The Monetary Policy: A Catalyst for Economic Growth

Monetary policy, a cornerstone of macroeconomic management, plays a pivotal role in shaping the trajectory of economic growth. It is a tool wielded by central banks to influence the money supply, interest rates, and ultimately, the economy's overall health. In a world where nations grapple with inflation, recessionary pressures, and global market volatility, the nuances of monetary policy have never been more critical.

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Understanding Monetary Policy

Monetary policy operates through two primary mechanisms: expansionary and contractionary policies. Expansionary policies, aimed at stimulating economic growth, involve lowering interest rates and increasing money supply to encourage borrowing, investment, and consumption. Conversely, contractionary policies seek to temper inflation by tightening the money supply and raising interest rates.

These mechanisms, while conceptually straightforward, wield a profound influence on economic growth. Their effectiveness, however, is contingent upon factors such as fiscal policy alignment, consumer confidence, and external economic conditions.

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The Direct Impacts on Economic Growth

1. Investment and Borrowing
   Lower interest rates, a hallmark of expansionary monetary policy, reduce the cost of borrowing for businesses and individuals. This encourages investment in capital projects, infrastructure, and technology—critical drivers of economic growth. For instance, during the global financial crisis of 2008, many central banks, including the Federal Reserve, slashed interest rates to near-zero levels, fueling investments to stabilize and stimulate the economy.

2. Consumption Dynamics
   When borrowing becomes cheaper, consumer spending typically rises. Increased demand drives production, creates jobs, and fosters a virtuous cycle of growth. However, if consumer confidence wanes, even low interest rates may fail to achieve the desired stimulus, as observed during pandemic-induced uncertainties in 2020.

3. Inflation Control
   While monetary policy is vital for growth, unchecked expansionary policies can lead to inflationary spirals, eroding purchasing power. Contractionary policies, by contrast, aim to stabilize prices, ensuring sustainable long-term growth. Striking the right balance between these objectives remains a complex but essential task for central banks.

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Transitioning Through Economic Cycles

The relationship between monetary policy and economic growth is particularly evident during economic transitions. In periods of recession, expansionary policies act as lifelines, fostering recovery. During booms, contractionary policies help prevent overheating by controlling inflation and maintaining macroeconomic stability.

Take, for example, the monetary tightening in the United States in 2022–2023. Faced with soaring post-pandemic inflation, the Federal Reserve aggressively raised interest rates to combat price pressures. While this slowed certain sectors, the broader goal was to stabilize the economy and lay the groundwork for sustainable growth.

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Challenges and Limitations

Despite its potential, monetary policy is not a panacea. Structural economic issues, geopolitical risks, and global interdependencies can dilute its impact. Emerging markets, for instance, often struggle with the "trilemma"—managing monetary autonomy, exchange rate stability, and capital flows simultaneously.

Moreover, prolonged reliance on monetary tools can lead to asset bubbles, excessive debt, and distorted market dynamics. Central banks must navigate these challenges with precision, often adjusting policies in real-time based on evolving economic indicators.

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The Role of Central Banks

Central banks, such as the European Central Bank (ECB) or the Bank of Russia, wield significant power in directing monetary policy. Their independence from political influence is crucial for maintaining credibility and effectiveness. Transparent communication, often in the form of forward guidance, ensures that businesses and consumers can make informed decisions in anticipation of policy shifts.

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The Road Ahead

As economies adapt to 21st-century challenges—digital transformation, climate change, and shifting demographics—the role of monetary policy in fostering growth is evolving. Central banks are increasingly incorporating non-traditional tools, such as quantitative easing or green finance initiatives, to address these emerging dynamics.

However, for monetary policy to truly catalyze economic growth, it must operate in tandem with robust fiscal policies, structural reforms, and international cooperation. The interconnectedness of global markets demands coordinated efforts to navigate shared challenges and leverage opportunities for collective prosperity.

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Conclusion

Monetary policy is more than just a mechanism to regulate money supply and interest rates—it is a dynamic and powerful tool that shapes the contours of economic growth. Its success lies in its adaptability, precision, and integration with broader economic strategies.

In an era marked by rapid changes and uncertainties, the ability of central banks to deploy monetary policy effectively will determine not only the resilience of economies but also their capacity for innovation, inclusivity, and sustainable growth. The stakes are high, but so are the opportunities for transformative impact.

Mexican peso crisis of 1994

The sharp depreciation of the Mexican peso in December 1994 marked one of the swiftest macroeconomic reversals in the history of developing economies and currency crises. President Ernesto Zedillo had barely been in office three weeks when, on December 19, 1994, his administration asked the Banco de Mexico to undertake roughly 15 percent devaluation of the peso, adjusting the pegged exchange rate from 3.45 pesos per dollar to 4.00 pesos per dollar (Sharma, 2001). It was a modest devaluation, but it undercut the confidence of foreign investors and touched off a wild speculative run against the peso. On December 22, 1994, the Banco of Mexico, unable to defend the peso against stampeding, panic-stricken foreign investors, allowed the peso to float. The peso immediately sank another 15 percent (Sharma, 2001). By February 16, 1995, the peso had depreciated 42 percent against the U.S. dollar (Torres, February 1995). The peso reached its nadir at 7.65 pesos per U.S. dollar (Sharma, 2001).

The outgoing President Carlos Salinas and the soon-to-be President Zedillo met on November 20, 1994, to discuss the currency situation. The Friday before, Mexico had lost $1.7 billion in a run on the peso. The two leaders agreed that devaluation on the order of 10 percent was needed, but the outgoing officials refused to devalue the currency on their watch (Wessel, July 1995).

The peso crisis caught many observers and investors by surprise. Mexico had become the darling of Wall Street. Mexico’s economic policy seemed to have all the right ingredients. It emphasized privatization and deregulation of state-owned enterprises, restrictive monetary and fiscal policies, and a pegged exchange rate relative to the U.S. dollar. The ratification of the North American Free Trade Agreement (NAFTA) in January 1994 opened Mexico’s economy to the largest consumer market in the world. Between 1989 and 1994, Mexico’s gross domestic product (GDP) growth averaged 3.9 percent (Sharma, 2001). Mexico’s inflation rate, which raged as high as 160 percent in 1987, sank to single-digit territory in 1993 (Sharma, 2001). Government indebtedness as a percent of GDP shrank from 15 percent in 1987 to 1 percent in 1992 and 1993 (Sharma, 2001). Between 1987 and 1994, government spending as a percent of GDP shriveled from 44 percent to 24.6 per cent (Sharma, 2001). In February 1994, Mexico’s foreign exchange reserves stood at $28 billion, well above the $6.3 billion level held in 1989 (Sharma, 2001). With the dawn of NAFTA, Wall Street saw no limits to Mexico’s potential.

