Introduction

This book is about a country's financial and monetary regime and the interaction between the regime and the economy. The financial and monetary regime is an important element of the economic and political environment in which we live and work, and some basic knowledge of it is necessary if one wants to consider oneself educated. In fact, anyone not familiar with the basic elements of the financial and monetary regime and its relationship to economic activity should consider him- /herself less than well informed, both as an individual and as a member of society. Lacking knowledge about its basic elements is not only dangerous to your economic health but dangerous to your ability to participate in the political process.

Knowledge of the financial and monetary regime will not guarantee economic success, but it will help you avoid mistakes that will surely limit your lifetime wealth.On a broader level, lacking knowledge about the basic elements of the financial and monetary regime renders you a low-information voter, or “useful idiot”, easily manipulated by politicians on either side of the aisle. The term gained new life in late 2014 when it became widely known that one of the major consultants to the 2010 Affordable Care Act claimed, to a group of economists at a conference, that the public's lack of economic understanding and their basic “stupidity” about economics played an important role in enacting a major overhaul of and expanded role of government in the U.S. health system (Bierman, 2014).

This was a dark day for the role of an economist in public policy, but it offers an important lesson. Irrespective of one's view of the Act, the mindset that subterfuge is acceptable for major expansions in government should give everyone pause about government activism. Government, whether to the right or left, does not always have the best interest of the individual in mind and often relies on uninformed voters to pass complex legislation and pursue policies that may not be in the best interests of the country. At a minimum, understanding the basic elements of the financial and monetary regime will help you manage your wealth and render you a more informed observer of important public policy debates that greatly influence your life and reduce your reliance on “talking heads”, who dominate the news media and who, unfortunately, haven't a clue about most of the contents of this book.

Introduction

Government regulation and supervision of the financial system constitute one of the three components of the nation's financial and monetary regime. Chapter 8 discussed how government regulation and supervision evolved over time as the nation's monetary standards shifted from commodity to representative commodity and, finally, to fiat-based standards. That discussion was designed to explain how government emerged as a major force in the nation's financial and monetary regime. The discussion in Chapter 8 was necessarily broad. This chapter is more focused, in two ways: First, the rationale for government regulation and supervision is expanded to incorporate different perspective of market failure; and, second, the important and specific types of government regulation and supervision are outlined.

Asymmetric Information, Adverse Selection and Lemons

The rationale for government regulation and supervision can now be extended to incorporate two other types of market failure that interfere with the ability of the nation's financial and monetary regime to operate smoothly. The two new perspectives of market failure are referred to as the asymmetric information and adverse selection problems. These are general problems in any market, and can be introduced by considering a market for a commodity such as a used car or home. George Akerlof (1970) is credited with bringing attention to how asymmetric information and adverse selection render the used car market less inefficient.His analysis is now referred to the “lemon problem” in the used car market. The principles, however, are general.

Asymmetric information refers to the fact the buyer and the seller of the used car do not have the same information set. The seller generally has more information about the car than the buyer. The seller knows the car engine burns too much oil or has a weak transmission even though the car drives well for short distances. The buyer does not have this knowledge, and, while the buyer can pay to have a mechanic examine the car, this is expensive and time-consuming and may not provide reliable information if the defect is subtle. That is, the seller knows the car is a lemon but the potential buyer does not. As a result, the potential buyer assumes the used car is of average quality irrespective of how well it is represented and, hence, will offer a price based on that assumption alone.

Introduction

In the introductory chapter, we established that a financial and monetary regime consists of three components:

The introductory chapter outlined the basic structure and responsibilities of each of the three components; discussed various measures of economic activity that are influenced by the nation's financial and monetary regime; and identified several notable periods of U.S. and world history in which the financial and monetary regime did not satisfactorily meet its responsibilities. These periods generated much economic and financial distress, reduced the standard of living for many, reduced the quality of life for many and on some occasions, as in Germany in the 1920s and early 1930s, contributed to geopolitical distress with grave consequences for world history.

The three components will be discussed in more detail in the coming chapters, but before we turn to that discussion there are four basic definitions and concepts needed to understand a country's financial and monetary regime: first, the concept and measurement of money; second, the concept and measurement of the value of money; third, the evolution of monetary standards; and, fourth, the relationship between money and economic activity.

The Concept and Measurement of Money

The following considerations provide the basis for understanding the U.S. money supply, as well as the money supply for any nation: the concept of money; measuring the money supply; the M1 and M2 measures of money; the “best” measure of money; and what is not money.

