Money and Monetary Policy for the Twenty-First Century...Money and Monetary Policy for the Twenty-First Century Jerry L. Jordan of the past millennium. It is super ficial because many

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW NOVEMBER/DECEMBER 2006 485

Money and Monetary Policy for the Twenty-First Century

Jerry L. Jordan

of the past millennium. It is superficial becausemany of the national currencies did not qualifyas “money” in the full sense. There are only afew “standards of value” that do not need to belinked to—or defined in terms of—some othermonetary unit. In the same sense that ten “dimes”or four “quarters” are the same as one U.S. dollar,many small-country currencies are defined interms of the major currency they are tied to.

For the few currencies that do serve as stan-dards of value, the issuing central banks musttake actions, which collectively are referred to as“monetary policy.” Such policy actions determinethe “quality” of the money over time. A money’squality is inversely related to the quantity of otherreal resources that are used in the economy along-side money to conduct money-type functions. Inplaces in the world plagued with unstable money,people spend much of their time getting paidmore frequently, dealing only in cash, makingmore frequent purchases, or hiring expensive

THE BASICS OF MONEYModern market economies would not be

possible without financial stability. However,as events around the world in the past decadedemonstrated, financial institutions are notsound and payments systems are not efficientwhen the value of money is not stable. Decadesof experience have demonstrated that prosperityis undermined when the value of money fluctu-ates. Stabilizing the value of money has becomethe primary, if not the sole, objective of centralbanks around the world. This is an essay aboutmoney—both the meaning of the word and thevarious ways people have sought over time tostabilize its value. The importance of stablemoney—and the roles of governments and centralbanks in providing it—will be presented in a dif-ferent light than it is in the conventional dialogue.

In a superficial sense, after decades ofincrease, the number of “monies” circulating inthe world began to decline during the final decade

This essay challenges the conventional wisdom about money and monetary policy. The role ofmoney in fostering prosperity is a function of the quality, as well as the quantity, of money. Inflationalways harms the performance of an economy. Deflations caused by productivity and innovationcan be virtuous. A definition of a non-inflationary environment is set forth. Rapid real growth andlow unemployment cannot cause inflation. There is no trade-off between inflation and employment.Higher commodity prices or “weak” exchange rates cannot cause inflation. High market interestrates are a symptom of inflationary policies. Low interest rates are a reflection of successful anti-inflationary policies, not “easy money.” (JEL E41, E42, E51, E52)

Federal Reserve Bank of St. Louis Review, November/December 2006, 88(6), pp. 485-510.

Jerry L. Jordan was the president of the Federal Reserve Bank of Cleveland from March 1992 to January 2003. Previously, he was director ofresearch at the Federal Reserve Bank of St. Louis. He is a senior fellow at the Fraser Institute and an adjunct scholar at the Cato Institute.This article was presented in part as the Homer Jones Lecture, March 8, 2006, in St. Louis Missouri, after being printed in Critical IssuesBulletin 2005, by the Fraser Institute; sections of the article are reprinted here with permission. The author thanks John Chant, Steve Easton,and Anna Schwartz for comments on drafts of this article.

© 2006, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.

money managers and financial advisers. That is,having money of lower quality means that moretime, effort, and resources are employed in gather-ing information about relative prices and conduct-ing transactions. Those resources could have beenused to raise the “potential output” of the econ-omy, which is the social payoff for policies thatmaintain sound money. The frequently referredto, but little understood, “cost of inflation” is theloss of output over time resulting from deteriora-tion of the quality of money.

The Nature of Money

My very great teachers (Alchian, 1977; Brunnerand Meltzer, 1971) taught that a society uses asmoney that entity that economizes best on theuse of other real resources to gather informationabout relative prices and to conduct transactions.This makes clear that the common—but wrong—statement of Gresham’s Law about “bad money”driving out “good money” needs to be restated.What we have observed through the millenniais that high-confidence monies drive out low-confidence monies (Hayek, 1976, p. 29; Mundell,1998).

Sometimes economists treat money as a factorof production that is separate from, and in addi-tion to, land, labor, or capital. This is not a usefulway to think about the role of money in society.It is derived from—and maybe reinforces—theidea that there must be enough money in circula-tion to “meet the needs of trade.” A more fruitfulway to think about the role of money in a marketeconomy is one in which sound money liberatesresources, especially resources used to gatherinformation and to conduct private transactions.This view draws attention to the importance ofthe quality of money. That money facilitates trans-actions appears to be clear to everyone; its rolein enhancing market knowledge about relativeprices, however, is less well understood.

Money’s effectiveness depends largely on itsquality. The quality of money is high when thevalue of money is stable. Money prices providehouseholds and businesses with reliable informa-tion about the relative costs of goods and services.They can make sound economic decisions andthis, in turn, fosters economic prosperity.

The economic efficiency that comes from astable monetary unit of account is one of thepieces of a Hayekian infrastructure that a marketeconomy requires. That is, a market economyrequires a foundation of enforceable propertyrights, generally accepted accounting principles,sound financial institutions, and a stable currency.Where public contracts are not honored andprivate contracts are not enforced, markets areimpaired. Where title to property is not certain,normal banking is not possible. Where financialstatements are not reliable, investment opportu-nities are obscured. Where the purchasing powerof money is not stable, resources are wasted ingathering information or are tied up (hoarded)as stores of value are used in producing and con-suming the wrong things.

Money, Prices, and Income

The prices of things people buy and sell andin which they invest are expressed in terms ofmoney units. Changes in the money prices ofgoods and assets convey information. If an econ-omy’s monetary unit is known to be a stable stan-dard of value, then changes in money prices willaccurately reflect changes in the relative valuesof goods and assets. That is, price fluctuationssignal changes in the demand for, and supply of,goods and assets; resources are then shifted towardmore valued uses and away from those less valued.This is essential in order for the economy toachieve the most economically efficient aggregateoutput. In other words, standards of living will behighest when all price changes can be interpretedas relative price changes. Similarly, all changesin interest rates would be changes in real interestrates—a reflection of changes in people’s prefer-ences about time, changes in the pace of innova-tion, or changes in the economy’s endowment ofproductive resources.

Unfortunately, in the world of fiat money,1

one can never be absolutely certain that observedchanges in the prices of specific things or changesin interest rates reflect real events such as crop

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1 Irredeemable paper currency that does not rest on a specie basissuch as gold but derives its purchasing power from the declaratoryfiat of the government issuing it.

failures, so mistakes are made in the allocationof productive resources. As a consequence, thewell-being of the society is less than optimal. Aform of monetary static (like a distracting noise)in the pricing of goods and services occurs whenthe standard of value—money—does not meanthe same thing over time. This static means thesignals that are coming to decisionmakers fromobserved price changes cannot be relied upon withcertainty when the use of productive resourcesis shifting.

In economies where changes in money pricesare contaminated by the changing purchasingpower of money, false signals are being sent tobusinesses and households. Bad decisions arebeing made, and resources are being misallocated.Standards of living—real incomes—fail to rise attheir potential rate. Nominal interest rates (thatis, the kind you see quoted every day) respond toshifting expectations about the future purchasingpower of money. Changes in real interest rates areobscured, so resources are misallocated. Sincesaving and investment decisions are affected,growth is impaired.

The objective of monetary policy is to mini-mize the misinformation associated with theconstantly changing (relative) prices of things.Absence of inflation is the ideal condition inwhich businesses and households make all deci-sions based on the assumption that all pricechanges currently observable or expected in thefuture are relative price changes; that is, theyreflect changes in the underlying demand for, orsupply of, everything. Naturally, if all price changesare relative price changes, for every observed orexpected rise or decline in some prices there mustbe corresponding price declines and rises in otherprices.2 For this condition to prevail, people—while they know that some prices will rise andothers will fall—must anticipate that on balancethey are safe in assuming the monetary standard—money—will buy the same universal array ofgoods over time. When innovation occurs andnew goods are invented, the average well-beingof the society is improved but not because theinformation content of money has changed.

Innovation involves “creative destruction”—theeconomic value of something old is reduced bythe discovery of a new product or more efficientway of producing the old product. Relative priceschange; a market system treats such changes assignals that resources are better used by shiftingaway from the old and toward the new.

A real increase in particular prices or wagesoccurs when there is a shift in demand away fromsome other good or factor input3 and toward thatgood or factor. When “improved efficiency” meansdiscovering ways of using the same amount oflabor but less of other factor inputs to producethe same output, a real wage gain occurs. In sucha circumstance, observed wage increases wouldbe associated with decreases in output prices tothe extent that the quantity of the good producedincreases as a result of the improved productivity.

An innovation that generally improves pro-ductivity in an economy will be associated withhigher real returns to productive capital (includ-ing human resources such as labor). The resultingincrease in observed interest rates—which arethemselves relative prices and subject to change—is a part of the mechanism by which resourcesare bid to their higher-valued uses. As will bediscussed later, if governmental (monetary) poli-cies sought to prevent the market from biddingup interest rates, the resulting expansion of thecentral bank’s balance sheet would cause monetaryunits to be created at a more rapid rate than peopledesire to add to their stocks of money balances.The effects would be observed in an accelerationof aggregate spending growth as people seek toexchange the excess balances for things they pre-fer. The bidding of the excess money units forother things causes the money prices to rise—more money units to acquire the same thing. Pricesignals are then distorted by the falling purchasingpower of the money used in the economy.

The challenges to monetary policymakers informulating and implementing policy actions tominimize inflation or deflation will be discussedin some detail below. Here, the important pointis that frequent changes in the prices of things

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2 Appropriately weighted.

3 Economists refer to the materials used to make things—wood,metal, plastics, etc.—as “factor inputs.”

and changes in market interest rates are normaloccurrences in a market economy, and an under-standing of how and why they are changing isimportant to both policymakers and the rest of us.

Inflation

It would be hard to get agreement on a defini-tion of inflation and even more difficult to getagreement on an acceptable measure of inflation.We have chosen instead to define the conditionsthat would prevail when there is an absence ofinflation or deflation. Common usage of the term“inflation” is misleading because it confusescause and effect. Often people think that inflationoccurs because “prices are rising.” But, that is toosimple. Such a diagnosis often leads naive politi-cians to think the appropriate prescription is eitherto put controls in place to prevent prices of thingsfrom going up; or they think the task is to ensurethat incomes rise at least as rapidly so that stan-dards of living do not erode. Both prescriptionsare wrong.

“To inflate” certainly means “to make larger,”but what is increasing is the number of moneyunits required to purchase the same basket ofgoods over time. The diagnosis should be thatmoney units are being created at a faster rate thanpeople want to add to their holdings of them.“Too much money chasing too few goods” is thefamiliar cause of inflation. The appropriate pre-scription is to avoid creating money at a pace thatis faster than people want to add to their moneybalances. How policymakers seek to do this isdiscussed in the boxed insert.