In hindsight, one economic statistic signaled trouble. Mexico’s current account deficit steadily climbed from $6 billion in 1989 to $20 billion by the end of 1993 (Sharma, 2001). Mexico’s imports were growing much faster than its exports. Current account deficits reflect either a high level of government deficit spending, high levels of private investment spending relative to savings, or some combination. In 1994, government deficit spending in Mexico was minimal, and the high level of private investment spending seemed to reflect Mexico’s bright future under NAFTA. Foreign portfolio investments in Mexican stocks and short-term bonds made possible the high level of investment spending. It also left Mexico vulnerable to a sudden outflow of foreign capital.

In 1994, foreign investors began to get jittery over the size of Mexico’s current account deficit. Mexico tamed inflation, but did not eradicate it. Under a pegged exchange rate, inflation increases the prices of domestic goods, but does not affect the price of imported foreign goods unless the peg is adjusted. Mexico failed to adjust the pegged exchange rate to compensate for domestic inflation, encouraging Mexico’s consumers to purchase more imported goods at the expense of domestically produced goods. As long as foreigners exhibited a strong appetite for Mexican stocks and bonds, the Mexican government felt no pressure to devalue its currency. The peso appeared to be in high demand at the current exchange rate.

In 1994, the strong foreign demand for portfolio investments in Mexico began to diminish over worries about Mexico’s rising current account deficit. Rising current account deficits often lead to a devaluation of a currency. If a currency depreciates 25 percent, foreign investors immediately see the value of their investment depreciate by 25 percent.

Part of the attraction of Mexican stocks and bonds had to do with low interest rates in the United States. Throughout 1993, the U.S. federal funds rate remained at 3 percent. In 1994, the Federal Reserve System started raising the federal funds rate, pushing it up to 5.5 percent by November 1994 (Sharma, 2001). As interest rates rose in the United States, investors became less willing to chase higher interest rates in developing countries and emerging markets. When the Mexican government announced a devaluation of the peso in December 1994, foreign investors decided it was time to get out of Mexico.

After the peso crisis, Mexico’s economy sank into steep recession. Inflation soared as devaluation lifted the prices of imported goods. In the United States, President Bill Clinton put together a nearly $50 billion rescue package (Greenwald and Carney, 1995). Without the rescue package, the Mexican government would have defaulted on a large amount of dollar-denominated government bonds. (In 1994, the Mexican government had started issuing dollar-denomniated bonds to ease investor fears about devaluation of the peso.) The rescue package helped calm markets and limited the damage inflicted on other Latin American countries.

See also: East Asian Financial Crisis, Currency Crises

Mughal Coinage

The Mughal emperor Jahangir (1605–1627) wrote in his diary of his new coinage bearing signs of the zodiac:

Previous to this the rule of the coinage was that on the face of the metal they stamped my name, and on the reverse side the name of the place and the year of the reign. At this time, it entered my mind that in the place of the month they should substitute the figure of the constellation which belonged to that month.

(Williams, 1997)

One of Jahangir’s coins bore a resemblance to himself with a cup of wine in his hands, a significant departure from Islamic coinage practice.

Evidence of Indian coinage prior to Alexander the Great’s invasion (329–325 b.c.) is scanty, but Indian coinage may have appeared soon after the invention of coinage in Lydia. Whatever the date, early Indian coinage seems to follow Greek models, and Alexander can be credited with spreading the techniques of Greek coinage in India. Indian coinage spread eastward in the wake of Indian culture and religion, and by the thirteenth century could be seen as far away as Indonesia and the Philippines.

In the sixteenth century the Mughals descended upon India from the northwest, establishing an Islamic kingdom. Under Islam a new ruler could expect to have his name mentioned at the daily Mosque prayers, and have the privilege to issue coinage bearing his name.

The money of account of the Mughals was the silver rupee, which also dates back to sixteenth-century India. To be accepted as money, coins had to bear the name of the current Mughal emperor, a custom that persisted even after the Mughal emperor existed in name only and the Mughal empire had splintered into autonomous kingdoms. Roughly 300 types of rupee circulated when the British reformed India’s currency and standardized the rupee early in the nineteenth century.

Under the Mughal system moneychangers, called shroffs, played a prominent and necessary role in monetary transactions. All large transactions required the presence of shroffs to count each coin and assign discounts according the wear of each coin and the time and location that each was struck.

Late in the eighteenth century the British introduced mechanical coinage into India. Mechanical coinage had been universal in Europe since 1700. In 1835 the British reformed India’s currency and standardized the rupee, ending the multitude of rupees and the need for shroffs. The British continued the practice of issuing coins in the name of the Mughal emperor, a necessary condition to make coins acceptable. Under the prestigious influence of the British Empire, the rupee became the standard unit of currency in the Persian Gulf and southern Arabia, and spread as far south as British East Africa, and Natal in South Africa.

Mosaic Silver Standard

The Law of Moses makes numerous references to the silver shekel as means of payment. The twenty-seventh chapter of Leviticus describes monetary substitutes that could free a person dedicated to the service of the Lord. It reads:

The Lord said to Moses, Say to the people of Israel, When a man makes a special vow of persons to the Lord at your valuation, then your valuation of a male from twenty years old up to sixty years old shall be fifty shekels of silver, according to the shekel of the sanctuary. If the person is a female, your valuation shall be thirty shekels. If the person is from five years old up to twenty years old, your valuation shall be for a male twenty shekels, and for a female ten shekels. If the person is from a month old up to five years old, your valuation shall be for a male five shekels of silver, and for a female your valuation shall be three shekels. And if the person is sixty years old and upward, then your valuation for a male shall be fifteen shekels, and for a female ten shekels…. If a man dedicates to the Lord part of the land which is his by inheritance, then your valuation shall be according to the seed for it; a sowing of a homer of barley shall be valued at fifty shekels of silver.

Later in the Book of Leviticus guilt offerings were also defined in shekels of silver.

Although the Ancient Hebrews held gold in high esteem for religious purposes, they did not use it as a type of money. The book of Leviticus gives detailed accounts of the use of gold for religious ornamentation, describing altars overlaid with gold, and a plate of pure gold fastened on Aaron’s turban, engraved with the words “Holy to the Lord.”

Silver probably replaced livestock as a form of money among the early Hebrews. The ancient Hebraic word for “lamb,” kesitah, appears in the Old Testament in contexts that indicate it was a monetary unit. The kesitah was probably a weight of silver equivalent to the price of a lamb, though it could have been a coin bearing the image of a sheep. The latter is an unlikely possibility because the Hebrews adopted coinage relatively late. The ancient Hebraic word for “livestock,” mikhne, also meant “purchase,” lending more credence to the theory that the early Hebrews had a sheep or lamb standard.

The Old Testament throws some light on the religious aspect of the origin of money. Before governments replaced tribes as the principal source of authority, religious authorities were the most able to sanction a commodity as a medium of exchange.

