Money and Financial Markets

Money and the Value of Money

Money is anything generally accepted as final payment for goods and services. Throughout history many things have been used around the world as money, including gold, silver, tobacco, cattle, and rare feathers or animal skins. In the U.S. economy today, there are three basic forms of money: currency (dollar bills), coins, and checks drawn on deposits at banks and other financial firms that offer checking services. Most of the time, when households, businesses, and government agencies pay their bills they use checks, but for smaller purchases they also use currency or coins.

People can change the type of the money they hold by withdrawing funds from their checking account to receive currency or coins, or by depositing currency and coins in their checking accounts. But the money that people have in their checking accounts is really just the balance in that account, and most of those balances are never converted to currency or coins. Most people deposit their paychecks and then write checks to pay most of their bills. They only convert a small part of their pay to currency and coins. Strange as it seems, therefore, most money in the U.S. economy is just the dollar amount written on checks or showing in checking account balances. Sometimes, economists also count money in savings accounts in broader measures of the U.S. money supply, because it is easy and inexpensive to move money from savings accounts to checking accounts.

Most people are surprised to learn that when banks make loans, the loans create new money in the economy. As we’ve seen, banks earn profits by lending out some of the money that people have deposited. A bank can make loans safely because on most days, the amount some customers are depositing in the bank is about the same amount that other customers are withdrawing. A bank with many customers holding a lot of deposits can lend out a lot of money and earn interest on those loans. But of course when that happens, the bank does not subtract the amount it has loaned out from the accounts of the people who deposited funds in savings and checking accounts. Instead, these depositors still have the money in their accounts, but now the people and firms to whom the bank has loaned money also have that money in their accounts to spend. That means the total amount of money in the economy has increased. This process is called fractional reserve banking, because after making loans the bank retains only a fraction of its deposits as reserves. The bank really could not pay all of its depositors without calling in the loans it has made. It also means that money is created when banks make loans but destroyed when loans are paid off.

At one time the dollar, like most other national currencies, was backed by a specified quantity of gold or silver held by the federal government. At that time, people could redeem their dollars for gold or silver. But in practice paper currency is much easier to carry around than large amounts of gold or silver. Therefore, most people have preferred to hold paper money or checking balances, as long as paper currency and checks are accepted as payment for goods and services and maintain their value in terms of the amount of goods and services they can buy.

Eventually governments around the world also found it expensive to hold and guard large quantities of gold or silver. As foreign trade grew, governments found it especially difficult to transfer gold and silver to other countries that decided to redeem paper money acquired through international trade. They, too, changed to using paper currencies and writing checks against deposits in accounts. In 1971 the United States suspended the international payment of gold for U.S. currency. This action effectively ended the gold standard, the name for this official link between the dollar and the price of gold. Since then, there has been no official link between the dollar and a set price for gold, or to the amount of gold or other precious metals held by the U.S. government.

The real value of the dollar today depends only on the amount of goods and services a dollar can purchase. That purchasing power depends primarily on the relationship between the number of dollars people are holding as currency and in their checking and savings accounts, and the quantity of goods and services that are produced in the economy each year. If the number of dollars increases much more rapidly than the quantity of goods and services produced each year, or if people start spending the dollars they hold more rapidly, the result is likely to be inflation. Inflation is an increase in the average price of all goods and services. In other words, it is a decrease in the value of what each dollar can buy.

The Federal Reserve System and Monetary Policy

Governments often attempt to reduce inflation by controlling the supply of money. Consequently, organizations that control how much money is issued in an economy play a major role in how the economy performs, in terms of prices, output and employment levels, and economic growth. In the United States, that organization is the nation’s central bank, the Federal Reserve System. The system’s name comes from the fact that the Federal Reserve has the legal authority to make banks hold some of their deposits as reserves, which means the banks cannot lend out those deposits. These reserve funds are held in the Federal Reserve Bank. The Federal Reserve also acts as the banker for the federal government, but the government does not own the Federal Reserve. It is actually owned by the nation’s banks, which by law must join the Federal Reserve System and observe its regulations.

There are 12 regional Federal Reserve banks. These banks are not commercial banks. They do not accept savings deposits from or provide loans to individuals or businesses. Instead, the Federal Reserve functions as a central bank for other banks and for the federal government. In that role the Federal Reserve System performs several important functions in the national economy. First, the branches of the Federal Reserve distribute paper currency in their regions. Dollar bills are actually Federal Reserve notes. You can look at a dollar bill of any denomination and see the number for the regional Federal Reserve Bank where the bill was originally issued. But of course the dollar is a national currency, so a bill issued by any regional Federal Reserve Bank is good anyplace in the country. The distribution of currency occurs as commercial banks convert some of their reserve balances at the Federal Reserve System into currency, and then provide that currency to bank depositors who decide to hold some of their money balances as currency rather than deposits in checking accounts. The U.S. Treasury prints new currency for the Federal Reserve System. The bills are introduced into circulation when commercial banks use their reserves to buy currency from the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that are deposited by a bank in one part of the country, but were written by someone who has a checking account with a bank in another part of the country. Millions of checks are processed this way every business day. Third, the regional Federal Reserve Banks collect and analyze data on the economic performance of their regions, and provide that information and their analysis of it to the national Federal Reserve System. Each of the 12 regions served by the Federal Reserve banks has its own economic characteristics. Some of these regional economies are concerned more with agricultural issues than others; some with different types of manufacturing and industries; some with international trade; and some with financial markets and firms. After reviewing the reports from all different parts of the country, the national Federal Reserve System then adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is controlling the nation’s money supply and the overall availability of credit in the economy. If the Federal Reserve System wants to put more money in the economy, it does not ask the Treasury to print more dollar bills. Remember, much more money is held in checking and savings accounts than as currency, and it is through those deposit accounts that the Federal Reserve System most directly controls the money supply. The Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits as reserves at the Federal Reserve System. A lower reserve requirement allows banks to make more loans and earn more money from the interest paid on those loans. Banks making more loans increase the money supply. Conversely, a higher reserve requirement reduces the amount of loans banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the economy is by lowering the rate it charges banks when they borrow money from the Federal Reserve System. This particular interest rate is known as the discount rate. When the discount rate goes down, it is more likely that banks will borrow money from the Federal Reserve System, to cover their reserve requirements and support more loans to borrowers. Once again, those loans will increase the nation’s money supply. Therefore, a decrease in the discount rate can increase the money supply, while an increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve, so changes in the discount rate are more important as a signal of whether the Federal Reserve wants to increase or decrease the money supply. For example, raising the discount rate may alert banks that the Federal Reserve might take other actions, such as increasing the reserve requirement. That signal can lead banks to reduce the amount of loans they are making.

