BARTER

Human beings have always needed to trade things with each other because
resources are distributed unevenly. One area is rich in wood, for instance, while
another supports animal grazing or crop production. This is a critical principle
of economics and banking, that resources are distributed unevenly on the
earth. This has ever been a source of trade. When trade does not occur evenly
or fairly, war is the inevitable result.
Trade began with whole barter - trading one item for another. This is the
simplest form of trading, and it continues around the world. However, it is
cumbersome and often won't work. It requires two people who each want what
the other has. If one party wants something else, whole barter breaks down.
So early on, people invented or discovered mediums of exchange or currency of
some kind. Beads, sea shells, salt, precious metals, gems, gold coins, tobacco
leaves, hemp and many other items have been used as currency.
The use of currency or money allows what is called split barter. Instead of
trading directly for what one wants, one of the parties accepts currency for the
transaction, and then trades the currency with someone else to obtain what they
want. The transaction is split into two transactions. The invention of currencies
greatly facilitated trade!
The main requirements for money or currency are
a) that it be readily identified and valued,
b) that it have some more or less stable value and
c) that the parties agree to use it as currency.
An important point is that currencies can be counterfeited or faked, and they
must maintain their value. This is not as much of a problem if the coin or item
has value itself. But it is a problem if, for example, an inherently valueless item
like a piece of paper is used as currency.

What Is Money? It Is More Than Pieces of Paper.

So money isn't just pieces of paper. It's a medium of exchange that facilitates
trade. Money is whatever is generally accepted in exchange for goods and
services accepted not as an object to be consumed but as an object that
represents a temporary abode of purchasing power to be used for buying still
other goods and services. Milton Friedman (1992)
Generally, economists have defined four functions of money which are as
follows:
(i) Medium of exchange
(ii) Measurement of value
(iii) Standard of deferred payments
(iv) Store of value.
These four functions of money have been summed up in a couplet which says:
Money is a matter of four functions , a medium, a measure, a standard and a
store.
These functions are explained below
(i) Money as a Unit of Value:
Money measures the value of various goods and services which are produced in
an economy. In other words, money works as unit of value or standard of value.
In barter economy it was very difficult to decide as to how much volume of
goods should be given in exchange of a given quantity of a commodity.
Money, by performing the function of common measure of value, has saved the
society from this difficulty. Now the value of various goods and services are
expressed in terms of money such as Rs. 10 per metre, Rs. 8/- per kilogram etc.
In this way, money works as common measure of value by expressing exchange
value of all goods and services in money in the exchange market. By working as
a unit of value, money has facilitated modern business and trade.
(ii) Medium of Exchange:
Right from the beginning, money has been performing an important function as
medium of exchange in the society. Money facilitates transactions of goods and
service as a medium of exchange. Producers sell their goods to the wholesalers

in exchange of money. Wholesalers sell the same goods to the consumers in

exchange of money.
In the same way, all sections of society sell their services in exchange of money
and with that buy goods and services which they need. Money, working as
medium of exchange, has eliminated inconvenience which was faced in barter
transactions. However, money can operate as medium of exchange only when it
is generally accepted in that role. Bank money can be treated as money simply
on the basis of their general acceptability for they are highly useful.
(iii) Standard of Deferred Payments:
Modem economic setup is based on credit and credit is paid in the form of
money only. In reality the significance of credit has increased so much that it
will not be improper to call it as the foundation stone of modem economic
progress. Money, besides being the basis of current transactions, is also the
basis of deferred payments. Only money is such a commodity in whose form
accounts of deferred payments can be maintained in such a way so that both
creditors and debtors do not stand to lose.
(iv) Store of Value:
It was virtually impossible to store surplus value under barter economy; the
discovery of money has removed this difficulty. With the help of money, people
can store surplus purchasing power and use it whenever they want. Saving in
money is not only secure but its possibility of being destroyed is very less.
Besides, it can be used whenever need be. By facilitating accumulation of
money, money has become the only basis of promoting capital formation and
modern production technique and corporate business facilitated there from.
WHY IS MONEY VALUABLE
The main thing that makes money valuable is the same thing that
generates value for other commodities: the demand (for money) relative
to its supply.
People demand money because it reduces the cost of exchange.
If the purchasing power of money is to remain stable over time, its supply

must be limited.When the supply of money grows rapidly relative to

goods and services, its purchasing power will fall.

Advantages of money
highly liquid as compared to stocks and bonds.
Disadvantages of money
Loses value during inflationary periods or episodes
Different Types of Money
a) Commodity Money has value as a commodity such as rice, cattle, seashells,
copper, stones, cigarettes as used in the POW camps of WWII.
Problems:
when valuable resources are used as money, those resources cannot be used for
consumption. Copper used to make pennies cannot be used to make electrical
wire.
There exists an incentive to debase the currency. Rulers would reduce the
amount of the precious metal in a coin. People would tend to circulate the
altered coins and save the coins which still had the greater amount of the
precious metal. This is known as Greshams law: bad money drives out good.
The supply of money is determined by supply of the commodity. The money
supply could fluctuate substantially. The discovery of new gold would mean
that the supply of money would increase and the price level would rise.
b) Fiat Money (has nothing to do with an Italian sports car) very little value as
a
commodity money because the public accepts it as money (not necessarily
because the government declares it as money) People accept it because they
believe that everyone else will accept it. This is very different from a fully
backed currency that is a currency that is backed by some commodity like gold
or silver. For example in the early part of this century the US still had silver
dollar notes. If one wanted one could take the note to the treasury and demand
the silver which was held since the inception of the note as a form of its
backing.

