Central Banking and the Money Supply

WHEN FIAT MONEY is not the only form of money, the monetary authority may wish to regulate money-creating institutions in order to control the total stock of money or to enhance revenue from seigniorage. To meet these ends, the monetary authority, which now may also be called a central bank, generally has two tools at its disposal—reserve requirements and loans to banks—in addition to its ability to print fiat money. In this chapter, we study the effects of each. We also ask in this chapter and the next whether control of the total money stock is always a worthwhile objective of the monetary authority. Legal Restrictions on Financial Intermediation Financial intermediation allows privately created assets to serve as money. One consequence of permitting unfettered intermediation is that if intermediation is not too costly to use and operate, people may choose to use inside money instead of fiat money. This will occur if the rate of return of inside money—net of transaction costs—exceeds that of government-created fiat money. If people prefer inside money to fiat money for every use of money, fiat money will lose its value. This would have two effects: First, prices would have to be expressed in some other unit of account. Second, the government would be unable to raise any revenue from seigniorage. If the government still wishes to maintain fiat money as a unit of account or a means of revenue, it must force people to hold fiat money.