HISTORY

The history of money spans thousands of years. Numismatics is the scientific study of money and its history in all its varied forms.



Many items have been used as commodity money such as natural scarce precious metals, cowry shells,barley, beads etc., as well as many other things that are thought of as having value.
Modern money (and most ancient money) is essentially a token — in other words, an abstraction. Paper currency is perhaps the most common type of physical money. However, objects of gold or silver present many of money's essential properties.



Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past, a standard of deferred payment. Any kind of object or secure verifiable record that fulfills these functions can serve as money.

Money is historically an emergent market phenomena establishing a commodity money, but nearly all contemporary money systems are based on fiat money. Fiat money is without intrinsic use value as a physical commodity, and derives its value by being declared by a government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for "all debts, public and private". The money supply of a country consists of currency (banknotes and coins) and bank money(the balance held in checking accounts and savings accounts). Bank money usually forms by far the largest part of the money supply.

The use of barter-like methods may date back to at least 100,000 years ago, though there is no evidence of a society or economy that relied primarily on barter. Instead, non-monetary societies operated largely along the principles of gift economics and debt. When barter did in fact occur, it was usually between either complete strangers or potential enemies.

Many cultures around the world eventually developed the use of commodity money. The shekel was originally a unit of weight, and referred to a specific weight of barley, which was used as currency. The first usage of the term came from Mesopotamia circa 3000 BC. Societies in the Americas, Asia, Africa and Australia used shell money – often, the shells of the money cowry (Cypraea moneta L. or C. annulus L.). According to Herodotus, the Lydians were the first people to introduce the use of gold and silver coins. It is thought by modern scholars that these first stamped coins were minted a The system of commodity money eventually evolved into a system of representative money.This occurred because gold and silver merchants or banks would issue receipts to their depositors – redeemable for the commodity money deposited. Eventually, these receipts became generally accepted as a means of payment and were used as money. Paper money or banknotes were first used in China during the Song Dynasty. These banknotes, known as "jiaozi", evolved from promissory notes that had been used since the 7th century. However, they did not displace commodity money, and were used alongside coins. Banknotes were first issued in Europe by Stockholms Banco in 1661, and were again also used alongside coins. The gold standard, a monetary system where the medium of exchange are paper notes that are convertible into pre-set, fixed quantities of gold, replaced the use of gold coins as currency in the 17th-19th centuries in Europe. These gold standard notes were made legal tender, and redemption into gold coins was discouraged. By the beginning of the 20th century almost all countries had adopted the gold standard, backing their legal tender notes with fixed amounts of gold.

After World War II, at the Bretton Woods Conference, most countries adopted fiat currencies that were fixed to the US dollar. The US dollar was in turn fixed to gold. In 1971 the US government suspended the convertibility of the US dollar to gold. After this many countries de-pegged their currencies from the US dollar, and most of the world's currencies became unbacked by anything except the governments' fiat of legal tender and the ability to convert the money into goods via payment.

Functions







In the past, money was generally considered to have the following four main functions, which are summed up in a rhyme found in older economics textbooks: "Money is a matter of functions four, a medium, a measure, a standard, a store." That is, money functions as a medium of exchange, a unit of account, a standard of deferred payment, and a store of value.However, modern textbooks now list only three functions, that of medium of exchange, unit of account, and store of value, not considering a standard of deferred payment as a distinguished function, but rather subsuming it in the others.

There have been many historical disputes regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. One of these arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value: its role as a store of value requires holding it without spending, whereas its role as a medium of exchange requires it to circulate. Others argue that storing of value is just deferral of the exchange, but does not diminish the fact that money is a medium of exchange that can be transported both across space and time. The term 'financial capital' is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly.

The emergence of money



According to Economist Carl Menger, money emerged spontaneously through the self-interested actions of individuals. No single person sat back and conceived of a universal medium of exchange, and no government compulsion was necessary to effect the transition from a condition of barter to a money economy. (Mises Daily: Monday, September 29, 2003 by Robert P. Murphy)

In his book Debt: The First 5,000 Years anthropologist David Graeber refutes the suggestion that money was invented to replacebarter. The problem with this version of history, he suggests, is the lack of any supporting evidence. His research indicates 'gift economies' were common, at least the beginnings of the first agrarian societies, when humans used elaborate credit systems based on gift economy to buy and sell goods prior to the invention of formal money. Since invading soldiers are not generally local, known andtrustworthy people, money may have been invented as an alternative to economic tool to discourage or deter armed robbery and looting.

