Money

D

Post World War II

Near the end of World War II (1939-1945) most of the Allied nations joined together in a conference held at Bretton Woods, New Hampshire, to set up a new international monetary system, replacing the international gold standard that had collapsed during the Great Depression. The conference also provided for the establishment of the International Monetary Fund (IMF). The U.S. dollar played a key role in the new system, becoming, in effect, the world’s currency. This was true, first, because all IMF members defined the value of their own currencies in terms of the dollar and, second, because the United States agreed to convert all dollars held by foreign governments into gold on demand and at the exchange rate agreed on when the IMF was established. Officially, this meant that the world was on a “gold exchange standard” since governments could change their currencies into gold via the U.S. dollar.

So long as the United States had most of the world’s gold supply, as was true after World War II, this system worked fairly well. When the quantity of dollars held by foreign governments began to exceed U.S. gold holdings by large amounts, however, the system started to falter. By the early 1970s foreign government holdings of U.S. dollars were over five times greater than the U.S. gold stock. In August 1971 President Richard M. Nixon suspended gold payments of U.S. dollars. This closing of the “gold window” effectively ended all ties between the U.S. dollar and either gold or silver. Since then the United States has had a fully managed currency system, one with no metallic base whatsoever. United States citizens are free to own, buy, and sell gold, but its price is determined in the same way as any other freely traded commodity—on the basis of supply and demand. Gold no longer serves as a medium of exchange. Federal Reserve notes are overwhelmingly the dominant form of currency in circulation today.

IV

Recent Developments

Several important developments took place in the U.S. monetary system in the early 1970s. Until 1971 the Federal Reserve System, also known as the Fed, defined the money supply as equal to the sum of currency in circulation (excluding bank vault cash) and demand deposits (checking accounts). This definition of the money supply ignored saving accounts and time deposits (accounts that earned interest but could not be withdrawn without penalty until they matured). Monetary authorities and economists became concerned that estimates of monetary growth could be misleading if those estimates ignored savings accounts and time deposits. In 1971 the Federal Reserve began publishing measures of broader monetary supplies. The monetary aggregates were given the names M1, M2, and M3. M1 was comparable to the original money supply measure—that is, currency in circulation and demand deposits. M2 equaled M1 plus accounts such as savings accounts and small time deposits. M3 was an even broader measure, adding in larger time deposits.

The 1970s saw the introduction of many types of monetary assets. The Federal Reserve continued to fine-tune its measures of these monetary aggregates. Money market mutual fund shares were added to M2. In 1980 the Federal Reserve began publishing estimates of a broader monetary aggregate, which was designated L and included M3 plus assets such as short-term Treasury bills and commercial paper. Over time, economists and monetary authorities have become less confident of M1 as a single measure of the money supply and have gravitated to broader monetary aggregates. Financial deregulation and other innovations have aided the trend toward identifying broader monetary aggregates as money supply measures. Nevertheless, M1 is still the best-known measure of money. As of June 2001 it totaled $1.1 trillion.

---

---

Also in 1980 the Depository Institutions Deregulation and Monetary Control Act was passed. It expanded the range of monetary instruments used by the financial community, gradually eliminated the ceiling on interest rates that savings and loan institutions are allowed to pay depositors, and made all banks subject to the reserve requirements of the Fed by 1989. Previously, only federally chartered banks were subject to the Fed.

A third important development occurred in 1982 when the Federal Reserve changed its monetary policy. Monetary policy involves action to influence the economy’s performance—its output and employment level as well as the inflation rate—by controlling the money supply and the rate of interest. The Federal Reserve specifically initiates and carries out monetary policy. The Fed can increase the reserves of commercial banks, thus making possible an expansion of the money supply, or it can target interest rates to accomplish the same purpose. In the late 1970s the Federal Reserve began to “target” the money supply—that is, the Fed tried to establish a stable rate of growth for the money supply. But in 1982 the Fed went back to the practice of targeting interest rates as the primary way of stimulating or tightening the economy, rather than using its ability to increase the reserves of commercial banks.

Recent experience with policy and legislation shows that the U.S. monetary system is still evolving. Historically, the nation has gone from a wholly metallic system, when coins were the primary money in circulation, to a managed system, in which, aside from the currency in people’s pockets, most of the money consists of entries in the books of banks. The 1990s saw a resurgence of the currency component of M1 because of the export of U.S. currency to areas such as Russia and Latin America where domestic currencies lost credibility. The global underground economy, also known as the black market, also draws in significant sums of U.S. currency. By June 2001 currency accounted for 48 percent of M1; the remaining 52 percent of total M1 consisted of checking account and other deposits, much of which came into existence through borrowing. According to some estimates over half of U.S. currency has quietly found its way to foreign currencies. The Federal Reserve System has no way of measuring exactly how much currency is going to foreign currency. The most popular U.S. currency in foreign countries is the one-hundred dollar bill. This outflow of currency raises concern about the amount of black market activity and illegal transactions involving the U.S. dollar. However, some economists note that the willingness of residents of foreign countries to hold $100 bills as a financial asset is a positive development for the U.S. Treasury Department.

See also Coins and Coin Collecting; Currency; Devaluation; Foreign Exchange; Inflation and Deflation.

	More from Encarta
	•  Presidential Myths Quiz •  Coffee break: Recharge your brain