Where do we stand in our monetary journey? First, we have learned that money is a financial tool invented to lubricate the economy. Without money we would be forced to use inefficient and complex simultaneous exchange as in the kidney transplantation market. Second, we determined the attributes of ideal forms of money, which helps us understand the progression of types of money. Third, we have learned the Goldilocks rule that some inflation, at a low rate, is "just right."

A mystery remains, however, and it is the one that worried me in the 1970s. All of our knowledge about money and inflation is great, but what is the use if inflation is an uncontrollable monster capable of toppling presidents and destroying societies? Knowing the enemy may have some benefits, but it would be much better if that enemy could be shackled.

The real mystery of inflation is that there is any mystery at all. There is no magic behind the cause and control of inflation. In The Wizard of Oz, the magic of the land is revealed when Dorothy pays attention to the man behind the curtain. Similarly, there are people who determine the inflation rate. Far from being an uncontrollable beast, inflation is a tame dog both created and completely controlled by monetary authorities.

Milton Friedman appropriately gets credit for the academic understanding of inflation. As in many other areas, however, Yogi Berra cap­tured its essence without a Ph.D. in economics. When asked how many pieces he wanted a pizza cut into, Berra replied by saying, "Just four, I'm on a diet." (Whether he actually made this joke is subject to dispute. Berra claims to be misquoted frequently. He coauthored a book titled / Really Didn 't Say Everything I Said.)

Regardless of its origin, the joke recognizes an obvious truth. A pizza contains the same number of calories regardless of how it is divided. Thus, the choice of the number of slices merely determines the size of each slice, not the size of the overall pizza.

Professor Friedman made the same discovery when it comes to the value of money. The decision on how much money to create doesn't have much effect on the overall size of the economy, but it does have an enormous effect on the value of money. He wrote, "Inflation is always and everywhere a monetary phenomenon." 16

When the amount of money is increased, the result is inflation. Inflation destroyed the value of seashells in Papua New Guinea . When their "money supply" increased because of the importation of planeloads of seashells, the value of each seashell decreased. Similarly, the German hyperinflation was caused by a massive increase in the supply of German marks.

Inflation is simple. When more money is created, the value of each piece of money declines. That is inflation.

What about the U.S. inflation of the 1970s? I was particularly scared by news reports that suggested inflation was some mysterious force. As Figure 5.2 shows, this inflation was not mysterious at all. It was, to quote Milton Friedman, "a monetary phenomenon."

The inflation of the 1970s was caused by a rapid growth in the money supply. Just as there is no mystery (to those in the know) for the cause of inflation, there is no mystery for its cure.

16% 1

FIGURE 5.2 1970s' U.S. Inflation Was Created by "Loose" Money

Source: U.S. Federal Reserve

In 1979, Paul Volcker became the chair of the U.S. Federal Reserve. With inflation running at about 13% a year, Chairman Volcker decided to stop the insanity. He slowed the growth of the money supply, and by 1983 inflation was down to 4%. Time magazine's cover from October 22, 1979 , pictured Volcker under the heading "The Squeeze of 1979." This squeeze cranked up interest rates so that some rates exceeded 20%. Imagine getting a car loan or a mortgage in such an environment, and it is easy to see how tight money slowed the economy and reduced inflation.

It's Good to Be the King

In The History of the World, Part I, Mel Brooks remarks, "It's good to be the king!" The king has unique powers to achieve his goals (either nefar­ious as in the movie, or noble). Similarly, the Federal Reserve has unique rights that allow it to control the money supply, and through the money supply, to control inflation.

The injection of money into an economy can have a powerful effect. A simple personal example came when I was living in western Uganda in the summer of 1997.1 was spending some time at a chimpanzee research station run by Harvard professor Richard Wrangham. Things were going fine, but I decided that I couldn't rely upon the station's truck for transport, and that I needed to buy my own vehicle.

Accordingly, I had my parents wire funds to a local bank so that I could purchase a motorcycle. With the help (and protection) of several of the research station's employees, I negotiated the purchase of a used motorcycle at the exorbitant price of $2,400.

As I rode the motorcycle along the local roads, people would greet me and then laugh to each other. They found the situation funny for many reasons. First, I was ridiculously large for the small motorcycle. Second, I had paid at least $1,000 more than a local would have paid (in Swahili, they said that I paid the "Mzungu," or European, price). Third, there were stickers on either side of the bike that showed a hunter with a spear. I was unaware that the spear was metaphorical, and that these stickers were public service messages to exhort the people to use condoms. So I became a mobile source of humor.

The actual purchase took place as follows. After reaching a deal on price, I went to the bank, took out the $2,400 in local currency. I was acutely aware that this represented close to a decade's wages for the locals. I had guards on either side as I took my backpack full of bills and picked up my condom-advertisement machine. The previous owner asked me to hurry so that he could return the funds to the bank before closing time. In fact, he then returned the bills to the exact same bank manager who had given them to me earlier in the afternoon.

As I lay under my mosquito netting that night, I marveled at the power of electronic entries in the banking system. My parents sent an electronic message to a bank in western Uganda . Less than 24 hours later, I had a motorcycle and the electronic bookkeeping showed that the motorcycle's previous owner had credit for $2,400. So by just moving a few electrons, I now controlled a motorcycle.

My motorcycle purchase created a whole cascade of effects. The previous owner was now rich with the proceeds of his sale. He used the money to buy a variety of products. The sellers of those products in turn purchased more goods. By injecting some money into the economy of western Uganda , I created a mini wave of prosperity. In my case, Uganda 's prosperity came at the expense of some in the United States . While I was $2,400 richer, my parents were $2,400 poorer. This was a zero-sum game where gains were offset by losses.

Being the king of the monetary world, however, the Federal Reserve plays by its own rules. For me to get money, my parents had to lose money. When the U.S. Federal Reserve buys something, no one's account is reduced. The Fed controls the electronic system of bank cred­its. Thus, the Fed can increase an account by $2,400 or $240 billion with no offsetting reductions. While the Federal Reserve uses its power to buy U.S. Treasury bonds, and not motorcycles, the effect is the same as my mini wave of prosperity.

Except, the Federal Reserve can create money from nothing. It simply pays for its purchases by crediting the seller's account. While private transfers are zero-sum activities, the purchases of the Federal Reserve are not.

Through these monetary operations, the Federal Reserve determines the growth rate of the money supply, though the decisions of other peo­ple impact the effect of monetary operations. For example, the speed at which people spend their new riches has implications for the economy. Even after taking account of the "velocity" of money, the Federal Reserve controls the money supply and thus determines the rate of inflation.