Fall 2000

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Professor Steven Horwitz                     MWF 10:50 - 11:50
108 Hepburn Hall                                   111 Hepburn Hall
229-5731 (office)
379-9737 (home before 9pm)

Office Hours: M,W 1-2 and F 9- 10:30 and by appointment

EMAIL: AIM: sghorwitz WEB:

Whatever you might think about money walking into this class, my guess is that you won't think the same after you walk out. There is no good so important to human economic and social order as money. In addition to being important, money is also mysterious, perplexing, and powerful. This class is designed to both understand money's importance and unlock some of its mysteries.

This class focuses fairly narrowly on monetary institutions and policy. We are going to spend little time discussing the world of stocks, bonds and high finance. For those of you interested in such topics, you should (also) take Economics 313. Instead, we will concentrate on the political economy of money and banking. It will be taken for granted that you've all had intermediate macro (252). Though I won't expect you to have remembered every detail, I will assume that you have some familiarity with the various macro models (especially Keynesianism) and the Phillips curve.

There are several goals in this class. First, we will try to understand the history, institutions, and operation of the American banking system. Although such knowledge is important for its own sake, the purpose here is to use it to understand how monetary institutions and policy affect real economic growth, both positively and negatively. Second, we will look at how central banks function, the goals they set for themselves, and how they operate in the very real political environment that surrounds them. Third, we will explore the importance of monetary stability by examining the damaging effects of deflation and inflation. In addition, we will briefly discuss the relevance of electronic money and digital cash for the issues we have explored. I'd like us to try to place these technological advances in a broader historical perspective.

The central issue for this course is whether or not the Federal Reserve System is the best possible way to organize the American banking system. In particular, we will compare it to a hypothesized unregulated "free banking" system and attempt to determine each system's costs and benefits. Ultimately the goal of this class is to get you to think critically about the origins, purpose and performance of the Fed, and government involvement in money more broadly, and the theories that support such activity. Even most economists take it for granted that money is one good that must be regulated by the political process. This class will challenge that assumption by asking you to assess critically the issues involved.


There are three required books for the class. These are George Selgin's The Theory of Free Banking, Robert Greenfield's Monetary Policy and the Depressed Economy, and Lawrence White's The Theory of Monetary Institutions. In addition, a set of outside readings will be made available to you at a nominal cost. A copy of the whole set of readings will also be on reserve at ODY. I will also make the class assignments, with the exception of the reading response papers, available on my web site. The course URL is A copy of the syllabus, the most recent version of my writing guide, and an old copy of the first exam will also be there.

Your grade in this course will be determined by three hour exams, a journal article precis, class participation and attendance and four one-page writing assignments. The exams will be short answers and essays, based on the lectures and the readings. The third of these exams will take place at the scheduled time for the final, but it will have only a little content from earlier in the semester.

I will pass out a separate assignment sheet for the journal article precis assignment. You will have to find an article from a professional economics journal that relates to material we have covered in class and write up a precis (critical summary) of it that links it to the course and its readings. I will also pass out a schedule that includes due dates for finding an article, meeting with me, and turning in a first draft. The final draft will be due on Friday December 8th at 3:00pm.

The other portion of your grade will be based on four reading response papers. At five unannounced times during the semester, I will hand out a page containing several questions pertaining to the reading for the following class. Your job will be to turn in a one page typewritten response to those questions. These are due at the start of class, no late ones will be accepted (email (it must be as an attached Word file) is okay, as long as it arrives in my inbox by 10:50). The purpose of these is to make sure you are keeping up with the readings and to see what you are getting out of them in addition to stimulating class discussion on the day they are due. Your grade on these will be based on both the quality of your answers and the effort that goes into them. You may keep the best 4 out of 5, so if you miss one or just can't get it done, we'll throw it out. These will be worth 5% each for a total of 20%.
Grading Breakdown: Grading Scale:
Exam 1 Fri Sept 29th 18%
Exam 2 Mon Nov 6th 18%
Journal article precis Fri Dec 8th 15%
Reading response papers 4 @ 5% each 20%
Exam 3 Thur Dec 21  1:30pm 23%
Class participation and attendance   6%

THIS SYLLABUS IS TO BE VIEWED AS A CONTRACT. This document is the final court of appeal for any questions concerning assignments, grades, or due dates. By remaining in this course, you agree to the expectations and requirements outlined here.



(G - Greenfield; S - Selgin; W - White)

NO CLASS Monday Oct 2nd and Friday Nov 10th

Topic (apprx. # of class periods) Reading



Introduction                                         S (pp. 3-12)
The origin of money                             Menger
Types of money and money's value
The social role of money prices             Hayek

We will begin with money's role as a social institution and see how it facilitates broader market relationships and social coordination. The cornerstone of this section, and in many ways the course, is Carl Menger's theory of the origin of money. Menger argues that money arose as an unintended consequence of barter exchange, rather than as the conscious product of human design. The use of money in exchange has enabled us to form money prices and dramatically increase the productivity and complexity of the economy. Money prices play an important role in economic coordination, and Hayek's paper explicates this role more fully.


The evolution of banking                            S (2); W (1, 3)
Deposit creation                                        Ritter and Silber, ch. 14
American financial history                           S (pp. 12-15)
    1863-1914                                            Horwitz (1992); W (4)
    1914-present                                         Timberlake

From the evolution of money we move to the evolution of monetary institutions. We will see that the evolution of banking is also a process of spontaneous order and describe the operation and benefits of a mature banking system. After a brief digression into the mechanics of bank deposit expansion, we turn to American financial history. We will highlight the conflict between the natural forces of order and the chaotic effects of regulatory intervention. These historical and institutional questions are crucial to understanding how past and present banking systems have worked and failed. One of themes we will explore is the degree to which market forces or government are responsible for the problems that have plagued the US banking system throughout history, with an eye toward understanding the plusses and minuses of the Fed.


