What is the U.S. Dollar based on, and what does this have to do with human happiness? In an important sense, the dollar is based on our collective public opinion. But then again, so is the rest of the economy.
One way to understand this is to look at how the amount of money in circulation is controlled, to the degree that it is controlled.
Why control the money supply? Because the amount of money in circulation can speed up or slow down economic activity – too much money leads to inflation, to little to deflation and depression. How this happens is related to interest rates, but that connection separate topic then the money supply itself.
One way to understand this is to follow the money, so to speak. A new Federal Reserve Note (a dollar) can be created as a replacement for an old bill, or as the paper version of a dollar that already exists as digits in an account. In these instances, banks buy currency from the government. That doesn’t change the overall money supply, but that doesn’t mean it’s not important. We’ll come back to it in a moment.
The Reserve can just create money by in essence printing it, but it only does that very, very rarely. Much more typically the Fed works with money it has held back from the system - money on the Fed's balance sheet but kept out of the economy. And no matter whether the new money has been freshly printed or kept in reserve, the Fed raises (or lowers) the money supply in a way that depends on the cooperation and confidence of the private economy.
Let's look at this in more detail. This can be confusing, but the point is to impact the amount of money at work. Because that’s when it can help speed or slow economic activity.
When the central bank wants to increase the money supply in the banking system (and the economy at large) it will buy Treasury Bonds from private banks, paying in cash or the equivalent. Both the bond and the currency have been issued by the government; with one hand the government has issued this debt, which another part of the government buys up. Both are similarly trustworthy. But this is more than moving coins from one hand to the other.
Because the private bank now has more money to put to active work. Think about it this way – the bond was not liquid, neither was the money the Fed had in reserve. But when one is traded for the other the Fed still has assets that are not working in the economy, but the bank now has money it can lend.
And since banks like to lend money (it's how they normally make their profit) the cash gets pushed out into the world to work. A larger money supply leading to more economic activity. If the Reserve wishes to tighten the availability of money (and slow the economy), it simply reverses the process. The rate and direction at which this happens controls the amount of money in the supply.
Let's look again for a second at where the Fed gets the money to buy the bonds. Typically that money is cash accrued as part of it's role as the central bank and banker of last resort - interest on loans, mandatory deposits from large banks, money appropriated by the Treasury Department. Some of this is money taken out of the economy when the Fed wants to reduce the money supply. Sometimes, very rarely, the Fed will simply print money. But the key again is that this is money that has been out of the banking system and the economy. The effect is the same whether it is newly minted or just held in reserve.
It seems like a zero sum game, like the total number of dollars is not changed. But keep in mind that the money the Fed has held back has not been having an impact on the economy.
One interesting way to think about this is to consider the way debt can duplicate money. In this case the bond and the dollars used to pay for it can exist in the economy at the same time. That's an important point, because a similar thing happens when the government (in this case Congress) increases it's bonded indebtedness. That also increases the money supply (more on that below), and that also works though the credit markets. And as we saw Congress or the Fed can retire some of the debt to reduce the money supply, because the process is easily reversible.
It would be possible for the Congress to ask the Fed and the Treasury department to print money to pay wages, contracts, etc. But it doesn't normally do that. Instead it also goes through the credit market.
Which brings us to another important point. This strange seeming idea of the government buying and selling its own debt to control the money in the economy has an important aspect related to feedback. This mechanism includes a private link, something out of government control; by monitoring the willingness of the bond market to trade dollars for treasury notes, the Fed and Congress get regular information about the health of both. When we speak about a fiat currency, based on the full faith and credit of the government, this is a way to test what that means.
So if investors lack confidence in the money introduced by the government, they would demand more of a premium to accept it, or they could conceivably refuse to take part entirely. In this way the dollar is linked to their impression of the government’s ability to pay its bills, which is in turn based on their opinion of its ability to tax. Which is in turn based on their opinion of the health of economy as a whole.
