A stable currency was so important to the Founders that they included “To coin money, [and] regulate the value thereof[1]” as one of the specific powers granted to Congress. They have delegated that power to the Federal Reserve, America’s central bank, and it regulates the value of the dollar by regulating the money supply. The primary gauge of monetary stability is price stability – if prices are in a general rise, money is losing value (inflation); if prices are in general decline, money is gaining value (deflation). Both are worse than price stability, if for different reasons. The Federal Reserve accomplishes this regulation by using interest rates, reserve requirements, and bond transactions. The money supply consists of cash, demand deposits (checking accounts), time deposits (savings accounts), and savings instruments (CDs, T-Bonds, etc).

The Fed manages the “prime interest rate”, which is what it charges banks for overnight loans. All other interest rates are set voluntarily by the banks themselves. The effect is well known, whereby higher interest tends to inhibit lending and lower rates encourages it. This affects the money supply because money lent out, largely, is deposited in other banks, where a portion is lent out again, and so on. Controlling the velocity of lending has a real effect on money in the system. A tightly bound collateral effect is that the prevailing interest rate impacts business activity, as borrowing is the method by which most businesses expand, improve capital equipment, conduct mergers and acquisitions, weather disruptions in cash flow, and so on.

Banks are required to hold a percentage of their deposits at the Fed in what is called a reserve requirement[2]. This to cover unforeseen circumstances that would require the bank in question to produce cash. Obviously, by manipulating this rate, the Fed can affect the amount of money available for lending. Since there are serious penalties for falling below the reserve requirements, most banks hold funds in excess of the actual requirement at the Fed, so manipulating this rate has more immediate and profound effect on the money supply than interest rate adjustments.

The Fed can also pump money into the economy by selling Treasury Bonds, or conversely, remove money from circulation by buying bonds back (or redeeming them). This method is the least aggressive approach in that it has the least impact on collateral economic issues.

The earliest attempts to stabilize economies were to simply fix prices, thinking this would take care of the problem. That always fails however because you can’t fix prices if you can’t fix costs, and you can’t fix costs because the world is a spot market. Realizing that prices are set by markets, distorting those markets is counterproductive, as noted earlier, because changing the rules doesn’t change the physics – markets will perform until they disintegrate because of alien requirements. The most benign way to guide markets without distorting them is to control the exchange medium.

The metric used by Fed economists to judge their work is the consumer price index (CPI), which is a basket of goods and services common to most American families – food, clothing, transportation, housing, etc. By pricing these goods and services as a control (setting the CPI at 100.0 for a given year), future performance may be judged by comparing it to the control. If a current CPI is, say, 103.4, we have experienced an inflation rate of 3.4% since the control year. Over time, the basket has been adjusted to fit contemporary usage, but overall, this has been a widely accepted method of judging the performance of currency.

The prime example of broken monetary policy is the German hyperinflation of the 1930s. Berlin’s answer to the Great Depression was to just print money in an effort to spur the economy. The result was that before long, the one million mark note was in common service, and workers were paid in cash each day at noon so they could rush outside and pass it to their wives to shop before prices went up again. The German experience demonstrated how intractable inflation can be, as after a tipping-point, it becomes self-sustaining – prices rising so fast as to preclude centralized response, which tends to be sluggish under the best of circumstances.

With that brief refresher on how markets and money work, and a brush with fiscal mechanics, we can now look at our current predicament.

[1] Constitution: Art 1 §8(5)

[2] Currently, the reserve requirement is 10%, so if a bank has deposits of $100 million, it must deposit $10 million with the Federal Reserve.