How Governments Use Money Policy, Not Law, to Manage the Economy
Anyone working in the Finance, Legal or Business sectors will encounter money on a daily basis, as part of their business. Laws, regulations and policies use the coercive power of the state to enforce certain parameters and orders within society. However, the driving factor of the economy is money. Money itself is just a method of exchange. It can’t truly be consumed like a good or service. Despite this, the circulation of money drives the exchange of goods and services within an economic area.
So what is money? The common definition of Money describes money as a method of exchange. Paper notes, bank balances and other units of currency are exchanged for goods. However, there is more to money than meets the eye. Money helps the government barter useful government services, for a portion of goods in the economy. It helps them take credit and shares in the total economic activity through taxes, levies and fees, through the money they print and circulate themselves. If there were no government services to spend your local currency on, money would lose a great deal of its utility, and remain as simple bits of paper. The paper notes require the backing of the government’s laws, authorities, police enforcement apparatus and banks to establish any value for its users.
In modern times, most governments function as large businesses in many respects. They participate in economic activity through the provision of services, and they barter the economic activity in their jurisdiction by regulating participants, levying taxes and controlling immigration. However, one of most influential means of participating in an economy for a government is through the provision and control of money supply.
Money Supply and Demand
The demand for money in an economy, or the local currency of a government is influenced greatly by the exchange rate and the total demand for goods and services. The relationship between the supply and demand for currency is shown in the below diagram.
The interest rate is represented by “r” above on the vertical column. The money supply is the fixed amount of currency circulated in the economy. The Md curve above represents demand for currency by individual consumers. As demand for currency increases (shifts up), the rate of interest also increases. This is because banks and other financial institutions will experience a “shortage” of money as more money is required by consumers. This money demand increase is usually due to an increase in demand for goods and services in the economy, and will mean that more currency is circulated to private hands. Therefore, in order to replenish supplies of money in their coffers, the central bank will have to incentivize saving, by offering a higher interest rate or “price”of holding money in government bonds. This is essentially the promise to give more money to a “saver” or “depositor” at a later time, in exchange for receiving and holding their money today.
This is the first way the government can influence the economy, interest rates and the level of economic activity. By raising interest rates, the government can reduce inflationary pressure (price increases), while also decreasing demand for goods. This is all against the promise to pay depositors more “interest” if they give their currency to the government instead of purchasing more goods. This basically means that the government will try to take a larger chunk of the money circulating in the economy, with the promise of paying more out from their coffers and supply held in their “vaults” at a later time. The relationship of money supply to the goods market is shown below.
The Y axis represents the supply of goods. LM is the money supply graphed against demand for money (IS), in relation to the goods market (Y). As demand for money increases, more money is circulated to private hands, in exchange for goods, leading to an increase in income/trade in goods(Y). As income and trade increases, so too does inflation (price of goods). In addition, banks begin to experience a money shortage, which leads them to increase interest rates, in order to retain more money.
The second way the government can influence the economy through money is by lowering interest rates. When interest rates are lowered, fewer people will be encouraged to save their currency, and more money will circulate. Therefore, more goods will be exchanged as individuals put their money towards goods rather than savings. This is done primarily, by selling or distributing money held in the banks coffers to the general public, thereby increasing the circulation of money. However, this happens up to a point, as the nature of the demand is such that after a certain point, individuals will not have incentive to spend more, regardless of the rate of interest. This is because there may simply not be enough need to use money for trade, perhaps due to a depressed economy. This is what is known as a liquidity trap, and is graphed below.
The third way the government can influence the economy is by increasing the money supply by money printing. They can print more money, to give people more physical cash in their pockets. However, this is a dangerous strategy in some respects, as it can cause inflationary pressure. For example, today a consumer of bread may have more customers buying bread, as customers have more money available. However, as bread supplies begin to run low, he will have to produce more to cater to demand, relatively quickly. This may increase his costs, and lower quality. Eventually, he will be unable to cope, and this may lead to a bread shortage. Therefore, demand for bread will increase while the supply of bread will go down. The overall result of this is no change in output, but with higher prices!
this graph shows how aggregate demand and aggregate supply may be affected by an increase in printed money.
The only time when printing money could help is when the government wants to keep the interest rates level, or peg the currency exchange rate to that of another country (i.e. the GCC/Arabian Gulf currencies are pegged to the US dollar for the most part). For example, if interest rates are low, and the money supply is being stretched, due to a high degree of economic activity, the exchange rate may begin to suffer. The exchange rate determines how much local currency holders can sell their currency, in exchange for currencies belonging to currency holders from other economies. When interest rates in the economy become higher, the economy can suffer, as a strong currency means that it is more expensive for foreign consumers to purchase goods, and perhaps even “identical” goods, from the domestic economy. As local money is more scarce, after being gobbled up in private trade, it is traded for a more units of foreign currency.
The graph above shows the demand and supply of money on the left, and the relationship between the interest rate and exchange rate on the right. As interest rates decrease, the value of the exchange rate in terms of domestic to foreign currency decreases, making prices in the economy more competitive.
Therefore, the exports of the local economy to foreign countries can become more expensive for foreigners, even if they are purchasing the same volume of goods. As a result, foreign demand for local produce will naturally decline. As exports decline, the economy will have less income and trade with foreign buyers. Therefore, overall income levels will decline, and the government will take in less tax revenue. In such cases, the government may be encouraged to print more money if they believe that it is needed to reduce the exchange rate and maintain the competitiveness of exports. This will decrease the interest rate, increase prices, and possibly increase the level of income (i.e. trade in goods, or level of exports) in the local economy.
What makes money valuable?
As seen above, the supply and demand for money in the local economy is quite a sophisticated, complex, and probably confusing phenomenon. However, the main point that should be understood is that it is the government, bartering their power, control of a geographic area and the goods within it, which can back any value attributed to a currency.
If there is widespread corruption, a breakdown of law and order, weak institutions of enforcement, predatory or monopolistic manipulation of the local economy, war or serious natural disasters in an economic area, this money market essentially breaks down. Money will be reduced to bits of paper, without the backing of any real governmental or authoritarian power.