Montesquieu

Charles Louis de Secondat, Baron de La Brede et de Montesquieu, wrote one of the most famous books in history, The Spirit of Laws (1748), in which he touched on the role of money in shaping laws.

Montesquieu’s book appears on every list of great books. The lessor-known full title of the book, almost rivaling Montesquieu’s modest name, was On the Spirit of Laws, or On the Relations Which Must Exist between the Laws and the Constitution of Each Government, the Manners, Climate, Religion, Commerce, etc. The book proposed to demonstrate that the character and tendency of laws (the spirit of laws) owed their origin first to climate and geography, and then to the physiology, economy, government, religion, morals, and manners of the people. The framers of the American Constitution copiously quoted The Spirit of Laws in their writings. Catherine the Great of Russia thought The Spirit of Laws should be “the breviary of sovereigns,” and expected those helping revise Russia’s laws to read extracts that she furnished.

Montesquieu briefly addressed the subject of money and how the evolution of money influences the civil laws of a people. His inquiry led him to these conclusions:

When a people have not the use of money, they are seldom acquainted with any other injustice than that which arises from violence; and the weak by uniting, defend themselves from its effects. They have nothing there but political regulations. But where money is established, they are subject to that injustice which proceeds from craft—an injustice that may be exercised in a thousand ways. Hence they are forced to have good civil laws, which spring up with the new practices of iniquity.

In countries where they have no specie, the robber takes only bare moveables, which have not

mutual resemblance. But where they make use of money, the robber takes the signs, and these always resemble each other. In the former nothing can be concealed, because the robber takes along with him the proofs of his conviction; but in the latter it is quite the contrary.

… The greatest security of the liberties of a people who do not cultivate the earth is their not knowing the use of money. What is gained by hunting, fishing, or keeping herds of cattle cannot be assembled in such great quantity, nor be sufficiently preserved, for one man to find himself in a condition to corrupt many others: but when, instead of this, a man has a sign of riches, he may obtain a large quantity of these signs, and distribute them as he pleases.

The people who have no money have but few wants; and these are supplied with ease, and in an equal manner. Equality is then unavoidable; and hence it proceeds that their chiefs are not despotic.

Unlike a modern monetary theorist, Montesquieu was concerned with the deeper social and anthropological significance of money, and suggests that the innovation of money contributes to social inequality, a theme that can be heard in the most ancient literature on the subject. He does not seem quite willing to give the innovation of money a ringing endorsement. In another section of his work, however, he says, “Should you ever happen to be cast by some adventure among an unknown people; Upon seeing a piece of money you may be assured that you have arrived in a civilized country. The culture of lands requires the use of money.”

Moneyer

Before the mechanization of coinage mints were staffed by moneyers, who physically struck the coins. In England at least, moneyers seemed to have owned their own tools. In 1484 Robert Hart, an English moneyer, bequeathed to his apprentice “my anvil, 4 hammers, a mallet, a pair of tongs, an hamnekyn, and 2 pairs of shears.”

Moneyer as an organized trade or skill stretches back to the ancient world. In the Roman Empire moneyers were members of a hereditary profession, recruited mainly from families holding high positions in government. A member of the moneyer caste could not resign without furnishing someone to take his place. In Rome, as in later societies, trust and character were an important qualification for the profession of moneyer. The same skills that allowed a moneyer to strike coins meeting official specifications could be put to work to forge counterfeit coins, or to debase official coinage at a secret profit to the moneyer.

English moneyers organized themselves into a company or guild and elected a leader, the provost, who could call a meeting of the moneyers at any time and impose mild disciplinary penalties. New recruits to the company had to serve as apprentices for seven years and take an oath to serve the company and the Crown loyally. The warden of the mint paid the provost, who in turned paid individual moneyers. Mints lay idle portions of the year and moneyers came to work only when the mint was in operation. The most important mint in medieval England was the Tower mint, and moneyers from the Tower mint were assigned to local mints in other parts of England. A few localities provided housing for moneyers while they were engaged at the mint. Some of the moneyers worked for goldsmiths when the mint lay idle, and judging from their debts, moneyers were not poor people.

Codes of law in medieval England regulated the conduct of moneyers. One provision stipulated that a moneyer found guilty of issuing debased or light coin should have the offending hand severed and fastened to the mint. Although the profits from forgery were high, the risks were also substantial. At Christmas in 1124 Henry III summoned all moneyers to Winchester, where, according to the Anglo-Saxon Chronicle, within a period of 12 nights all were mutilated. According to the Margam Annals, 94 were punished. By the close of Henry’s reign 19 out of 30 mints had shut down, probably because of a shortage of moneyers.

In the seventeenth century mechanization began to replace the moneyers. Moneyers were now supervisors who oversaw the work of laborers operating machinery. The term moneyer does not seem to have been used in the United States. It was still applied to English mint workers into the nineteenth century, but it fell into disuse in the twentieth century. Today there are no craftsmen working at mints who bear the title “moneyer.”

Money Superstitions

Various sorts of money, particularly in the Far East, have been thought to possess special powers, bringing good luck or ill, sometimes associated with meaningful inscriptions. Zhouyuan tongbao coins, tenth-century Chinese coins struck from bronze, purportedly possessed the power to cure illness and aid in childbirth. These coins may have owed some of their alleged special powers to the bronze statues taken from over 3,000 Buddhist temples to furnish the bronze for the mint. The inscription on these coins read, “everywhere—new beginning, circulating treasure.”

The Chinese also made coin swords by tying coins to an iron rod. These swords were supposed to drive away illness and evil spirits. To make coin swords the Chinese favored coins issued by the Kangxi emperor (1662–1723). This emperor reigned a full 60 years, and his name came to be associated with good health. His grandson, Qianlong, also reigned as emperor for 60 years, and his coins, the Qianlong tongbao coins, were also in demand to fashion sword coins.

The Chinese were also prone to bury coins with the dead for use in the afterlife, a practice condemned by the government. The Chinese went so far as to issue “hell notes,” paper money to be buried with the dead to pay for necessities in the next life. The Hong Kong Chinese still print up imitation paper money in the form of notes issued by the Bank of Hell, at least some of which are denominated in “dollars,” and millions of these notes are burnt at the Chinese New Year. Even checks are written on the Bank of Hell to honor ancestors.

Money Market Mutual Fund Accounts

Money market mutual fund accounts (MMMFA) arose during the 1970s as a financial innovation designed to circumvent Regulation Q, a federal rule that limited the interest rate payable on checking and savings accounts to less than 6 percent.

The high inflation rates of the 1970s put unreasonably low government ceilings on checking and savings account interest rates. Ninety-day treasury bills were exempt from interest rate ceilings, but these bills were only available in denominations of $10,000, outside the reach of the small saver. Other large denomination financial instruments, such as commercial paper and banker’s acceptances, were also inaccessible to small savers.