The organization of the Fed
Regulation and bank failures                         White (5-6)


Bond markets and interest rates
Theory and practice of central banking          Ritter and Silber, chs. 15-17
How do central banks actually behave?         White (7-9)

The historical perspective we have developed can be used to understand the creation and organization of the Federal Reserve System. We will also take a look at the theory behind the need for government involvement in money and banking, particularly in the area of bank failures. We then come to the core of the course: the exploration of the relationship between the supply of money and macroeconomic stability and growth. We will undertake a careful analysis of the Fed's tools, such as reserve requirements, the discount rate, and open market operations, and how they affect its various targets. These targets include various measures of reserves, which in turn change the money supply and interest rates. We will discuss the flaws in this process and what they imply for the Fed's ability to create and maintain monetary order. We will conclude by exploring what really motivates central banks in the political environment in which they operate, including the search for seignorage and political business cycles.


Natural rate theory
    The quantity theory of money
    Keynes and the demand for money
    The evolution of the Phillips curve             Cagan

Monetary equilibrium theory                         S (3-5; pp. 82-85)

In this section we will examine two different, but not mutually exclusive, theoretical approaches to the relationship between money and real output. The quantity theory of money/natural rate theory tries to explain the relationship between the money supply and real output, by focusing on the way in which money affects the price level. Central to these relationships is the demand for money. Our exploration of natural rate theory will take us from the early quantity theorists, through Keynes and Monetarism, up to current issues in rational expectations and the New Classical economics.

In contrast, monetary equilibrium theory, though also concerned with the relationships among money, prices, and real output, focuses on the way in which changes in the money sector affect the interest rate, which in turn affects prices and output. Although the two approaches share much, the monetary equilibrium approach has been lost in both the Keynesian revolution and the monetarist response, and the overwhelming prevalence of central banking systems across the world. Our main goal in this section is to compare and contrast the two approaches and note each one's relationship to a particular set of monetary institutions.



The political economy of inflation                 Horwitz (2000, ch. 4)

We can see the importance of a banking system's ability to maintain monetary equilibrium by seeing what happens during monetary disequilibria. Here we will discuss the various economic and political apects of inflation. Our focus will be on the costs inflation imposes on economic systems and how that retards economic growth and socio-political stability. We will also take a brief look at how inflation might trigger business cycles and its relationship to fiscal policy by discussing budget deficits and monetization of the debt.


Effects of an excess demand for money         G (1)
The banking system during deflation              G (2-3)
Deflation and price and wage flexibility          Vedder and Gallaway

Deflation is the other form of monetary disequilibrium and we will explore it both theoretically and through illustrations taken from the Great Depression of the 1930s. Our discussion will show deflation's destructive potential, despite its rarity in real world economies. We will emphasize the interplay between poor monetary policy and wage and price rigidities that can, and did during the Great Depression, turn the minor effects of excess demands for money into major economic catastrophes.


Price level vs. interest rate targets
Rules vs. discretion                                        W (10-11)
Do we need a central bank?                           S (7-10)
E-money and the future of monetary policy     Selgin; Ely

What is the Fed up to now? Here we will briefly try to answer this question by discussing both the current state of theory and practice in monetary policy. Our focus will be on the debate over the possibility and desirability of targeting either some measure of prices or some interest rate. Perhaps as no surprise, we will see that neither target is completely desirable and neither is likely to work, either economically or politically. We will also examine the rules versus discretion debate and lead into our discussion of free banking by exploring its advantages compared to both rules and discretion. Our discussion of deflation and inflation emphasized the importance of a monetary regime's ability to minimize deviations from monetary equilibrium. We can reflect on that point through a comparison of central and free banking. The point here is not to convince you of the correctness of either side, but rather to indicate the important issues and to show which of them are at the core of current debates among monetary theorists. We will conclude with a brief discussion of electronic money and the questions that it poses for monetary policy.





Greenfield, Robert. 1994. Monetary Policy and the Depressed Economy, Belmont, CA: Wadsworth.

Selgin, George A. 1988. The Theory of Free Banking: Money Supply under Competitive Note Issue, Totowa, NJ: Rowman and Littlefield.

White, Lawrence H. 1999. The Theory of Monetary Institutions, Malden, MA: Blackwell.

RESERVE READINGS: Cagan, Phillip. 1987. "Monetarism," in The New Palgrave, London: MacMillan.

Ely, Bert. 1997. "Electronic Money and Monetary Policy," in The Future of Money in the Information Age, James Dorn, ed., Washington DC: Cato Insitute.

Hayek, F. A.. 1945. "The Use of Knowledge in Society," reprinted in Individualism and Economic Order, Chicago: University of Chicago Press, 1948.

Horwitz, Steven. 1992. Monetary Evolution, Free Banking, and Economic Order, Boulder: Westview Press, chapter 5

_____________. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, New York: Routledge, chapter 4.

Menger, Carl. 1892. "On the Origin of Money," Economic Journal 2.

Ritter, Lawrence and William Silber. 1994. Principles of Money, Banking and Financial Markets, 8th edition, New York: Basic Books, chs. 14-17.

Selgin, George. 1997. "E-Money: Friend or Foe of Monetarism?" in The Future of Money in the Information Age, James Dorn, ed., Washington DC: Cato Insitute.

Timberlake, Richard. 1984. "Federal Reserve Policy Since 1945," in Money in Crisis, Barry N. Siegel, ed., San Francisco: Pacific Institute.

Vedder, Richard K. and Lowell E. Gallaway. 1993 Out of Work: Unemployment and Government in Twentieth-Century America, New York: Holmes and Meier, chapter 5.