Monetary Economics

The dollar bill is a symbol of America as iconic as the Statue of Liberty or the American Flag. Consumers all over the world recognize the green paper as a valuable commodity and will often go to great lengths to obtain it. It has many nicknames, including bread, greenback, dough, bacon, moolah, cheddar, dinero and loot. Someone wanting to acquire a certain product needs only to hand a store cashier the number of bills denoted on the product’s price tag, and the item becomes his.

In itself, however, the dollar bill is nothing more than ink printed on paper. It cannot be used to build useful objects or woven into clothing. It cannot be melted down and molded into a pot or a piece of jewelry. So from what does the dollar derive its value? How does it retain that value over time, even when other currencies exist? How can other paper currencies have more or less value than the dollar? Moreover, what is the role that the dollar plays in economics?

These are the questions explored in monetary economics. Monetary economics examines how currencies enter the marketplace and become accepted as mediums of exchange for goods and services. It also analyzes government regulation of money and financial institutions, the structure and interaction of monetary systems, financial history and the demand for money—basically, anything involving bankers and banknotes. Because the exchange of money pervades the economic system at every level, monetary economics is largely a study in macroeconomics.

Monetary economics formally emerged as a field of study in the 1950s through the concept of monetarism as described by economist Milton Friedman. Monetarism postulates that government regulation of a nation’s money supply can ensure economic stability by keeping prices and inflation under control. In this way, monetary economics is an offshoot of Keynesian economics, which calls for an active government role in balancing economic fluctuations. Prior to Friedman’s observations, however, monetary economics had informally been in play for decades.

To understand the need for monetary economics, it’s important to know the purpose and characteristics of money. Prior to 1200 B.C., humans bartered and traded commodities to obtain the goods they wanted. This method of exchange, however, depended on a “coincidence of wants”: the consumer had to possess a good the merchant wanted for the exchange to occur. Also, determining the value of one item compared to another was very difficult. Almost no standard price for goods existed. The bartering system, therefore, was often slow, frustrating and riddled with inefficiency. Consumers soon demanded an easier way to exchange goods.
Standardized currency eventually became the solution to inefficient exchange. Currency first appeared in China around 1200 B.C. in the form of cowrie shells. The shells possessed intrinsic value since they were used to make jewelry and other ornaments.

They were also small and easy to carry in large quantities. Merchants only had to demand a certain number of shells for their products, and consumers could buy them. Metal coins emerged as an alternative between 1000 and 500 B.C. Coins also had inherent value because they were made from scarce metals and could be melted down and shaped into tools or weapons.
Paper currency, also known as fiat currency, however, possesses no inherent value and can be generated quite easily in large amounts, leading to inflation. The value of money partially depends upon its scarcity. When too much is released into circulation, consumer demand for goods and services rises rapidly, driving up prices. As a result, the purchasing power of the currency is reduced. Sometimes prices can rise too quickly, shutting many consumers out of the market and causing economic disruption. China discovered this drawback to using paper currency in the 1400s when the country printed too much money. The consequences were so severe that China stopped using paper currency for several hundred years.
Economists sought to resolve paper currency’s inflationary problem by backing each banknote with a standard unit of precious metal. The metals were stored in government reserves with banknotes issued in their place. The most famous example is the gold standard adopted by the U.S. in 1873. The gold standard valued each dollar at 1.5 grams of gold, which would be granted to anyone wishing to exchange their paper for hard currency. While the gold standard kept inflation in check, it also greatly restricted the amount of money that could be circulated. This became a problem during war when countries on the gold standard became indebted to each other. Paying foreign debts in gold strained U.S. gold reserves, leaving consumers with unbacked currency.

Money, like almost anything in a market economy, is subject to the law of supply and demand. Market demand for money determines its value. When supply exceeds demand, monetary value plummets, creating inefficiency and placing a great strain on the economy. When demand exceeds supply, consumers and businesses may lack the means to conduct important transactions, causing the economy to stagnate or crash. Monetary economics, then, seeks to keep the supply of money balanced with demand. Whenever it fails, the results are often disastrous.

Take the Great Depression, for example. Adherence to the gold standard through World War I had greatly reduced U.S. gold reserves. When the stock market began falling in 1929, consumers panicked and rushed to banks to exchange their paper currency for gold. The run on the banks drained gold reserves further and left the Federal Reserve without the liquidity, or hard cash, it needed to deal with the economic crisis. As a result, the stock market crashed, interest rates skyrocketed, paper money became worthless, businesses went bankrupt and unemployment soared. Shortly thereafter, in 1933, the U.S. abandoned the gold standard and later established fiat currency as the new legal tender. Since that time, new monetary economic policies have been used to manage the dollar’s value and keep it stable.

Keeping currency stable is important because money functions as more than just a means of exchange. Money establishes a single standard of value, known as a unit of account, for goods and services and is widely used as a store of value. In other words, accumulating money makes one wealthy because, as long as it is accepted in the marketplace, money can be used to obtain virtually any good or service. Money takes on different forms as well. To an economist, money exists as paper currency, commodities (e.g., gold and oil) and credit. Therefore, instituting policies that protect asset liquidity, credit availability and commodity value promotes economic stability, investment and growth.

Of course, like any theory, monetary economics has its shortcomings. Examining all the ways money interacts and shapes economies is quite complex and involves nearly all aspects of an economy. Although monetary economics is primarily concerned with regulating the money supply, it is also used to interpret changes or fluctuations in interest rates, currency exchange rates, prices, and the net worth of businesses and individuals. At times, monetary economics has failed to explain certain phenomena, such as why some markets remain unresponsive to economic policies designed to stimulate growth. Economists have also made errors in creating policy, leading to economic recession. Critics of monetary policy occasionally question the validity and desirability of such intervention in economic activity. However, economists who study and implement monetary policy are often some of the most powerful and influential people in the world: Alan Greenspan, Ben Bernanke, Paul Krugman and Timothy Geithner, to name a few.