In this section we ask two main questions:
(1) How is paper money issued? and
(2) What determines its value?
These two questions lead to several related questions: What causes inflation and deflation? How does a
central bank operate? How is money related to recession and unemployment? These are vital questions.
Most economists agree that mismanagement of the money supply is a major cause of both inflation and
recession. Recessions are especially harmful, as anyone who remembers the Great Depression of the 1930’s
can attest. Between 1929 and 1933, real output fell by a third, and unemployment reached 25%.
Inflation, while not as devastating as a recession, is also dangerous. At the end of World War I in 1919,
the exchange value of the German mark stood at 14 marks to the dollar. By November of 1923, inflation
had raised the exchange rate to 4
marks per dollar. Hitler's Munich beer-hall putsch occurred in the
same month. In Russia, a similar hyperinflation was followed by the rise of communism. Inflation was
obviously not the only culprit behind these upheavals. One could argue that inflation and revolution were
both caused by the breakdown of the government. Nevertheless, the harmful effects of inflation are
undeniable: Savings lose their value; borrowers get to pay off their debts in inflated currency, gaining at the
expense of lenders, and buyers and sellers must both endure the inconvenience of unstable prices.
In most countries, the money supply is managed by a government-run central bank. In America, this
central bank is called the Federal Reserve. With the notable exception of the Great Depression, the Federal
Reserve has avoided the kinds of catastrophic monetary crises that have struck many other countries.
Inflation and recession have been kept within tolerable levels. Still, businessmen pay close attention to the
actions of the Federal Reserve (the "Fed") because experience has taught them that if the Fed's monetary
policy is too "tight" then a recession is likely to follow. Similarly, if the Fed's monetary policy is too
"easy", they will expect inflation.
Early Paper Money
Paper money is probably as old as paper itself. Imagine some ancient shopper who wanted to buy a loaf
of bread from a baker, but found to her surprise that she had no coins in her purse. If the baker knew her to
be a reliable person who paid her bills, he would very likely be willing to sell her the bread on credit. The
shopper could then write out a piece of paper that said "I owe you 1 oz. of silver coins", or something to
that effect. The baker would then put the shopper's IOU in his cash box and keep it until the shopper
brought in the coins she had promised.
Now suppose that the baker needs to buy a bag of flour from the miller. But when the baker reaches into
his cash box to get coins to pay the miller, he finds he does not have enough coins. Looking a little further,
he notices the shopper's IOU. If he is lucky, the miller might know the shopper. "Tell you what.", says the
miller, "Pay me with the shopper's IOU that you have in your cash box. I live near her, and the next time I