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8.8 Monetary Policy

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Understand the operation of the Federal Reserve.
  2. Understand the impacts and limitations of monetary policy.

Another way in which government can affect economic performance is by controlling the supply of money in circulation. This is called monetary policyControlling the supply of money to change economic outcomes..

The Wonderful World of Money

First, a word about money. Humans have been using money as a means of exchange for a long time. Early forms of money have ranged from rare shells to cocoa beans; rare metals such as gold and silver also have long been popular. Money is a store and standard of value—it allows flexibility and lowers transaction costs by serving as a medium of exchange. Without money, we’d have to barter. There are groups who promote barter relations between people and businesses, but in order for barter to work, I must have exactly what you want in equal value to what I want, and you have to have exactly what I want. So money greases the wheels of the economy. It’s much easier to just give someone money in exchange for a good or service, versus finding exactly what they want in trade.

Money needs to be portable, divisible, uniform and durable. Gold and silver hence became popular as money because they are soft metals and easy to make coins and bricks out of; they are durable; and you can weigh them to determine if they are what they claim to be.

But they’re heavy. As trading relationships between cities grew in medieval Europe, it became easier to send a paper note representing the value of the gold involved from, say, Florence to Milan, rather than shipping all that gold. Eventually people began to just trade the paper notes; hence paper money was born in the west. (The Chinese also used paper money at different times in their history, but often returned to silver and other metals.)

Gold Bugs

For a long time, paper money was somewhat looked down upon, as the paper has less intrinsic value than does gold. So, typically, paper money was backed by gold; for much of the 19th century, you could go to a bank and trade your paper for gold.

You will hear the occasional critic claim that we should be back on the gold standard, or some other commodity standard. This would severely limit the money supply, which tends to limit inflation. But this also presents certain problems. If you can’t change the money supply, you can’t prime the economic pump when necessary. Moreover, if there’s not enough money in circulation, the economy is less likely to grow, if only because people hoard money (at that point, by definition, it is a scarce commodity). Some scholars assert that the world faced a 20-year depression from the 1870s to the 1890s because there was a shortage of money, a situation rescued only by the discovery of gold in South Africa and elsewhere in the 1880s and 1890s. In the 20th century, most nations, including the United States, jettisoned the gold standard, so that now paper money is the main standard of value. Fans of gold argue that prices have far outstripped the gain in value of gold, but the truth of the matter is that gold is much less valuable now than it was 100 years ago. And paper money, also sometimes called fiat money (and not because you can buy an Italian car with it), is backed by something—by the strength of the economy that issued the money. Around the world, currency values fluctuate along with the performances of the underlying economies.

What matters most about money is how much is in circulation. Money is measured in a couple of categories:

  • M1—Cash money, which includes 2–3 percent coins, 25–30 percent paper currency and the rest in checking accounts.
  • M2—this includes M1 plus savings accounts and certificates of deposit (CDs).

The Money Supply

Different schools of economic thought disagree on how much the money supply matters. Monetarists say it’s the only thing that matters; others say it doesn’t matter at all. Neither of these points of view makes much sense to me. The evidence is that it does matter, but it’s not the only thing that matters.

True story: A group of couples with young children formed a babysitting co-op. This way they could have babysitters they knew and trusted, and be able to have an occasional evening out. So the group printed up coupons, each good for one evening of babysitting, and gave each couple two coupons. In a short period of time, people were going out less than they had before they formed the co-op. The reason was simple: money, in the form of the coupons, was in such short supply that no one was willing to spend any coupons. Everyone was willing to babysit, but nobody wanted to part with the scarce coupons. Eventually they issued more coupons and people started going out again. At one point, however, they had too many coupons in circulation, and nobody wanted to babysit because there were so many coupons available. So it took a few tries to reach a point where the price of babysitting was neither too high nor too low.

Nonetheless, the world is never entirely free of gold bugs, who argue that a return to the gold standard is the answer to the nation’s economic woes. For example, sometime Libertarian/Republican presidential candidate Ron Paul proposes to do away with the Federal Reserve. (And if not gold, some other basket of commodities.) As we’ve already noted, a fixed money supply would stop inflation. It also would contract the economy right along with prices. With less money, less business will be done. Gold Monday likely would look a lot like Black Tuesday did in 1929. It would also rob the country of the ability to use monetary policy as a tool, both against inflation and recessions.

