Monetary policy is a term that has been thrown around a lot since the 80’s, and even more since the 2008 financial crisis.
It sounds like something technical and complex. But what does it actually mean?
Monetary policy refers to how money is actively managed in the economy. Most people probably don’t even realize that money is actively controlled like this. In fact, it has always struck me as quite strange that not much interest arises among the general population when it comes to money.
We work for it, covet it, spend it… We are very much in tune with the functional side of money. But the actual meaning and origin of it is something we choose to ignore. After all knowing about money is not going to help you get more. Or is it?
I will try to explain in as brief and concise a manner possible what money is, where it comes from and how it has evolved since it first appeared. This is the only way in which we can understand how monetary policy works and affects us.
What is money?
Money is simply a good that we use to exchange other goods. Money evolved from bartering to facilitate trade. In reality, no one “needs” money, to the extent that money is not the final thing you are trying to get. You are trying to get goods and services using the money.
Before money was “invented”, so to speak, people used to barter, which is a straight up trade. I give you X amount of cows and you give me Y chickens. This system can work in a very simple economy. But it’s easy to see it’s shortcomings as the economy grows and there are more goods. I might want to sell cows but don’t actually want your chickens. I might actually want tomatoes instead. So I have to find someone with tomatoes who wants cows. Or in its defect find out what the tomato guy wants and change my cows for that.
Money comes into the equation to help us assign a value to things, thus making it much easier to trade. As a society, we decide to use a certain good as a kind of intermediary device for all trades. We could decide, for example, that rocks will be used in exchanges.
So I sell you my X cows for Z rocks, which should be the equivalent of Y chickens. But now I can use the rocks to buy the tomatoes since the tomato farmer knows he can then, in turn, use the rocks to buy what he desires.
Money comes in handy to measure the value of things. But money is also paramount in the process of saving. I can’t keep my cows for 10 years. But I can sell them and keep the money I get (in this case rocks) for as long as they last.
With this simple analysis, we can already begin to see that money is used for something much more important and that there are certain characteristics that money should have.
The virtues of money
There are three basic uses of money, each one requiring a specific virtue.
Money is used to exchange goods.
In its simplest form, money is something you can take with you and use to exchange for goods.
This means it has to be somewhat easy to transport and it must be commonly accepted wherever it is that you make your purchases. Also, money has to be easily countable and divisible. This makes it easier to make big and small purchases using the same thing.
Money is used as a unit of measure.
This is the way we assign a value to things. It doesn’t suffice to say we accept salt, as was the case with the Romans, in exchange for goods. You need to measure that salt and say how many grams or kilos each good is worth.
As a result, money has to be easily divisible, allowing you to make both small and big purchases. But most importantly, the value of money has to remain stable. It would be no use to assign prices and value in terms of grams of salt if the next day everyone turns around and says salt is worthless, or salt now is a lot more precious. This would mean buyers and sellers would have to constantly be changing the price of things and reassessing the value of their money.
I like to illustrate this point by imagining money as a rule that we use to measure prices. Imagine you had a ruler, but the units kept changing. So from one day to another 10cm becomes 10mm for example. This would absolutely defeat its purpose. You wouldn’t actually be able to measure things as the ruler would give a different reading on different days.
This would be incredibly tedious and confusing, which is something that doesn’t help business and the economy as a whole.
Money is used to store and accumulate wealth.
As I mentioned earlier, another problem that arises from not having money is the increased difficulty of storing wealth. To be able to store wealth money has to be durable. If you are planning to store something for over 20 years, it better last. Furthermore, extending on the two points made above, the money you store has to maintain its value, throughout the years, and hopefully, still be commonly accepted in trade. (Though this is not as important as long as its value remains).
The origin of money
The first forms of money came about in spontaneous, decentralized ways. Money has been around before governments, and back in the day when there was no body of power deciding what was considered money or not. It was simply up to the people to decide. Eventually, central geographical areas and societies would reach some kind of consensus.
Throughout history, many different goods have been used as money. From seashells to salt and even working tools.
But without a doubt, the most accepted and prevalent form of money in our history has been precious metals, namely, gold and silver.
This is because precious metals possess all the “virtues” we outlined before.
Gold is easy to carry and can be divided easily. It’s also easy to measure its value by weighing it. Gold and silver coins are practical to carry around and use in trade.
On the other hand, we can use gold bullion or lingots to store our wealth. Gold does not decay or erode in any form. It stands the test of time and is not too bulky. Even today, one could store a small fortune in their own home using gold.
Lastly, and most importantly, the value of gold is accepted worldwide and has remained stable throughout history.
Value is a subjective thing. A price is just an aggregate of everyone’s subjective valuation of something.
Gold has value because it’s nice to look at and we use it to decorate things. It sounds silly but it’s true. Another reason gold is valuable, is because it’s rare and this is the key to what makes gold such a good form of money. The supply of gold is limited. The only way you can get more gold is by mining it. As of today, an astonishing 98% of the gold in existence has already been mined.
This is the main factor that contributes to keeping its price stable and makes gold such a great form of money.
Imagine we were still using salt as money, and suddenly a huge salt mine is discovered, there would be a great increase in the supply of salt which would make it less valuable. Prices would have to adjust and any savings you had would become a lot less valuable.
Gold detractors like to mention that “you can’t eat gold”, but, to be fair, you can’t make a sandwich with 10-pound bills either.
Their point, really, is that gold isn’t actually useful, in a practical sense, which is true, but that doesn’t matter. People have always valued gold. Moreover, the fact that it’s useless is another guarantee that its price won’t change.
