If you tried to buy something with a piece of paper, you might run into some trouble unless, of course, the piece of paper was a 100-dollar bill. But what is it that makes that bill so much more interesting and valuable than other pieces of paper? After all, there’s not much you can do with it. You can’t eat it; you can’t build things with it; and burning it is actually illegal. So what’s the big deal?
Of course, you probably know the answer. A 100-dollar bill is printed by the government and designated as official currency while other pieces of paper are not. But that’s just what makes it legal. What makes the 100-dollar bill valuable, on the other hand, is how many or few of them are around. Throughout history, most currencies including the US dollar were linked to valuable commodities and the amount in circulation depended on the government’s gold or silver reserved. But after the US abolished the system in 1971, the dollar became what is known as “fiat money”, meaning not linked to any external resource but relying on, instead, solely on the government’s policy to decide how much currency to print.
So which branch of our government sets the policy? The Executive, the Legislative or the Judicial? The surprising answer is: None of the above. In fact, monetary policy is set by independent Federal Reverse System, or the FED, made up of 12 regional banks in major cities around the country. Its board of governors, which is appointed by the president and confirmed by the Senate, reports to Congress and all of the FED’s profits go into the US Treasury.
But to keep the FED from being influenced by the day-to-day vicissitudes of politics, it is not under the direct control of any branch of government. So why doesn’t the FED just decide to print indefinite hundreds of billion dollar bills to make everyone happy and rich? Well because then the bill wouldn’t be worth anything. Think about the purpose of currency, which is exchanged for goods and services. If the total amount of currency in circulation increases faster than the total value of goods and services in the economy, then each individual piece would be able to buy a smaller portion of those things than before. This is call “inflation”. On the other hand, if the money supply remained the same while more goods and services are produced, each dollar value would increase in the process known as “deflation”.
So which is worse? Too much inflation means that the money in your wallet today would be worth less tomorrow, making you want to spend it right away. So well this would stimulate business but also would encourage over-consumption or hoarding commodities like food or fuel, raising the prices and leading to consumer shortages and even more inflation. But deflation would make people want to hold on to their money and the decrease in consumers’ spending would reduce businesses’ profits, leading to more unemployment and a further decrease in spending causes the economy to keep shrinking. So most economists believe that well too much of either is dangerous and a small consistent amount of inflation is necessary to encourage economic growth.
The FED uses vast amount of economic data to determine how much currency should be in circulation including previous rates of inflation, international trends and the unemployment rate. Like in the stories of Goldilocks, they need to get the number just right in order to stimulate growth and keep people employed without letting inflation reach disruptive levels. The FED not only determines how much that paper in your wallet is worth but also your chances of getting and keep the job will you earn it.
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