The obvious political risk of talking as thoughinflation means that prices of things and people’swages are rising is that people come to fear thatpolicymakers are out to deny them the well-deserved wage increase or higher price for theirproducts that other people seem willing to pay.Public surveys reveal that people form ideas aboutinflation based on prices of things they buy. Theyrarely see higher prices of things they sell as any-thing other than just rewards for their labors.

The expressions “price stability” or “stableprices” are not more helpful. Prices of things—both goods for current consumption and invest-ment assets—are constantly changing. All

innovation implies lower (relative) prices forprevious goods and technology. The familiarpattern for all newly introduced goods is for theirprices to fall as methods of production and distri-bution are improved and as economies of scaleare achieved. Conversely, as wealth rises, peoplespend a declining share of their income on certain“necessities” and larger shares of their incomeon goods thought of as luxuries. Such shifts inconsumption patterns may be associated withrising prices of the more sought-after goods. Theseare natural manifestations of a market economy.It would be highly undesirable to have—and tohave policies designed to maintain—stable prices.

People know very well that the money pricesof some things will rise (cars, concert tickets,impressionist paintings, greens fees, tuition, etc.)even though they cannot be sure by how much.Money prices of other things will fall (refrigerators,telephone calls, computers, televisions, VCRs,carpets, microwave ovens, etc.), even though theycannot be sure by how much. Most of the time formost things (food, gasoline, clothing, prescriptiondrugs, etc.) they cannot be too certain whetherthe money prices in the future will be higher orlower. Such uncertainties cannot be eliminatedfrom a market economy. As a consequence, peoplehave always chosen to use as money (subject tothe effectiveness of criminal prohibitions bygovernments) the entity that their own experiencesuggests is more likely to be exchangeable in thefuture for known quantities of things they desire.Uncertainty about present and future relativevalues of things is precisely why people holdmoney balances at all. When alternatives areavailable, they will choose to use as money thecurrency they are least uncertain about withrespect to future money prices. Because peopleknow they get hurt by inflation, for over 40 years—from the 1930s to the 1970s—the U.S. governmentmade it illegal for American citizens to hold goldas a way of protecting themselves.

Time and other resources are required toshop—to gather information about relative pricesof various goods, services, and investment assets.People will naturally prefer to use the monetaryunits that economize best on the use of their timeand productive resources to gather information

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about relative prices and to conduct transactions.In recent decades, the world has had ample oppor-tunity to observe ordinary people in Latin America,the former Soviet Republics, and central Europechoose to use U.S. dollars (and, increasingly,euros) rather than the currency supplied by theirown governments. Obviously, they do so basedon an expectation that the information availableto them regarding the relative values of things ismore reliable when denominated in dollars thanin rubles, pesos, dinars, or bahts!

Bad experiences have taught most people thatneither inflation nor deflation enhances economicperformance. What also occurs, but is not as easyto observe, is that unanticipated inflations anddeflations induce redistributions of wealth—especially between debtors and creditors—butthey leave the average standard of living lower.According to a former Governor of the FederalReserve, “a place that tolerates inflation is a placewhere no one tells the truth.” He meant, of course,

that true changes in the relative values of thingscannot be observed from stated prices when thepurchasing power of money is not stable.

An appropriate policy with regard to moneywould be to create the institutional arrangementsthat minimize the uncertainty that people encoun-ter about the money prices both of goods availablefor current consumption and of investment assets.Individuals not only want to exchange the pro-ceeds of their current labors for immediate con-sumption, they want to minimize uncertaintyabout their future ability to exchange varioussavings and investment assets for subsequentconsumption. The types of money that exhibitthe best track records for minimizing these infor-mation costs will be the preferred monies.

Money and Interest Rates

A confusion arising from the popular usageof the word “money” is that bankers claim tolend money and bank customers claim to borrow

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MONEY IS NOT INCOME

As noted earlier, even the word “money” cannot be used without ambiguity. It would be hardto find anyone who would admit to having more money than they want. But, their behavior suggestsotherwise. Every purchase or investment involves a reduction in money holdings. Acquiringmoney balances requires selling something or spending at a slower rate relative to cash income.The confusion comes from the unfortunate popular habit of using the word money to mean incomeor wealth. It is natural for humans to desire more income—ability to consume. Money is the meansby which indirect exchange takes place. It is a good that is held for the services it renders. Likeany other good, a person can certainly be holding more money balances than desired relative toother things. When one’s money balances are judged to be too large, disposing of excess moneyin favor of some thing is the least costly adjustment one can make.

In truth though, people do not normally desire to hold something simply because society treatsit as money. Rather, they desire to have available claims to consumption—they want to buy things.Naturally, how much they can buy will depend on the prices of things in money units, so theamount of money they hold will depend on how much they expect things to cost. They form theirexpectations about how much things will cost in the future based on the experiences they havehad in the past. If they generally have observed that the money prices of virtually everything theybuy are always rising—a condition usually referred to as inflation—they are rational in thinkingthat will also be the case in the future. Under such circumstances, their current money holdingswill be, on average, smaller than if they thought that the money prices of at least some of the thingsthey want to buy will be lower in the future.

money. But, people do not increase their indebted-ness in order to hold greater idle cash balances!The extension of credit by financial intermediariesdoes not alter the amount of money in the economy.Nevertheless, the unfortunate expressions—“borrowing money” and “lending money”—contribute to an erroneous idea about therelationship between the “amount of money” andobserved interest rates. People (and their electedrepresentatives) believe that interest rates wouldbe lower if only there were more money avail-able. This Ptolemaic view of the world persistseven in the face of much sad experience thatcountries “enjoying” rapid money growth havehigh interest rates.

People hold a variety of financial assets—inaddition to money—as stores of value. Often theseassets are claims to certain amounts of moneyunits at various times in the future. But, they donot want a certain amount of money in the future.They want to buy things. If they think the pricesof things they will want to buy in the future willbe higher, they know they will have to have moremoney units. Being able to earn higher interestrates on their assets is one way of having thegreater amount of money that will be required bythe expected higher prices of things. By the sametoken, borrowers of money are willing to payhigher interest rates if they expect their invest-ments to generate larger volumes of money unitsas the money prices of things rise.

There is a common fallacy that “low” interestrates can “cause inflation” and that “high” interestrates are part of the solution. This is completelybackward. When people—both businesses andhouseholds—start to anticipate that prices will berising faster in the future, they make adjustments.Sometimes they make purchases sooner thanotherwise to “get ahead” of the price rise. Theymay even go into debt to do so. They also seek tominimize any “idle balances” they hold in theform of cash or low-yielding balances in theirchecking accounts. But, while one family or onebusiness may reduce its money holdings, the econ-omy cannot do so. Actions by anyone to spendor invest only increases someone else’s moneybalances. If everyone is trying to do the samething, prices of goods and assets will get bid up—

the real purchasing power of money falls—andhigher interest rates will have to be offered toinduce people to hold—rather than spend—thestock of money in circulation.

These market dynamics explain why higherinterest rates are always and everywhere observedin the places where the value of money is fallingfastest, while the lowest interest rates are observedwhere money is holding its value. There is onlyone monetary policy that can produce low interestrates: a policy of stable money. Once people startto expect the value of money to erode—the averageof money prices to rise—observed interest ratescan also be expected to rise. Any attempts to resistthese natural market dynamics artificially willonly make matters worse.

Even when businesses and households in aneconomy expect the value of money to be stableover time, there will be fluctuations in interestrates that reflect the changing pace of innovation,agricultural developments, natural disasters, wars,and other real events. Monetary authorities cannotavoid the need to analyze the forces tending toalter interest rates. Those market dynamics ema-nating from a monetary imbalance must beresponded to. Errors in interpreting the forcesoperating to change interest rates has been themost common source of mistakes in the formula-tion of monetary policies in the modern world.

Money and Exchange Rates

People in every modern economy buy thingsfrom, and sell things to, people in other countries.How much they have to pay when they buy andhow much they can get when they sell dependson the exchange rate between the domestic moneyand the money of the other country. The exchangerate between any two currencies depends on manythings, including the inflation rates of each coun-try and “acts of God” in one of the countries.

Wealth gains and losses in one country canresult from changes in the exchange rate causedby developments in the other. When internationalterms of trade are altered by foreign develop-ments—wars, agricultural conditions, etc.—thereare redistributional effects in the domestic econ-omy: The effects on import-competing firms isopposite to that on exporting firms, and the prices

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of tradable goods change relative to the prices ofnon-tradable goods. Furthermore, asset prices areinfluenced differently than goods prices. In all,many prices are affected, in different directions,with some people being positively or negativelyaffected relative to other people. None of thesedevelopments, though, has any certain effect onthe stability of the domestic currency.

Even though price indices that include foreigngoods—and domestic goods that compete withforeign goods—may increase or decrease as a con-sequence of international developments, it is notcorrect to identify such statistical observationsas inflation or deflation. A shortfall of the coffeecrop will influence coffee prices in importingcountries. And, to the extent consumers pay thehigher prices, they will experience a real incomeloss and consequently will purchase less of otherthings. What is observed is the higher price ofcoffee in the price statistics. What is not so readilyobservable is the associated lower demand for,and prices of, other things compared with whatotherwise would have occurred. Relative priceshave changed, but the average of prices dependson the income and substitution effects and thechoices people make.

It is common—but wrong—for someone tosay that “higher inflation is caused by highercosts of imports such as oil.” What is true is thatmisinterpretation of a “price shock” caused by achange in the external exchange rate or by a realevent such as a sudden drop in oil productioncan result in a mistake in monetary policy. Suchmisinterpretations and policy mistakes have fre-quently resulted in inflations (and deflations) thatcould have been avoided.

Money, Growth, and Employment

Contrary to simple intuition, one often seesnews reports suggesting that “too much” economicgrowth will reduce the purchasing power ofmoney—will “cause inflation,” in familiar lan-guage. Yet, every person knows that a bumper cropof anything will yield lower prices and a poorharvest will be followed by higher prices. It issimply not logical (or correct) to argue that anincrease in production will foster a general riseof prices. Concerns that faster total growth of out-

put in the economy will cause a fall in the pur-chasing power of money—inflation—are simplywrong.4 Similarly, it is false to say that “too manypeople working” or “too low unemployment” can“cause inflation.”5

Market economies have an inherent tendencyto grow. How much growth occurs depends onincentives for working, for achieving productiveefficiencies, and for introducing new products.In addition to tax laws and regulation, economicpolicies influence these incentives by fostering amonetary regime that provides reliable informa-tion about the relative values of productiveresources, both in the present and in the future.That happens only when the monetary unitemployed by the economy is of known and stablevalue. Anything less than stable money gives inac-curate signals about relative values, so resourcesare not allocated to their most productive uses.Growth, consequently, is less than it would be ifmoney prices could be relied upon to reflect rela-tive underlying supplies of, and demands for,productive resources accurately.