ADVANTAGES OF FIAT MONEY

4

I.
II.
III.

uses relatively little of societys resources

no incentive to debase this type of currency
supply not tied to commodity. Therefore it potentially has less
susceptibility to lead to fluctuation in the money supply. It can grow with
the economy.
problem

I.

government controls money supply and it may cause inflation by printing

too much money.

Receipt Money
During the days of the Roman Empire, goldsmiths maintained vaults where they
stored their gold. It followed logically that they might also store gold for other
people for a fee. Thus, the first banks were born. The goldsmiths gave their
depositors receipts for gold deposited and because the receipts could be
redeemed by a bearer at any time, they had intrinsic value and were traded as
money. Goldsmiths also loaned money from their reserves and collected interest
just as is done today.
Fractional Money
Of course, goldsmiths quickly realized they only needed 10 to 15% of their
stockpiles on hand for redeeming customer receipts for "their" gold. So it
logically followed that to collect more interest, they could loan more money
than they had on hand by using receipts backed by nothing except the
goldsmith's knowledge that all their depositors would not come to collect their
gold on any given day. Thus was born fractional receipt money, the precursor to
our present day banking system. As long as these illegal and fraudulent loans
were repaid, no one was the wiser. But if the loans failed (flood, drought), the
goldsmith was caught short. This began a "run on the bank" and only the first in
the door were made whole. The rest lost their money and "hung" the goldsmith.
Without the crime of loaning more money in receipts than the goldsmith had on
hand in real gold, there would never be a run on the bank to redeem the receipts.
Of course, at the time this was considered a serious crime because it was
recognized clearly as fraud. The money did not exist and everyone understood
it.
Money Supply Definitions
Most liquid M1 = currency held by the public (not including the banks) 25%
5

+ demand deposits (non-interest checking accounts) >74%

+ other checkable deposits (interest bearing checking)
+travellers checks 1%
Less liquid M2 = M1
+ savings deposits
+ money market mutual fund share, deposits
+ small time deposits (<$100,000)
+ other
Least liquid M3 = M2
+ large time deposits (>$100,000)
We usually refer to M1 as the money supply.Credit cards are not money-they
are short-term loans which must be paid off using money.
Causes of the Development of Money
"Money originated very largely from non-economic causes: from tribute as well
as from trade, from blood-money and bride-money as well as from barter, from
ceremonial and religious rites as well as from commerce, from ostentatious
ornamentation as well as from acting as the common drudge between economic
men."
One of the most important improvements over the simplest forms of early barter
was the tendency to select one or two items in preference to others so that the
preferred items became partly accepted because of their qualities in acting as
media of exchange. Commodities were chosen as preferred barter items for a
number of reasons - some because they were conveniently and easily stored,
some because they had high value densities and were easily portable, and some
because they were durable. These commodities, being widely desired, would be
easy to exchange for others and therefore they came to be accepted as money.
To the extent that the disadvantages of barter provided an impetus for the
development of money that impetus was purely economic but archaeological,
literary and linguistic evidence of the ancient world, and the tangible evidence
of actual types of primitive money from many countries demonstrate that barter
was not the main factor in the origins and earliest development of money.
Many societies had laws requiring compensation in some form for crimes of
violence, instead of the Old Testament approach of "an eye for an eye". The
author notes that the word to "pay" is derived from the Latin "pacare" meaning
originally to pacify, appease, or make peace with - through the appropriate unit
of value customarily acceptable to both sides. A similarly widespread custom
was payment for brides in order to compensate the head of the family for the
loss of a daughter's services. Rulers have since very ancient times imposed taxes
on or exacted tribute from their subjects. Religious obligations might also entail
payment of tribute or sacrifices of some kind. Thus in many societies there was
6

a requirement for a means of payment for blood-money, bride-money, tax or

tribute and this gave a great impetus to the spread of money.
Objects originally accepted for one purpose were often found to be useful for
other non-economic purposes and, because of their growing acceptability began
to be used for general trading also, supplementing or replacing barter.
Thus the use of money evolved out of deeply rooted customs; the clumsiness of
barter provided an economic impulse but that was not the primary factor. It
evolved independently in different parts of the world. About the only
civilization that functioned without money was that of the Incas.
The Invention of Banking and Coinage
The invention of banking preceded that of coinage. Banking originated in
Ancient Mesopotamia where the royal palaces and temples provided secure
places for the safe-keeping of grain and other commodities. Receipts came to be
used for transfers not only to the original depositors but also to third parties.
Eventually private houses in Mesopotamia also got involved in these banking
operations and laws regulating them were included in the code of Hammurabi.
In Egypt too the centralization of harvests in state warehouses also led to the
development of a system of banking. Written orders for the withdrawal of
separate lots of grain by owners whose crops had been deposited there for safety
and convenience, or which had been compulsorily deposited to the credit of the
king, soon became used as a more general method of payment of debts to other
persons including tax gatherers, priests and traders. Even after the introduction
of coinage these Egyptian grain banks served to reduce the need for precious
metals which tended to be reserved for foreign purchases, particularly in
connection with military activities.
Precious metals, in weighed quantities, were a common form of money in
ancient times. The transition to quantities that could be counted rather than
weighed came gradually. The talent is a monetary unit with which we are
familiar with from the Parable of the Talents in the Bible. The talent was also a
Greek unit of weight, about 60 pounds.
Many primitive forms of money were counted just like coins. Cowrie shells,
obtained from some islands in the Indian Ocean, were a very widely used
primitive form of money - in fact they were still in use in some parts of the
world (such as Nigeria) within living memory. "So important a role did the
cowrie play as money in ancient China that its pictograph was adopted in their
written language for money." Thus it is not surprising that among the earliest
countable metallic money or "coins" were "cowries" made of bronze or copper,
in China.
In addition to these metal "cowries" the Chinese also produced "coins" in the
form of other objects that had long been accepted in their society as money e.g.
spades, hoes, and knives. Although there is some dispute over exactly when
7