The general concept of money: The concept of money can be approached from two perspectives. The first considers money in the most general sense and the second considers money in terms of the important functions it performs in the economy.

The general concept of money views money as any item a society decides to use to make payments for debt, goods or services. History records many different items that have been accepted by society to function as money. Shells, precious stones, pearls, sharks’ teeth, gold, silver and even cigarettes in POW camps during past wars have served as money.

There are many excellent monetary economics textbooks in terms of coverage and pedagogical tools written by accomplished monetary economists. So why another textbook? This book differs from the traditional money and banking textbook in three significant ways: first, it offers a unifying framework; second, it approaches many topics from a different perspective from other textbooks; and, third, it offers a less encyclopedic approach than that presented in other textbooks.

Unifying Framework in This Book

The topics and the order of chapters are presented in the context of a unifying framework referred to as the nation's financial and monetary regime. The nation's financial and monetary regime consists of these three parts: 1) the financial system; 2) government regulation and supervision; and 3) central banks and central bank policy. Each component of the regime is addressed in a logical order so that the student can obtain a unified perspective of the most important topics covered in a monetary economics course.

Approach to Topics in This Book

In the context of the unifying framework of the nation's financial and monetary regime, this book offers different perspectives, both in terms of pedagogical presentation and issues.

First, discussion of central bank policy itself is organized around a five-step sequence to assist student understanding of the role of central banks and central bank policy: 1), the central bank; 2), the tools of monetary policy; 3), policy instruments; 4), the model; and, 5), the final policy targets. Like the unifying framework of the nation's financial and monetary regime, this five-step sequence provides a unifying framework for the student to organize the many elements of central banks and central bank policy.

Second, the book aims to incorporate history and policy along with the analytical concepts necessary to understand the nation's financial and monetary regime; that is, the subject is viewed more from a political economy perspective than from the analytical and detailedmodel perspective ofmost traditional textbooks. The analytical subjects are not central to the book and are developed only to the extent necessary to understand the nation's financial and monetary regime. The IS/LM model is not included. Instead, the “old” and “new” Phillips curves, along with a brief introduction to the AD/AS model, are used to illustrate the relationship between central bank policy and the economy.

Introduction

Interest rates are key variables in the nation's economy and determined by the interaction of lenders and borrowers in the financial system. Interest rates and changes in interest rates impact virtually every type of private and public spending, the financial health of private and public enterprises, the value of wealth of individuals and the nation, and the economic and financial relationship a country has with the rest of the world. Not only are interest rates a key variable in every lending and borrowing transaction, they are the focal point of monetary policy. Virtually every central bank conducts policy by setting an interest rate target and then uses its tools of monetary policy to achieve that target. The interest rate target indicates the direction of monetary policy. Lacking basic knowledge about interest rates is clearly dangerous to your own economic health, aside from the more general problem of being clueless about monetary policy and the financial system in general.

This and the next two chapters discuss interest rates from three perspectives. In this chapter, the following basic concepts needed to understand interest rates are discussed: the essential nature of the interest rate; the distinction between interest rates in indirect and direct finance; efforts by government to regulate interest rates; and basic technical aspects of interest rates. In the next chapter, the determinants of the level of interest rates in terms of the flow of funds framework are outlined. This framework can then explain why interest rates change over time. In that discussion, we lump all interest rates together into just one interest rate to focus on the basic determinants of the level of the interest rate, which can then be applied to any one of the many interest rates in the financial system. In the chapter after next, the assumption of one interest rate is dropped to focus on the structure of interest rates. The structure of interest rates explains how different interest rates are related to each other and how key elements of the relationship are used to measure risk in the financial system; indicate changes in the public's expected inflation; and indicate the probability the economy will expand in the future or the probability the economy will contract in the future.

Introduction

The terms strategy and tactics are frequently used to describe the actual formulation and implementation of monetary policy designed to influence economic activity. The terms are sometimes used interchangeably; however, the terms are different in important ways, but, combined, they help us understand how monetary policy is formulated and implemented.

The strategy of monetary policy refers to the final policy targets – that is, the “what the central bank wants to accomplish” part of monetary policy. Strategy focuses on the final policy targets (Step 5) in the sequence of the central bank decision process. Central banks since the Great Inflation period have elevated price stability as the primary final policy target. A total of 29 central banks as of 2015 have adopted explicit inflation targets and conduct their day-to-day tactical operations in the context of that final policy target. The Federal Reserve and a number of other central banks instead utilize implicit inflation targets.While price stability has been elevated as a primary long-term goal of Federal Reserve policy, the Federal Reserve is constrained by its so-called “dual” mandate, which provides the operational and political framework that guides the Federal Reserve's final macroeconomic policy targets.

