Lesson 7b: Money and Monetary Policy

KEY FORCES IN AMERICAN HISTORY

2.  Economic freedom, rule of law, and well-defined property rights promote growth and prosperity.

3.  Inflation (deflation) happens when the money supply grows more quickly (slowly) than output.

ECONOMIC CONCEPTS that support the historical analysis:

Financial Intermediation

Money, the Money Supply, and Money Creation

Fiat Money

Central Bank

Inflation (Deflation)

Rules v. Discretionary monetary policy

Fixed v. Floating exchange rates

Supply and Demand

CONTENT STANDARDS

History Standards (from National Standards for History by the National Center for History in the Schools)

Era 7 – 1:  The student understands how Progressives and others addressed problems of industrial capitalism, urbanization, and political corruption

Era 7 – 3:  The student understands how the United States changed from the end of World War I to the eve of the Great Depression

Era 8 – 1:  The student understands the causes of the Great Depression and how it affected American society

Era 9 – 1: The student understands the economic boom and social transformation of postwar United States

Era 10 – 2: The student understands economic, social, and cultural developments in contemporary United States

Economics Standards (from Voluntary National Content Standards in Economics)

Standard 11:  Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.

Standard 19:  Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. By creating uncertainty about future prices, inflation can reduce the rate of growth of national living standards.

Standard 20:  Federal government budgetary policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

KEY IDEAS

• Central banks perform two functions: They serve as “lenders of last resort” – i.e. they provide liquidity to the banking system during a crisis (they are the bankers’ bank); and through the regulation of the commercial banks, central banks control the money supply, and hence they exert influence on inflation (deflation) and interest rates.
• If central banks allow the money supply to expand more quickly (slowly) than real output, then inflation (deflation) is often the result.
• Central banks (or whatever government entity controls them) must decide whether they will follow a monetary rule or a discretionary monetary policy.
• A monetary rule – e.g. gold standard – makes it difficult, though not necessarily impossible, for the monetary authorities to exercise discretion in controlling the money supply, influencing interest rates, and so forth.
• A discretionary policy, often associated with fiat currencies, gives the monetary authority much more latitude in controlling the money supply, influencing interest rates, and so forth.
• Central bank independence is often a feature of countries that experience economic growth and prosperity.