The Role of Money:

• A medium of exchange used to transact goods and services in an economy.

• While money is not wealth—otherwise the government could make us all twice as rich by simply printing twice as much money—a well-designed and well-maintained monetary system facilitates the production and distribution of wealth.

• Many economies in the distant past functioned without money; people simply bartered their products and labor with one another.

• Money is equivalent to wealth for an individual only because other individuals will supply the real goods and services desired in exchange for that money, but, from the standpoint of the national economy as a whole, money is not wealth, it is just an artifact used to transfer wealth or to give people incentives to produce wealth.

• Although money itself is not wealth, an absence of a well-functioning monetary system can cause losses of real wealth, when transactions are reduced to the crude level of barter.

Inflation

• A decrease in the purchasing power of money seen in a rise in prices.

• The national price level rises for the same reason that prices of particular goods and services rise—namely, that there is more demanded than supplied at a given price.

• Without a corresponding increase in the volume of output, the prices of existing goods and services simply rise because the quantity demanded exceeds the quantity supplied at current prices and either people bid against each other during the shortage or sellers realize the increased demand for their products at existing prices and raise their prices accordingly.

• More sophisticated methods of increasing the quantity of money have been used in countries with government-controlled central banks, but the net result is still the same: An increase in the amount of money, without a corresponding increase in the supply of real goods, means that prices rise—which is to say, inflation.

• The big problem with money created by the government is that those who run the government always face the temptation to create more money and spend it.

• Inflation is not only a hidden tax, it is also a broad-based tax.

• The rate of inflation is often measured by changes in the consumer price index, which is only an approximation because the prices of different things change differently.

Deflation

• An increase in the purchasing power of money seen in a fall in prices.

• While inflation has been a problem that is centuries old, at particular times and places deflation has also created problems, some of them devastating.

• Just as inflation tends to be made worse by the fact that people spend a depreciating currency faster than usual, in order to buy something with it before it loses still more value, so a deflation tends to be made worse by the fact that people hold on to money longer, especially during a depression, with widespread unemployment making everyone’s job or business insecure.

Banks

• A business that allows people to borrow money and safety deposit their money.

• By transferring their money to a bank, individuals and enterprises are able to have their money guarded by others at lower costs than guarding it themselves.

• The system of financial intermediaries enabling many people to spend money that belongs to many other strangers for investments or consumer purchases.

• Commercial banks of course charge interest for this service but, because economies of scale and risk-pooling make the commercial banks’ costs lower than that of their customers, both the banks and their customers are better off financially because of this shifting of risks to where the costs of those risks are lower.

• Banks not only have their own economies of scale, they are one of a number of financial institutions which enable individual businesses to achieve economies of scale—and thereby raise the general public’s standard of living through lower production costs that translate into lower prices.

• Businesses typically do not apply for a separate loan each time their current incomes will not cover their current obligations.

• In a complex modern economy, businesses achieve lower production costs by operating on a huge scale requiring far more labor, machinery, electricity and other resources than even rich individuals are able to afford.

• Most giant corporations are not owned by a few rich people but draw on money from vast numbers of people whose individually modest sums of money are aggregated and then transferred in vast amounts to the business by financial intermediaries like banks, insurance companies, mutual funds and pension funds.

• Many individuals also transfer their own money more directly to businesses by buying stocks and bonds, but that means doing their own risk assessments, while others transfer their money through financial intermediaries who have the expertise and experience to evaluate investment risks and earnings prospects in a way that most individuals do not.

• In short, economies of scale enable banks to guard wealth at lower costs per unit of wealth than either private businesses or homes, and enable the Federal Reserve Banks to guard wealth at lower costs per unit of wealth than private banks.

• Individuals decide whether to put their money into an insured savings account, into a pension plan, or into a mutual fund or with commodity speculators, while these financial intermediaries in turn evaluate the riskiness and earnings prospects of those to whom they transfer this money.

• Banks also finance consumer purchases by paying for credit card purchases by people who later reimburse the credit card companies and the banks behind them, by paying monthly installments that include interest.

• The banking system is thus a major part of an elaborate system of financial intermediaries which enables millions of people to spend money that belongs to millions of strangers, not only for investments in businesses but also for consumer purchases.

• Fractional Reserve Banking: The requirement for banks to hold a fraction of reserve money to cover deposits, using the remaining capital for lending.

• Since all the depositors are not going to want their money at one time, the bank lends most of it to other people, in order to earn interest on those loans.

• Since some of these bank credits are re-deposited in other banks, additional rounds of expansion of the money supply follow, so that the total amount of bank credits in the economy has tended to exceed all the hard cash issued by the government.

• One of the reasons this system worked was that the whole banking system has never been called upon to actually supply cash to cover all the checks written by depositors.

• While most depositors are not going to ask for their money at the same time under normal conditions, there are special situations where more depositors will ask for their money than the bank can supply from the cash it has kept on hand as reserves.

• A bank may be perfectly sound in the sense of having enough assets to cover its liabilities, but these assets cannot be instantly sold to get money to pay off the depositors.

• Insecure property rights are just one of the things within the control of government that has a major impact on the risks of banking, because banks are almost invariably regulated by governments around the world, more so than other businesses, because of the potential impact of banking crises on the economy as a whole, the specific nature of that regulation can increase or decrease the riskiness of banking.

• Financial institutions have even more incentives to engage in risky behavior after having been insured, since riskier investments usually pay higher rates of return than safer investments.