Money and Productivity

Traditionally, economists talk about thingsbeing produced using some combinations of land,labor, and capital, where capital is taken to meantools, machines, buildings, and so on. Productiv-ity—productive efficiency—improves when thesame output can be obtained with less of at leastone of these inputs. As noted earlier, economistssometimes include “money” in the productionfunction, as a factor of production that is in addi-tion to land, labor, and capital. As such, thequantity of money appears to be an alternative to(or maybe in addition to) lumber, copper, workers,or other factors. This unfortunate way of thinkingabout the role of money in the economy tends tobe derived from—and maybe to reinforce—notionsthat there is “not enough money” in circulation.Such a false diagnosis is dangerous because itusually is accompanied by a prescription that

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4 For a discussion of why rapid growth does not cause inflation,see Federal Reserve Bank of Cleveland (2000).

5 For further discussion of these issues, see Federal Reserve Bankof Cleveland (1999).

the monetary authorities can make people betteroff by creating money units at a faster rate. Thatis certainly wrong.

It is easy to imagine, and probably common,for the lending officer of a bank to respond to acustomer’s request to borrow more funds by say-ing, “I would like very much to lend you some(more) money but the central bank is making creditvery tight and I have no more to lend…how aboutgolf on Sunday?” The would-be borrower is leftwith the impression that the currently availablestock of money is already being “used” by some-body else and that the central bank is preventinghim from expanding his business by failing toincrease the total availability of money. A popular(but wrong) conclusion is that the output of theeconomy is being restrained by the inadequacyof money growth.

The alternative way to think about the role ofmoney is that improving the quality of moneyreduces the use of other real productive resourcesemployed in the task of gathering informationabout relative values and conducting transactionsand, therefore, increases the productive potentialof the economy. That is, instead of being a supple-ment to other productive resources, money thatis more stable liberates such resources from beingemployed in activities associated with uncertain-ties that exist when the purchasing power ofmoney is unstable. When the form of money avail-able in the economy is not reliable—that is, itspurchasing power over time is not stable—someof other resources will be employed in dealingwith the uncertainties. As monetary policies tostabilize the currency start to become effectiveand credible, other resources can be redeployedin more productive ways. In the end, the produc-tive potential of the economy is greatest whenthe fewest of other resources are utilized in per-forming tasks for which money is intended—gathering information about relative values andconducting transactions.

From this analysis it should be clear that amonetary shock—an unanticipated change in theavailability of money—would reduce the poten-tial output of the economy. That is because theactions taken by businesses and households toreadjust their actual money balances to desired

levels will cause unavoidable changes in relativeprices and the average level of all prices and, thus,introduce uncertainty into the economy. Naturally,such increased uncertainty causes resources tobe committed to hedging, arbitrage, and specula-tion. Furthermore, since the quality of priceinformation is diminished, mistakes will be madein interpreting signals about real demands for, andsupplies of, goods and services. Overproductionof some things and underproduction of otherthings will mean that society’s well-being is lessthan it could be.

Resources flow to their highest-valued usesonly when the changing prices of things reflectshifts in fundamental real demands for, and sup-plies of, goods, services, and productive resources.Monetary disturbances introduce price changesthat mask these fundamental forces. Consequently,excess production of some things and shortagesof other things can occur simultaneously.

In a world with stable population and a givenset of goods and services where no new productsare invented, one would expect the money pricesof final goods to gradually decline at the samepace as the improving productive efficiency ofthe economy’s resources. The gains in wealth tothe society from the higher productivity wouldbe distributed to inhabitants in the form of “higherreal incomes.” That is, their unchanged moneyincomes would gradually command a larger basketof goods as increased availability of goods andservices pressed down on money prices. This“productivity norm” (Selgin, 1990 and 1997) forthe average of money prices can be thought of asa static baseline for the purchasing power ofmoney: It would tend to rise in an expandingeconomy. It neglects population growth, laborforce participation rates, introduction of newproducts, external trade, and distortions arisingfrom tax structures and regulation. Nevertheless,it describes how people in an economy benefitfrom a stable currency.6

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6 “An increase in the quantity of goods produced...must bring aboutan improvement in people’s conditions. Its consequence is a fallin the money prices of the goods...But such a fall in money pricesdoes not in the least impair the benefits derived from the additionalwealth produced...But one must not say that a fall in prices causedby an increase in the production of the goods concerned is theproof of some disequilibrium which cannot be eliminated otherwisethan by increasing the quantity of money” (Mises, 1949, p. 431).

It is important to note that a condition of“rising purchasing power of money” is most com-monly described by the pejorative “deflation.”This unfortunate custom has caused mostobservers to believe that a gradually falling “pricelevel” is as bad, or even worse than, a graduallyrising “price level.” Our analysis concludes therecan be—and historical experience has demon-strated—“virtuous deflations” during periods ofrapidly rising productivity.7

Money and Innovation

People can readily observe the effects of theintroduction of new or better products: The moneyprices of old goods fall. The phenomenon is mostobvious in examples such as computers. Theavailability of faster machines reduces the demandfor, and therefore the prices of, slower models.The new availability of improved software, betterfabrics, longer-lasting tires, compact disks withmore capacity, and so on is accompanied by lowerprices of the products they replace. But, if radialtires are cheaper and last longer than the bias tiresthey replace, it means people are richer as theirincomes will acquire a higher standard of living.That, in turn, means they can consume more ofsomething else. The increased demand for otherthings that is made possible by the availabilityof cheaper tires means the money prices of otherthings will be higher. Thus, while prices are notstable, the role played by money is unchanged.That is, the value of money can be stable eventhough the money prices of things must be chang-ing in an expanding economy.

As is the case with increased efficiency inproducing existing products discussed above, thebenefits of greater wealth influence prices intwo ways: (i) lower prices of less desirable olderproducts and (ii) higher real incomes as a conse-quence of the lower prices of the goods that aresuperseded, allowing greater demand for—andhigher prices of—other goods. If the pace ofinnovation is rapid and totally new products aswell as improved products are introduced veryfrequently, the pace of obsolescence of old prod-

ucts must also be rapid. In such a regime, onewould expect to see frequent and significantdeclines of not only the prices of the inferiorproducts but also the capital stock that producesthem. That is, “creative destruction” impliesfalling prices of both goods and productive assetsthat are superseded by superior products. If suchis not observed, it is evidence that the purchasingpower of the currency is not stable.

Countries and Monies

There are many currencies in the worldtoday—more than 100. There are only a few stan-dards of value—fewer than a dozen. A hundredyears ago there was only one standard of value—gold—but already many national currency units.A dominant trend of the past century was theproliferation of national currencies, especially asnew nation-states emerged from the breakup ofthe colonial empires and the Soviet Union. Itseemed that one criterion of nationhood was anational currency. That trend may well have beenreversed as the century ended.

The dominant monetary system amongcolonies was one that relied on currency boardsfor establishing monetary stability (Schwartz,1993). The newly formed nations, however, aban-doned the currency-board system for a number ofreasons. Currency boards lost their standing asvaluable institutions for establishing monetarystability after World War II because of the dramaticchange in conventional intellectual beliefs, espe-cially the erosion of the legitimacy of imperialism.Perhaps more significant, however, was the pre-vailing belief that a central bank, with discretion,would outperform a rule-bound currency board.

Aside from national pride, the idea that anation-state should have its own currency andindependent monetary policy was intellectuallysupported by the idea that some positive rate ofinflation was optimal. Even when economistswould not defend deliberate debasement of thecurrency, authorities often rationalized inflationon grounds of political necessity, especially inthe face of often large and growing national debts.The political expediency of the “unlegislated taxof inflation” seemed for a while to have had a nearuniversal appeal. Over time, the political benefits

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7 For more discussion of types of deflations, see Federal ReserveBank of Cleveland (2002).

of deliberate inflation have been counterbalancedby financial innovations in domestic and globalmarkets. In fact, the balance appears now to haveshifted such that the costs associated with risinginflation outweigh any residual benefits. Firstcentral bankers, then ministers of finance, andfinally politicians generally are finding that areputation for tolerance of inflation is undesirable.

Twenty-five years ago, it was fairly commonto hear even prominent, well-respected econo-mists argue the merits of a weak external valueof the national currency (devaluation) in order togain some presumed competitive advantage overtrading partners. Such notions now seem increas-ingly quaint. It is now unimaginable that a politi-cian anywhere would achieve success by arguingthat accelerating inflation and a weak currencywould benefit local constituents. Much of whathas happened in recent years perhaps reflects therise in so-called “financial market vigilantism,”which imposes a level of discipline not anticipatedyears ago.

Neither monetary sovereignty nor independentmonetary policy is deemed to be worth very muchin today’s global financial markets. Moreover,seigniorage is quite small in a noninflationaryworld. Hence, it is becoming more widely under-stood that any net benefits associated with main-taining a national central bank and a nationalcurrency are quite small. Increasingly, the behav-ior of businesses and households around the worldhas included the pragmatic adoption of standardsof value that serve their purposes irrespective ofnational origin. For a couple of decades, the peopleof the former Yugoslav republics used the Deutschemark as their preferred monetary standard forthe same reason that people in many countriesaround the world use the U.S. dollar. A reputationfor stability of purchasing power means more tothe consumer than the local content or nationalorigin of the currency. As we have seen in the caseof consumer goods, when the barriers to the freeimportation and use of products and services ofsuperior quality are removed, people pragmati-cally choose quality and performance over patri-otic gestures.

Reflecting these forces, the importation ofmonetary policy from another country has been

a growing trend in recent years. Just a few yearsago, 11 sovereign countries of Western Europeimplemented their plan to shift monetary policydecisionmaking from the autonomous nationalcentral banks to a newly created supranationalcentral bank and phased out the 11 national cur-rencies in favor of a single monetary standard tobe used by all. Soon other countries started givingup any notions of monetary autonomy and anational currency. Ecuador and El Salvador areexamples of countries that have joined others inunilaterally adopting the U.S. dollar as their offi-cial standard of value.

GOVERNMENTS AND MONEYWe do not pretend, that a National Bank canestablish and maintain a sound and uniformstate of currency in the country, in spite of theNational Government; but we do say that it hasestablished and maintained such a currency,and can do so again, by the aid of that Govern-ment; and we further say, that no duty is moreimperative on that Government, than the dutyit owes the people, of furnishing them a soundand uniform currency.—Abraham Lincoln (1839)

Abraham Lincoln connected sound bankingwith political liberty, affirming that governmenthas both the ability and the obligation to providea stable currency. His belief in the importance ofa sound currency has been shared by most thinkersfor the past 250 years. Lincoln’s view that govern-ment would actually provide a stable currency,however, has enjoyed less acceptance. Skepticismabout the government’s role with regard to moneyhas been the dominant view since the founding ofthe republic. These doubts are well summarizedby the prominent twentieth-century economistLudwig von Mises:

Whatever a government does in the pursuit ofaims to influence the height of purchasingpower depends necessarily upon the ruler’spersonal value judgments. It always furthersthe interests of some people at the expense ofother groups. It never serves what is called thecommonweal or the public welfare. (Mises,1949, p. 422)

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Constitutional forms of government usuallyspecified a stable currency, but as James Buchananobserved, such provisions have been inadequate:

This framework role for government also wasconsidered to include the establishment of amonetary standard, and in such fashion as toinsure predictability in the value of the desig-nated monetary unit. (It is in the monetaryresponsibility that almost all constitutions havefailed, even those that were allegedly motivatedoriginally by classical liberal precepts. Govern-ments, throughout history, have almost alwaysmoved beyond constitutionally authorizedlimits of their monetary authority.) (Buchanan,1994, p. 4)

Debates about Money

History is unfortunately replete with examplesof governments trying to print money in order tofinance their expenditures. Friedrich von Hayek,winner of the 1974 Nobel Prize in EconomicSciences, puts it this way: “History is largely ahistory of inflation, and usually of inflationsengineered by governments and for the gain ofgovernments” (1976, p. 29). In recent times, thehyperinflation of Germany in the 1920s and ofBolivia, Argentina, and Brazil in the 1980s are allexamples of governments debasing their curren-cies and engaging in what Mises called “a fraudu-lent attempt to cheat the public” (1949, p. 782).