these developments first took place, the Chinese tool currencies were in general
use at about the same time as the earliest European coins and there have been
claims that their origins may have been much earlier, possibly as early as the
end of the second millennium BC. The use of tool coins developed (presumably
independently) in the West. The ancient Greeks used iron nails as coins, while
Julius Caesar regarded the fact that the ancient Britons used sword blades as
coins as a sign of their backwardness. (However the Britons did also mint true
coins before they were conquered by the Romans).
These quasi-coins were all easy to counterfeit and, being made of base metals,
of low intrinsic worth and thus not convenient for expensive purchases. True
coinage developed in Asia Minor as a result of the practice of the Lydians, of
stamping small round pieces of precious metals as a guarantee of their purity.
Later, when their metallurgical skills improved and these pieces became more
regular in form and weight the seals served as a symbol of both purity and
weight. The first real coins were probably minted some time in the period 640 630 BC. Afterwards the use of coins spread quickly from Lydia to Ionia,
mainland Greece, and Persia.
Intangible Money
The break with precious metals helped to make money a more elusive entity.
Another trend in the same direction is the growing interest in forms of
electronic money from the 1990s onwards. In some ways e-money is a logical
evolution from the wire transfers that came about with the widespread adoption
of the telegraph in the 19th century but such transfers had relatively little impact
on the everyday shopper.
The evolution of money has not stopped. Securitisation, the turning of illiquid
assets into cash, developed in new directions in the 1990s. One much publicised
development was the invention of bonds backed by intangible assets such as
copyright of music, e.g.Bowie bonds, named after those issued by the popstar
David Bowie. (See also Something Wild, the first novel dealing with Bowie
bonds).
Noteworthy Points Regarding the Origins of Money
Money did not have a single origin but developed independently in many
different Parts of the world.
Many factors contributed to its development and if evidence of what
anthropologists have learned about primitive money is anything to go by
economic factors were not the most important.

 Money performs a variety of functions and the functions performed by

the earliest types were probably fairly restricted initially and would NOT
necessarily have been the same in all societies.
Money is fungible: there is a tendency for older forms to take on new
roles and for new forms to be developed which take on old roles, e.g.
(this is my example) on English banknotes such as the 5 pound notes it
says "I promise to pay the bearer on demand the sum of five pounds" and
below that it carries the signature of the chief cashier of the Bank of
England. This is a reminder that originally banknotes were regarded in
Britain, and in many other countries, as a substitute for money and only
later did they come to be accepted as the real thing.
RECENT DEVELOPMENTS IN MONEY AND BANKING
Relative decline of banks and thrifts: Several other types of firms offer
financial services.
Consolidation among banks and thrifts :Because of failures and mergers,
there are fewer banks and thrifts today. Since 1990, there has been a
decline of 5000 banks.
Convergence of services provided has made financial institutions more
similar:
Globalization of financial markets:
Significant integration of world financial markets is occurring and recent
advances in computer and communications technology suggest the trend
is likely to accelerate.
Electronic transactions: Internet buying and selling, electronic cash and
"smart cards" are examples.
In the future, nearly all payments could be made with a personal
computer or "smart card."
Unlike currency, E-cash is "issued" by private firms rather than by
government.
To control the money supply the Fed will need to find ways to control the
total amount of E-cash, including that created through Internet loans.
BANKING
Banking is one of the key drivers of any nations economy. Why? It provides
the liquidity needed for families and businesses to invest for the future. Bank
loans and credit means families don't have to save up before going to college or
buying a house, and companies can start hiring immediately to build for
future demand and expansion. Here's how banking works. Banks provides a safe
9

place to save excess cash, known as deposits. That's because deposits are
insured by the Federal Deposit Insurance Corporation. Instead of sitting
uselessly under the mattress, banks can turn every one of those dollars into ten.
That's because they only have to keep 10% of your deposit on hand. They lend
the other 90% out. Banks primarily make money by charging higher interest
rates on their loans than they pay for deposits.
ASSETS LIABILITIES AND BANK CAPITAL
A balance sheet (aka statement of condition, statement of financial position) is
a financial report that shows the value of a company's assets, liabilities, and
owner's equity at a specific period of time, usually at the end of an accounting
period, such as a quarter or a year. An asset is anything that can be sold for
value. A liability is an obligation that must eventually be paid, and, hence, it is
a claim on assets. The owner's equity in a bank is often referred to as bank
capital, which is what is left when all assets have been sold and all liabilities
have been paid. The relationship of the assets, liabilities, and owner's equity of a
bank is shown by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
A bank uses liabilities to buy assets, which earns its income. By using liabilities,
such as deposits or borrowings to finance assets such as loans to individuals or
businesses, or to buy interest earning securities, the owners of the bank can
leverage their bank capital to earn much more than would otherwise be possible
using only the bank's capital.
Type of Banks
You are probably most familiar with retail banking. Commercial banks are the
most common, and include global banks such as Bank of Nigeria and
Citigroup. Community banks are smaller commercial banks. They focus on the
local market, and provide more personalized service that's based on
relationships. Online banks operate over the Internet. There are some that are
online-only banks, such as ING and HSBC. However, most banks now offer
online services.
Savings and loans target mortgages. Credit unions provide personalized service,
but are usually restricted to employees of companies or schools. Shariah
banking was developed to conform to the Islamic prohibition against interest
rates.
10