Mutual funds raise capital by selling shares to investors, and invest the capital in an array of assets. They distribute the income from these investments to shareholders, minus management and other fees. Money market mutual funds sell shares to investors, but the value of shares is manipulated to remain at a fixed amount, such as $1 per share. The proceeds from the sale of shares are invested only in safe, short-term assets, such as U.S. treasury bills, giving small savers access to the high earnings of the high-denomination assets.

Small savers can often open a MMMFA with a small investment, maybe as little as $500 but usually between $2,000 and $4,000. As long as a minimum investment is maintained, the shareholder of a MMMFA enjoys limited check-writing privileges, generally in minimum amounts of $500 against their share holdings. A MMMFA is technically not a deposit subject to the regulations of a depository institution, but the accounts are managed to act as a deposit with check-writing privileges. Although an MMMFA cannot boast of the safety of deposits insured by the Federal Depository Insurance Corporation (FDIC), MMMFAs often invest a high proportion of their capital in U.S. treasury bills, giving them the same guarantee of the federal government as deposit insurance.

With check-writing privileges, MMMFAs began to serve same purposes as checking accounts, an important component of the money supply. Between 1976 and 1992 MMMFAs grew from $2.4 billion to $360 billion, due to the movement of deposits from checking and savings accounts. The Federal Reserve System includes MMMFA accounts in M2, a monetary aggregate economists often consider the best operational definition of the money supply.

On 14 December 1982 banks received authorization to offer money market deposit accounts (MMDAs), which offer depositors comparable interest rates on assets similar to MMMFAs and have the added advantage of protection from the FDIC. At first MMDAs grew rapidly at the expense of MMMFAs, and the depository institutions regained ground lost to MMMFAs. By the 1990s MMMFAs had established themselves as an important monetary asset, but the volume of MMMFAs remained below the volume of the MMDAs.

Monetary Unions of Ancient Greece

In the ancient Greek world groups of smaller cities that had common trading interests and were too small to support individual mints formed monetary unions. These unions minted coins that were legal tender in all the member cities, which also split the profits from the coinage. These union coins might be struck in one federal mint, or several member cities might operate mints that shared in minting the union coinage. Often one side of these union coins bore a common symbol of the monetary union and the reverse side bore a symbol of the city where the coin was issued. Coins issued at different mints under the authority of a monetary union possessed a uniform weight and purity. These coins served as an international currency in their trading area, restricting the need for moneychangers, and avoiding the business hazards of fluctuations in foreign currency markets.

A monetary convention between Phocea and Mitylene, adopted around 400 b.c., represents one of the few agreements for a monetary union whose details survived for our inspection. The prerogative for striking coins alternated between each city on an annual basis. Each year one city closed its mint while the mint in the other city met the need for coins that year. These cities agreed to issue electrum coins identical in weight and purity, but without a uniform emblem, and the coins from either mint were legal tender in both cities.

At the end of the fifth century a group of towns and tribes on the western coast of Greece formed a monetary union, but knowledge of this union is limited to what can be gathered from the coins. Its coins were based on the silver stater of Corinth, a popular coin in the trading area around Italy and Sicily, and its coins bore identical images; a head of Athena on the obverse side, and Pegasus on the reverse side. This union thrived until the second century b.c. when the Roman invasion put an end to it.

The cities of Boeotia, north of Attica, joined into a monetary union that lasted from early times until the coming of Rome. The union began coining silver and later added a uniform bronze coinage. Although struck at different mints, the coins were uniform in weight and purity, and bore on the obverse side a badge that represented the union and on the reverse side a symbol of the city of origin.

One of the largest of the monetary unions federated as many as 43 cities at one time, including Corinth, Argos, and Lacedaemon. Its silver coins dominated trade within the Peloponnese from 280 b.c. to 146 b.c. when the area became a Roman province.

These unions were sometimes the by-products of military alliances. Mobilization of an army always created a demand for coinage, and armies were instrumental in spreading coinage. Also, cities that patronized the same religious temples, or sacred games and festivals, were more likely to issue a federated currency that supported shared activities.

The strengths of a monetary union remain very real in areas such as Europe, where small but sophisticated economies function in close geographical proximity. In 1998 the European Monetary Union planned the final step toward monetary unification with the introduction of a single European currency.

Monetary Theory

Monetary theory, an important subarea of macroeconomics, proposes to explain the relationship between the money stock and the macroeconomic system. Macroeconomics is the part of economics concerned with the economy as a whole, as opposed to individual industries or sectors. Fluctuations in the economy as a whole, that is, in aggregate output, cause fluctuations in the unemployment rate, interest rates, and average prices.

Monetary theory analyses the role of money in the macroeconomic system in terms of the demand for money, supply of money, and the natural tendency of the economic system to adjust to a point that balances the supply and demand for money, a point that is called monetary equilibrium. One sector of the macroeconomic system is conceived as the monetary sector, and the monetary sector has a natural tendency to converge to monetary equilibrium.

A phenomenon such as inflation can be attributed to an excess of the supply of money relative to the demand. Excess money supply causes the value of money to drop, which manifests itself as higher prices, causing each unit of money to buy less. A stock market crash can be attributed to an excess demand for money relative to supply, causing stockholders to sell stocks to raise money. Theoretically, the macroeconomic system converges to equilibrium and one necessary condition for macroeconomic equilibrium is monetary equilibrium.

Monetary theory usually assumes as a rough approximation that the money supply is fixed by monetary authorities, and can be changed as necessary for the public’s interest. The demand for money, however, is outside the control of public officials and is a function of other economic variables, particularly aggregate income, interest rates, the price level, and inflation. Aggregate income determines the amount of money households and businesses plan to spend in the near future. Households and businesses hold money because they plan to buy things in the near future.

Money holdings of households and businesses that will not be needed for purchases in the near future may be invested in long-term assets (stocks and bonds) that earn income. Money holdings earn little or no income. When money holdings are used to purchase stocks and bonds, the demand for money decreases, and the demand for stocks and bonds increases. Rising interest rates decrease money demand as money holdings are drawn into the purchase of bonds. Falling interest rates cause bonds to become less attractive, raising the demand for money.

Like rising interest rates, inflation means that money can be put to better use in other places, perhaps in the purchase of gold, silver, or real estate. Inflation reduces the demand for money, but deflation makes hoarding money an attractive investment, increasing the demand for money. Higher price levels, however, will eventually increase the demand for money, as money is needed to finance more costly transactions. Inflation reduces the demand for money at first, but when the inflation ceases, the demand for money will level out at a higher level than existed before the inflation started.

When monetary authorities change the money supply, the macroeconomic system adjusts to bring the demand for money in line with the supply of money. If the money supply is increased while the economy is in a recession, the extra money will probably flow into the stock and bond markets, stimulating business. As the economy expands, income grows, and the demand for money grows, catching up with the supply of money and restoring monetary equilibrium. If the money supply is increased while the economy is at full employment, the extra money will cause an increase in the demand for goods relative to supply. Prices will go up until the real (inflation adjusted) value of the money supply has fallen sufficiently to stop the inflation.