Until the second half of the twentieth cen-tury, there was little disagreement that a stablecurrency was best; the debate centered on howto provide it. Following World War II, the notionthat some inflation might be desirable (or at leastshould be tolerated) entered debates about publicpolicy for a relatively short time. But, after painfulinflation experiences in the 1960s and 1970s, thequestion of whether to eliminate inflation is nolonger widely debated.

In the closing years of the millennium, theproblem of how to provide a stable value of moneyregained prominence. Alternative approaches tostabilizing currencies were pursued around theworld, and public-policy debates returned to thisissue because people were rethinking the role ofgovernment in their societies. The monetaryinstitutions likely to appear during the twenty-first

century will reflect the dynamic economic andpolitical processes currently at work. It remainsto be seen whether nations achieve and maintainstable currencies because of government, asAbraham Lincoln believed, or in spite of govern-ment, as thinkers as diverse as James Madison,Mises, and Hayek contended.

The sentiment that government powers shouldbe constrained by constitutional design is certainlynot unique to the monetary arena. For example,James Madison set forth principles of governmentthat underscore his views on money. In his elabo-ration of the “rule of law,” he comments, “To tracethe mischievous effects of a mutable governmentwould fill a volume” (Madison, 1977 [1788]). Hisdoubts about elected representatives’ ability toprovide a stable currency are reflected clearly inhis adherence to a specie (gold or silver) standard.Madison’s defense of an exclusive role of Congressboils down to a distrust of populist sentiments:“A rage for paper money, for an abolition of debts,for an equal division of property, or for any otherimproper or wicked project, will be less apt topervade the whole body of the Union than a par-ticular member of it” (Madison, 1977 [1787]).

The history of money over the past two cen-turies shows the world groping for differentinstitutional structures that limit governments’temptations to debase money in order to satisfysome short-sighted political objectives. Theapproaches used in the past have been functionsof the nature of money prevailing at the time andof societies’ views about the proper role of govern-ment. The approaches used in this century willsurely be different from those of the past two ifeither of these two factors changes materially. Inparticular, while government will surely havesome responsibility in providing a stable currency,government’s exact role should not be taken forgranted.

Historical Views of Money. Adam Smithdefined the role of money as a medium ofexchange, describing it as “the great wheel ofcirculation” (Smith, 1976 [1776], p. 309). How-ever, money functions in at least two other ways:as a store of value and as a standard of value(unit of account). When we hold money, we trustthat it will largely maintain its worth. If the value

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of currency is allowed to erode under conditionsof inflation, the ability of money to serve as astore of value is seriously hampered. As a unitof account, money serves as a measuring stick,telling us how many units of something exchangefor a unit of money.8

An often-overlooked consideration is that,while money is an integral part of society becauseof its service of these three roles, it is not desiredfor its own sake. Smith pointed out:

No complaint, however, is more common thanthat of a scarcity of money. Money, like wine,must always be scarce with those who haveneither wherewithal to buy it, nor credit toborrow it… It is not for its own sake that mendesire money, but for the sake of what they canpurchase with it. (1976 [1776], pp. 458-60)

This confusion between more money andmore purchasing power has contributed in largepart to the pervading lack of trust in the provisionof money by government. As Mises suggests,governments are often tempted to answer the cryfor more purchasing power by simply creatingmore money. But in so doing, the opposite effectis achieved—the purchasing power of money isactually reduced. The result, as Alchian and Allenexplain, is inflation: “a rise in the number of dol-lars required to purchase a given standard of liv-ing” (1977, p. 484). If inflation makes individualsuncertain about what to ask or what to give forgoods or services, then the quality of money dete-riorates, reducing its effectiveness as a medium ofexchange. Money is no longer either an efficientstore of value or an efficient unit of account,because this “ruler” with which we make ourmeasurements is continually changing.

Three points are clear. First, inflation is highlyundesirable. Second, governments have incentivesto abuse their power of mintage, which, coupledwith historical experience, has slowly created a

consensus among citizens that they cannot trusttheir governments with unfettered control overmoney. Third, the mechanisms people have con-trived to protect themselves from the seeminglyarbitrary debasement of currency have variedover time.

The Gold Standard. For most of recordedhistory, governments have taken some role inproviding money to the economy. In early times,that role was limited to “authentication,” verify-ing that coins contained the indicated metals.Even in historical monarchies, however, theauthorities would occasionally lie to their peopleabout money. People’s dual reliance on, anddistrust of, government with regard to the valueof money is an age-old phenomenon. The viewthat, despite all contrary assurances, governmentswill eventually abuse their powers as counter-feiters led countries to develop institutions aimedat limiting a government’s ability to print addi-tional money. One such method was the gold andsilver standards followed (on and off) by mostcountries from 1821 to 1973.

Specie-backed currency took money out ofimmediate government control. For example, ifthe dollar were defined as equal to 1/20 of anounce of gold, then the number of dollars that theUnited States could issue would be constrained byits holdings of gold reserves. Moreover, if Britainthen defined its currency as to equal 5/20 of anounce of gold—as it did before World War I—theexchange rate would be fixed at $5 per pound. Ifeither government issued more currency thanprescribed by its gold standard—say, to finance abudget deficit—it would lose gold reserves to thecountry with the more stable currency. In this way,gold strengthened a government’s covenant withits public not to erode the purchasing power ofits money.

The unfortunate problem with a specie stan-dard was that the value of money was only asstable as the value of the specie backing it. Thisled Benjamin Franklin to note that because “silveritself is of no certain permanent Value, being worthmore or less according to its Scarcity or Plenty,therefore it seems requisite to fix upon somethingelse, more proper to be made a Measure of Values”(1729; italics in original). Although a specie stan-

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8 An appreciation of this role was evident in the thinking ofThomas Jefferson, who confided to a friend: “There is, indeed, oneevil which awakens me at times, because it jostles me at every turn.It is that we have now no measure of value. I am asked eighteendollars for a yard of broadcloth, which, when we had dollars, I usedto get for eighteen shillings; from this I can only understand that adollar is now worth two inches of broadcloth, but broadcloth is nostandard of value. I do not know, therefore, whereabouts I stand inthe scale of property, nor what to ask, or what to give for it” (1819).

dard could clearly result in undesirable swingsin the purchasing power of money, the costs ofhaving a fiat currency were thought to be evenhigher. In a letter to a friend, Madison stated:

It cannot be doubted that a paper currency,rigidly limited in its quantity to purposesabsolute necessary, may be equal and evensuperior in value to specie. But experiencedoes not favor reliance on such experiments.Whenever the paper has not been convertibleinto specie, and its quantity has depended onthe policy of the Government, a depreciationhas been produced by an undue increase, oran apprehension of it. (Madison, 1820)

Later, commenting on a “Report on a State’sBank,” Madison wrote, “But I am not yet weanedfrom the opinion long entertained, that the onlyadequate guarantee for the uniform and stablevalue of a paper currency is its convertibility intospecie” (1831; emphasis added). Repeating hisview that a stable paper currency is theoreticallypossible, doubts remained: “But what is to ensurethe inflexible adherence of the Legislative Ensurerto their own principles and purposes?” (1831).Madison left no doubt about what is essential: amoney that has stable value. His doubts about thepeople’s elected representatives providing a stablecurrency are reflected clearly in his adherence toa specie standard, especially given his recognitionthat paper money supplied by an honest govern-ment is superior to a specie standard.

The quantity theorists of the late nineteenthcentury, John Stuart Mill and Alfred Marshall,also believed that, although a gold standard pro-vided undesirable swings in currency value, itwas the only way for governments to provide astable paper currency. Mill observed:

After experience had shown that pieces ofpaper, of no intrinsic value, by merely bearingupon them the written profession of beingequivalent to a certain number of francs, dol-lars, or pound… governments began to thinkthat it would be a happy device if they couldappropriate to themselves this benefit… Theonly question is, what determines the valueof such a currency…We have seen, however,that even in the case of metallic currency, theimmediate agency in determining its value is

its quantity… The value, therefore of such acurrency is entirely arbitrary. (Mill, 1907;emphasis added)

Citing the nineteenth-century economist,William Jevons, Mill asserts, “so that the relationof quantity to uses is the only thing which can givevalue to fiat money.” That being the case, Millthought that convertibility (to metal) was the onlything to prevent temptation to “depreciate thecurrency without limit” (Mill, 1907).

For the first 195 years following theDeclaration of Independence, most governmentpaper currencies were linked to specie. The U.S.dollar was defined in terms of a weight of gold(or occasionally silver). However, this did notcompletely restrain governments from manipulat-ing the value of their currencies. First, in orderto generate revenue, countries would frequentlyabandon the gold standard during times of war.Second, even without officially abandoning gold,countries could and did periodically redefine thevalue of their currencies in terms of gold. Insteadof allowing gold or foreign reserves to consistentlydrain from their coffers, they would “be forced”to devalue their currency.

At first glance, it would appear that a goldstandard provided no real discipline if countriescould devalue their currencies at will. The disci-pline came from the fact that countries actuallycould not do so without suffering a cost. If therewas a threat that a country would devalue its cur-rency, massive speculative attacks would ensueas investors attempted to shed themselves of thatcurrency. The devaluing country would eventuallylose massive amounts of foreign reserves (goldand foreign currencies). Over 1966 and 1967, forinstance, Britain lost nearly 28 million ounces ofits gold reserves defending its currency and, ona single day, November 17, 1967, lost reservesvalued at more than $1 billion.

The common wisdom is that the frequencyand destabilizing effects of such attacks causedthe Bretton Woods system, and thus the last vestigeof a gold standard, to be abandoned in 1973. Whilethis is correct on a superficial level, the underly-ing cause was that, despite the threat of specula-tive attacks, governments around the world wereunwilling to do what was necessary to maintain

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a stable currency—namely, to limit the supply offiat money. Mises was blunt in his condemnationof deliberate, governmentally engineered devalu-ations of currency, and his criticism of the statedas well as the unstated objectives of a devaluationpolicy are as relevant today as when he wroteHuman Action over 50 years ago: “It is impossibleto take seriously the arguments advanced in favorof devaluation” (1949, p. 790).