Investment banking has become much more important since many banking laws
were deregulated in the 1990s. These banks traditionally were small, privatelyowned companies that helped corporations find funding through initial public
stock offerings (IPOs) or issuing bonds, facilitating mergers and acquisitions
(M&A), and operating hedge funds for high net-worth individuals.
Fractional-reserve banking is the practice whereby banks retain only a portion
of their customers' deposits as readily available reserves (currency or deposits at
the central bank) from which to satisfy demands for payment. The remainder of
customer-deposited funds are used to fund investments or loans the bank makes
to other customers. Most of these funds are later redeposited into banks,
allowing further lending. Thus, fractional-reserve banking permits the money
supply to grow to a multiple of the underlying reserves of base money originally
created by the central bank.
Fractional-reserve banking predates the existence of governmental monetary
authorities and originated many centuries ago in bankers' realization that
depositors generally do not all demand payment at the same time.
Savers looking to keep their valuables in safekeeping depositories
deposited gold and silver at goldsmiths, receiving in exchange a note for
their deposit. These notes gained acceptance as a medium of exchange for
commercial transactions and thus became as an early form of circulating paper
money.
As the notes were used directly in trade, the goldsmiths observed that people
would not usually redeem all their notes at the same time, and they saw the
opportunity to invest their coin reserves in interest-bearing loans and bills. This
generated income for the goldsmiths but left them with more notes on issue than
reserves with which to pay them. A process was started that altered the role of
the goldsmiths from passive guardians of bullion, charging fees for safe storage,
to interest-paying and interest-earning banks. Thus fractional-reserve banking
was born.
However, if creditors (note holders of gold originally deposited) lost faith in the
ability of a bank to [pay] their notes, many would try to redeem their notes at the
same time. If in response a bank could not raise enough funds by calling in loans
or selling bills, it either went into insolvency or defaulted on its notes. Such a
situation is called a bank run and caused the demise of many early banks
11

Starting in the late 1600s nations began to establish central banks which were
given the legal power to set reserve requirements and to issue the reserve assets,
or monetary base, in which form such reserves are required to be held. The
reciprocal of the reserve requirement, called the money multiplier, limits the size
to which the transactions in money supply may grow for a given level of reserves
in the banking system. In order to mitigate the impact of bank failures and
financial crises, governments created central banks public (or semi-public)
institutions that have the authority to centralize the storage of precious metal
bullion amongst private banks to allow transfer of gold in case of bank runs,
regulate commercial banks, impose reserve requirements, and act as lender-oflast-resort if any bank faced a bank run. The emergence of central banks reduced
the risk of bank runs inherent in fractional-reserve banking and allowed the
practice to continue as it does today.
Over time, economists, central banks, and governments have changed their views
as to the policy variables which should be targeted by monetary authorities. These
have included interest rates, reserve requirements, and various measures of
the money supply and monetary base.
Functions of the Federal Reserve
1) Oversee the banking system
2) control the money supply (imperfectly)
3) lender of resort
How it works
In most legal systems, a bank deposit is not a bailment. In other words, the
funds deposited are no longer the property of the customer. The funds become
the property of the bank, and the customer in turn receives an asset called
a deposit account (a checking or savings account). That deposit account is
a liability of the bank on the bank's books and on its balance sheet. Because the
bank is authorized by law to make loans up to a multiple of its reserves, the
bank's reserves on hand to satisfy payment of deposit liabilities amounts to only
a fraction of the total which the bank is obligated to pay in satisfaction of its
demand deposits.

12

Fractional-reserve banking ordinarily functions smoothly. Relatively few

depositors demand payment at any given time, and banks maintain a buffer of
reserves to cover depositors' cash withdrawals and other demands for funds.
However, during a bank run or a generalized financial crisis, demands for
withdrawal can exceed the bank's funding buffer, and the bank will be forced to
raise additional reserves to avoid defaulting on its obligations. A bank can raise
funds from additional borrowings (e.g., by borrowing in the interbank lending
market or from the central bank), by selling assets, or by calling in short-term
loans. If creditors are afraid that the bank is running out of reserves or is
insolvent, they have an incentive to redeem their deposits as soon as possible
before other depositors access the remaining reserves. Thus the fear of a bank
run can actually precipitate the crisis.
Many of the practices of contemporary bank regulation and central banking,
including centralized clearing of payments, central bank lending to member
banks, regulatory auditing, and government-administered deposit insurance, are
designed to prevent the occurrence of such bank runs.
Economic function
Fractional-reserve banking permits a bank to make loans against the reserves it
takes in as demand deposits. Full-reserve banking would not permit lending
from demand deposits. Fractional-reserve banks can thus offer demand
accounts, which provide immediate liquidity to depositors, and also provide
longer-term loans to borrowers, and act as financial intermediaries for those
funds.
Less liquid forms of deposit (such as time deposits) or riskier classes of
financial assets (such as equities or long-term bonds) may lock up a depositor's
wealth for a period of time, making it unavailable for use on demand. This
"borrowing short, lending long," or maturity transformation function of
fractional-reserve banking is a role that many economists consider to be an
important function of the commercial banking system.
Additionally, according to macroeconomic theory, a well-regulated fractionalreserve bank system also benefits the economy by providing regulators with
powerful tools for influencing the money supply and interest rates. Many
economists believe that these should be adjusted by government to promote
various public policy objectives.
13