The Mesopotamian civilization developed a large scale economy based on commodity money. The Babylonians and their neighboringcity states later developed the earliest system of economics as we think of it today, in terms of rules on debt, legal contracts and law codes relating to business practices and private property. Money was not only an emergence, it was a necessity.

The Code of Hammurabi, the best preserved ancient law code, was created ca. 1760 BC (middle chronology) in ancient Babylon. It was enacted by the sixth Babylonian king, Hammurabi. Earlier collections of laws include the code of Ur-Nammu, king of Ur (ca. 2050 BC), the Code of Eshnunna (ca. 1930 BC) and the code of Lipit-Ishtar of Isin (ca. 1870 BC). These law codes formalized the role of money in civil society. They set amounts of interest on debt... fines for 'wrong doing'... and compensation in money for various infractions of formalized law.

The shekel was an ancient unit of both weight and currency. It was first used in Mesopotamia around 3000 BC to define a specific weight of barley and equivalent amounts of materials such as silver, bronze and copper. The use of a single unit to define both mass and currency was a similar concept to the British pound, which was originally defined as a one pound mass of silver.

Commodity money

Bartering has several problems, most notably that it requires a 'coincidence of wants'. For example, if a wheat farmer needs what a fruit farmer produces, a direct swap is impossible as seasonal fruit would spoil before the grain harvest. A solution is to trade fruit for wheat indirectly through a third, "intermediate", commodity: the fruit is exchanged for the intermediate commodity when the fruit ripens. If this intermediate commodity doesn't perishand is reliably in demand throughout the year (e.g. copper, gold, or wine) then it can be exchanged for wheat after the harvest. The function of the intermediate commodity as a store-of-value can be standardized into a widespread commodity money, reducing the coincidence of wants problem. By overcoming the limitations of simple barter, a commodity money makes the market in all other commodities more liquid.
Many cultures around the world eventually developed the use of commodity money. Ancient China, Africa, and India used cowry shells. Trade in Japan's feudal system was based on the koku – a unit of rice. The shekel was an ancient unit of weight and currency. The first usage of the term came from Mesopotamia circa 3000 BC and referred to a specific weight of barley, which related other values in a metric such as silver, bronze, copper etc. A barley/shekel was originally both a unit of currency and a unit of weight.

Wherever trade is common, barter systems usually lead quite rapidly to several key goods being imbued with monetary properties. In the early British colony of New South Wales, rum emerged quite soon after settlement as the most monetary of goods. When a nation is without a currency it commonly adopts a foreign currency. In prisons where conventional money is prohibited, it is quite common for cigarettes to take on a monetary quality, and throughout history, gold has taken on this unofficial monetary function.

Standardized coinage

It has long been assumed that from early times, metals, where available, have usually been favored for use as proto-money over such commodities as cattle, cowry shells, or salt, because they are at once durable, portable, and easily divisible.The use of gold as proto-money has been traced back to the fourth millennium BC when the Egyptians used gold bars of a set weight as a medium of exchange, as had been done earlier in Mesopotamia with silver bars. The first known ruler who officially set standards of weight and money was Pheidon. From approximately 1000 BC China used money in the shape of small knives and spades made of bronze, and had used cast bronze replica of cowrie shells even before that. A Persian 309–379 AD silver drachmfrom the Sasanian DynastyBC precious metals in ingot form had been used in international commerce, but not in common transactions. The first manufactured coins seems to have taken place separately in India, China, and in cities around the Agean sea between 700 and 500 BC.
The first stamped money (having the mark of some authority in the form of a picture or words) can be seen in the Bibliothèque Nationale of Paris. It is an electrum stater of a turtle coin, coined at Aegina island. This coin dates about 700 BC. Other coins made of Electrum (a naturally occurring alloy of silver and gold) were manufactured on a larger scale about 650 BC in Lydia (on the coast of what is now Turkey). Similar coinage was adopted and manufactured to their own standards in nearby cities of Ionia, including Mytilene and Phokaia(using coins of Electrum) and Aegina (using silver) during the 6th century BC. and soon became adopted in mainland Greece itself, and the Persian Empire (after it incorporated Lydia in 547 BC. The use and export of silver coinage, along with soldiers paid in coins, contributed to the Athenian Empire's 5th century BC, dominance of the region. The silver used was mined in southern Attica at Laurium and Thorikos by a huge workforce of slave labour. A major silver vein discovery atLaurium in 483 BC led to the huge expansion of the Athenian military fleet.
While these Aegean coins were stamped (heated and hammered with insignia), the Indian coins (from the Ganges river valley) were punched metal disks, and Chinese coins (first developed in the Great Plain) were cast bronze with holes in the center to be strung together. The different forms and metallurgical process makes it appear they were invented separately .
It was the discovery of the touchstone which led the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a result, monetary gold spread very quickly from Asia Minor, where it first gained wide usage, to the entire world.