Alternative Monetary Arrangements

Separation of the Central Bank and theTreasury. Another way to keep governments“honest” is to remove the power to inflate fromthose with the most incentive to inflate. This isachieved by making the central bank—whichhas the power to inflate—highly independent ofthe Treasury—which has the incentive to inflate.This institutional structure is not a panacea buthas proven especially useful: Studies have shownthat countries where central banks are more inde-pendent have lower inflation rates on average(Alesina and Summers, 1993).

The high-inflation era of the 1970s showedus what countries unfettered by fixed exchangerates and a dollar convertible into gold will doleft on their own. Addressing this deficiency,the U.S. Congress passed House ConcurrentResolution 133 in 1975, requiring the FederalReserve to announce annual targets for monetarygrowth rates. In 1978, the Full Employment andBalanced Growth (Humphrey-Hawkins) Act waspassed, requiring the Federal Reserve to explainthese objectives and any deviations from them.Most major central banks experimented with thisform of “instruments monitoring” in the 1970sand 1980s, establishing growth rates for variousmoney measures in an effort to put boundarieson the rate of inflation.

Despite the relatively low inflation ratesrealized by most industrial countries around theworld since 1983, the call for further institutionalconstraints on central banks is growing. Oneexample is legislation enacted by New Zealandand other countries that the sole objective ofcentral banks is to provide price stability.

Currency Boards. An institutional constraintthat has been adopted by smaller countries thatlack an established reputation for low inflation

is the currency board, similar to those initiallyadopted by former colonies. The central ideabehind currency boards is to look more seriouslyat the discipline provided by fixed exchangerates. For example, in order to maintain a fixedexchange rate between a small country and theUnited States, the small country’s monetary policymust, in essence, be dictated by the UnitedStates. If the United States has the credibility tomaintain low inflation, the hope is that thecountry with the currency board will also achievecredibility over time.

Currency boards are much like a small-scaleversion of Bretton Woods except that there is nolonger a link between the dollar and gold to guar-antee that the United States will follow a policyof low inflation. Currency boards are probablybest described as small boats anchoring them-selves to a large ship. Because the large ship isnot firmly anchored, the small countries are lefthoping that rough seas will not cause the largeship and, thus, the small boats to drift too far offcourse.

Private Currencies. Perhaps the most inter-esting mechanism by which a stable currencymight be achieved was proposed by Hayek (1976)in Denationalisation of Money (see also Friedmanand Schwartz, 1986). Although central banks,currency boards, and the gold standard eachattempt to restrain a government’s tendency toinflate, Hayek suggested that governments beremoved altogether from the provision of money.He contended that if private currencies areallowed to circulate freely, competition willensure that the value of these currencies willremain constant. If any issuer attempts to collecttoo much seigniorage by printing excessiveamounts of its currency, consumers will substituteout of that currency into a competing currencywith a more stable purchasing power. The offend-ing currency will cease to circulate as money.Thus, currency issuers will have an incentive toremain honest.

Writing almost 30 years ago, Hayek wasclearly ahead of his time. His proposal that govern-ments be completely removed from the businessof issuing money is not likely to come to fruitionin the near future. Nevertheless, his basic propo-

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sition that competition will provide the necessaryincentive to keep people (or countries) honest isrelevant today. International currencies areincreasingly competing to become the currencyof choice. The rapid “dollarization” or “euroiza-tion” in central Europe, the former Soviet Union,and Latin America shows how a foreign currencycan become a legitimate substitute for a domesticcurrency that has failed to maintain its value.Paradoxically, it may be the end of fixed exchangerates and the flawed discipline provided by thatsystem that have allowed internationally compet-ing currencies to flourish.

Recent history teaches us that Hayek wascorrect when he pointed out that

Gresham’s law will apply only to differentkinds of money between which a fixedexchange rate is enforced by law. With vari-able exchange rates, the inferior-quality moneywould be valued at a lower rate and, particu-larly if it threatened to fall further in value,people would try to get rid of it as quickly aspossible. The selection process would go ontowards whatever they regarded as the best sortof money among those issued by the variousagencies [or countries], and it would rapidlydrive out money found inconvenient or worth-less. (Hayek, 1976, p. 31)

Money, Taxes, and Deficits

Governments impose taxes on people in avariety of ways but always on nominal moneyprices and incomes. Consequently, debasementof the currency always generates greater nominaltax revenue for the taxing authorities. When taxstructures are progressive and not indexed, realtax revenue rises when the average of moneyprices of things rises—the value of a currencyerodes. Furthermore, much of the debt of govern-ments is fixed in nominal money units. Thus,debasement of the currency works to the advantageof the governmental taxing and spending author-ities. Government’s command over the economy’soutput rises while the government’s creditors arerepaid with reduced purchasing power. The effectof these institutional arrangements is that therelative share of the economy absorbed by thegovernment increases when the purchasing powerof a currency is declining.

Governments usually require that people’s taxliabilities be disposed of by remitting liabilitiesof the central bank to the account of the Treasuryat the central bank. When governments incurdeficits and issue debt, they are giving to securityholders the promise that they (or their successors)will raise sufficient tax revenue in the future (orissue new bonds) to repay the borrowed sums.At times, the issuance of the debt instruments ofthe government (increased supply of securities)causes at least temporary downward pressure onsecurity prices (higher interest rates). If the policyof the central bank is to maintain a fixed level ofmarket interest rates and accommodate alldemands for credit at that rate, the central bankwill passively expand its balance sheet—issuegreater quantities of currency and bank balances.Without any corresponding increase in the public’sdesire to hold greater balances, the excess creationof liabilities of the central bank will result in abidding up of the money prices of goods, services,and other financial assets. This dynamic has beencommon even when the central bank is prohibitedfrom directly purchasing the newly issued debtinstruments of the government.

Root Demands for Fiat Monies

As noted above, people throughout the worlduse U.S. dollar notes in everyday commerce eventhough their own governments also furnish acurrency. They use the U.S. currency even whenit is illegal to do so. If asked why they do so, theywill say it is simply because the value of the dollaris more stable than other currencies. Two ques-tions arise: Why isn’t the domestic currency stable,and why is the value of the dollar more stable?Both are fiat currencies, that is, their value is notdefined in terms of something else, such as gold.Both may be legal tender in the home country,but the U.S. dollar is legal tender in only a fewcountries outside the United States.

So, why do money prices rise more rapidlyin terms of one currency than the other? Theanswer can only be that some monetary authori-ties create new units of their currency at a ratethat is faster, relative to demand to hold it, thanother monetary authorities do. Clearly, if the

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amount of money people want to be holding isalways exactly the amount there is, the purchas-ing power of the currency can be neither risingnor falling. A disturbance to this happy situationcan occur one of three ways: (i) people decide tohold less (more) of the currency and the processof ridding themselves of the excess (or acquiringlarger balances) causes money prices to adjust;(ii) monetary authorities create money units atfaster (slower) rates than people want to add totheir holdings; (iii) favorable or unfavorable sur-prises in the amount of things available to pur-chase (natural disasters, crop failures, bumpercrops, etc.) cause changes in both relative pricesand the average of prices because the society isricher or poorer.

The first possible disturbance—changes inpeople’s desire to hold some of the currency—raises questions about what goes into a decisionto hold any of a currency, especially if there isan alternative available. The most fundamentalreason that inferior currencies continue to be heldeven though a superior alternative is available isthat taxes must be paid to the domestic govern-ments in units of the national currency. Thenecessity to remit tax receipts in the form of theliabilities of the national central bank ensures atleast some transitory demand for the currency.Since there is a demand, it would be possible toconstrain the supply so that there is neither anexcess nor a deficient supply relative to thedemand. The reason most, if not all, prices ofthings in terms of that currency rise is that themonetary authorities do not constrain the newsupply to match the demand exactly. The usualreason they do not do so is that the governmentcommits to disburse funds to people in amountsthat are greater than the sum of tax receipts andproceeds from debt issuance.

Introduction of New Monies

There has never been a “phoenix-like” cur-rency.9 Because the central role of money is mini-

mization of information and transaction costs,people will not use an entity as money, a mediumof indirect exchange, if they have no prior expe-rience upon which to base their expectations aboutthe prices of things expressed in terms of the pro-posed money. Historically, then, new claims tomoney (i.e., money substitutes) had to circulatefor a period of time sufficiently long to establisha “track record” in the minds of people. Warehousereceipts (such as gold certificates) were an earlytype of paper claims to money that evolved intopaper fiat monies.

As described above, U.S. dollars were origi-nally defined to be (and convertible into) specifiedamounts of gold. For domestic purposes, dollarsbecame a fiat currency in 1933 when the govern-ment made it illegal for American residents to owngold. Nevertheless, for official, international pay-ments made by one government to another, dollarscontinued to represent claims to gold until theearly 1970s. For the past three decades, dollarshave been simply the liabilities of Federal ReserveBanks.

In the second half of the twentieth century,numerous currencies have been introduced bygovernments. In every case, the new entity wasinitially defined in terms of a known medium ofexchange. After World War II, the GermanDeutsche mark was defined to be worth 1/4 of aU.S. dollar and the Japanese yen was introducedas 1/360 of a U.S. dollar at a time the dollar wasstill defined as 1/35 of an ounce of gold. For over25 years these currencies were claims to dollarsand, indirectly, to gold.

Newly liberated countries in the final decadeof the twentieth century introduced new curren-cies but always defined in terms of, pegged to, andconvertible into other familiar national currencies,such as U.S. dollars, Deutsche marks, Britishpounds, or yen. When the domestic experiencewith a currency has been favorable for sufficientlylong that confidence about future purchasing

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9 “The acceptance of a new kind of money presupposes that thething in question already has previous exchange value on accountof the services it can render directly to consumption or production.Neither a buyer nor a seller could judge the value of a monetary

unit if he had no information about its exchange value—its pur-chasing power—in the immediate past...A medium of exchangewithout a past is unthinkable. Nothing can enter into the functionof a medium of exchange which was not already previously aneconomic good and to which people assigned exchange valuealready before it was demanded as such a medium” (Mises, 1949.pp. 411, 426).

power is high, governments have chosen to delink(float) their nation’s money relative to foreigncurrencies.

CENTRAL BANKS AND MONEYThe Tools of Monetary Policy

The tools available to central banks to influ-ence the purchasing power of their currency arequite few. Since it is their own liabilities that serveas money, altering the size of the central bank’sbalance sheet is the essential monetary tool. Theassets of the balance sheet usually include loansto banking companies and securities that may bedenominated in either the domestic currency ora foreign currency. In either case, the securitiesare mostly the obligations of the domestic or aforeign government. Central banks can, if theychoose, control the size of their balance sheetsvery precisely. That being the case, they can uni-laterally determine the supply of central bankmoney. The demand for central bank money hasseveral sources: Domestic (and maybe foreign)households and businesses have a demand for thenotes issued by the central bank; and commercialbanking companies (and maybe others) holdreserve or clearing balances at the central bank,based on their business needs or legal reserverequirements.