Modern central banking allows banks to practice fractional-reserve banking

with inter-bank business transactions with a reduced risk of bankruptcy. The
process of fractional-reserve banking expands the money supply of the economy
but also increases the risk that a bank cannot meet its depositor withdrawals.
Money creation process
Money creation
There are two types of money in a fractional-reserve banking system operating
with a central bank:
1. Central bank money: money created or adopted by the central bank
regardless of its form precious metals, commodity certificates,
banknotes, coins, electronic money loaned to commercial banks, or
anything else the central bank chooses as its form of money
2. Commercial bank money: demand deposits in the commercial banking
system; sometimes referred to as "chequebook money"
When a deposit of central bank money is made at a commercial bank, the
central bank money is removed from circulation and added to the commercial
banks' reserves (it is no longer counted as part of M1 money supply).
Simultaneously, an equal amount of new commercial bank money is created in
the form of bank deposits. When a loan is made by the commercial bank (which
keeps only a fraction of the central bank money as reserves), using the central
bank money from the commercial bank's reserves, the m1 money supply
expands by the size of the loan. When a deposit of central bank money is made
at a commercial bank, the central bank money is removed from circulation and
added to the commercial banks' reserves (it is no longer counted as part of M1
money supply). Simultaneously, an equal amount of new commercial bank
money is created in the form of bank deposits. When a loan is made by the
commercial bank (which keeps only a fraction of the central bank money as
reserves), using the central bank money from the commercial bank's reserves,
the m1 money supply expands by the size of the loan. This process is called
"deposit multiplication".

14

Money multiplier
The expansion of $100 through fractional-reserve banking with varying reserve
requirements. Each curve approaches a limit. This limit is the value that the
"money multiplier'" calculates.
The most common mechanism used to measure this increase in the money
supply is typically called the "money multiplier". It calculates the maximum
amount of money that an initial deposit can be expanded to with a given reserve
rate. Formula
The money multiplier, m, is the inverse of the reserve requirement, R:

Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also
be expressed as a fraction:

So then the money multiplier, m, will be calculated as:

This number is multiplied by the initial deposit to show the maximum amount
of money it can be expanded to.
The money creation process is also affected by the currency drain ratio (the
propensity of the public to hold banknotes rather than deposit them with a
15

commercial bank), and the safety reserve ratio (excess reserves beyond the legal
requirement that commercial banks voluntarily hold usually a small amount).
Data for "excess" reserves and vault cash are published regularly by the Federal
Reserve in the United States. In practice, the actual money multiplier varies
over time, and may be substantially lower than the theoretical maximum
Money supplies around the world

Components of the euro money supply 19982007.

16

Money supply
Fractional-reserve banking determines the relationship between the amount of
"central bank money" in the official money supply statistics and the total money
supply. Most of the money in these systems is "commercial bank money".
Fractional-reserve banking allows the creation of commercial bank money,
which increases the money supply through the deposit creation multiplier. The
issue of money through the banking system is a mechanism of monetary
transmission, which a central bank can influence indirectly by raising or
lowering interest rates (although banking regulations may also be adjusted to
influence the money supply, depending on the circumstances).
The actual increase in the money supply through this process may be lower, as
(at each step) banks may choose to hold reserves in excess of the statutory
minimum, borrowers may let some funds sit idle, and some members of the
public may choose to hold cash, and there also may be delays or frictions in the
lending process. Government regulations may also be used to limit the money
creation process by preventing banks from giving out loans even though the
reserve requirements have been fulfilled.
Regulation
Because the nature of fractional-reserve banking involves the possibility of bank
runs, central banks have been created throughout the world to address these
problems.
Central banks
Government controls and bank regulations related to fractional-reserve banking
have generally been used to impose restrictive requirements on note issue and
deposit taking on the one hand, and to provide relief from bankruptcy and
creditor claims, and/or protect creditors with government funds, when banks
defaulted on the other hand. Such measures have included:
1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank
Charter Act 1844 (UK)
17

5. Sanction on bank defaults and protection from creditors for many months
or even years, and
6. Central bank support for distressed banks, and government guarantee
funds for notes and deposits, both to counteract bank runs and to protect
bank creditors.
Reserve requirements
The currently prevailing view of reserve requirements is that they are intended
to prevent banks from:
1. generating too much money by making too many loans against the
narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although
the reserve is thought to be a legal minimum, it is understood that in a
crisis or bank run, reserves may be made available on a temporary basis).
In practice, some central banks do not require reserves to be held, and in some
countries that do, such as the USA and the EU they are not required to be held
during the day when the banks are lending, and banks can borrow from other
banks at near the central bank policy rate to ensure they have the necessary
amount of required reserves by the close of business. Required reserves are
therefore considered by some central bankers, monetary economists and
textbooks to only play a very small role in limiting money creation in these
countries. Most commentators agree however, that they help the banks have
sufficient supplies of highly liquid assets, so that the system operates in an
orderly fashion and maintains public confidence. In addition to reserve
requirements, there are other required financial ratios that affect the amount of
loans that a bank can fund. The capital requirement ratio is perhaps the most
important of these other required ratios. When there are no mandatory reserve
requirements, which are considered by some economists to restrict lending, the
capital requirement ratio acts to prevent an infinite amount of bank lending.
Liquidity and capital management for a bank
Capital requirement and Market liquidity
To avoid defaulting on its obligations, the bank must maintain a minimal reserve
ratio that it fixes in accordance with, notably, regulations and its liabilities. In
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practice this means that the bank sets a reserve ratio target and responds when
the actual ratio falls below the target. Such response can be, for instance:
1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.
Because different funding options have different costs, and differ in reliability,
banks maintain a stock of low cost and reliable sources of liquidity such as:
1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks.
As with reserves, other sources of liquidity are managed with targets.
The ability of the bank to borrow money reliably and economically is crucial,
which is why confidence in the bank's creditworthiness is important to its
liquidity. This means that the bank needs to maintain adequate capitalisation and
to effectively control its exposures to risk in order to continue its operations. If
creditors doubt the bank's assets are worth more than its liabilities, all demand
creditors have an incentive to demand payment immediately, causing a bank run
to occur.
Contemporary bank management methods for liquidity are based on maturity
analysis of all the bank's assets and liabilities (off balance sheet exposures may
also be included). Assets and liabilities are put into residual contractual maturity
buckets such as 'on demand', 'less than 1 month', '23 months' etc. These
residual contractual maturities may be adjusted to account for expected counter
party behaviour such as early loan repayments due to borrowers refinancing and
expected renewals of term deposits to give forecast cash flows. This analysis
highlights any large future net outflows of cash and enables the bank to respond
before they occur. Scenario analysis may also be conducted, depicting scenarios
including stress scenarios such as a bank-specific crisis.