Using such a system still required several steps and mathematical calculation. The touchstone allows one to estimate the amount of gold in an alloy, which is then multiplied by the weight to find the amount of gold alone in a lump. To make this process easier, the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed, so as long as the manufacturer was aware of the origin of the coin, no use of the touchstone was required. Coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was, however, extremely common for governments to assert that the value of such money lay in its emblem and thus to subsequently reduce the value of the currency by lowering the content of valuable metal.

Gold and silver were used as the most common form of money throughout history. In many languages, such as Spanish, French, and Italian, the word for silver is still directly related to the word for money. Although gold and silver were commonly used to mint coins, other metals were used. For instance, Ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money", which were large slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of their value.
Metal based coins had the advantage of carrying their value within the coins themselves — on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities European observers like Isaac Newton, Master of the Royal Mint observed with unease.
Stability came into the system with national Banks guaranteeing to change money into gold at a promised rate; it did, however, not come easily. The Bank of England risked a national financial catastrophe in the 1730s when customers demanded their money be changed into gold in a moment of crisis. Eventually London's merchants saved the bank and the nation with financial guarantees.
Another step in the evolution of money was the change from a coin being a unit of weight to being a unit of value. A distinction could be made between its commodity value and its specie value.

Trade bills of exchange



Bills of exchange became prevalent with the expansion of European trade toward the end of the Middle Ages. A flourishing Italian wholesale trade in cloth, woolen clothing, wine, tin and other commodities was heavily dependent on credit for its rapid expansion. Goods were supplied to a buyer against a bill of exchange, which constituted the buyer's promise to make payment at some specified future date. Provided that the buyer was reputable or the bill was endorsed by a credible guarantor, the seller could then present the bill to a merchant banker and redeem it in money at a discounted value before it actually became due. The main purpose of these bills nevertheless was, that traveling with cash was particularly dangerous at the time. A deposit could be made with a banker in one town, in turn a bill of exchange was handed out, that could be redeemed in another town.

These bills could also be used as a form of payment by the seller to make additional purchases from his own suppliers. Thus, the bills – an early form of credit – became both a medium of exchange and a medium for storage of value. Like the loans made by the Egyptian grain banks, this trade credit became a significant source for the creation of new money. In England, bills of exchange became an important form of credit and money during last quarter of the 18th century and the first quarter of the 19th century before banknotes, checks and cash credit lines were widely available.
Tallies

