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Understanding Money

Who Controls the Money Supply?

As you can see by now, both people and countries have a need for economic stability. But economic stability does not mean that financial conditions should stay the same for a long period of time. Indeed, as we discussed in the previous section, the economy has a life of its own, moving through business cycles in which periods of expansion are followed inevitably by periods of contraction.

Since change is inevitable, working towards economic stability means doing the best we can to moderate the business cycles. Our goal is to make the expansions as manageable and predictable as possible (thereby avoiding inflation), and to make the contractions as short and mild as possible (thereby avoiding recessions).

I have mentioned that, in the last 150 years, the United States has gone through 33 business cycles, many of which have had devastating periods of inflation and recession. Although there are no perfect solutions, it is possible to manage the economy somewhat. For example, the last period of economic expansion started in March of 1991. When I wrote the first version of this essay, in May of 2001, the economy was still doing well. In fact, it was, by far, the longest period of economic expansion in modern history.

It is an interesting characteristic of a healthy economy that it cannot stay the same for very long.

What is it that helps keep an economy healthy and stable? There are a number of important factors, and I will summarize them for you at the end of the essay. (At the time, you will see that one such factor is the Internet.) For now, I want to discuss the element that is most under our control: the size of the money supply.

The health of an economy is very much dependent upon its money supply. Virtually every transaction requires money and, without enough money, the rate of commerce will slow down. Moreover, in order for the economy to grow, individuals, companies and governments must be able to borrow money as they need it. If there is not enough money, interest rates will go up, borrowing money will become more expensive, and the economy will slow down.

It is an interesting characteristic of a healthy economy that it cannot stay the same for very long: the level of productivity must either grow or shrink. Since we prefer that the economy grow, we must make sure that it always has enough new money. If the economy does not get enough new money, it will, over time, begin to contract.

Imagine the economy is a pot of water boiling on the stove. To keep the pot boiling, you constantly have to be adding just the right amount of heat. If you add too little heat, the water cools down and stops boiling. If you add too much heat, the boiling gets out of control.

In the same way, if the economy doesn't get enough new money when it needs it, economic activity will slow down to the point where it will cause a recession. Conversely, if too much new money is put into the economy for too long, it will cause prices and wages to spiral up and up, which will cause inflation.

The basic idea behind modern economic management is for someone to control the money supply in such a way that the economy gets the right amount of new money at the right time. For example, during recessions, the money supply should be increased to speed the recovery. During times of inflation, the money supply should be decreased to hold down prices and wages. Indeed, it may even be possible to avoid recessions and inflation by manipulating the money supply preemptively.

In most countries, an organization called a CENTRAL BANK is in charge of controlling that country's money supply. All industrialized countries have a central bank and, in Europe, the European Union has a central bank of its own to control the Euro and the European-wide money supply. In the United States, the central bank is called the FEDERAL RESERVE, often referred to as the FED.

The Federal Reserve was created by the U.S. Congress in 1913 in an attempt to avoid the booms and busts that had caused such severe problems in the 19th century. The Fed is a hybrid organization, part public and part private, that was set up specifically so as to avoid being subject to short-term political pressures.

The Fed is based in Washington, D.C. and is run by a Board of Governors consisting of seven people who are appointed by the President and confirmed by the Senate. Under the supervision of the Board of Governors are 12 regional Federal Reserve Banks that oversee various parts of the banking system. Although the Board of Governors is a public agency, the Federal Reserve Banks are actually private organizations, although in many ways, they function as public agencies.

From among the seven Governors, the President appoints one to be Chairman, to run the board and to act as chief executive of the Fed. As you will see in a moment, the Fed is an extremely important organization. As a result, the Chairman of the Fed is the second most powerful person in the United States, after the President himself, and one of the most important people in the world.

The U.S. Federal Reserve provides four main services. First, it acts as the money manager for the United States, regulating the money supply as necessary. (We'll talk about the details in the next section.) Second, the Fed acts as the official bank of the federal government. Third, the Fed regulates the U.S. banking system. Finally, the Fed serves as a sort of super-bank, providing special services to all the other banks in the country.

In the context of our discussion, the Federal Reserve is important because it is charged with the task of keeping the financial system as healthy as possible. To do so, the Fed manipulates the money supply in a way that (it hopes) will avoid inflation and recessions, and will encourage the economy to grow in as stable a manner as possible.

In this way, the Fed and other central banks around the world have enormous influence over the lives of people everywhere, much more than most people realize. For example, if the Fed thinks the U.S. is in danger of excessive inflation, it may reduce the money supply in order to cool down the economy. This, however, will increase unemployment, which, in turn, will affect people's marriages, their self-esteem, and their financial well-being, not to mention their ability to buy a house, send their children to college, and save for retirement.

In a very real sense, the Federal Reserve has huge power over the U.S. economy and, indirectly, over people's lives. And yet, very few people understand what the Fed is and how it works. To show you one aspect of the system, I am going to describe to you how money is created and how the Fed manipulates the U.S. money supply. This is something that I want you to understand because, later in the essay, I am going to explain how the Internet also affects the supply of money, and you will see how everything is related.

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