Monetary theory supplies the theoretical foundation for monetary policy, which has to do with the regulation of the money supply growth rate. Economists disagree as to whether the money supply growth rate should be speeded up and slowed down to meet the apparent needs of the economy, or whether the money supply growth rate should remain at a fixed amount, probably between 3 and 5 percent per year. Many contemporary economists argue that a fixed money supply growth rate is the best guard against inflation and economic instability.

Monetary Law of 1803 (France)

The French Monetary Law of 1803 ratified the franc as the French money of account and established France on a bimetallic system.

From the Carolingian monetary reform in the eighth century until the French Revolution, the livre was the money of account in France. Under the Carolingian system each livre consisted of 20 sols, and each sol consisted of 12 deniers. These basic provisions of the Law of 1803 were first passed in Calonne’s law of 1785, named after a comptroller general of French finances. The chaos of revolution disrupted the implementation of Calonne’s law, but on 7 October 1793 France acted on the precedent set by the United States and Russia, and established a decimal monetary system. In 1795 the French revolutionary government changed the name of the money of account from livre, to franc. In 1799 the terms franc, dixieme, and centime replaced livres, sols, and deniers as the official units required in accounting.

The Law of 1803 fixed in law the provisions of Calonne’s law, based upon a decimal monetary system with the franc as the French monetary unit. The franc had two legal equivalents, one in silver and the other in gold. The law declared that “Five grams of silver, nine-tenths fine, constitute the monetary unit, which retains the name of franc.” The law also provided that the mint strike silver coins in denominations of a quarter franc, half franc, three-quarter franc, 1 franc, 2 francs, and 5 francs.

After declaring the specifications and denominations of the silver franc, the law stated that “There shall be coined gold pieces of twenty francs and of 40 francs.” The 20-franc Napoleon coin weighed 6.45 grams, making a gold franc equal to 0.3225 grams of gold. The defined metal contents of the silver franc and the gold franc established a bimetallic system in which a gram of gold was 15.5 times as valuable as a gram of silver.

Both gold and silver coins were legal tender, and unlike the old livres each coin bore a stamp of its value. Anyone, including a foreigner, was free to bring gold and silver to French mints for coinage. The law specified that:

The expense of coinage alone can be required of those who shall bring material of gold and silver to the Mint. These charges are fixed at nine francs per kilogramme of gold, and at three francs per kilogramme of silver. When the material shall be below the monetary standard, it shall bear the charges of refining or of separation.

(Laughlin, 1968)

Just as England became the headquarters for the gold standard during the nineteenth century, France became the staunch defender of bimetallism. A bimetallic ratio of between 15 and 16 to 1 continued until the 1870s when the value of silver began to fall significantly, forcing France and other bimetallic countries in Europe off the bimetallic standard in favor of the gold standard. The United States abandoned bimetallism in favor of the gold standard during the same period.

Monetary Multiplier

The monetary multiplier shows the multiple by which the money stock can expand given an initial infusion of fresh funds into the banking system.

A central bank, such as the Federal Reserve System, can infuse additional funds into commercial banks by purchasing government bonds owned by commercial banks or commercial bank customers. The central bank can also loan funds to commercial banks, but purchasing bonds has a more permanent impact.

A customer of a commercial bank sells a bond to the Federal Reserve System, taking the proceeds of the sale and depositing it in an account at the commercial bank. Under a fractional reserve system of banking, the commercial bank has to hold only a fraction of the new deposit, say 20 percent if the legal reserve ratio is 20 percent, and the remainder the commercial bank can lend to a borrowing customer. Whatever amount is loaned out is likely to be deposited in either the bank making the loan, or more likely, in another bank. The bank that receives this second deposit originating from the bank loan only has to keep a fraction of the new deposit, and can lend the remainder. Therefore a second loan will be made.

The customer that first sold a bond to the Federal Reserve System still has the proceeds of that sale in the form of a bank deposit, and two subsequent bank deposits have been created, causing a magnified expansion of the money supply, the bulk of which is bank deposits. The expansionary process will continue, as the proceeds of a second loan will, in all probability, land in a bank deposit, giving another bank a new deposit from which it can make a loan. Each bank that receives a new deposit must hold a fraction of the new deposits as reserves, and may lend the remainder.

Because each subsequent new deposit is smaller than the previous new deposit, the cumulative expansion of new deposits slows to a halt. The monetary multiplier shows how far bank deposits could theoretically expand under ideal conditions. If the monetary multiplier is five, then an initial infusion of $1,000 of fresh funds into commercial banks could lead to a maximum expansion of bank deposits of $5,000.

The simplest monetary multiplier is calculated by taking the reciprocal of the legal reserve ratio. A legal reserve ratio of 20 percent produces a monetary multiplier of five. This simplest multiplier ignores the possibility that banks may purposely maintain a reserve ratio above the legal reserve ratio, or that some funds loaned out by a bank may leak into circulation, never to be deposited in another bank. In practice the actual monetary multiplier will be less than the theoretical monetary multiplier based only on the legal reserve ratio.

More complicated multipliers incorporate a currency to deposit ratio to adjust for the leakage of cash into circulation.

The funds that the Federal Reserve System injects into commercial banks is sometimes called high-powered money, because a series of commercial banks making loans will multiply that initial injection of funds into a much larger money stock increase. The monetary multiplier also shows that the money supply is not entirely in the hands of the Federal Reserve System, but expands and contracts with the eagerness of commercial banks to make loans, giving the commercial banks as much influence on the money supply as the printing presses at the Bureau of Engraving.

Monetary Aggregates

Monetary aggregates measure the money stock, which is defined as the sum of highly liquid assets that serve either as a medium of exchange, standard of value, or a store of value. Money supply measures in terms of monetary aggregates are necessary because many assets serve the same purpose as currency; for example, checking accounts, savings accounts, etc. Therefore, operational measures of the money stock must take these assets into consideration.

In the United States the monetary aggregate denoted M1 is the most narrowly defined measure of the money stock, and a broader measure, denoted M2, includes everything in M1 plus additional assets. M3 is even a broader measure, including everything in M1 and M2 and more.

M1 includes all the currency not held by the Treasury, Federal Reserve Banks, foreign financial institutions, and commercial banks, plus an array of checkable deposits and travelers’ checks. Currency included in M1 is the currency circulating as a medium of exchange. Commercial bank vault cash is excluded because it is represented in depositors’ accounts, and summing the vault cash with customer checking accounts would be counting those funds twice. The largest share of checkable deposits are called demand deposits, because the bank owes that money to the depositor on demand, without prior notice or other conditions. Bank customers often call these accounts checking accounts. Another checkable account is the negotiable order of withdrawal (NOW) account, an interest-bearing account at thrift institutions that resembles a savings account but has checking privileges. Automatic transfer service (ATS) accounts, which automatically transfer funds from an interest-bearing savings account to a checking account as needed, are also included as checkable deposits in M1, as are Credit Union Share Drafts (CUSDs).

