By Stephen Simpson
Money can be thought of as any good that is widely used or accepted in the transfer of goods and services. Today, there are three common forms of money in use. Commodity money is a good whose inherent value serves as the value of money – gold or silver being one good example. Fiat money is a good whose value is less than the value of money it represents – paper money, for instance. Bank money consists of accounting credits that can be drawn on by the depositor – checking accounts, for instance. (For more, see What Is Money?)
Money serves multiple functions in an economy. Money is first and foremost a medium of exchange. When all parties in an economy will accept money, it eliminates the need for a double coincidence of wants that goes with barter – that is, both parties have to want what the other is offering. Accordingly, money as a medium of exchange is much faster and more convenient in commerce.
Money also is supposed to hold value over time. A dollar bill or gold coin will still be valuable tomorrow or a year from now, but a fish has very little value after a couple of days because of decomposition.
Finally, money also provides a convenient unit of account. If someone quotes a price of $100 everyone will understand the value that represents. In comparison, 4.5 pounds of tungsten may have the same value, but quoting prices in tungsten is not useful as hardly any consumers can relate to the value it represents. (For related reading, see The History Of Money: From Barter To Banknotes.)
Demand for money is determined by the price level and the level of activity within an economy. Interest rates effectively serve as the cost of money, and rates are determined by the demand for money – when demand for money falls (often because economic activity has declined), rates fall and when demand for money increases, rates rise.
The Fed and the Banking System
In most countries, money is supplied by the central bank. In the United States the central bank is the Federal Reserve. The Federal Reserve not only supplies money and sets the price of money through a variety of mechanisms, but also regulates the banking system of the United States. (For related reading, see How The Federal Reserve Manages Money Supply.)
Banks are institutions that effectively buy and sell money - "buying" money from depositors, who give up the utility of spending that money in exchange for interest and safe-keeping and "selling" money to borrowers in the form of loans.
The United States, and virtually all Western economies, operates a fractional reserve banking system. This is a banking system where banks hold a government-determined minimum amount of cash or "safe" securities (called the required reserve) determined as a percentage of the bank's deposits. Banks are then free to loan the remainder to customers.
Required reserves also lead to an economic concept called the money multiplier. As the name suggests, a multiplier is a system where an initial is magnified through the system. The money multiplier is expressed as the equation: 1 / required reserve ratio. In the case of a banking system with a 10% required reserve, for instance, every $1 deposited with a bank ultimately leads to $10 in the money supply ( 1 / 0.10 ) as the deposited money is loaned out, re-deposited, loaned out again and so on. (For more, see The Multiplier Effect.)
While fiscal policy is conducted by a nation's government, monetary policy is handled by a country's central banks (which have varying amounts of independence around the world).
In the United States, monetary policy is largely conducted through three mechanisms – open market operations, reserve requirements and interest rates (in the form of discount rates).
Open market operations refer to the buying (or selling) of Treasury securities by the Federal Reserve. If the Fed wishes to increase the money supply, it goes into the market and buys securities. Conversely, by going into the market and selling securities, the Fed can remove liquidity and decrease the money supply. (For more, see How The U.S. Government Formulates Monetary Policy.)
Altering the reserve ratio either increases or reduces a bank's capacity to lend. By law, all banks must retain a specified minimum percentage of deposits, while remaining free to loan the remainder. When the reserve ratio is increased, banks are unable to make as many loans and the money supply decreases (and vice versa when the ratio is decreased).
Finally, the discount rate is the Fed's mechanism for essentially setting the price of money. By raising or lowering the Fed Funds rate, the Federal Reserve can induce banks to borrow more or less money, money which can in turn be lent out to the banks' customers and increase the money supply. (For more, see How Interest Rates Affect The Stock Market.)
Keynesian arguments argue that monetary policy can be used to influence aggregate demand, lessening the severity or length of recessions and slowing growth before an economy becomes overheated. The theory is that lower rates stimulate more consumption from consumers and more investment from businesses and vice versa for higher rates.
Monetarists do not support this view. Monetarists largely believe that changing the money supply does not produce any long-term changes in GDP and only impacts price levels (increasing or decreasing inflation). In other words, by raising or lowering rates through monetary policy, governments risk inflation and destabilizing the economy, but cannot produce any sustained change in growth.
These arguments about the efficacy of monetary policy revolve in large part around a concept known as the velocity of money. The velocity of money basically refers to the frequency with which a unit of money is spent in a given period of time; the higher the velocity, the smaller the supply of money can be for a given level of economic activity. Monetarists hold that velocity does not change quickly or often (if at all) and that an increase in money supply simply increases prices. (For related reading, see What Is The Quantity Theory Of Money?)
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