If gold suddenly became a renewable non-polluting source of energy its price would skyrocket. Like with the salt example, this would disrupt prices, as everything is valued in gold.
But that’s unlikely to happen. In all its history and for the foreseeable future, gold will remain just a shiny, yellow metal. Which makes it the best form of money.
The recent history of money
So around the 1800s, with the development of industry and international trade, it became pretty standard for countries to use gold and silver as their currency. The British Pound is in fact named like this because it used to be made up of exactly 1 pound of silver.
Countries started standardizing the coinage of gold and silver, which was great for trade.
A silver pound could be used all around the world without any inconvenience. People didn’t even have to bother weighing the coins anymore. Every British Pound had a pound of silver, and people took this at face value (for some time). This monetary system is often referred to as the Classical Gold Standard
But coins were limited in some ways, as large amounts of them could be heavy. As a result, people starting using notes too. The first notes to arise were simply promises to pay the bearer of that note in gold.
The first U.S. dollars stated quite clearly on the front that they were redeemable in gold.
It wasn’t long after the development of notes that western governments realized there could be a lot of benefit in controlling the use and production of money.
In fact, monetary fiddling has been around for centuries. In the Roman Empire, it wasn’t unusual for emperors to fund wars by debasing the currency. This meant issuing coins with less of the precious metal in them, normally mixed with another to maintain the same weight. This system would “trick” people for a while. But eventually, prices would rise as a consequence.
Abraham Lincoln discovered he could do quite the same thing when he started issuing greenbacks. This was back in the day when gold was still at the center of our currency system. These greenbacks were like regular notes, except they weren’t redeemable in gold. Of course, in the end, this meant higher prices too since there was more money but the same amount of goods.
This may be the oldest form of monetary policy, commonly known as devaluation.
In more recent years, countries have also used this technique to gain an edge on rival countries. The idea is that by devaluing the currency, one’s exports become cheaper to the outside world and they will be more competitive, which should help the economy.
Modern Monetary Policy
What many people don’t realize is that until 1971, gold was still at the center of our currency system. All currencies back then could be exchanged into dollars, which in turn could be exchanged into gold at a fixed price. This would “limit” the actions of monetary policy.
Since 1971, we have had a system of floating currencies. This has ushered in a new wave of monetary management.
Before that, monetary policy was generally geared towards maintaining the stability of a currency’s value in terms of gold.
How did banks do this? By controlling the supply of money. If the value of the money was above that of gold, you simply issue more money. If it’s below, then you buy it back, using gold, or even bonds. Imagine the supply and demand curves from my previous article. We have demand for money and supply of money. The idea is that by controlling the supply, we can maintain the stability of the price of money, even if demand changes.
Nowadays, all currencies are managed by Central Banks via adjustment of the total supply of base money. Base money consists of paper bills and coins (typically about 90%), and bank reserves (10%).
Central Banks today, such as the Bank of England, adjust base money every day, through their various open market operations. The only difference between the Bank of England’s present system and a gold standard, or any other system — currency peg, currency basket, commodity basket, CPI target, monetarist aggregate target, etc. — is when and how much to adjust base money. The present system is a short-term interbank interest rate target. When the market interest rate for interbank credit is above the BoE target, the BoE increases base money supply. When the market interest rate is below the target, the BoE reduces base money supply.
Open market operations, basically consist of the BoE either buying or selling government bonds. When they buy debt from the government, they are increasing the supply of money. If they sell government debt, they are reducing the supply of money.
The BoE buys the bonds by creating new money. It’s worth noting that the BoE doesn’t typically buy bonds directly. It may instead buy the debt from other banks, or simply offer a line of credit to certain banks to buy the bonds. The results, however, are always the same.
The question we must answer is whether interest-rate targeting is a good monetary policy, and if so if it’s superior to a fixed value targeting.
Economists now believe that the economy can be somehow “aided” through monetary policy. The basic idea is that by decreasing the interest rate, more money will be spent, people will borrow more and spend more. The economy will enter a virtuous circle.
Leading up to the 2008 financial crisis, central banks kept decreasing interest rates in an effort to stop the bubble from bursting Was this helpful?
Furthermore, after the 2008 meltdown, central banks around the globe continued to lower interest rates. When they could not do that anymore, they resorted to straight-out purchases of debt (quantitative easing). In the U.S. not only banks but even auto firms were essentially rescued using money created out of thin air.
So central banks are essentially creating money, which others have to work for, to bail-out banks and fund governments on the brink of bankruptcy. It really isn’t very different than what the Roman Empire did, or how Abraham Lincoln funded his war.
But of course, you can’t just keep printing money without consequences. Eventually, a price has to be paid and the people paying the price are everyday users of the currency. People like you and me who receive no benefits from money printing but all its drawbacks, mainly, currency devaluation
See below the evolution of the U.S. dollar in terms of gold since the 1700s. Since abandoning the gold standard the value of the dollar has fallen by almost 1000%.
And this is only the effect on your money. Much more can be said on how this form of tampering actually affects the whole economy, induces mistakes, punishes savers and destroys capital. I shall probably make this the subject of another article.
For now, simply keep in mind the importance of money. And remember that the money we are all forced to use today is controlled by central banks which are actually private institutions. They are managing the currency according to their best interest, not yours.
Your best interest is to have a stable currency. Which you can still do. You simply have to make sure you keep your savings denominated in a currency that has maintained its value for millennia; gold.