Checkable deposits owned by other depository institutions, the U.S. government, foreign banks, and other official institutions are excluded from M1. M1 therefore represents highly liquid assets acceptable as a medium of exchange. Often cash is preferred over checks for small transactions, but for large transactions checks are preferred over cash.

M2 includes everything in M1 plus small repurchase agreements (less than $100,000), money market deposit accounts and money market mutual fund accounts when minimum deposits are less than $50,000, and savings and small time deposits (less than $100,000). A repurchase agreement is an arrangement under which a commercial bank sells a government bond to a large depositor and agrees to buy it back at a higher price in the future, overnight in some cases. It is an underhanded means of paying interest, and grew into prominence when regulations forbade interest rate ceilings on checking accounts. Money market deposit accounts and money market mutual fund accounts require high minimum deposits, pay high interest, and allow only checks written above a certain amount, such as $500. M2 does not include deposits held in tax-exempt retirement accounts, or those owned by the federal government, foreign governments, or commercial banks. M2 embraces assets less liquid than the assets included in M1, but assets that can readily be converted into cash.

M3 includes everything in M2, but adds large repurchase agreements and time deposits, eurodollar accounts, large time deposits, and money market mutual fund accounts held by institutions. Eurodollar accounts are accounts owned by U.S. residents at foreign branches of U.S. banks worldwide, and all banking offices in Canada and the United Kingdom.

An even broader monetary aggregate is L. L includes everything in M3 plus short-term treasury bonds, commercial paper, U.S. savings bonds, and bankers’ acceptances. Commercial paper is an unsecured promise to pay. It is sold at a discount from a face value and matures in a short time, no more than nine months. Bankers’ acceptances, meaning a bank accepts (or guarantees) another firm’s promise to pay, provide short-term financing for commercial trade.

M3 and L are less liquid assets than M1 and M2, but they represent readily accessible purchasing power, and are therefore included in the broader definitions of money.

Monetarism

Monetarism is a school of macroeconomic theory emphasizing the causal role of the money stock in aggregate economic fluctuations, and holding that the key to aggregate economic stability lies with a steady, noncyclical growth path in the money supply. The aggregate economic system experiences upswings and downswings manifested in such statistics as the unemployment rate. These cyclical swings are a response to imbalances between the total demand for all goods and services relative to the total supply, as opposed to imbalances between supply and demand in individual markets, such as the market for automobiles.

According to monetarism, the aggregate economic system has strong intrinsic tendencies to gravitate toward a full-employment equilibrium, and these tendencies will assert themselves in the absence of shocks to the money stock growth rate. If the money stock growth rate is stable, the aggregate economic system will mirror that stability. Economists who adhere to the tenets of monetarism are called monetarists.

In policy terms monetarism means that central bank monetary policy should set target rates of growth of money stock measures, and rather single-mindedly pursue those targets. Keynesian monetary policy, the orthodox policy in the 1950s and 1960s, emphasized interest rates as a target of monetary policy, raising interest rates to slow down the economy and reducing interest rates to speed things up. Monetarists contended that the Keynesian policies took the focus off the money stock and replaced it with subjective ideas about what interest rates should be. According to monetarism financial markets should determine interest rate levels.

Monetarism rose to prominence in the 1970s as inflation began to eclipse unemployment as the most dreaded economic problem. Monetarists contended that the relationship between inflation and money stock growth was virtually a one-to-one relationship, and that money stock growth was feeding the inflation. Monetarists clung to the money stock theory as the sole explanation of inflation, excluding the possible role of government budget deficits, powerful unions, monopolistic corporations, harvest failures, and shortages of key raw materials.

Although restricted money stock growth seemed a plausible antidote against inflation, the first effects of restricted money stock growth were seen in rising unemployment rates rather than falling inflation rates, making the tactic a touchy matter in democratic societies subject to the moods of voters. A president no less conservative than Richard Nixon preferred to give wage and price controls a try rather than put the economy on a prolonged diet of restricted money stock growth.

The decade of the 1980s saw what might be called a monetarist experiment. The governments of Margaret Thatcher in the United Kingdom and President Reagan in the United States imposed strict monetarist policies of restricted money stock growth in an effort to break the back of double-digit inflation. In the United States the prime interest rate soared to 20 percent, and unemployment reached double-digit levels. Thatcher’s policies put the  

United Kingdom through similar rigors. The tight money policies put these economies through recessions deeper than any economic contraction since the 1930s.

Monetarist policies succeeded in bringing down inflation rates, and unemployment rates began to fall back, suggesting that monetarist policies were succeeding. Nevertheless, in October 1987 stock markets crashed in New York and London, and central banks began increasing money stock growth to reinflate world financial markets. Contrary to monetarists’ expectations the added money stock growth did not trigger another round of inflation. During the 1990s inflation has been less than expected based upon money stock growth, casting a bit of doubt on monetarism.

At the very least it can be said that monetarism brought a stoical quality to economic policy making that was needed to endure the pain of disinflating the economies of the world. Notwithstanding the departure in the 1990s from monetarist policies based upon strict, steady growth rates in money stocks, inflation rates have steadily subsided, perhaps reflecting the policy effects of new knowledge gained from the monetarists’ theoretical explorations.

Milled-Edge Coinage

A milled-edge coin has various forms of graining, ribbing, or serrulation around its circumference. In an Order of Council of May 1661 Charles II, king of England, set forth that all coin was to be struck as soon as possible by machinery, with grained or lettered edges, to stop clipping, cutting, and counterfeiting. As the order reveals, the motivation for the serrulated edges lay in the search for a means to discourage clippers, who removed bits of precious metal from the edges of coins, diminishing the metal content of coins without rendering them completely unacceptable in exchange. Hammered coins minted by hand produced coins of irregular shape that invited clipping.

Mechanized minting began in Italy, which may also have been the birthplace of the milled edge. Mechanized minting passed from Italy to France and Germany, and then to Spain and England. In 1553 Eloy Mestrell fled from Paris where he was engineer to the mint, and arrived in London, bringing knowledge of the methods of a horse-powered mill that turned out uniform blank coins, stamped with uniform images, and a milled-edge circumference. The machine for milling the edge made use of counterrotating hand screws. Mestrell’s coins that survived are of impressive quality, but he faced strong opposition from established moneyers. After an inquiry yielded adverse findings, Mistrell was relieved of his duties at the mint, and six years later he was hanged for counterfeiting.