Managing the Money Supply

Most nations have a central bank that is in charge of managing that country’s money supply. In the U.S., the money supply is largely controlled by the Federal Reserve Board (the Fed)The nation’s central bank, which is in charge of controlling the money supply.. The Federal Reserve Act was passed by Congress in 1913, creating the Federal Reserve System. The nation had been without a central bank since the 1830s, when President Andrew Jackson blocked congressional efforts to renew the charter of the Bank of the United States. As a consequence, the money supply was under the control of large private banks (and the mining industry, since any new gold strike meant that more money would be in circulation). The nation thus suffered a serious economic downturn about every dozen years or so, which, by the Panic of 1907, prodded government to leaders to take action and create the Fed.

The Fed is an odd mix of public and private. It’s a government agency; its top officials are appointed by the president and confirmed by the Senate, but it’s also a private bank run by private bankers. By not being subject to election, it is hoped the Fed will make the tough choices needed to keep the economy moving, and not worry so much about short-term political pressure.

The Fed has a chairman and vice chairman, and a board of governors, plus 12 regional Fed banks scattered across the country. The Fed controls the money supply through setting the discount rate, reserve requirements, and through open market operations.

  • The reserve requirement tells banks how much of their customers deposits they can lend out and how much they have to keep on hand. A lower reserve requirement gives banks more leeway to make loans. Typically, the reserve requirement is around 20 percent.
  • The discount rate is the rate the Fed charges member banks (and nearly all U.S. banks are members of the Federal Reserve system) on short-term loans. A higher rate of interest makes money more expensive, which means banks will charge more for loans to their customers. And if you remember the law of demand—at higher prices, consumers want less of a product—you can see that higher interest rates mean less borrowing and less economic growth.
  • Open-market operationsThe buying and selling of U.S. government debt securities by the Fed to change the amount of money in circulation, hence driving interest rates up or down.: This is the Fed’s most common tool. The Fed buys and sells U.S. Treasury securities (remember all those bonds the government sells to fund the deficit?) to influence interest rates and the money supply. If the Fed buys securities (in the open market), investors have more cash in their hands. Under these circumstances, money is more plentiful, loans are cheaper, and economic activity can pick up. If the Fed sells U.S. government bonds, investors have less cash in hand—the money supply shrinks, loans become more expensive, and economic activity slows down.

Why would the Fed do that? The Fed is assigned with two sometimes conflicting tasks: Ensuring economic growth and keeping a lid on inflation. If the economy overheats, inflation can result. As basically a bunch of bankers, the Fed detests inflation, and will try to kill it by tightening the money supply. But if the economy is stagnant or shrinking, increasing the money supply can help nurse it back to health.

Does this work? Sometimes, and sometimes remarkably effectively. In the late 1970s and early 1980s, inflation in the U.S. topped 10 percent. It was killing banks and lenders, destabilizing commerce and industry, and making consumers feel helpless as their savings and investments were eaten up by rising prices. The Fed, under Chairman Paul Volcker, engaged in an experiment in strict monetarism. Strict monetarists believe that the only thing that matters is the precise growth rate of the money supply. So the Fed put the brakes on that, interest rates soared, and the inflation dragon was at least temporarily caged if not slain. As with most policy choices, there were tradeoffs. High interest rates hurt the auto industry (often, you have to borrow money to buy a car) and all but killed the housing industry, which may be as much as 25 percent of the U.S. economy (you borrow a lot of money to buy a house). Inflation went away, replaced by the steepest recession since the Great Depression of the 1930s (and the deepest economic downturn until the Great Recession of 2007). By the mid-1980s, however, the Fed ended its monetarist experiment and the economy began to recover.

Expansionary monetary policy can have a positive effect on the economy. In 1987, easy Fed monetary policy kept a stock market tumble from becoming anything more than a blip. Expansion by the Fed also helped the economy recover in the early 1990s. In the Great Depression, tight money policy probably helped contribute to the worst economic era in the nation’s history.

Nonetheless, monetary policy doesn’t always work. What the Fed can control is the money supply, not demand. And while cheap money encourages people to borrow, nobody’s borrowing if they’re afraid they won’t be able to repay the loans. Businesses in particular don’t borrow to expand production if nobody’s buying in the first place. So, despite constant efforts by the Fed amid the Great Recession of 2007, the economy didn’t fully recover because nobody was borrowing anyway. Arguably, things could have been much worse without the Fed’s actions, but at some point, lower interest rates and plenty of available money becomes the equivalent of pushing on a string: the back end moves, but the front end of the string goes nowhere.

Key Takeaways

  • The Federal Reserve Board controls the money supply in the U.S. Most nations have a central bank that performs a similar function.
  • Monetary policy can make the economy heat up or cool down, but monetary policy by itself may not be enough to encourage consumer or business demand.


  1. What tools does the Fed use to influence economic outcomes?
  2. Why might monetary policy sometimes not help the economy recover?