Money can be defined as any commodity that is used as a “means of payment,” for whatever is exchanged for the goods and services that are bought. Murray N. Rothbard, Economist, looks at money in this manner, “Many useful goods have been chosen as moneys in human societies. Salt in Africa, sugar in the Caribbean, fish in colonial New England, tobacco in the colonial Chesapeake Bay region, cowrie shells, iron hoes, and many other commodities have been used as moneys. Not only do these moneys serve as media of exchange; they enable individuals and business firms to engage in the “calculation” necessary to any advanced economy. (Taking Money, 1).” In the United States of America, Money is created by banks. It began as a commodity in the form of gold. Carrying it around was risky, there was trouble determining the actual worth, using it in its physical state was cumbersome and dangerous. To resolve the dilemma, Goldsmith’s , who in the 16th and 17th century eventually evolved into Banker’s, stored large amounts of gold for the merchants because they had the best security systems in that time. In return, merchants were given slips of paper with the amount of gold that was being held for them. Over time this system evolved into what is now know as the banking system. The paper that was given to the merchant was a promise to pay gold on demand (Brue, McConnell, 3-4). Banks create money today by lending it. The money supply consists of the currency held by the public and deposit accounts made by the banks. These create a financial system known as the “Fractional Reserve System”. Banks keep only a portion of the funds deposited with them. Banks borrow funds from those with savings and in turn lend those funds to those in need of funds. Banks make money by charging a higher percentage interest rate than is paid to depositors for use of their money. If banks kept their available funding after their reserve requirements have been met, depositors might have to pay banks to provide safekeeping services for their money.
The Federal Reserve
Created by Congress, the Federal Reserve, also call “The Fed” is the central bank of the United States. It controls the money supply by providing the nation with a flexible, safe and more stable money supply and financial system. To control the money supply the Federal Reserve uses three methods. The first is called Open market Operations.
In an Open Market operation the government buys and sells government securities to increase the money supply. If the level of reserve balances in the banking system lags, seasonal, cyclical or permanent changes in the supply of reserve balances affect interest rates.
Another method the Feds use to control the money supply is by “Altering the Reserve Requirements.” Law requires that the fed puts aside a portion of deposits held as reserve as cash on hand or as a reserve account balances at a reserve bank. To manipulate the money supply Fed can lower the required reserve rate. When it is lowered, banks are able to make more loans, money stock is expanded (short term) and interest rates become lower. This is intended to persuade investors and consumers to spend more money. Raising the reserve requirements gives the opposite effect, loans become restricted, the money stock is decreased, interest rates get higher and consumer purchases decline. The Great Depression is an example of what happens when the economy does not function properly. The economic slump was blamed on many factors, one of which was a drastic decrease in consumer spending. Paul Alexander Gusmorino, author of “Main Causes of the great Depression”, has this to say about the decrease of spending:” The U.S. economy was also reliant upon luxury spending and investment from the rich to stay afloat during the 1920’s. The significant problem with this reliance was that luxury spending and investment were based on the wealthy’s confidence in the U.S. economy. If conditions were to take a downturn (as they did with the market crashed in fall and winter 1929), this spending and investment would slow to a halt (Gusmorinao World, 1996).” Individuals lost confidence in banks and the economy and the result was the Great Depression, an era that would set precedence for planning future economic stability.
The last method that the fed uses to control the money supply is to adjust the interest rate. By increasing the interest rate to banks, the money supply decreases. That means that consumers are holding on to money and spending is careful and low. Subsequently, by decreasing interest rates, money supply increases and consumers are less careful about how and what they spend their money on.
To help promote national economic goals the Fed created a” Monetary Policy”. The goal of economic policy makers is to “reduce inflation while achieving satisfactory growth in employment, output and productivity (Monthly Labor, 1).” GDP represents economic production and growth; these factors have an important impact on everyone within the economy. For example, when the economy flourishes, unemployment is low and salaries increase as businesses demand labor to meet the growing increasing economy. A major change in GDP, increasing or decreasing, usually has an important effect on the stock market. A dim economy usually indicates that there will be a decrease in profits for companies, which in turn causes stock prices to decrease. Negative GDP growth is bad news to investors. One feature that economist’s use to determine a recession is negative growth. Monetary policy is made up of actions used by the Federal Reserve to promote economic goals by influencing the availability and cost of money. By altering the federal funds rate, the “Federal Reserve influences the demand for, supply of, and balances that the depository institutions hold at Federal Reserve Banks (Federal Open, 1).” Also, when the rates of federal funds change, it causes a succession of changes in foreign exchange rates, long-term interest rates, the amount of money and credit, and other economic variables, such as employment output and the prices of goods and services. After examining the number of indicators of current and future economic expansions the Fed turns its focus to economic activity that lags. If economic growth should be stimulated in that particular market, a decision is made whether or not to alter the federal funds rate. A decrease in the federal funds interest rate stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that will weaken the sustainability of an economic expansion. In the early 80;’s reducing inflation was a major economic concern facing policy makers in the U.S. Consumer Prices were reportedly at a high of 13.3% at the end of 1979 and by 1982 inflation rates had dropped to 3.8 %. This decline was attributed to the decisions made by the fed to decrease the federal fund rate. Patrick Jackman, author of “Consumer prices in the 1980’s: the cooling of inflation says this about the fed’s decision making; “ The success in reducing inflation was largely attributable to monetary policy resulting form actions of the Federal Reserve Board. In October 1979, the Federal Reserve modified its monetary policy by giving greater emphasis to holding growth of the monetary stock within target ranges and allowing interest rates to vary widely (Consumer, 1).” The most important monetary control used by the feds is the “Open market operations.” It is flexible and open market operations influence the federal funds rate—the interest rate that depository institutions pay when they borrow unsecured loans of reserve balances overnight from each other. Banks borrow reserves in the federal funds market in order to meet reserve requirements set by the Federal Reserve, and to ensure adequate balances in their accounts at the Fed to cover checks and electronic payments that the Fed processes on their behalf. Changes in the federal funds rate often have a strong impact on other short-term rates. (Consumer, 2-3)
Gusmorino, Paul A., III. “Main Causes of the Great Depression.” Gusmorino World (May 13, 1996). Online. Internet: http://www.gusmorino.com/pag3/greatdepression/index.html. March 29, 2009.
Brue, McConnell. (2004). Economics: Principles, problems and policies (16th Ed.). New York: McGraw-Hill.
Rothbard, Jerry N. “Taking Money back” .http://mises.org/story/2882, Retrieved March 30, 2009
http://www.federalreserve.gov/monetarypolicy/fomc.htm. Retrieved March, 27, 2009.
Monthly Labor Review, Consumer prices in the 1980’s: The Cooling of Inflation
August 1990, Vol. 113,