The Paris mint again lost talent to London in 1625 when Nicholas Briot, chief engraver in Paris, left France out of frustration over the opposition of the established moneyers. Between 1631 and 1640 Briot minted silver coins with milled edges, but hammered coins still dominated English coinage. In 1649 Pierre Blondeau, an engineer from the Paris mint, arrived in London. Blondeau had developed an inexpensive and practical method of producing the milled edge, prompting Louis III of France to ban the minting of hammered coins in 1639. In England Blondeau minted a token quantity of milled-edge coins. Apparently, both Briot and Blondeau returned to France after the Commonwealth government refused to progress beyond the experimental stage with the new methods of coinage.

After the Restoration returned Charles II to the throne, he recalled Blondeau from France, and awarded him a 21-year contract to develop and apply methods for making milled and engrained edges. The contract for turning out blanks and stamping fell to three Flemish brothers, John, Joseph, and Phillip Roettier. In 1663 the Tower mint produced a one-pound coin that signaled the beginning of mechanized minting in England.

Methods for minting coins with the serrulated or corrugated edge also passed from France to Spain. In the English colonies and early United States, the Spanish milled dollar was among the most popular and widely circulated coins, passing as legal tender for brief periods. The Spanish milled dollar established the dollar as the principal unit of currency in the United States.

The practice of milled-edge coinage continues to the present day. In the United States, coins in denominations larger than a nickel have milled edges.

Mercantilism

The first principle of mercantilism can be found in the idea that the greatness and power of a state are determined by the abundance of money (precious metals). This stock of money grows with what is now called a favorable balance of trade. The exports of home commodities should exceed in value the imports of foreign commodities, and this positive balance of trade is settled with the importation of money or precious metal.

Historically, this supply of gold and silver acquired through a positive trade balance made it easier for monarchs to raise funds either by loans or taxes. An edict in 1603 of Henry IV, king of France, stated that the arts and manufactures were to be encouraged as the only means of preventing the exportation of precious metals out of the kingdom and the resulting enrichment of other countries.

Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations discussed mercantilism at length. He described the “restraints on importation” along with the “encouragements of exports” by which a nation could turn the balance of trade in its favor. Restraints on imports, in the form of duties or prohibitions, were applied to the import of such foreign goods as could be produced domestically. They could also be directed to the imports from countries with which an unfavorable balance of trade existed. Goods that were imported for the purpose of reexport could enter duty free, and the encouragements to exports took the form of subsidies for the production of exportable goods, advantageous commercial treaties, and the establishment of colonies.

Smith strongly attacked the logic of the mercantilist system. He argued that a high per capita output played a much larger role than the stock of domestic precious metal in determining a nation’s economic welfare. John Maynard Keynes in his book The General Theory (1936) referred to “what now seems to me to be the element of scientific truth in mercantilist doctrine. At a time when domestic authorities had no direct control over the domestic interest rate the effect of a favorable balance of trade on the influx of precious metals was their only indirect means of reducing the domestic rate of interest and so increasing the inducement to home investment.”

In modern times Japanese economic policy has been described as mercantilist. The Japanese have maintained a favorable balance of trade and have enjoyed above-average economic growth.

Medici Bank

The Medici Bank, perhaps the most famous bank of Renaissance Italy, rose to the top rank of European financial institutions during the fifteenth century. It accepted time deposits, the sum of which was several times larger than the invested capital, and was a lending institution. This was unlike some of the exchange banks of the time that were primarily involved in fund transfers associated with international trade. The Medici Bank was the chief bank for the Curia, and it had branches in the major cities of Italy, as well as London, Lyons, Geneva, Bruges, and Avignon.

In Renaissance Italy openly charging interest (usury) was prohibited, but interest charges were hidden in bills of exchange through which foreign currency was purchased for delivery at a future date. Profit was at the mercy of the foreign exchange markets. What was called a dry exchange involved no transfer of goods or foreign exchange and effectively guaranteed interest to the lender. In 1429 dry exchanges were outlawed in Florence, but the law was suspended at least temporarily in 1435, right after the Medici became the de facto, if not legal rulers, of Florence. The Medici Bank was organized as a partnership with the Medici family being the largest investor in the parent company and the parent company being the largest investor in the branch partnerships. The parent company functioned like a modern holding company. The system of branch banks was organized such that one branch could be declared independent by rearranging accounts. Such arrangements protected the parent bank from the bankruptcy of individual branches due to localized economic difficulties.

Members of the Medici family entered the Florentine banking business in the latter 1300s. In 1393 Giovanni di Bicci de’ Medici (1360–1429) took ownership of the Roman branch of a bank owned by one of his Florentine cousins. He removed the headquarters of his bank to Florence in 1397, the official founding date for the Medici Bank. At the time Rome was a source of funds, whereas Florence offered a better market for making loans. By 1402 the Medici Bank had opened a branch bank in Venice, another important outlet of investment opportunities. By then the bank boasted a total of seventeen employees at its headquarters in Florence, five of whom were clerks.

In the fourteenth and fifteenth centuries wool and cloth industries were the export mainspring of the Florentine economy. In 1402 the Medici Bank loaned 3,000 florins (nearly one-third of its original capital) to finance a Medici family partnership to produce woolen cloth. The year 1408 saw the establishment of a second and more successful shop for producing woolen cloth. In addition to banking, the Medici traded wool, cloth, alum, spices, olive oil, silk stuffs, brocades, jewelry, silver plate, citrus fruit, and other commodities, diversifying their risks by investing in a range of ventures.

In 1429 Giovanni di Medici died, passing the management of the bank into the hands of his eldest son, Cosimo. Under Cosimo’s leadership the Medici Bank became the largest banking house of its time. In 1435 the bank opened a branch in Geneva, the first branch beyond the Alps. The Medici opened another woolen cloth manufacturing shop and acquired a silk shop in 1438. The Medici Bank opened a branch in Bruges in 1439, and branches in London and Avignon in 1446. The Milan branch was opened in 1452 or 1453. The Geneva branch was transferred to Lyons in 1464.

When Cosimo died in 1464 the bank had passed its peak. An invalid son, Piero de’ Medici, assumed management of the bank. According to Machiavelli, he began calling in loans, causing a contraction in credit and numerous business failures. Piero died in 1469. Piero’s son, Lorenzo the Magnificent, was a great statesman. He had a humanistic education without business training or experience. He turned the management of the bank over to managers, and the bank gradually lost ground. On Lorenzo’s death in 1492, his son, Piero di Lorenzo, assumed control of the Medici political and business interests in Florence. Piero had neither business nor political acumen, and in 1494 the Medici were ousted from Florence. The bank, already tottering on bankruptcy, was confiscated, and was not successful under its new owners.

Mat Currency of Samoa

Prior to World War II mats were the closest things to currency on the islands of Samoa. The women of Samoa wove mats of two to three yards square, investing months and sometimes years making a single mat. In British currency the mats ranged between 2 and 40 shillings in value. Samoans paid the wages in mats for artisans engaged in constructing houses and boats. Private ownership of land was vague, and rent took the form of gifts in mats. The bridegroom and his friends received a large number of mats at the celebration of the wedding. Chiefs married several women, in part to get their hands on more mats.