Since there is a demand for money from thecentral bank and the potential to control the sup-ply, monetary policies to stabilize the value of thecurrency are possible. The difficulty is in estimat-ing the demand by people to hold central bankmoney. The domestic public’s desire to holdnotes issued by the central bank tends to grow inproportion to incomes, although changes in theforgone interest from investments can influencecurrency demands (higher market interest ratesmean you hold less cash). Also, the commercialbanks’ demand for balances at the central bankis a derived demand. The public’s demand forchecking-type accounts and other reservabledeposits at the financial intermediaries determinesthe amounts of balances held at the central bank.If some liabilities of banks, but not others, are sub-

ject to legal reserve requirements, shifts in thepublic’s preferences between types of depositswill affect the derived demand for balances at thecentral bank. Similarly, if different sizes or typesof financial intermediaries are subject to differentlegal reserve ratios, shifts in deposit balancesamong the institutions will affect the deriveddemand for central bank balances. In other words,institutional arrangements affect the difficulty orease of estimating the demand for the liabilitiesof the central bank.

Where it is judged to be difficult to estimatethe demand for central bank money, the monetaryauthorities typically target an overnight interestrate at which they passively accommodateincreases and decreases in the demand for theirliabilities. While that ensures that there can beneither an excess supply of nor an excess demandfor central bank money on an overnight basis, itdoes not ensure secular10 stability in the purchas-ing power of the currency.

The public’s desire to hold balances at thedepository intermediaries is influenced by severalfactors—including the opportunity cost of forgonereturns on alternative assets,11 domestic as wellas foreign. This means changes in investmentopportunities as well as consumption plans influ-ence the balances desired by businesses andhouseholds. So, the changing yields on alternativesavings and investment assets have an indirecteffect on the demand for central bank liabilities.Depending on the source of these changing yields,the induced change in the outstanding stock ofcentral bank money may or may not be consistentwith maintaining stable purchasing power at theinitial overnight bank rate.

Knowing the prevailing operating proceduresof central banks is important for understandingthe risk of unintended increases or decreases inthe purchasing power of money. As mentionedabove, it is common for central banks to target an

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10 “Secular” means of, or relating to, a long term of indefiniteduration.

11 When the public holds money, they receive either no nominalreturn on their cash, or very little—less than could be earned onnormal investments—on deposits in banks. It is in this sense thatwe speak of there being an “opportunity cost” of holding money(instead of holding interest-bearing investments).

overnight interbank rate: The operating desk ofthe central bank buys and sells (in the market)securities previously issued by the government.A purchase of securities by the central bankincreases12 the supply of central bank liabilitieswhile a sale of securities reduces the supply. Ineffect, the operating desk sets a price at which itis willing to buy (sell) securities from privateholders—the central bank’s demand for the debtinstruments of the government is unlimited at thatprice (interest rate). If the market supply of secu-rities to the central bank increases (the demandby private holders for such securities decreases),the quantity of central bank money will increase.

For example, if innovations in the economyraise the perceived returns on real productivecapital (which can mean anything from bettermanagement to new machines), there will be atendency for the interest rates offered on financialinstruments to rise as well.13 There will be bothan increase in the demand for loanable funds(money borrowed from a bank) and a decrease inthe demand to hold fixed-rate instruments suchas government securities. The higher return onfinancial assets means a higher opportunity costof holding bank notes or low-yielding balances inbanks. This will foster a decline in the quantitydemanded as people and businesses seek to reducethe amount of money they hold. Other things beingheld the same, if the central bank’s operatingprocedure involves pegging a nominal overnightinterest rate, the marketplace forces pressing downon security prices (up on interest rates) will bemet by an expansion in the stock of central bankmoney, even though the amount of moneydemanded is declining!

Temporarily, the expansion of the supply ofcentral bank money reduces the upward pressureon market interest rates even though an excesssupply of money has been created (increased

supply and falling quantity demanded). Undersuch circumstances, the excess supply of suchmonies will cause purchasing power to erode asthe weighted average of money prices that arerising will exceed the weighted average of pricesthat are falling. The adjustment process—infla-tion—will continue (i) until the returns on realproductive capital fall to the initial lower levelor are brought down to that level by the inflationtax or (ii) until the central bank raises the peggedlevel of the overnight bank rate to the point wherethe amount of central bank money demanded isthe amount outstanding.

Conversely, if diminished economic prospectsare reducing perceived yields on productivecapital—or are causing a general preference formore liquidity in the form of secure bank depositsand other low-risk financial instruments—securityprices will be bid up (market interest rates willbe bid down) and the lower forgone yields willcause people to try to increase their holdings ofbank deposits and currency. That means greaterdemand for central bank money; but the onlysource is the central bank. If the monetary author-ities do not correctly analyze these fundamentaleconomic forces and they fail to lower the nominalovernight intervention rate, the operating desk ofthe central bank will be selling (or buying fewer)securities and the central bank balance sheet willshrink (supply goes down) or grow too slowly ata time when the amount of central bank moneydemanded is rising. In time, the weighted averageof money prices that are falling will exceed theweighted average of prices that are rising untilpeople want to hold balances that are consistentwith the amount of central bank money in circu-lation. This process, deflation, results in a generalrise in the purchasing power of money.

The critical element, then, in the formulationof monetary policy actions is ascertaining theforces at work in the economy that are tending topress upward or downward on the structure ofmarket interest rates, including the perceivedyields on real productive capital. Since observedinterest rates in a world of fiat money include an“inflation premium,” market rates will changebecause people come to expect the average ofmoney prices to rise at a faster or slower rate while

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12 When the central bank purchases a security from the general public(usually a bank), it pays money for the security. This money is aliability of the central bank, an increase in money held by thepublic, and, of course, a reduction in the number of securitiesheld by the public.

13 Higher expected rewards to real productive capital cause peopleto buy more of the new productive assets. As they do so, they seekto reduce their holdings of old financial assets. This will cause theprice of the old assets to fall, which in turn raises their yield.

the expected yields on real productive capitalmay be changing simultaneously in the same oropposite direction. Sifting through the variety offorces at work is essential in making judgmentsabout the appropriate level for the overnight bankrate when deciding on the prices at which govern-ment securities will be bought or sold.14

Talking about Monetary Policy

Popular usage by “Fed watchers” of theexpression “monetary policy” is quite differentfrom the way it is used in this essay. Even quali-fiers such as monetary policy objectives andmonetary policy actions usually require elabora-tion in order to be clear. At least one dictionarydefinition of policy is “a high-level overall planembracing the general goals and acceptable pro-cedures, especially of a government body.” Yet,the most frequent references we see in the dailypress about monetary policy include characteri-zations of policy as “tight” or “easy” or claimsthat the monetary authorities are going to “tighten”or “loosen” monetary policy. How can a “high-level overall plan” be characterized as tight oreasy? Maybe it is fair to characterize the actionsto achieve the objectives as being “tighter” or“easier” (than previously?), but it certainly is notappropriate to talk about the objectives as beingtight or easy.

Even the most avid “fine tuner” of monetarypolicy has a long-term objective in mind, andpeople who share the same objective may differon the appropriate tactics to be successful. Exces-sive focus on the short-term actions to implementa policy runs the risk of confusing observersregarding the ultimate objective. If observers donot know the intended destination, or do not agreewith the destination, they will naturally second-guess the appropriateness of course corrections.

If the ultimate objective is well understood—and agreed to—it is reasonable to hold policy-makers accountable for actual results. Goodintentions are not enough if the results are bad.However, the results can be judged as successful

or not relative only to what was intended. Withoutunderstanding and agreement about objectives,there is no way for accountability to be tied toperformance.

The fact that there are long and variable lagsbefore monetary policies take effect means thatobjectives must be stated in a multi-year context.15

If the time horizons of the policymakers and theobservers differ, it may be difficult to get agree-ment on appropriate weights to give to any tran-sition costs when compared with the benefits ofprogress toward achieving the ultimate objective.As a result, disagreements about the appropriate-ness of a specific policy action may reflect nothingmore than differences in the preferred time pathto the destination. All that gets lost in the familiarchatter about whether the policy action represents“tightening” or “loosening.”

The Formulation and Implementationof Monetary Policy

The consumption behavior of householdstends to reflect expectations about their longer-term ability to consume. This phenomenon hasbeen called the life-cycle hypothesis, standardor standardized income, and, of course, by MiltonFriedman, permanent income (Friedman, 1957).The basic idea is familiar. Transitory changes inmeasured income or cash flow fluctuate aroundsome longer-term average; household consump-tion behavior does not fully reflect these transi-tory changes in the short run. Sharp increases inmeasured cash-flow income are not fully reflectedin corresponding increases in current consump-tion; nor are sudden rapid declines in measuredcash-flow income reflected in correspondingdeclines in consumption spending.

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14 See the discussion of targeting interest rates in www.clevelandfed.org/Annual01/essay.htm.

15 The time it takes monetary policy to influence the other macro-economic variables such as nominal and real output and the rateof change of prices is known as the lag. Sometimes the lag is shortand sometimes it is long. It differs as a function of people’s expec-tations. After a period of no inflation, people tend to interpret anincrease in prices as temporary and not necessarily a permanentprice increase. After a period of rapid inflation, they interpret anincrease in prices as more inflation. How quickly people adjust tochanges in policy is related to their experience and their underly-ing conception of why changes are taking place. It is in the sensethat lags depend upon past experience and what people see ascausing the changes that we say that policy lags are long and vari-able—depending on experience.

Changing Productivity. Both the theoreticalframework and empirical observations tradition-ally suggest that permanent income is relativelysteady, while transitory changes in measuredincome are more variable. However, it can alsobe the case that periods of rising or falling pro-ductivity and changes in the pace of technologicalinnovation produce a generalized perception thatpermanent income is rising or falling relative tomeasured or cash-flow income. People may cometo form these expectations in a variety of ways.

Rising Productivity. Sustained periods ofsteady employment and growing paychecks maylead people to expect that not only has their realstandard of living risen but that it will continueto rise in the future, possibly at a faster rate thanpreviously expected. Or, they may come to expectfewer or shorter periods of unemployment. Or,they may observe that their 401K savings plansor defined-contribution retirement programs nowpromise a higher future stream of income thanpreviously thought. In a variety of ways, peoplecome to expect that they will be able to consumemore in the present, as well as in the future, thanthey previously thought.

As a result of any (or some combination) ofthese various forces at work in a “new economy,”households perceive that their long-term abilityto consume is higher.16 The availability of creditmeans that people can increase their spending inanticipation of the future increase in their incomes.This, in turn, means households will consume agreater share of their current measured incomeso, consequently, the contemporaneous personalsaving rate will fall. Clearly, this analysis suggeststhat, in such an environment, a low or even neg-ative saving rate is unavoidable and is not a prob-lem to be addressed by economic policies.

