Core Economic Principles: Money, Banking, and Monetary Policy Explained

Understanding Core Economic Concepts

Functions of Money

The three essential functions of money are:

• Medium of Exchange: Money facilitates transactions, allowing depositors to make withdrawals from bank accounts, often by writing checks or using electronic transfers.
• Unit of Account: Money serves as a common measure for prices and value, simplifying economic calculations.
• Store of Value: Money provides a means of holding wealth over time, though its value can be affected by inflation.

How Banks Function and Generate Profit

Banks operate by accepting deposits and then issuing loans from these pooled funds. To remain profitable and continue operations, the interest rate banks charge on loans must be higher than the interest rate they pay on deposits.

How Banks Create Money in the Financial System

In a system of fractional reserve banking, money is initially deposited, and then new loans are created from a portion of that deposit. When these loans are used and paid to someone else, that money is often redeposited into the banking system, allowing banks to create even more loans. Through this process, an initial deposit effectively leads to the creation of additional money within the broader financial system.

The Relationship Between the Federal Reserve and Banks

The Federal Reserve (the Fed) plays a crucial role in the financial system. It is responsible for controlling monetary policy, acts as the central bank for other banks, and oversees bank regulation to ensure stability and compliance.

Intended Effects of Quantitative Easing (QE)

Quantitative Easing (QE) is a monetary policy tool where a central bank targets the supply of money by buying or selling government bonds. When the economy slows down and the central bank aims to stimulate economic growth, it buys government bonds. This action typically lowers short-term interest rates and increases the overall money supply. However, this strategy loses effectiveness when interest rates approach zero, at which point central banks must consider alternative strategies to boost the economy.

Exchange Rate Fluctuations and Their Impact on Goods and Services

Exchange rate fluctuations directly influence the relative cost of goods and services in international trade. When a country's currency strengthens, its goods become more expensive for foreign buyers, and imported goods become cheaper for domestic consumers. Conversely, when a currency weakens, its exports become more competitive (cheaper for foreigners), and imports become more expensive for domestic buyers.

The exchange rate itself often fluctuates depending on the overall health and performance of an economy at a given time. Generally, if an economy is performing well, its currency may strengthen, potentially making goods and services relatively more expensive for international trade partners. If an economy is struggling, its currency might weaken, which could make its goods and services appear cheaper to foreign markets.

Expectations, Money Supply, and the Phillips Curve

Note: The expectations theory does not fully account for why the Phillips Curve does not work as it is supposed to, but it is one significant reason. Unemployment is determined by many factors.

The Phillips Curve: Inflation and Unemployment Dynamics

The Phillips curve illustrates the relationship between the rate of inflation and the rate of unemployment. Historically, the Phillips curve suggested an inverse relationship: as levels of unemployment decrease, inflation tends to increase. However, this relationship is not linear. Graphically, the short-run Phillips curve typically traces an L-shape when the unemployment rate is plotted on the x-axis and the inflation rate on the y-axis.

The original question posed was: “Explain the relationship between expectations and increases to the money supply, and why the short-run Phillips curve eventually could not account for the relationship between inflation and unemployment.”

While the provided text describes the Phillips curve, it does not fully address the relationship between expectations, money supply increases, and the breakdown of the short-run Phillips curve. This complex topic involves how economic agents' expectations of inflation can shift the Phillips curve, leading to a vertical long-run Phillips curve where no trade-off exists between inflation and unemployment in the long run, especially after repeated increases in the money supply lead to higher inflation without sustained reductions in unemployment.