>>he birth of economics as a disciplineis usually dated to 1776, whenAdam Smith published The Wealthof Nations. His book is most famous for itsearly appreciation of the “invisible hand”of markets, which harnesses private inter-est to the public good. But there’s a lotmore in The Wealth of Nations. Amongother things, it contains a passionate de-fense of what were, in Smith’s time, new-fangled inventions: banks and papermoney.Today we take it for granted that we cantrade pieces of elaborately printed paper—green paper, in the United States—for al-most any good or service. We also take forgranted that in many cases we don’t evenneed the pieces of paper: we can write acheck or swipe a card, both of whichamount to promises that a bank will pro-vide green paper or its equivalent at a latertime.In Adam Smith’s time, however, most ofthe world’s business was still conductedwith gold or silver coins. Paper money andbank accounts—though well established inhis native Scotland—were still regarded withsuspicion in much of the world. That’s why Smith felt it necessary to explain thevirtues of a modern monetary system thatwould allow a nation to conduct its businessA WAGGON-WAY THROUGH THE AIRWhat you will learn inthis chapter:The various roles moneyplaysand the many forms it takes inthe economy.How the actions of private banksand the Federal Reserve deter-mine the money supply.How the Federal Reserve usesopen-market operationstochange the monetary base.Erik Dreyer/Stone/GettyTchapter32113Money, Banking, and the FederalReserve Systemwhile freeing up that gold and silver forother uses. Using paper money instead ofgold and silver coins, he said, was likefinding a way to build a road without di-verting any land from other uses—build-ing “a sort of waggon-way through theair.”In this chapter, we’ll look at how a mod-ern monetary system works and at the in-stitutions that sustain and regulate it. Thistopic is important in itself, and it’s also es-sential background for the understandingof monetary policy,which we will examinein Chapter 14.According to an old proverb, “With money in yourpocket, you are wise, and you are handsome, andyou sing well, too.”
322PA R T 5SHORT-RUN ECONOMIC FLUCTUATIONSUNCORRECTED Preliminary EditionMoneyis any asset that can easily beused to purchase goods and services. Currency in circulationis cash held bythe public.Checkable bank depositsare bank ac-counts on which people can writechecks.The money supplyis the total value of fi-nancial assets in the economy that areconsidered money.The Meaning of MoneyIn everyday conversation, people often use the word moneyto mean “wealth.” If youask, “How much money does Bill Gates have?” the answer will be something like,“Oh, $40 billion or so, but who’s counting?” That is, the number will include thevalue of the stocks, bonds, real estate, and other assets he owns.