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THE FEDERAL RESERVE AND THE BANKING SYSTEM

Centralization and Public Control
Board of Governors

Assistance & Advice

Federal Open Market Committee

(FOMC)

The 12 Federal Reserve Banks

Central Bank Role

Quasi-Public Banks

Bankers Banks

Commercial banks &Thrifts

Federal Open Market Committee

The Federal Open Market Committee (FOMC), a committee within the Federal
Reserve System, is charged under United States law with overseeing the nation's
open market operations (i.e., the Fed's buying and selling of United States
Treasury securities). It is the Federal Reserve committee that makes key
decisions about interest rates and the growth of the United States money supply.
It is the principal organ of United States national monetary policy. The
Committee sets monetary policy by specifying the short-term objective for the
Fed's open market operations, which is currently a target level for the federal
funds rate (the rate that commercial banks charge between themselves for
overnight loans).
The FOMC also directs operations undertaken by the Federal Reserve System in
foreign exchange markets, although any intervention in foreign exchange
markets is coordinated with the U.S. Treasury, which has responsibility for
formulating U.S. policies regarding the exchange value of the dollar.
FUNCTIONS
1 Membership
2 Meetings
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 3 Decision-making process
4 Consensus
5 Congressional oversight
6 Interest Rate Targeting: Criticism and Alternatives
The Federal Open Market Committee was formed by the Banking Act of 1933
and did not include voting rights for the Board of Governors. The Banking Act
of 1935revised these protocols to include the Board of Governors and to closely
resemble the present-day FOMC, and was amended in 1942 to give the current
structure of twelve voting members: the seven members of the Federal Reserve
Board and five of the twelve Federal Reserve Bank presidents.
All of the Reserve Bank presidents, even those who are not currently voting
members of the FOMC, attend Committee meetings, participate in discussions,
and contribute to the Committee's assessment of the economy and policy
options. The Committee meets eight times a year, approximately once every six
weeks.
Meetings
Modern-day meeting of the Federal Open Market Committee at the Eccles
Building, Washington, D.C.
By law, the FOMC must meet at least four times each year in Washington, D.C.
Since 1981, eight regularly scheduled meetings have been held each year at
intervals of five to eight weeks. If circumstances require consultation or
consideration of an action between these regular meetings, members may be
called on to participate in a special meeting or a telephone conference, or to
vote on a proposed action by proxy. At each regularly scheduled meeting, the
Committee votes on the policy to be carried out during the interval between
meetings, requiring members to think ahead.
Attendance at meetings is restricted because of the confidential nature of the
information discussed and is limited to Committee members, non member
Reserve Bank presidents, staff officers, the Manager of the System Open
Market Account, and a small number of Board and Reserve Bank staff.

