Robert J. Stonebraker, Winthrop University
The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop
University
The Role of Money
Money…is, in its effects and laws, as beautiful as roses.
…Ralph Waldo Emerson
In the official jargon of economics, money is a medium of exchange. In everyday words, money is what you spend. Nickels are money. Quarters are money. Twenty-dollar bills are money. But for large purchases we typically do not use any of these. For large purchases (and to pay those ugly credit card bills) we write checks. Checking deposits are money. In fact, checking deposits comprise the bulk of the money supply in the U.S.
The government clearly controls the number of nickels, quarters and twenty-dollar bills in circulation. Through the Federal Reserve System, the government also controls the amount of bank deposits.
The Federal Reserve System, commonly known as The Fed, began in the early 1900’s to oversee and regulate the banking system in the U.S. To minimize political chicanery, Congress created the Fed as an independent agency controlled by a Board of Governors rather than Congress or the President. Members of the Board are appointed to their fourteen-year terms by the President and subject to Senate approval, but once appointed they largely are free from partisan pressure. The Chairperson of the Board of Governors, currently Ben Bernanke, wields a disproportionate amount of clout and is probably the single most powerful voice in the U.S. if not the world, economy.
Open market operations
How does the Fed operate? What does it do? The Fed has a wide array of regulatory powers and functions, but its primary impact comes through its open market operations. Open market operations are simple enough on the surface, they are transactions in which the Fed either buys or sells government bonds “in the open bond market.” However these transactions affect the supply of money in the economy, the level of interest rates in the economy, and the equilibrium levels of aggregate demand and GDP.
How does it all work? First, consider the market for government bonds. Most government bonds are in the form of short-term, large denomination Treasury Bills that can be bought and sold through brokers just like corporate stocks. Corporations, especially banks and financial firms, frequently buy these bonds to earn interest on short-term funds. If Prudential has access to $10 million for three days, it might buy $10 million of bonds. It can hold the bonds for three days and then resell, essentially earning interest for three days. Though less often in the news than stock markets, billions of dollars of transactions regularly flow through these government bond markets.
By buying and selling government bonds, the Fed effectively can create or destroy bank deposits; that is it can create or destroy money. Think through an example. Suppose the Fed buys $10 million of government bonds in the open market from Prudential. The Fed writes out a check for $10 million and gives it to Prudential in return for the bonds. What will Prudential do with the check? Prudential will do just what you do when receiving a check; it will deposit the check in its bank account. Ah. Magic. A new $10 million checking deposit ($10 million of new money) has suddenly appeared out of nowhere. Every time the Fed buys government bonds, it creates new money in the economy. It pulls an asset called a government bond out of the economy and puts in another asset called a checking deposit. But the bond was not directly spendable; it was not money. The checking deposit is spendable; it is money.
Your initial reaction might be, “so what?” No one is any richer, no new wealth or income has been created. The Fed merely has swapped one asset worth $10 million for another worth $10 million. The magic continues.
What does a bank do with deposits? If you deposit $100 in your account, does the bank tuck that $100 in a drawer waiting for you to return and reclaim it? No. Banks are private firms pursuing profits; they earn their profits by using your deposits. They do keep part of the deposits on reserve to meet anticipated withdrawals, but they lend most of the dollars we deposit to other customers. Some of those loans will go to individual consumers as home loans or car loans, but most go to local and regional businesses. The dollars we deposit might be repackaged as a loan to a local manufacturer to expand its factory or to a local builder to finance his inventory. The difference between the interest the bank earns on these loans and what it pays us for our deposits provides the bank profit. A bank with no loans is a bank with no income.
Are you still with me? Return to the Prudential example. The Fed has written a $10 million check to Prudential that is deposited into Prudential’s bank account. Prudential’s bank is not about to sit on those dollars. Prudential’s bank is going to scout out new lending opportunities to turn those idle deposits into profit-making loans. How can the bank convince someone to borrow? The same way that Wal-Mart convinces you to buy new socks -- it offers a good deal. In this case, the bank will offer a good rate of interest on the loan. In economic parlance, those new deposits are loanable funds. The new surplus of loanable funds drives down the price (or rate of interest) until someone is willing to buy (or borrow).
What’s next? Suppose Prudential’s bank decides to keep $1 million on reserve and then lends the other $9 million to Exxon to expand a refinery. Exxon takes the $9 million and spends it. Exxon’s $9 million refinery expansion is $9 million of new investment (I) demand that, in turn, can raise the equilibrium level of GDP.
Do you see the linkages? Follow them through once more. First, the Fed buys bonds in the open market. It pays by writing a check that is then deposited in the banking system. This new deposit is new money and creates loanable funds for the receiving bank. To induce someone to borrow, the bank cuts the rate of interest. As the rate of interest falls, local firms are encouraged to borrow and invest. The new investment raises AD and the equilibrium level of income or GDP.
In short, Fed open market purchases raise the supply of money, and ultimately the levels of AD and GDP in the economy. Can you guess the effect of open market bond sales by the Fed? Yes. Exactly the opposite.
When the Fed sells bonds, the buyer writes a check and gives it to the Fed. This pulls deposits out of the banking system (and into the Fed instead). This cut in the supply of deposits (or money) creates a shortage of loanable funds in banks. The shortage drives up the price (or the rate of interest) for loans that, in turn, makes firms less willing to borrow and invest. A cut in investment pulls down AD and lowers the equilibrium level of GDP.
Monetary policy
We already learned that Congressional fiscal policy could change AD by changing taxes and government spending. Fed monetary policy can accomplish the same thing through open market operations.
Fiscal policy shifted the G and/or C components of AD, monetary policy’s initial impact is on I. If the Fed sees the economy sinking into a recession it can increase the supply of money by buying government bonds in the open market. This new money creates a surplus of loanable funds, drives down the rate of interest and raises investment demand. Similarly, if inflationary pressure is beginning to build, the Fed can cut the supply of money by selling bonds. This pulls deposits out of the banking system, creates a shortage of loanable funds, drives up rates of interest and decreases investment demand.
_______________________
Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:
1. Describe the basic structure and functions of the Federal Reserve System and identify its chairperson.
2. Explain the processes through which the Fed can increase or decrease the supply on money.
3. Explain the process through which changes in the supply of money create changes in the demand for real goods and services and, in turn, equilibrium GDP.
4. Identify and explain the monetary policies that might be used to counter problems of inflation and unemployment.