The Fed no longer emphasizes its measurements of the money supply, in part because new forms of credit make the money supply hard to define and control. More on that below as well. But like central banks have done for centuries, the Fed rather works by making marginal changes in interest rates. The looser money is and the lower borrowing costs are, the more economic growth should be stimulated. With the inverse for tighter money.
In other words, in good neo-classical economic fashion, the central bankers are not so much interested in what the total supply and demand numbers are for their product (in this case that product being money) they only have to monitor the change in price (the shift in the interest rate) that comes from adding or subtracting units at the margins. In this sense, control of the money supply can be seen as a form of marginal utility as described by Alfred Marshall, and in that it resembles most other modern markets.
So the Federal Reserve makes money more or less available in order to change interest rates. When news reports say the fed is setting a target interest rate, what the reserve is actually doing to reach that interest rate is putting money in or taking money out of the system (via the network of large banks it works with, the people the Fed buy and sell bonds with) until the cost of borrowing (to be exact, fed funds rate) matches the number selected.
As referenced above, this way for stimulating or slowing economic growth has a direct parallel to fiscal or Keynsian stimulus. Through that mechanism, Congress will go into debt (or pay off debt) to increase (or decrease) spending. When the economy is slowed, one classic form of fiscal stimulus is to make additional Food Stamp or unemployment compensation payments, the point being that payments made through those programs can go out quickly and are very likely be used almost entirely and almost immediately. Cutting (or if the economy is overheating, raising) taxes would have a similar impact, but generally takes longer.
The point is it all works the same way. The government going into debt increases the money supply because both the debt and the money Congress has to spend exist at the same time. In some situations, this has an advantage over central bank interest rate cuts as a form of economic stimulus, because if an economy is depressed enough, lowering interest rates might not spark any more economic activity. While Congress can decide to spend or not, at will.
If all of this sounds inflationary, as if it should be constantly driving up prices by adding currency worth less and less, remember that the economy is almost always growing. Unless the country is in recession it will require an ever-larger money supply to match the added goods and services being produced. And all of the above mechanisms are at least intended to be used in a non-inflationary manner, with an awareness that too much currency, like too little, can have a negative economic impact.
There is yet another way for new money to be introduced. Let’s back up and review - fiscal stimulus puts new money into the economy through government borrowing – Congress appropriates new spending and new debt, the Treasury Department in essence adds to the federal checking account, and the checks are written. If there is a need for paper money to cash the checks, dollars are printed and introduced along with the replacement currency mentioned above. As we have seen the central bank system of buying or selling government debt does something similar.
But a far most important way of adding to the money supply is not centrally controlled in that way, although in an important sense it may be unconsciously driven by some of the same kinds of measurements. The private sector also adds to the money supply, much more dramatically than the government.
Simply put, banks and other lenders create money by lending out more than they have.
Think about it this way. A bank or credit card company sends you a credit card application with a five thousand dollar limit. You fill out the application, are accepted and go out and buy five thousand dollars worth of stuff. You now have five thousand dollars more stuff, and five thousand dollars in debt, plus interest. The merchants get their money from your bank and deposit it in their bank. Their bank now has five thousand dollars more than it had before. And if it needs currency, it can go to the government and buy five thousand one dollar bills.
So now there are five thousand new dollars in the economy. Where did they come from? When were they created? They were created by the interaction of you, the merchants and the banks. There is an unspoken confidence that you, and millions of other people just like you, will produce enough (when the bills come due) to pay for the goods and services you now enjoy. In a broader sense you, the merchants, and the banks are all betting that the economy will grow enough to support the debt it is adding on.
People working for the banks, credit card companies and the financial industry are charged with the task of evaluating how good a risk that is. But as a whole the system is not designed to pay attention to the size of the money supply it is increasing, only to the marginal utility of adding more credit in one particular instance.
It operates by what we might call collective subjective action, as in another context could Adam Smith’s invisible hand. If the central bank raises or lowers interest rates, that influences those moves. But ultimately the decision to lend or borrow is made by thousands of separate individuals, each answering to a separate set of demands. Just as it is in most large markets.
All of which suggests the question - why do interest rates have such an impact on the rate of economic growth?