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Decision-Making Process
Before each regularly scheduled meeting of the FOMC, System staff prepare
written reports on past and prospective economic and financial developments
that are sent to Committee members and to non member Reserve Bank
presidents. Reports prepared by the Manager of the System Open Market
Account on operations in the domestic open market and in foreign currencies
since the last regular meeting are also distributed. At the meeting itself, staff
officers present oral reports on the current and prospective business situation, on
conditions in financial markets, and on international financial developments.
In its discussions, the Committee considers factors such as trends in prices and
wages, employment and production, consumer income and spending, residential
and commercial construction, business investment and inventories, foreign
exchange markets, interest rates, money and credit aggregates, and fiscal policy.
The Manager of the System Open Market Account also reports on account
transactions since the previous meeting.
After these reports, the Committee members and other Reserve Bank presidents
turn to policy. Typically, each participant expresses his own views on the state
of the economy and prospects for the future and on the appropriate direction for
monetary policy. Then each makes a more explicit recommendation on policy
for the coming intermeeting period (and for the longer run, if under
consideration).
Consensus
Finally, the Committee must reach a consensus regarding the appropriate course
for policy, which is incorporated in a directive to the Federal Reserve Bank of
New Yorkthe Bank that executes transactions for the System Open Market
Account. The directive is cast in terms designed to provide guidance to the
Manager in the conduct of day-to-day open market operations. The directive
sets forth the Committee's objectives for long-run growth of certain key
monetary and credit aggregates.
It also sets forth operating guidelines for the degree of ease or restraint to be
sought in reserve conditions and expectations with regard to short-term rates of
growth in the monetary aggregates. Policy is implemented with emphasis on
supplying reserves in a manner consistent with these objectives and with the
nation's broader economic objectives.
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Congressional oversight
Under the Federal Reserve Act, the Chairman of the Board of Governors of the
Federal Reserve System must appear before Congressional hearings at least
twice per year regarding the efforts, activities, objectives and plans of the
Board and the Federal Open Market Committee with respect to the conduct of
monetary policy. The statute requires that the Chairman appear before the
House Committee on Banking and Financial Services in February and July of
odd numbered years, and before the Senate Committee on Banking, Housing,
and Urban Affairs in February and July of even numbered years.
Interest Rate Targeting: Criticism and Alternatives
The committee's practice of interest rate targeting has been criticized by some
commentators who argue that it may risk an inflationary bias. Possible
alternative rules that enjoy some support among economists include the
traditional monetarist formula of targeting stable growth in an appropriatelychosen monetary aggregate, and inflation targeting, now practiced by many
Central Banks. Under inflationary pressure in 1979, the Fed temporarily
abandoned interest rate targeting in favour of targeting non-borrowed reserves.
It concluded, however, that this approach led to increased volatility in interest
rates and monetary growth, and reversed itself in 1982.
Current Fed Chairman Ben Bernanke spoke sympathetically as a Governor in
2003 of the inflation targeting approach. He explained that even a Central Bank
like the Fed, which does not orient its monetary policies around an explicit,
published inflation target, nonetheless takes account of its goal of low and stable
inflation in formulating its interest rate targets. Bernanke summed up his overall
assessment of inflation targeting as follows:
Inflation targeting, at least in its best-practice form, consists of two parts: a
policy framework of constrained discretion and a communication strategy that
attempts to focus expectations and explain the policy framework to the public.
Together, these two elements promote both price stability and well-anchored
inflation expectations; the latter in turn facilitates more effective stabilization of
output and employment. Thus, a well-conceived and well-executed strategy of
inflation targeting can deliver good results with respect to output and
employment as well as inflation.

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Although communication plays several important roles in inflation targeting,

perhaps the most important is focusing and anchoring expectations. Clearly
there are limits to what talk can achieve; ultimately, talk must be backed up by
action, in the form of successful policies. Likewise, for a successful and
credible central bank like the Federal Reserve, the immediate benefits of
adopting a more explicit communication strategy may be modest. Nevertheless,
making the investment now in greater transparency about the central bank's
objectives, plans, and assessments of the economy could pay increasing
dividends in the future.
In keeping with his 2003 speech as Governor, Bernanke as Chairman has
attempted to promote greater transparency in Fed communications. The Fed
now indicates publicly the range within which it would like to see future
inflation.
Federal Reserve Bank Rotation on the FOMC
Committee membership changes at the first regularly scheduled meeting of the
year.
Financial services are the economic services provided by the finance industry,
which encompasses a broad range of organizations that manage money,
including credit unions, banks, credit
card companies, insurance companies, consumer finance companies, stock
brokerages, investment funds and some government sponsored enterprises. As
of 2004, the financial services industry represented 20% of the market
capitalization of the S&P 500 in the United States
History of financial services
The term "financial services" became more prevalent in the United States partly
as a result of the Gramm-Leach-Bliley Act of the late 1990s, which enabled
different types of companies operating in the U.S. financial services industry at
that time to merge.
Companies usually have two distinct approaches to this new type of business.
One approach would be a bank which simply buys an insurance company or
an investment bank, keeps the original brands of the acquired firm, and adds
the acquisition to its holding company simply to diversify its earnings. Outside
the U.S. (e.g., in Japan), non-financial services companies are permitted within
the holding company. In this scenario, each company still looks independent,
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and has its own customers, etc. In the other style, a bank would simply create its
own brokerage division or insurance division and attempt to sell those products
to its own existing customers, with incentives for combining all things with one
company.
Banks
A "commercial bank" is what is commonly referred to as simply a "bank". The
term "commercial" is used to distinguish it from an "investment bank," a type of
financial services entity which, instead of lending money directly to a business,
helps businesses raise money from other firms in the form of bonds (debt)
or stock (equity).
Banking services
The primary operations of banks include:
Keeping money safe while also allowing withdrawals when needed
Issuance of check books so that bills can be paid and other kinds of
payments can be delivered by post
Provide personal loans, commercial loans, and mortgage loans (typically
loans to purchase a home, property or business)
Issuance of credit cards and processing of credit card transactions and
billing
Issuance of debit cards for use as a substitute for checks
Allow financial transactions at branches or by using Automatic Teller
Machines (ATMs)
Provide wire transfers of funds and Electronic fund transfers between
banks
Facilitation of standing orders and direct debits, so payments for bills can
be made automatically
Provide overdraft agreements for the temporary advancement of the
Bank's own money to meet monthly spending commitments of a
customer in their current account.
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 Provide internet banking system to facilitate the customers to view and

operate their respective accounts through internet.
Provide Charge card advances of the Bank's own money for customers
wishing to settle credit advances monthly.
Provide a check guaranteed by the Bank itself and prepaid by the
customer, such as a cashier's check or certified check.
Notary service for financial and other documents
Accepting the deposits from customer and provide the credit facilities to
them
Other types of bank services
Private banking - Private banks provide banking services exclusively
to high net worth individuals. Many financial services firms require a
person or family to have a certain minimum net worth to qualify for
private banking services. Private banks often provide more personal
services, such as wealth management and tax planning, than normal retail
banks.
Capital market bank - bank that underwrite debt and equity, assist
company deals (advisory services, underwriting and advisory fees), and
restructure debt into structured finance products.
Bank cards - include both credit cards and debit cards. Bank Of America
is the largest issuer of bank cards.
Credit card machine services and networks - Companies which provide
credit card machine and payment networks call themselves "merchant
card providers".
FOREIGN EXCHANGE SERVICES
Foreign exchange services are provided by many banks around the world.
Foreign exchange services include:

Currency exchange - where clients can purchase and sell foreign currency
banknotes.
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Foreign Currency Banking - banking transactions are done in foreign

currency.