The third way the Federal Reserve System can adjust the supply of money and the availability of credit in the economy is through its open market operations—the buying or selling of government bonds. Open market operations are actually the tool that the Federal Reserve uses most often to change the money supply. These open-market operations take place in the market for government securities. The U.S. government borrows money by issuing bonds that are regularly auctioned on the bond market in New York. The Federal Reserve System is one of the largest purchasers of those bonds, and the bank changes the amount of money in the economy when it buys or sells bonds.

Government bonds are not money, because they are not generally accepted as final payment for goods and services. (Just try paying for a hamburger with a government savings bond.) But when the Federal Reserve System pays for a federal government bond with a check, that check is new money—specifically, it represents a loan to the government. This loan creates a higher balance in the government’s own checking account after the funds have been transferred from the privately owned Federal Reserve Bank to the government. That new money is put into the economy as soon as the government spends the funds. On the other hand, if the Federal Reserve sells government bonds, it collects money that is taken out of circulation, since the bonds that the Federal Reserve sells to banks, firms, or households cannot be used as money until they are redeemed at a later date.

The Wall Street Journal and other financial media regularly report on purchases of bonds made by the Federal Reserve and other buyers at auctions of U.S. government bonds. The Federal Reserve System itself also publishes a record of its buying and selling in the bond market. In practice, since the U.S. economy is growing and the money supply must grow with it to keep prices stable, the Federal Reserve is almost always buying bonds, not selling them. What changes over time is how fast the Federal Reserve wants the money supply to grow, and how many dollars worth of bonds it purchases from month to month.

To summarize the Federal Reserve System’s tools of monetary policy: It can increase the supply of money and the availability of credit by lowering the percentage of deposits that banks must hold as reserves at the Federal Reserve System, by lowering the discount rate, or by purchasing government bonds through open market operations. The Federal Reserve System can decrease the supply of money and the availability of credit by raising reserve ratios, raising the discount rate, or by selling government bonds.

The Federal Reserve System increases the money supply when it wants to encourage more spending in the economy, and especially when it is concerned about high levels of unemployment. Increasing the money supply usually decreases interest rates—which are the price of money paid by those who borrow funds to those who save and lend them. Lower interest rates encourage more investment spending by businesses, and more spending by households for houses, automobiles, and other “big ticket” items that are often financed by borrowing money. That additional spending increases national levels of production, employment, and income. However, the Federal Reserve Bank must be very careful when increasing the money supply. If it does so when the economy is already operating close to full employment, the additional spending will increase only prices, not output and employment.

Effect of Monetary Policies on the U.S. Economy

The monetary policies adopted by the Federal Reserve System can have dramatic effects on the national economy and, in particular, on financial markets. Most directly, of course, when the Federal Reserve System increases the money supply and expands the availability of credit, then the interest rate, which determines the amount of money that borrowers pay for loans, is likely to decrease. Lower interest rates, in turn, will encourage businesses to borrow more money to invest in capital goods, and will stimulate households to borrow more money to purchase housing, automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money supply. If the supply of money and credit grows much faster than the production of goods and services in the economy, then prices will increase, and the rate of inflation will rise. Inflation is a serious problem for those who live on fixed incomes, since the income of those individuals remains constant while the amount of goods and services they can purchase with their income decreases. Inflation may also hurt banks and other financial institutions that lend money, as well as savers. In a period of unanticipated inflation, as the value of money decreases in terms of what it will purchase, loans are repaid with dollars that are worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to protect themselves by demanding higher interest rates on loans and savings accounts. This will be especially true on long-term loans and savings deposits, if the higher inflation is considered likely to continue for many years. But higher interest rates create problems for borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then interest rates are again likely to rise, leading to decreased spending for capital investments and consumer durable goods (products designed for long-term use, such as television sets, refrigerators, and personal computers). Such decreased spending will hurt many businesses and may lead to a recession, an economic slowdown in which the national output of goods and services falls. When that happens, wages and salaries paid to individual workers will fall or grow more slowly, and some workers will be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the Federal Reserve’s actions with monetary policy very closely. There are regular reports in the media about policy changes made by the Federal Reserve System, and even about statements made by Federal Reserve officials that may indicate that the Federal Reserve is going to change the supply of money and interest rates. The chairman of the Federal Reserve System is widely considered to be one of the most influential people in the world because what the Federal Reserve does so dramatically affects the U.S. and world economies, especially financial markets.