The Monetary System: What It Is and How It Works
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There have been three great inventions since the beginning of time: fire, the wheel, and central banking.
—Will Rogers
The two arms of macroeconomic policy are monetary and fiscal policy. Fiscal policy encompasses the government’s decisions about spending and taxation, as we saw in the previous chapter. Monetary policy refers to decisions about the nation’s system of coin, currency, and banking. Fiscal policy is usually made by elected representatives, such as the U.S. Congress, British Parliament, or Japanese Diet. Monetary policy is made by central banks, which are typically set up by elected representatives but allowed to operate independently. Examples include the U.S. Federal Reserve, the Bank of England, and the Bank of Japan. Will Rogers was exaggerating when he said that central banking was one of the three greatest inventions of all time, but he was right in implying that these policymaking institutions have a great influence over the lives and livelihoods of citizens of all nations around the world.
Much of this book is aimed at explaining the effects and proper role of monetary and fiscal policy. This chapter begins our analysis of monetary policy. We address three related questions. First, what is money? Second, what is the role of a nation’s banking system in determining the amount of money in the economy? Third, how does a nation’s central bank influence the banking system and the money supply?
This chapter’s introduction to the monetary system provides the foundation for understanding monetary policy. In the next chapter, consistent with the long-
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