In the business or entrepreneurial sector, risingproductivity and an enhanced pace of technologi-cal innovation mean that the marginal efficiencyof capital is higher.17 Consequently, in return forgiving up consumption today, relatively more will

be available for consumption tomorrow. Realinterest rates rise as new opportunities bring ahigher rate of return on new business investment.

These higher real interest rates are not a matterof policy choice or of anyone’s discretion. Ratherthey are a manifestation of economic forces thatresult in better uses for available productiveresources. With households and businesses bothincreasing their claims on current productiveresources, real interest rates must rise in compet-itive markets.

Gold Standard. Higher real interest ratesneed not imply higher nominal interest rates.Just to exclude complications for the moment,consider the case under a gold standard. Increasedproductivity growth and technological innova-tion in an environment of monetary stabilityimplied by a gold standard means that the pricelevel falls. That is, output of goods and servicesincreases because of higher productivity but thequantity of money—gold—remains in relativelyfixed supply. Thus, the purchasing power ofmoney rises in the face of greater productivity.The falling price level means that greater perma-nent real income can be distributed to societywith the same level of nominal income. Thefalling price level also implies that unchangednominal interest rates, or possibly even lowernominal interest rates, correspond to higher realinterest rates. These higher real rates are theessential market mechanism by which competi-tion between consumers and investors rationspresent consumption against augmented futureconsumption. But, we’re not on a gold standard.

Fiat Money. The alternative to commoditymoney, as we have seen, is “managed money,”a discretionary monetary policy regime using aprocedure that “pegs” the interest rate. Theupward pressure on real interest rates that is anecessary consequence of greater productivityand the faster pace of technological innovationinitially will put upward pressure on nominal,i.e., market, interest rates. Greater and greaterinjections of central bank money will then benecessary to keep the pegged level of the nomi-nal overnight interbank rate unchanged. Risingmarket interest rates mean that the opportunitycost of holding money balances is rising. That,

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16 In economists’ jargon, they have moved to a higher indifferencecurve.

17 Again, in economists’ jargon, the production possibility boundaryhas both shifted out and changed its shape.

in turn, means the quantity of money demandeddeclines and the rate at which money changeshands increases as households and businessesseek to rid themselves of undesired money hold-ings. This combination of excess money holdingsand the faster growth of central bank moneymeans that a higher rate of nominal final demandgrowth would be accommodated by a moreexpansionary rate of money growth. Again, toomuch money chasing after too few goods. In suchan environment, the increase in nominal interestrates, while initially reflecting upward pressureon real interest rates, would be augmented by arising inflation premium. The overnight inter-bank rate would be under persistent upwardpressure so long as it continued to lag behindmarket-determined interest rates.

This dynamic process describes an environ-ment in which acceleration in the pace of techno-logical innovation and productivity growth couldinadvertently become an inflationary process. Acentral bank’s actions to maintain an unchangedovernight rate would accommodate nominal priceincreases by failing to accommodate increases inthe real interest rate. As a result, credit marketswould be unable to play their role in rationingavailable real productive resources amongstheightened competing demands that reflect theincreased return to real capital. Of course, thisanalysis is symmetric: A sustained decelerationof the pace of technological innovation and pro-ductivity growth would imply a fall in the equi-librium real rate and a necessity to reduce thecentral bank’s intervention rate in order to avoida procyclical downward thrust of monetaryinjections.

Policy Neutrality

In the analysis above, “real interest rates”refer to inflation-adjusted nominal interest rates,that is, anticipated yields on an investment afterallowing for changes in the purchasing power ofmoney. For example, the rate of inflation that isexpected over the life of a bond is subtracted fromthe nominal yield to obtain the real yield.

Sometimes one hears or reads references tothe “real federal funds rate” or “real overnightinterbank rate.” This makes no sense. Because

there is no meaningful one-day inflation rate,there is no statistical measure of anticipatedchanges in the purchasing power of money in asingle day that can be used to measure a realreturn for one day.

As an alternative to referencing “real interestrates,” economists employ a concept of a “naturalrate of interest.” While this natural rate cannotbe observed, the forces that would tend to causecyclical or secular increases or decreases wouldinclude such factors as the changing productiv-ity trends and pace of technological innovationdiscussed above. Sometimes the natural rate isassociated with the average rate of real outputgrowth over long periods. Demographic patterns,political and economic institutional arrangements,and even geopolitical developments will alsoinfluence this “natural” rate.

One thing that does not influence the naturalrate is the overnight, interbank rate targeted bycentral banks. It is simply impossible for centralbanks to “push up” or “hold down” market interestrates. However, actions by the central bank totarget an overnight intervention rate in the faceof sometimes strong pressures at work on marketinterest rates have a major impact on the perform-ance of an economy over time.

As defined above, a world without inflationis one in which people make decisions in theconfident expectation that all observed changesin money prices of goods, services, and assets arechanges in relative prices, and all observed changesin interest rates are changes in real rates. That is,the “inflation premium” in nominal interest ratesis zero, so only those forces that influence thenatural rate of interest are causing changes inmarket interest rates.

A neutral monetary policy would be one inwhich injections of liquidity by the central bankare faster or slower as necessary to maintain thisnon-inflationary environment. When forces areat work to raise the natural rate of interest, actionsto peg the intervention rate at an unchanged levelwould require larger and larger injections of cen-tral bank money. However, as described above,in that same environment the quantity of moneypeople want to hold idle is declining. Increasingsupply and falling demand is not neutral.

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To remain neutral, the intervention rate tar-geted by the central bank must rise in concertwith a rising natural rate. Likewise, if the pace oftechnological advance and productivity growthslows, it is necessary to reduce the interventiontarget rate in order to maintain the neutral stance.These dynamics show that changes in the targetedintervention rate cannot be taken as indicationsof the “tightness” or “easiness” of the thrust ofpolicy. The mere observation that the announcedtarget rate has been increased or decreased doesnot indicate that the stance of policy actions ismore “stimulative” or “restrictive.”

On the contrary, failure to change the targetrate in concert with forces influencing the naturalrate would mean that policy actions have become,de facto, more or less expansionary. The paradox,then, is that maintaining neutrality of the thrustof monetary policy actions requires changes in theannounced target intervention rate as frequentlyas policymakers obtain information indicatingthat the natural rate of interest has risen or fallen.

COMPETING CURRENCIESThe concepts of competitive money, currency

boards, and the independence of the central bankwere no doubt far from the mind of AbrahamLincoln when he spoke of the government’s obli-gation to provide a stable currency. However, theseare a few of the mechanisms by which govern-ments have tried to achieve this end. It must beremembered, however, that these different optionsare not independent.

The potential for the forces of competitionthat have served market economies so well todiscipline a country’s ability to print money freelyis particularly promising. According to Hayek,“[i]t might prove to be nearly as difficult for ademocratic government not to interfere withmoney as to regulate it sensibly” (1976, p. 74;emphasis added). He argues that countries aroundthe world should abolish “any kind of exchangecontrol or regulation of the movement of moneybetween countries” and provide “the full freedomto use any of the currencies for contracts andaccounting” (1976, p. 74). Further, there shouldbe “the opportunity for any bank located in these

countries to open branches in any other on thesame terms as established banks” (1976, p. 17).

Laws could be changed in various ways inthe United States to foster more effective compe-tition. For example, federal law (Title 31, Section5103) states that “United States coins and currency(including Federal Reserve notes…) are legaltender for all debts, public charges, taxes, anddues. Foreign gold and silver coins are not legaltender for debts.” This law might be altered sothat contracts written in terms of foreign or alter-native domestic monetary units, including specie,could compete with dollars. Almost 30 years ago,the British House of Lords “ruled that in Englishcourts, foreign creditors could now have theirclaims recognized in their own currencies” (TheFinancial Times, 1975).

Governments must have a role in the enforce-ment of contracts. As Mises observed in HumanAction, the laws and courts of a country

define what the parties to the contract had inmind when speaking of a sum of money…Theyhave to determine what is and what is not legaltender. In attending to this task the laws andthe courts do not create money [emphasis inoriginal]…In the unhampered market economythe laws and the judges in attributing legaltender quality to a certain thing merely estab-lish what, according to the usages of trade, wasintended by the parties when they referred intheir deal to a definite kind of money” [empha-sis added]. (Mises, 1949, p. 780)

Legislation requiring enforcement of “specificperformance” by the courts would increase theopportunity for currency competition. Currently,in most countries of the world, when there is adispute involving a contract that is stated in termsof a currency or unit (such as gold) other than thenational currency, courts will not require perform-ance in the stated unit but will require that an“equivalent payment” in the national currencybe paid.

Money in the twenty-first century will surelyprove to be as different from the money of thepast century as that money was from that of thenineteenth century. Just as fiat money replacedspecie-backed paper currencies, electronicallyinitiated debits and credits will become the dom-

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inant payment modes, creating the potential forprivate money to compete with government-issuedcurrencies. Such competition between private andgovernmental monies may help countries aroundthe world to finally live up to Lincoln’s challengeof fulfilling “the duty [government] owes thepeople, of furnishing them a sound and uniformcurrency.”

SUMMARYStable money enhances growth. Whenever the

purchasing power of money is falling (the impacton the weighted average of all prices from thosethat are rising exceeds that of those that are falling)productivity improvements are smaller. The fasterthe average of prices rise, the slower the produc-tivity improvements. This result is unavoidablebecause the changes in money prices of goods andfactors of production do not accurately reflectchanges in relative values. Consequently, busi-nesses and households make mistakes that theywould not have made if they could be confidentthat all observed price changes are the result ofshifts in the supply of, or demand for, some thingsrather than other things. Furthermore, when thevalue of money is not stable, changes in interestrates are not necessarily changes in real interestrates. To the extent that changes in interest ratesreflect uncertainty about the future purchasingpower of money, mistakes in the allocation ofresources occur.

The most common forms of money in use inthe world today are the liabilities of central banks.The almost universal requirement that taxes bepaid to governments in the form of the liabilitiesof a central bank ensures that there is a demandfor such liabilities. However, to some extent thedemand for central bank liabilities is a deriveddemand, dependent on people’s usage of the lia-bilities of financial intermediaries such as banks.Institutional arrangements such as interest pro-hibitions or ceilings and idle reserve requirementscan affect the demand for central bank liabilities,making the amount demanded at any time difficultto estimate.

Central banks control the supply of centralbank money by acquiring or disposing of securi-

ties, usually those issued by a sovereign govern-ment. In effect, central banks choose levels ofnominal interest rates at which they have a hori-zontal demand for the liabilities of the govern-ment. If they guess correctly, the rate at whichprivate holders supply securities to the centralbank will generate additional central bank liabil-ities at the same rate as businesses and householdsdesire to add to their holdings (indirect in thecase of “inside money,” the deposit liabilities offinancial intermediaries). The value of money isstable when there is neither an excess supply ofnor an excess demand for the liabilities of thecentral bank.