In contrast, the tactics of monetary policy refer to the “how the central bank accomplishes its strategic goals” part ofmonetary policy. Tactics refer to the choice of tools ofmonetary policy, choice of the policy instrument (money or interest rates) and how those policy instruments are used in the context of the macroeconomic model to achieve the final policy targets. Hence, tactics focus on Steps 2, 3 and 4 of the sequence of the central bank decision process.

The previous chapter focused on strategy. This chapter focuses more on the tactics of monetary policy, in three steps. First, this chapter reviews how the Federal Reserve formulates, implements and informs the public about its tactical and strategic operations. In this regard, the Federal Open Market Committee is the center ofmonetary policy in the United States. Second, the issue of tactics is broadened by considering the Taylor rule as a framework to understand tactically how the Federal Reserve, or any central bank, can achieve the objective of price stability as it formulates and implements monetary policy on a short-run basis. The Taylor rule is a much different tactical approach that is a substitute for the discretionary approach emphasized by most central banks.

Introduction

In Chapter 2 the evolution of monetary systems was outlined. The monetary system has evolved from commodity money to representative commodity money and, finally, to the current stage of the modern monetary system. The modern monetary system is based on depository institutions that issue promises to pay, represented by bank notes in Hickenlupper's Bank, and checking accounts, in today's system based on depository institutions. In the modern system, depository institutions hold only a fraction of their promises to pay as reserves; the promises to pay and the fractional reserve maintained by the depository institution are both fiat money in which the face value is defined independently of any commodity; depository institutions issue new promises to pay when they lend and invest; and the modern system imposes a fiduciary responsibility on depository institutions to conduct their operations so as not to adversely affect the public's willingness to use their promises to pay as money.

The modern system is essentially an inverted pyramid that eliminates many of the problems of a commodity and representative commodity system; however, there is never a free lunch. The modern system itself has several inherent problems that require government to take amore active role in the nation's financial and monetary regime than required in the commodity and representative commodity systems.

This chapter focuses on inherent problems in commodity-based systems and the modern monetary system that rationalize a role for government in the nation's financial and monetary regime. In fact, government financial regulation and supervision through regulatory agencies is now considered one of the three components of the nation's financial and monetary regime. This role significantly influences the private aspects of the nation's financial system. In addition, the government even becomes a part of the financial system, setting up government-sponsored enterprises that provide subsidized credit to certain parts of the economy deemed economically and politically important. Not only does the second component consist of government regulation and supervision, the third component, represented by the nation's central bank and central bank policy, is under the control of the government.

The history of money started as a market innovation, then at an early stage incorporated government, which remained relatively small for many centuries, until the twentieth century. Today government is a major part of the nation's financial and monetary regime.

Introduction

Step 1 of the sequence of central bank policy focused on the institutional design of the central bank in general and the institutional design of the Federal Reserve in particular. The actual formulation and execution of monetary policy are concentrated in a central committee in most central banks. In the case of the Federal Reserve, the FOMC is the center point of the formulation and execution of monetary policy.

Step 2 of the sequence focused on the monetary policy tools and how the central bank, in the context of the money supply process, is able to influence the money supply, interest rates and credit. Central banks and the Federal Reserve possess a variety of general monetary policy tools, but for all practical purposes open market operations are the tool of monetary policy, because they are powerful and flexible and the initiative to use the tool resides solely with the central bank, whereas the other tools lack at least one of these characteristics.

In Step 3 of the sequence, the tools are directed toward one of two monetary policy instruments – the monetary aggregates or interest rates – in order to increase the probability of monetary policy achieving its final policy target or targets. The central bank can target only one instrument because the other instrument is required to change in order to achieve the target of the chosen instrument. Monetary aggregates are, ultimately, an important part of central bank policy, because in the long run inflation or deflation are directly related to the monetary aggregates, but in the shorter run the interest rate is the preferred policy instrument.

This chapter moves to Step 4 and provides an overview of the evolution, historical development and current version of macroeconomic models to understand the formulation and execution of monetary policy.

Macroeconomic Models of the Economy: Beginnings

Central bank policy from the time central banks began to function in the eighteenth and nineteenth centuries has always been conducted in the context of some understanding of the interrelationships between important macroeconomic variables of the economy – GDP, unemployment, prices, money, interest rates, credit, etc. – and how central bank policy actions influence specific variables (policy instruments) to influence other variables (final policy targets).