Money and Monetarism

To monetarists, inflation came from too much money chasing too few goods. Prices rose when the banking system, meaning the Federal Reserve in its various ways of influencing banks, created money faster than

the rest of the economy produced goods. If the Federal Reserve contracted the money supply, then prices would go down because there would be less money for goods. This deflation, monetarists believed (and Keynesians agreed), would slow down economic activity because it would make more sense to hold dollars, which would buy more goods later, than to invest or spend them, receiving fewer dollars later given price declines. Monetarists such as Nobel laureate Milton Friedman argued that, if the Federal Reserve maintained a steady, moderate rate of growth of the money supply, the economy would avoid both depression and inflation.

Perhaps this is true, but the Fed's actions also influenced interest rates, because the price of something depends on its supply. Rates depend as well on the demand for money, which brings us to the Federal Reserve's role in managing the federal debt.

Government bonds, "T-bills," and so on are the safest of all investments because the government can get money in ways that private industry cannot match and because, if the government went under, everything else would collapse with it anyway. The government will pay whatever interest is necessary to sell its bonds. If the government increases its sale of bonds (deficit) during an economic downturn, these sales will soak up idle cash and put it to (relatively) productive use. But if idle money is scarce, then the deficit must divert cash from other kinds of investments (crowd them out) and, in the competition for investment money, can drive interest rates upward. Keynesians and neoclassicists claim that less investment, lower profits from investment, and eventually lower economic growth result.

The Federal Reserve can intervene in this process by buying bonds from its member banks. When it buys a bond, it credits the seller's reserve account. Banks are allowed to lend an amount several times their reserves; therefore, expansion of reserves allows a proportionate expansion of lending. Some of that lending will come back into the banks as demand deposits (checking accounts), to be lent out again as the cycle repeats. Thus, when the Fed buys bonds, it increases demand deposits and bank reserves, the major bases of the money supply. It also increases bank lending, so interest rates should go down. Conversely, when the Fed sells bonds (debiting banks' reserve accounts), it contracts the money supply, thus driving interest rates higher.

The purchase of bonds is how the Federal Reserve "prints money" to pay for the government's expenses. The Fed's decision to purchase depends upon whether it is more concerned with steadying the money supply (then it will not buy bonds) or keeping interest rates low (then it will buy them).

If monetarists were right, the Federal Reserve could stop inflation by

reducing the money supply. But the resultant higher interest rates might send the economy into a recession. Keynesians were nervous about using such potent measures. Because supply-siders believed interest rates mattered less and tax rates more to business interests, the supply-siders were more optimistic that a tax cut could be combined with monetary restraint to increase production and reduce inflation. To Keynesians the combination of tight money and large tax cuts guaranteed only high interest rates that would bring the economy down in a resounding crash.