When the public’s supply of securities to thecentral bank changes, the growth rate of centralbank liabilities also changes. If the public’s demand(direct and indirect) for central bank liabilities isnot changing in the same direction and by thesame amount, the average purchasing power ofmoney (the weighted average of the prices of goodsand services) will rise or fall as people seek to dis-pose of excess, or acquire additional, obligationsof the central bank. Such adjustments alter relativeprices and induce resource reallocations! Unavoid-ably, then, output potential is temporarily reduced.Maximum output—and highest standards of liv-ing—is achieved only when the purchasing powerof money is stable.

REFERENCESAlchian, Armen. “Why Money?” Journal of Money,

Credit, and Banking, February 1977, 9(1, Part 2),pp. 133-40.

Alchian, Armen and Allen, William R. Exchange andProduction: Competition, Coordination, and Control,2nd ed. Belmont, CA: Wadsworth Publishing, 1977.

Alesina, Alberto and Summers, Lawrence H.“Central Bank Independence and MacroeconomicPerformance: Some Comparative Evidence.”Journal of Money, Credit, and Banking, 1993, 25(2),pp. 151-62.

Brunner, Karl, and Meltzer, Allan H. “The Uses ofMoney: Money in the Theory of an Exchange

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Economy.” American Economic Review, December1971, 61, pp. 784-805.

Buchanan, James M. “Notes on the LiberalConstitution.” Cato Journal, Spring-Summer 1994,14(1), p. 1-9; see p. 4.

Federal Reserve Bank of Cleveland. “Governmentsand Money.” 1995 Annual Report, 1995;www.clevelandfed.org/annual/essay.htm.

Federal Reserve Bank of Cleveland. “Theory Aheadof Rhetoric: Economic Policy for a ‘New Economy’.”1999 Annual Report, 1999;www.clevelandfed.org/Annual99/theory.htm.

Federal Reserve Bank of Cleveland. “Theory Aheadof Rhetoric: Measurement and the ‘New Economy’.”2000 Annual Report, 2000;www.clevelandfed.org/Annual00/essay.htm.

Federal Reserve Bank of Cleveland. “Rhetoric Alignedwith Theory: Talking Productively about InterestRates.” 2001 Annual Report, 2001; www.clevelandfed.org/Annual01/essay.htm.

Federal Reserve Bank of Cleveland. “Deflation.”2002 Annual Report, 2002;www.clevelandfed.org/Annual02/essay.cfm.

Financial Times, November 6, 1975.

Franklin, Benjamin. A Modest Enquiry into theNature and Necessity of a Paper-Currency.Philadelphia, PA: New Printing Office, 1729.

Friedman, Milton. A Theory of the ConsumptionFunction. Princeton, NJ: Princeton University Press,1957.

Friedman, Milton, and Schwartz, Anna J. “HasGovernment Any Role in Money?” Journal ofMonetary Economics, January 1986, 17, pp. 37-62.

Hayek, F.A. Denationalisation of Money: An Analysisof the Theory and Practice of Concurrent Currencies.London: Institute of Economic Affairs, 1976, p. 29.

Jefferson, Thomas. Letter to Nathaniel Macon,Monticello, January 12, 1819.

Jordan, Jerry L. “Governments and Money.” CatoJournal, Fall/Winter 1996, 15(2-3), pp. 167-77;www.cato.org/pubs/journal/cj15n2-3-2.html.

Lincoln, Abraham. “Many Free Countries Have LostTheir Liberty.” Speech on the Subtreasury,Springfield, Illinois, December 26, 1839.

Madison, James. “The Utility of the Union as aSafeguard against Domestic Faction and Insurrection(continued).” The Federalist, No. 10. FranklinCenter, PA: The Franklin Library, 1977 [1787].

Madison, James. “Alleged Danger from the Powers ofthe Union to the State Governments Considered.”The Federalist, No. 45. Franklin Center, PA: TheFranklin Library, 1977 [1788].

Madison, James. Letter to C.D. Williams, February1820.

Madison, James. Letter to Mr. Teachle, March 15, 1831.

Mill, John S. Principles of Political Economy,Laurence Laughlin, ed. New York: D. Appleton, 1907.

Mises, Ludwig von. Human Action: A Treatise onEconomics. New Haven, CT: Yale University Press,1949.

Mundell, Robert. Uses and Abuses of Gresham’s Lawin the History of Money, 1998;www.columbia.edu/~ram15/ grash.html.

Schwartz, Anna J. “Currency Boards: Their Past,Present, and Possible Future Role.” Carnegie-Rochester Conference Series on Public Policy,December 1993, 39, pp. 147-85.

Selgin, George. “Monetary Equilibrium in the‘Productivity Norm’ of Price Level Policy.” CatoJournal, 1990, 10, pp. 265-87.

Selgin, George. Less than Zero: The Case for aFalling Price Level in a Growing Economy. IEAOccasional Paper. London: Institute of EconomicAffairs, 1997.

Smith, Adam. An Inquiry into the Nature and Causesof the Wealth of Nations, Edwin Cannan, ed.Chicago: University of Chicago Press, 1976 [1776].

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APPENDIX

The American “Dollar” and Other Monetary Terms

Just what is a “dollar” anyway? Everyone knows what gold is; they know what silver is; or at leastthere are some guys in the lab who will tell us the gold or silver content of any piece of metal. But a“dollar”? We have pieces of paper saying “one dollar” and other pieces of paper saying more dollars.We have stocks and bonds that are quoted as being traded for so many dollars and everyone keeps gettingbills from the electric company, the gas company, and the IRS to send them so many dollars. Fortunately,employers have agreed to give us some dollars every month. Now, if we can just keep a balance betweenthe number of dollars our employer promises to give us each month (assuming we can trust him) andthe number of dollars all kinds of people say we must turn over to them—or we’ll hear from theirlawyers—we’ll be okay.

Back to the beginning. What is this thing called a “dollar” that some people promise to give us andother people insist that we give to them? Well, it turns out that some valley in the Bohemian part of whatwe now call the Czech Republic has a lot to do with it. There, coins were made out of metal to help peoplemake indirect exchanges between what they produced and what they wanted. The German word forvalley is thal and it was common to refer to the metal coins produced in the valley as taler coins (the“h” being silent in German). That was often shortened to simply talers. In English, taler coins or talerssounded like dollar coins, or simply dollars, which was how the British referred to some metal coinsmade in Spain.

After the Spanish staked their claims on large chunks of the “new world,” they started getting boatloads of gold and silver and stamping out a lot of coins. The Spanish monetary unit at the time was thereal, and an eight-reales coin—a “piece of eight”—was referred to by English-speakers as a “dollar.”

The American colonists kept their accounts in British pounds, shillings, and pence but they did nothave available to them very many British coins. What they had mostly were Spanish and Portuguesecoins, and the most common coin available to them was the Spanish “dollar” coin. Other coins availablewere the Spanish doubloon and pistole, the Portuguese moidore and johannes, and the French guineaand pistole. (Compared with these alternatives, we are fortunate that the coins the colonists had mostof were Spanish dollars.)

Because the proportion of precious metal in all these coins varied and the colonists kept their booksin terms of British pounds, it was necessary to define each of the various other metal coins in terms ofBritish pounds. Keeping pounds as the unit of account but using Spanish dollars as the dominant mediumof exchange was, of course, a very cumbersome arrangement. As British subjects, however, the colonistsdid not have a good alternative.

After the Declaration of Independence, it finally became opportune to think about a unique monetarysystem appropriate to the newly evolving nation. It seems that Thomas Jefferson quite pragmaticallyconcluded that, since the most familiar coin in use was the Spanish dollar coin, it would be best toadopt a “dollar” as a standard. That meant a dollar had to be defined in terms of something of knownvalue—other than British pounds. He also concluded that since “every schoolboy” could multiply anddivide by ten, it would be best to have money units that were in terms of tenths of a dollar and multiplesof ten dollars. Jefferson found the British use of eighths of a money unit to be cumbersome, at best. So,even though the Spanish had minted a “dollar coin” to be a “piece of eight” (consisting of eight reales),the colonists ultimately defined a dollar coin to be 24.75 grains of pure gold or 371.25 grains of puresilver. They further decided to mint a ten-dollar gold coin as well as a one-dollar gold piece and a one-dollar silver piece, and to mint silver coins of one-tenth of a dollar and copper coins of one-hundredthof a dollar.

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Thus, the dollar—like every other thing that has served as money—was initially defined in termsof something of known value. Only gradually during the twentieth century did people come to acceptthat the word “dollar” stood in its own right as a concept of value. In other words, for almost 200 yearsa dollar was a claim to money—gold—and formally became money only in 1973 when the link to goldwas severed.

A Dollar as Money Is Distinct from Assets Denominated in Dollars

Currently, there is only one source of dollars: the liabilities of Federal Reserve Banks. Everythingelse is a substitute for, or claim to, dollars. Actual dollars come in two forms: Federal Reserve notes andbalances (deposits) at Reserve Banks that are maintained by depository institutions, such as a commercialbank. All transactions using Federal Reserve notes are final, certain, immediate, and (often) anonymous.That is why people like using them. Although you do not see it directly, all taxes paid by householdsand businesses to the federal government must be in the form of a transfer of ownership of balances heldat a Federal Reserve Bank to the account of the U.S. Treasury at the Federal Reserve Banks.

People commonly exchange promises to pay and receive certain amounts of dollars at definite timesin the future (bonds). Ultimately, the payor is giving a promise (which the courts will enforce) to acquireand deliver to the payee a certain number of Federal Reserve Bank notes or bank balances denominatedin dollars (that are claims to balances at the Federal Reserve Banks) at a certain date in the future.Consequently, only dollars serve the function of money—indirect exchange—in the United States.

Claims to money—such as balances at financial intermediaries (banks and so on)—are a part of themonetary system. Yet, it is important to distinguish between various stores of wealth (mainly, financialassets) that are denominated in units of money and the entity that serves as money. The purchasingvalue of the dollar, for example, is not influenced by the aggregate “dollar value” of equity markets,debt markets, money-market funds, foreign-held “eurodollar” balances, or any other instruments thatare specified in legal contracts to pay and receive dollars.

Some Monetary Terms

Coin metal tokens used as media of exchange, either full-bodied (i.e., containing the amount ofprecious metal indicated by the standard) or merely representational (like paper notes)

Currency (i) name of a unit of account, e.g., “dollar,” “pound,” “yen”; (ii) paper notes used as amedium of exchange

Monetary standard the (legal) (official) definition of the value of a currency in terms of somethingelse, like, e.g., gold, silver, or the discretion of the government (fiat)

Dollar (i) liability of Federal Reserve Banks; (ii) U.S. unit of account and medium of final exchange;(iii) U.S. legal tender—a judicially enforceable right to receive payment or compensation in a certaincurrency

Indirect exchange interpersonal exchange of goods or services that employs an intermediate entity(money) rather than direct barter of final consumables

Money (i) standard of value; (ii) media of exchange used in indirect exchange; (iii) that entity thateconomizes best on the use of other real resources in gathering information about relative values andconducting transactions

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Money and Monetary Policy for the Twenty-First Century...Money and Monetary Policy for the Twenty-First Century Jerry L. Jordan of the past millennium. It is super ficial because many