requests. The bank will fail. When banks fail, the remaining depositors lose their deposits completely. [note: modern depositors are insured against bank failure by FDIC to protect deposits up to $100,000].

Bank runs aren’t the only problem banks face. Another more basic problem is “what to use for money?” Historically, gold, silver, and government-issued coins were the most common monies. But metals are cumbersome and difficult to use. So eventually people began trading and using the paper receipts they got when they made a deposit at the bank. These receipts were quite fancy (to prevent counterfeiting) and issued by the bank itself. These paper receipts, properly called bank notes, were the original paper money. They were actually receipts that could be taken to the issuing bank and redeemed for gold, silver, or coins. For example, consider this image of a $5 dollar bill likely to be seen in Michigan in the early 1900′s:

At first glance, it looks like any ordinary $5 dollar bill. It has Abraham LIncoln on the front and the Lincoln Memorial on the back.  It’s green. But look closer.  It says that the “First National Bank of Sault Ste Marie will pay to the bearer five dollars” and it’s labeled “National Currency” at the top. The bank issued this note itself a common early practice.(for more examples see:  http://www.banknotes.com/us.htm)

Historically, paper money proved quite popular. After all, who wants to carry all that gold or coins around when you can use a few scraps of paper. Eventually each commercial bank issued it’s own bank notes or paper money. This brought a new problem since not everybody would accept just any bank’s notes. Eventually governments moved to control the issuance of paper money. What we call currency was born.

Government control or standardization of the issuance of paper money created new problems. In particular, a problem of controlling the quantity of money arose. The problem was how to ensure that banks actually had enough reserves (cash) on-hand to pay withdrawal demands and to make sure that the quantity of money wasn’t growing too fast or too slow. After a series of banking panics in the 19th centuries, most nations moved to create central banks. The U.S. twice attempted to create a permanent central bank between 1788 and 1836. However, after that Congress banned having a central bank. In 1909 we had another of the increasingly frequent banking panics, except this one threatened to take down all of the large New York city and Wall Street banks. Following this crisis, Congress created The Federal Reserve System in 1913, our version of a central bank.

Central banks solve a wide range of problems. They can regulate the creation of the new money that banks create when they make loans. They regulate commercial banks to ensure banks are solvent, have adequate reserves,and are not taking excessive risks. They facilitate transactions between different banks and help to clear checks. They provide a mechanism to exchange one nation’s currency into another nation’s currency (foreign exchange), which facilitates international trade. They replace worn-out and used coins and currency (ever wonder what happened to that dollar bill you tore and taped together?). Central banks are useful, particularly to commercial banks. Central banks also have the potential to be useful to the nation and the larger economy through monetary policy, if the leaders of the central bank choose to do so.

Because central banks have the powers to provide these services, they also have enormous economic power and influence. In short, central banks can influence the money supply, the general level of interest rates (especially short-term rates and rates on government bonds), and how fast commercial banks create new money in an economy.  Through interest rates, they usually have enormous influence on how much investment spending happens in the economy and how much consumer spending occurs, meaning the can influence real GDP. Although the central bank doesn’t directly set most interest rates, their decisions on the one interest they can set (discount rate), they can strongly influence all other rates either up or down.  This means central banks have enormous power to influence (not control) the growth of GDP.

In today’s modern economies central bank monetary policies are at least as important, if not more important, than government fiscal policies in determining whether we achieve our macroeconomic goals. In the period since the late 1970′s when pure Keynesian fiscal policy began to fall out of favor with policy-makers, central banks assumed even greater importance.  In most of the industrialized, developed economies of the world, it has been central banks (The Fed, Bank of England, EuroBank, Bank of Japan, etc) that have done most of the “heavy lifting” in managing policy to achieve macroeconomics goals, with Keynesian fiscal policy often being considered as a second-option in case monetary policy failed such as it did in 2008-09,

The Federal Reserve System

The Federal Reserve System is an extremely powerful institution. The comments of just one member of the Board of Governors can cause traders and investors on the stock exchanges to push stock prices up or down the same day. And that’s just when The Fed talks. When The Fed acts, markets and the entire economy respond.

The currency with the largest circulation in the world is the U.S. dollar. Since, The Federal Reserve System can increase or decrease the reserves of banks that loan U.S. dollars, it is one of the most powerful economic organizations on the planet.