The value of the mats varied with the quality of material, and perhaps equally important, with historical and sentimental associations. Mats that had been used as the “top mat” at a wedding, or conclusion of a peace treaty, acquired a sentimental and historical significance that enhanced their value in the eyes of Samoans, despite wear and tear and the normal deterioration of age. The governor of Samoa during the period of German colonialism received a request that mats be rendered unpawnable because of their sacredness and significance. Mats endowed with special historical and sentimental significance became heirlooms that were rarely traded, but ordinary mats were exchanged frequently.

These mats had no fixed negotiable value, falling short of a completely evolved medium of exchange in that important area. Some of their uses, however, bore a closer resemblance to modern money. At election time candidates for king and chief distributed mats to voters, and whoever could afford to distribute the most mats stood the best chance of winning the election. After the election, successful candidates received mats as gifts from the people. Samoans did fix fines and blood money in mats, and assuaged the feelings of angry husbands with gifts of mats.

Having no fixed negotiable value, mats could not function as a monetary unit of account, an important function of money. However, mats did function as a medium of exchange, and a store of value. Samoans saved mats for their children to inherit.

Mat money may owe its origin to the collectivist nature of Samoan society. Private ownership was not well defined. Land was vaguely claimed by individuals, but movable objects, including modern money, had to be given up at the request of a friend or family member, and taking movable objects without permission was also common. Mats, however, acquired sentimental attachments that lifted them above the vulnerability of other movable objects, and made them the only possible means of storing value.

Massachusetts Bay Colony Paper Issue

The colonial government of the Massachusetts Bay Colony has the dubious distinction of being the first to issue paper money in America. The first hesitant steps toward the issuance of paper money occurred in 1676 when the colonial government raised a loan from provincial merchants and issued treasury receipts as an acknowledgment of debt, expecting these receipts to circulate as currency. Public lands secured the loan.

In 1690 the Massachusetts Assembly enacted legislation that authorized the government to issue paper money. The immediate circumstance that forced the hand of the assembly was the need to pay soldiers returning from a war expedition into Canada. Paper money is similar to many other inventions in that pressures of war often serve to speed up its development and acceptance, a theme that can be explored into the twentieth century.

Although war expenditures provided the immediate pretext for the paper money issue, broader concerns helped create a political environment receptive to the issuance of paper money. In 1686 the governor’s council cited the “great decay of trade and obstructions to manufactures and commerce in this country, and multiplicity of debts and suits thereupon, principally occasioned by the present scarcity of coin” (Nettels, 1934). William Penn later commented that “the want of money to circulate trade has put Boston herself upon thinking of tickets to supply the want of coin” (Nettels, 1934). The law of 1690 also mentioned “the present poverty and calamities of the country, and through a scarcity of money, the want of an adequate measure of commerce” (Nettels, 1934).

Historically, paper money has either taken the form of bank notes, precursors to the modern Federal Reserve Note in the United States, or bills issued directly by government treasuries. The Massachusetts paper money was of the latter variety. The government issued the paper money and levied taxes that could be paid with the paper money. As long as the paper money issue was commensurate with the tax levy, the money maintained its value.

The first bills issued by the Massachusetts colonial government were not legal tender for all debts. The legislation of 1692 specified that the bills be accepted “in all payments equivalent to money,” effectively making the bills legal tender. Bills issued between 1702 and 1712 were not legal tender, although after 1710 these bills could be used to stay out of debtors’ prison until legal-tender currency could be obtained.

The Massachusetts paper money held its value reasonably well until 1713. Bills issued in 1709 were not redeemable in taxes until four years beyond the issue date, and the period of redemption for paper money issued between 1710 and 1712 was postponed for six or seven years. During the interim between issuance and redemption the bills earned 5 percent interest, but many more bills were issued than were needed to pay taxes. The bills depreciated in value and hard specie flowed out in foreign trade.

In 1716 the assembly established a public bank that issued bank notes secured by land.

In 1748 over 2 million pounds of paper money were in circulation when Massachusetts received a large reimbursement from England for war expenses, and used the proceeds to redeem paper money at about 20 percent of its face value. Gresham’s law that bad money drives out good money had played out its ruthless logic in Massachusetts as paper money virtually displaced the specie. After 1720 the English government began to restrict the ability of colonial governments to issue paper money with legal-tender status. Experiences of the colonial governments with paper money led members of the Constitutional Convention to endow the Congress of the federal government with the sole privilege to coin money.

Massachusetts Bay Colony Mint

The Massachusetts Bay Colony boasted of the first and only mint in the American colonies before the American Revolution. The colonial economies fought against a currency shortage that acted as a brake on economic activity. The largest component of the circulating coin in the colonies was the Spanish dollar or pieces of eight, but all currency tended to leave America faster than it came in because of the huge need for imported products from Europe. There were no local coins per se, and the mint of Massachusetts was erected on the initiative of the Massachusetts colonial government to meet the need for a colonial currency.

The mint was erected in 1652 and remained in operation for 30 years, eventually falling victim to the royal displeasure of the English Crown. Apparently, it was subject to the orders of the General Court of Massachusetts. The first order issued on 27 May 1652 said:

That all persons whatsoeuer have libertie to bring into the mint house, at Boston, all bullion, plate, or Spanish coyne, there to be melted and brought to the alloy of sterling siluer by John Hull, master of the sd. Mint, & his sworne officers, & by him to be coyned into twelue pence, six pence, & three pence peeces.

(Watson, 1970)

These silver coins were of small denominations for the time.

The mint house was a square building constructed of wood, measuring 15 feet on each side, and 10 feet high. The coins were legal tender in the area under the jurisdiction of the General Court.

The Massachusetts mint debased its coins about 22 percent relative to the silver content of English coins of the same denominations. The officials of Massachusetts approved of this debasement in an effort the keep the coins from going to Europe in payment for American imports of foreign goods. The European merchants, however, simply raised the prices of their products in Massachusetts coin, and there remained the problem of hard specie leaving the American colonies.

The English government complained about debasement of the coins, contending that coinage should be uniform throughout the empire. To be sure, the English government occasionally changed the silver content of its own coins, but was unwilling that the silver content could vary among colonies. It also objected to the coinage of copper or other inferior metals that would solely support internal trade.

The operation of the mint contributed to the friction that led the English government to revoke the first charter of the Massachusetts Bay Colony in 1684, which was the last year that the mint operated. Other colonies asked for permission to establish mints, but the English government refused. The coins from the mint continued to circulate in the American colonies until after the Articles of Confederation authorized individual states to establish mints. The constraints that a coin shortage placed upon the colonial economy helped lift the discontent of the colonists to a revolutionary pitch.