Pioneer In Monetary Theory

Photo: The Bettmann Archive.

Irving Fisher spent most of his adult life as a professor of eco­nomics at Yale University. An accomplished mathematician, he used those skills to explain many of his theories. In his best known formulation, the equation of exchange. Professor Fisher showed the relationship between the quantity of money in circu­lation and the level of prices.

The equation of exchange is stated as follows:

MV = PQ, where:

M = money supply

V= velocity of circulation

P = average price of goods and services

Q = quantity of units sold

Simply stated, the equation of exchange tells us that total spending is equal to the total value of the goods and services produced by the economy. Let's see why.

M is the total amount of money in circulation, and V is its velocity. Velocity is simply the number of times that money turns over in a year. In other words, the amount of money in circulation, multiplied by the number of times it is spent (MV) is equal to the total amount of money spent by the economy in the course of the year.

To illustrate, let's suppose that each student in your class produced a product for sale, and that the selling price of each item is $1. Your teacher buys the product from the student sitting in the first row, first seat. That student uses the dollar to buy the product from the student in the second seat.

The process continues around the room as each student uses the dollar from the preceding student to buy the product of the next student. Assuming that there are 30 class members (including the teacher), 30 items will be sold. One dollar bill will be exchanged 30 times. Applying the equation of exchange, the total amount of money in circulation will be $30 because:

M = $1; V = 30; and MV = $1 x 30 = $30.

The equation of exchange helps to explain why prices (and therefore the value of money) fluctuate. Since MV = PQ, it follows that when V and Q are constant, any change in the money supply will directly affect prices. In other words, when the money supply increases, so will prices, and vice versa. We can also see that increases in the money supply will not result in price increases if the output of goods and services is increased at the same or a faster rate

The Federal Reserve System

The Federal Reserve System, or the Fed as it is often called, was created by an act of Congress in 1913. As the nation’s central bank, the Federal Reserve System has four separate and distinct roles that profoundly affect the economy:

· Provides banking services for financial institutions;

· Serves as the federal government’s bank;

· Supervises member banks;

· Manages the nation’s supply of money and credit.

The Fed is made up of a Board of Governors, 12 district banks, and two committees: the Open Market Committee and the Federal Advisory Council.

· Board of Governors.TheBoard of Governors establishes policies for the system. It consists of seven persons appointed by the President for 14-year terms.

· Twelve District Banks.The Federal Reserve System is built around 12 geographic districts. District Federal Reserve banks supervise banking in each of these areas.

· Open Market Committee.. The Open Market Committee is made up of the seven members of the Board of Governors and presidents of five of the district banks. Its primary responsibility is to regulate the nation’s money supply.

· Federal Advisory Council. The Federal Advisory Council does just that: it offers advice on the nation’s financial problems. It is comprised of 12 prominent commercial bankers, one selected from each district.

Summary

Money be anything that is generally accepted in payment for goods or services. It provides us with a medium of exchange, a measure of value, and a store of value. Our principal forms of money are currency and demand deposits (checking accounts).

When we speak of the "value of money," we are referring to the amount of goods and services that can be bought with it, or its “purchasing power." The purchasing power of money can increase, as it would during a period of deflation, and it can decrease, as it does during periods of inflation.

The causes of inflation are generally described as either demand-pull or cost-push. Demand-pull inflation is caused by an excess of purchasing power that serves to drive up prices ("too much money chasing too few goods"). Cost-push inflation is brought about by rising production costs that feed upon one another. Although certain groups within the economy may benefit from the increasing prices associated with inflation, more individuals and the economy as a whole are likely to suffer.

Financial institutions such as commercial banks, savings and loan associations, and savings banks are essential to the smooth operation of our economic system. Although the most important functions of banks are to provide a safe place for the deposit of funds and to serve as a source of loans, they also offer a number of other financial services.

Demand deposits held by the commercial banks comprise me largest component of the money supply. Because commercial bank loans are typically added to demand deposits, we can say that the lending ability of the banks serves to "create money." How much money the commercial banks can create is limited by the reserve ratio, which directly affects the amount of money that a bank can lend at any particular point in time.

The Federal Reserve System is the nation’s central bank. It provides banking services for financial institutions and supervises their activities. It also acts as a bank for the federal government.