The Federal Reserve Bank and Interest Rates: The “Price” of (Borrowed) Money

A lot of confusion exists in the news media and among the general public about the relationship between The Federal Reserve and interest rates. It is often stated that The Federal Reserve “sets” interest rates. Strictly speaking, this isn’t true. There are many, many different interest rates depending on the loan involved: mortgage rates for home loans, prime rates on business loans, Fed Funds rate for inter-bank loans, the discount rate for Fed-to-banks loans, and outrageous rates for credit cards. If by “set” we mean The Fed meets in a room and picks a number and that’s the interest rate, then the only interest rate The Federal Reserve is able to “set” is the discount rate.

Although The Fed doesn’t “set” the Fed Funds rate, it does have enormous influence on the Fed Funds rate. The Fed Funds rate, you should recall from previous units, is the
interest rate that banks charge each other. Every day some banks have excess reserves for which they don’t have borrowers. At the same time, other banks are finding themselves either short of reserves or have borrowers but excess reserves to lend. Letting money sit idle is expensive – it’s lost profits for a bank. So banks with excess reserves make “overnight” loans to other banks that have too many borrowers but no reserves. The interest rate banks charge each other in this “money market” is called the Fed Funds rate, even though The Federal Reserve isn’t doing the lending. The Fed Funds rate is market rate. It’s determined by supply and demand. When there are more banks with more reserves to lend (supply) than other banks want to borrow (demand) the price of the loans (the Fed Funds interest rate) goes down. When there’s a shortage of reserves to lend, the price (interest rate) goes up. The Federal Reserve doesn’t directly set the Fed Funds rate. But, The Federal Reserve has tremendous influence on the Fed Funds rate. How? Since The Fed can increase or decrease bank reserves, it is effectively able to control the amount of money (reserves) that the banks have to lend each other. The Fed can control the supply of money. By increasing or decreasing the supply of money, The Fed can push the Fed Funds rate up or down. In practice, since 1988, The Federal Reserve has set “targets” for what it wants the Fed Funds rate to be. Whenever the Fed Funds rate gets too high, The Federal Reserve conducts open market operations (buys securities) and increases bank reserves, increasing the money supply, and driving the Fed Funds rate back down. If the Fed Funds rate gets too low in The Federal Reserve’s opinion, then The Fed removes excess reserves from the banking system (sells securities or raises required reserve ratio), which reduces the supply of money and raises the Fed Funds rate.

The other interest rates are only indirectly affected by Federal Reserve actions. The Fed Funds interest rate can be thought of as the “price of the raw materials” for a bank. If the Fed Funds rate goes up, then it has raised the cost to the bank of obtaining money to lend to home-owners, businesses, car owners, etc. Banks typically raise these other interest rates whenever there is a sustained increase in the Fed Funds rate. Vice versa when Fed Funds rate falls. For example, in late 2000 the Fed Funds rate was typically close to 6%. Banks would borrow from each other at 6% and lend the money to businesses at 9%, the “prime” rate that businesses were paying on loans. The bank was making its profit on the spread (3%) between the two rates. Two years later, the Fed Funds rate had dropped to 2%. As a result, the prime rate dropped to approximately 5%. The banks’ profit spread was still there at 3%. There is no law or mechanism that forces banks to lower other interest rates when the Fed Funds rate drops. Only competition between banks causes this. Indeed, during this same two-year period mortgage interest rates dropped, but not as much as the Fed Funds rate or prime rate did.

So, we can see that The Federal Reserve doesn’t directly “set” interest rates, but it does have an enormous influence on the general level of interest rates. The Federal Reserve can “drive rates up” by reducing the supply of bank reserves available to lend or by making borrowing bank reserves (discount rate or Fed funds rate) too expensive. It can also, in theory at least, “drive rates down”by increasing the supply of money. In practical terms, the power to drive rates up is greater. Attempts to drive rates down won’t always work quite as well. For one reason, once the interest hits 1% or less, it can’t really go much lower. Another reason is that while The Federal Reserve can make sure banks have plenty of money to lend, The Federal Reserve can’t make sure that there are people wanting to borrow the money. On occasions, this has been a problem. For example 2002 The Federal Reserve flooded the banking system with extra money and reserves, but there were relatively few borrowers who wanted to take out new loans. The Federal Reserve can only control the supply of money.  In the past 3 years, this has been a particularly difficult problem.  Since the Great Recession/Financial Crisis of 2008-09, The Fed has made sure that banks have plenty of bank reserves.  Banks have been swamped with excess reserves, yet they haven’t been loaning out the money.  Instead, they have largely used the money as a safety cushion or used to speculate in derivatives markets.

How Monetary Policy Can Stimulate/Contract the Economy Through Interest Rates

How do interest rates affect GDP, aggregate demand, and to a lesser degree, short-run aggregate supply? The mechanism of this transmission is mostly through investment spending and consumer spending on durables like cars.