Wire transfer - where clients can send funds to international banks

abroad.
INVESTMENT SERVICES

Asset management - the term usually given to describe companies which

run collective investment funds. Also refers to services provided by others,
generally registered with the Securities and Exchange Commission
as Registered Investment Advisors.

Hedge fund management - Hedge funds often employ the services of

"prime brokerage" divisions at major investment banks to execute their
trades.

Custody services - the safe-keeping and processing of the world's

securities trades and servicing the associated portfolios. Assets under
custody in the world are approximately US$100 trillion.

INSURANCE
Insurance brokerage - Insurance brokers shop for insurance (generally corporate
property and casualty insurance) on behalf of customers. Recently a number of
websites have been created to give consumers basic price comparisons for
services such as insurance, causing controversy within the industry.
Insurance underwriting - Personal lines insurance underwriters actually
underwrite insurance for individuals, a service still offered primarily
through agents, insurance brokers, and stock brokers. Underwriters may
also offer similar commercial lines of coverage for businesses. Activities
include insurance and annuities, life insurance, retirement
insurance, health insurance, and property & casualty insurance.
Reinsurance - Reinsurance is insurance sold to insurers themselves, to
protect them from catastrophic losses.
Other financial services
Intermediation or advisory services - These services involve stock
brokers (private client services) and discount brokers. Stock brokers assist
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investors in buying or selling shares. Primarily internet-based companies

are often referred to as discount brokerages, although many now have
branch offices to assist clients. These brokerages primarily target
individual investors. Full service and private client firms primarily assist
and execute trades for clients with large amounts of capital to invest, such
as large companies, wealthy individuals, and investment management
funds.
Private equity - Private equity funds are typically closed-end funds,
which usually take controlling equity stakes in businesses that are either
private, or taken private once acquired. Private equity funds often use
leveraged buyouts (LBOs) to acquire the firms in which they invest. The
most successful private equity funds can generate returns significantly
higher than provided by the equity markets
Venture capital is a type of private equity capital typically provided by
professional, outside investors to new, high-potential-growth companies
in the interest of taking the company to an IPO or trade sale of the
business.
Angel investment - An angel investor or angel (known as a business angel
or informal investor in Europe), is an affluent individual who provides
capital for a business start-up, usually in exchange for convertible debt or
ownership equity. A small but increasing number of angel investors
organize themselves into angel groups or angel networks to share
research and pool their investment capital.
Conglomerates - A financial services conglomerate is a financial services
firm that is active in more than one sector of the financial services market
e.g. life insurance, general insurance, health insurance, asset
management, retail banking, wholesale banking, investment banking, etc.
A key rationale for the existence of such businesses is the existence of
diversification benefits that are present when different types of businesses
are aggregated i.e. bad things don't always happen at the same time. As a
consequence, economic capital for a conglomerate is usually substantially
less than economic capital is for the sum of its parts.
Debt resolution is a consumer service that assists individuals that have
too much debt to pay off as requested, but do not want to file bankruptcy
28

and wish to pay off their debts owed. This debt can be accrued in various
ways including but not limited to personal loans, credit cards or in some
cases merchant accounts. There are many services/companies that can
assist with this.

Chairman of the Federal Reserve

The Chairman of the Board of Governors of the Federal Reserve System is
the head of the central banking system of any nation. Known colloquially as
"Chairman of the Fed", "Fed Chairman" or "Fed Chief". The Chairman is the
"active executive officer" of the Board of Governors of the Federal Reserve
System.
The Board of Governors of the Federal Reserve did not exist prior to the major
reorganization of the Fed in 1935 (Banking Act of 1935). Prior to that time, the
"Federal Reserve Board" (created in 1913 under the Federal Reserve Act) had a
Board of Directors. The directors' salaries were significantly lower (at $12,000
when first appointed in 1914]) and their terms of office were much shorter prior
to 1935.
Prior to 1935, the heads of the twelve district "Federal Reserve Banks" were
called "Governors". In the 1935 act, the district heads had their titles changed to
"President.
The others prior to 1935 were "Chairman of the Board of Directors of the
Federal Reserve System", with much more circumscribed power.
As stipulated by the Banking Act of 1935, the President appoints the seven
members of the Board of Governors of the Federal Reserve System; they must
then be confirmed by the Senate and serve for 14 years. Once appointed,
Governors may not be removed from office for their policy opinions. The
chairman and vice-chairman are chosen by the President from among the sitting
Governors for four-year terms; these appointments are also subject to Senate
confirmation. By law, the chairman reports twice a year to Congress on the
Federal Reserve's monetary policy objectives. He also testifies before Congress
on numerous other issues and meets periodically with the Secretary of
the Treasury.

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REFERENCES
1. http://en.Wikipedia.org
2. General economics: money and banking
3. http://en.wikipedia.org/wiki/Fractional_reserve_banking
4. http://www.preservearticles.com/201104115268/4-essential-functions-ofmoney.html
5. http://economics.about.com/cs/studentresources/f/money.htm

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OLADEPO FAVOUR MOYINOLUWA

12EA002371
BFN 111
ASSIGNMENT: MONEY AND BANKING

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