Principle 8: Fiscal and Monetary Policies influence people’s decisions
Objectives
Explain the relationships depicted in the Monetary Equation of Exchange.
Identify the winners and losers from a strong currency.
Trace the hard money/soft money controversy that led to the establishment of the Federal Reserve System.
Identify the three major functions of the Federal Reserve.
Why you want to learn this
The monetary history of the U.S. will help you to understand the current Federal Reserve System and the political controversies that exist today.
The Monetary Equation of Exchange
The amount of money in circulation is important to a healthy economy. The proper money supply will help the economy maintain full employment with stable prices. Either too much or too little can have serious effects on real income, output, and employment.
The situation can be expressed in the equation of exchange.
MV = PQ
where M = the amount of money in circulation,
V = the velocity of money, how often that money changes hands in a particular time period,
P = the overall price level , and
Q = real output
Assuming V is constant, then the amount of money in circulation determines the monetary value of PQ, nominal GDP. The question is the relationship between M and P and Q.
If M increases by the same rate as Q (real GDP) increases, there is neither inflation nor deflation. If M increases by a faster rate than Q, inflation results; if M increases by a slower rate than Q, deflation results.
The historical central bank controversy
Determining the proper amount of money in the economy is tricky business. Too much money means inflation, too little means unemployment. In our economy, it is the Federal Reserve System (FED) that determines the appropriate amount of money in circulation and takes steps to supply that amount.
The United States was one of the last of the major nations to establish a central bank. The Bank of England, the German Bundesbank, the Banque de France were all established earlier than the Federal Reserve Bank of the United States. The reason stems from a deep distrust of central banks by Thomas Jefferson and other founders. While Alexander Hamilton argued strongly in favor of a central bank and a national currency, Jefferson and his Republicans feared that too much power would be granted to a few individuals. Since Jefferson was a champion of the “common man,” and had a great fear of centralized power of any kind, he was opposed to a strong central bank. The controversy continued through the establishment and demise of the First and Second Banks of the United States. Andrew Jackson killed the Second Bank by letting its charter expire.
The struggle for a central bank continued into the 20th century and revolved around the “hard money,” “soft money” issue, culminating in the election of 1896, pitting farmers and laborers against bankers and industrialists. In his famous “Cross of Gold” Speech, William Jennings Bryan decried the greed of the bankers and industrialists and made an impassioned plea for a soft money such as silver or “greenbacks.”
The issue was this. So-called “hard money” that is money backed by gold, was limited in supply. With a limited supply of money, inflation could not occur. In fact, as Gross Domestic Product increased, with no increase in the amount of money available to buy it, the only thing that could happen is that prices would fall.
The Election of 1896
In the election of 1896, McKinley and the Republicans advocated a strong currency, slow growth in M, and low inflation (P). With hard money such as currency backed by gold, the money supply could only increase by the amount of the increase in the official gold holdings of the U.S. Treasury. Since the supply of gold in the world is limited, this would result in a very slow increase in the money supply, slower than increases in real output, with the resultant deflation.
With a currency backed by silver, which is much more plentiful than gold, or by green pieces of paper backed by nothing (such as the dollars we use today but called “greenbacks” in the late nineteenth and early twentieth centuries), the currency (M) could be increased much more rapidly and the economy could face inflation.
So who cared? Well the workers and farmers cared a great deal as did the bankers and industrialists. The reason is that inflation and deflation affect debtors and creditors differently as you recall from Summary 10d. Farmers and workers tend to be borrowers (debtors) who like inflation and don’t like deflation, while bankers and industrialists tend to be lenders (creditors), who dislike inflation and do like deflation.
People in debt like inflation because they pay back their debt with cheaper dollars. Assume that you borrow $10,000 and repay it over a ten-year period. If the inflation rate is higher than the rate of interest, you win. During periods of high inflation, the $10,000 that you repay will not buy the same amount of goods and services as the $10,000 that you borrowed. During periods of deflation, however, prices are falling and the $10,000 that you repay will buy much more than the $10,000 that you borrowed. This would be OK if your income were not falling also.
During the 30-year period leading up to the election of 1896, farmers had seen their crop prices continue to fall and workers had seen wages fall. As a result, debt repayment became a continuously larger proportion of their expenditures. Deflation was bad for them, and they wanted a soft currency to pump up wages and farm prices. The lenders, of course, were on the opposite end of the spectrum and wanted a hard currency (gold) to ensure that the amount owed to them did not fall in terms of purchasing power. William Jennings Bryan, the Democratic presidential candidate addressed the national convention with the famous statement, “You shall not crucify labor upon a cross of gold.” The election of 1896 resulted in a Republican victory and President McKinley saw no reason to promote an inflationary policy.
Establishment of the Federal Reserve System
The Panic of 1906 was the worst downturn the United States had experienced to date. Acting much like a central bank, J.P. Morgan extended credit to failing banks. It was probably this event that led to the final realization that a major economic power such as the United States, a Central Bank, and Congress established the Federal Reserve System seven years later, on December 23, 1913.
The Federal Reserve Bank was established with a certain degree of independence so that it would not be subject to political constraints. A Board of Governors, headquartered in Washington, D.C, manages the FED. It is composed of 12 districts that are (in theory) independent of the Board of Governors. This was thought to be appropriate in 1913 because the twelve districts were, in a sense, separate economies with distinct economic issues. The credit needs of New York, at different times of the year, were quite different from the needs of Dallas. Because the U. S. economy has become so integrated, the economic reasons for 12 different Banks may not be as clear today, but the political reasons probably are.
Three Functions of the Federal Reserve
The Federal Reserve System, established by the Federal Reserve Act of 1913, has three main functions.
1. It acts as a banker to member banks. Banks can deposit and withdraw funds from the FED. They can borrow money from the FED. The FED also provides check-clearing services for its members. If you live and bank in Chicago, and write a check to a friend in Los Angeles, the FED will debit your bank's account and credit the L.A. bank's
.
2. The FED acts as a banker to the federal government. The U. S. Treasury deposits and withdraws money from its account at the FED. It also borrows money from the FED.
3. Finally, and most importantly for macroeconomic policy, the FED influences interest rates and U.S economic activity. In the next summary, we will investigate the importance of this function of the Federal Reserve System.
The history of money in the United States is a colorful one replete with bitter personal conflicts between different founders of the Nation, presidents and central bankers, Republicans and Democrats, bankers, farmers, workers, and others. There is so much conflict because the amount of money in the economy affects everyone. What some consider too much is too little for others. In the next unit, we will investigate ways in which the Federal Reserve influences U.S. economic activity.
1. The Equation of Exchange states that Real GDP is determined by:
a. The amount of money in circulation
b. The velocity of money
c. Both of the above
d. Neither of the above
2. Which of the following was in favor of hard currency and a strong central bank?
a. Hamilton
b. Jackson
c. Jefferson
d. Bryan
3. Which of the following is an accurate statement?
a. Farmers favored a strong currency because it would increase farmer revenue.
b. Farmers and laborers favored a strong currency because it would reduce the value of their debt.
c. Bankers favored a strong currency to maintain the purchasing power of their loan repayments.
d. All the above are accurate statements.
4. Which of the following is NOT a function of the Federal Reserve?
a. Acting as a banker to member banks
b. Acting as a banker to the Federal Government
c. Stabilizing the price of oil
d. Influencing interest rates and U.S. economic activity