Remember the AD-AS model. At any given moment in time, the economy is at a short-run equilibrium at the intersection of AD and SRAS. In other words, we are spending and trying to buy the same amount of goods (AD) that producers want to sell us (SRAS), given the current price level. For real GDP to change this point of intersection must move. But to make the short-run equilibrium (the point of intersection) change, one of the curves must shift. The focus of fiscal policy was on making the AD curve shift. The way fiscal policy makes AD shift is by increasing the amount of government spending (G). Since G is one component of AD (remember AD = C+I+G+X-M), an autonomous decision by government to increase G shifts AD to the right. Along with the shift in AD, the point of intersection shifts right and real GDP increases.

Monetary policy ultimately works the same way in that it shifts the Aggregate Demand (AD) curve. But where fiscal policy changes G, monetary policy changes I. It also changes a small part of C, but it works to just focus on changing I. Monetary policy works by changing interest rates. When interest rates go down, businesses (and consumers, too) are encouraged to spend more on investment (or houses, or new cars).

For expansionary monetary policy, the process works a little like this:

  • The Fed conducts an open market operation and buys securities/bonds from banks, creating excess reserves in the banking system.
  • Banks have a large excess reserves and need to make loans so the bank can make profits. Banks compete to get borrowers by lowering interest rates
  • The lower interest rates encourage businesses to increase their investment spending. For example, Acme Corp might have a potential expansion project that requires them to borrow $1million and the project would ultimately return a 7% return on investment. If interest rates are high (over 7%), the project isn’t profitable. But when interest rates drop below 7%, the project becomes more attractive. With the lower interest rates, firms like Acme decide to borrow and spend the money on investment projects.
  • Consumers might also be attracted by the lower interest rates and decide to buy a new car or new house.

The increased investment spending (I) and consumer spending (C), both begin the same circular-flow multiplication process we saw with fiscal policy. Acme pays the borrowed money to a contractor, who then pays the construction employees, who then increase their spending at the grocer, who then increases his spending, etc, etc.

In summary, we can say:
Fed buys bonds and announces lower interest rates >> drives interest rates down >> encourages more borrowing & spending >> increases AD (shifts right) >> increased GDP

If The Fed wanted a contractionary policy, the reverse holds true. The Fed could move to reduce bank excess reserves by selling bonds to banks who have to use their excess reserves to pay for the bonds. That makes it harder for banks to make loans and create M1. When the interest rates rise, businesses and consumers cut back some of their spending. Businesses cancel expansion projects. Consumers make their old used items last longer and don’t buy a new house or new car. Spending declines and AD shifts left, reducing GDP.

So, in the short-run, in theory The Fed (or any central bank), has very powerful tools to increase or decrease Aggregate Demand. In doing so, it can affect real GDP and the price level. How The Fed uses these tools is called monetary policy. One of the advantages of monetary policy over fiscal policy is that monetary policy can be implemented very, very quickly. Indeed, it is possible with modern electronic financial markets for The Fed to implement a major change in monetary policy literally within hours or even minutes. In October 1987 when the stock market crashed and lost 23% of it’s value in one day, people were nervous about whether it would be repeat of the 1929 crash which led us into the Great Depression. People were concerned that the drop in the stock market would cause some banks to fail. But on the same day as the market was crashing, The Fed Open Market committee was able to meet via teleconference and made a policy decision to increase bank reserves. That same afternoon, the New York Fed conducted open market operations that provided banks with the necessary reserves and liquidity to prevent any failures. Within a period of hours, The Fed responded to changes in the economy and prevented a huge stock market crash from spiralling into another recession or depression. Contrast this quick-response capability with the lag times needed to implement changes in fiscal policy. Fiscal policy requires months, even a year or more, to implement significant discretionary changes in policy. This is a major reason why most developed nations look to their central banks to manage the short-term fluctuations in the economy and to keep the economy from sliding into recessions.

Reading Guide – Assigned Readings

In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:

Chapter  12 – Monetary Policy
JIm’s Comment: Given that this book is cramming all of money, banking, and monetary policy into one chapter, this is chapter is relatively good and avoids a lot of common errors.   Read the whole chapter.

Practice Quiz

Click here for the Unit 11 practice quiz.  The practice quiz will open in a new tab/window.


Unit 11 Worksheet – Data and Directions.  After you complete the data problems on this worksheet page, you should answer the questions and enter your answers in learning mgt system (Moodlerooms at HFCC).

Closer Look

Some interesting videos about monetary policy, money, and banking:

What’s Next?

This unit wraps up our study of macroeconomics. In the remaining units of this course we will look at particular social issues and their economic aspects, many of which span both micro- and macro- economics.