The acceptance of symbolic forms of money opened up vast new realms for human creativity. A symbol could be used to represent something of value that was available in physical storage somewhere else in space, such as grain in the warehouse. It could also be used to represent something of value that would be available later in time, such as a promissory note or bill of exchange, a document ordering someone to pay a certain sum of money to another on a specific date or when certain conditions have been fulfilled.
In the 12th Century, the English monarchy introduced an early version of the bill of exchange in the form of a notched piece of wood known as a tally stick. Tallies originally came into use at a time when paper was rare and costly, but their use persisted until the early 19th Century, even after paper forms of money had become prevalent. The notches were used to denote various amounts of taxes payable to the crown. Initially tallies were simply used as a form of receipt to the tax payer at the time of rendering his dues. As the revenue department became more efficient, they began issuing tallies to denote a promise of the tax assessee to make future tax payments at specified times during the year. Each tally consisted of a matching pair – one stick was given to the assessee at the time of assessment representing the amount of taxes to be paid later and the other held by the Treasury representing the amount of taxes be collected at a future date.
The Treasury discovered that these tallies could also be used to create money. When the crown had exhausted its current resources, it could use the tally receipts representing future tax payments due to the crown as a form of payment to its own creditors, who in turn could either collect the tax revenue directly from those assessed or use the same tally to pay their own taxes to the government. The tallies could also be sold to other parties in exchange for gold or silver coin at a discount reflecting the length of time remaining until the taxes was due for payment. Thus, the tallies became an accepted medium of exchange for some types of transactions and an accepted medium for store of value. Like the girobanks before it, the Treasury soon realized that it could also issue tallies that were not backed by any specific assessment of taxes. By doing so, the Treasury created new money that was backed by public trust and confidence in the monarchy rather than by specific revenue receipts.

Money creation by the central bank
Within almost all modern nations, special institutions exist (such as the Federal Reserve System in the United States, the European Central Bank (ECB), and thePeople's Bank of China) which have the task of executing the monetary policy and often acting independently of the executive. In general, these institutions are calledcentral banks and often have other responsibilities such as supervising the smooth operation of the financial system. There are several monetary policy tools available to a central bank to expand the money supply of a country: decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements. All have the effect of expanding the money supply.
The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial assets, such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency entering market circulation (while sales of these assets remove money from circulation).
Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency, the price of gold, or indices such as Consumer Price Index. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight. The other primary means of conducting monetary policy include: (i) Discount window lending (as lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics



. Quantitative easing
Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.
Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate is no longer effective because interest rates are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap

Physical currency

In modern economies, relatively little of the money supply is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.
Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.
Money multiplier

In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank moneyunder a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves; this multiple is thereciprocal of the reserve ratio, and it is an economic multiplier..In equations, writing M for commercial bank money (loans), R for reserves (central bank money), and RR for the reserve ratio, the reserve ratio requirement is that the fraction of reserves must be at least the reserve ratio. Taking the reciprocal, which yields meaning that commercial bank money is at most reserves times the latter being the multiplier.

If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an approximate equality, and commercial bank money is central bank money times the multiplier. If banks instead lend less than the maximum, accumulatingexcess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier.
In the United States since 1959, banks lent out close to the maximum allowed for the 49-year period from 1959 until August 2008, maintaining a low level of excess reserves, then accumulated significant excess reserves over the period September 2008 through the present (November 2009). Thus, in the first period, commercial bank money was almost exactly central bank money times the multiplier, but this relationship broke down from September 2008.
As a formula and legal quantity, the money multiplier is not controversial – it is simply the maximum that commercial banks are allowed to lend out. However, there are various heterodox theories concerning the mechanism of money creation in a fractional-reserve banking system, and the implication for monetary policy.

Definition
The money multiplier is defined in various ways. Most simply, it can be defined either as the statistic of "commercial bank money"/"central bank money", based on the actual observed quantities of various empirical measures of money supply, such as M2(broad money) over M0 (base money), or it can be the theoretical "maximum commercial bank money/central bank money" ratio, defined as the reciprocal of the reserve ratio, The multiplier in the first (statistic) sense fluctuates continuously based on changes in commercial bank money and central bank money (though it is at most the theoretical multiplier), while the multiplier in the second (legal) sense depends only on the reserve ratio, and thus does not change unless the law changes.
For purposes of monetary policy, what is of most interest is the predicted impact of changes in central bank money on commercial bank money, and in various models of monetary creation, the associated multiple (the ratio of these two changes) is called the money multiplier (associated to that model). For example, if one assumes that people hold a constant fraction of deposits as cash, one may add a "currency drain" variable (currency–deposit ratio), and obtain a multiplier of.
These concepts are not generally distinguished by different names; if one wishes to distinguish them, one may gloss them by names such as empirical (or observed) multiplier, legal (or theoretical) multiplier, or model multiplier, but these are not standard usages.
Similarly, one may distinguish the observed reserve–deposit ratio from the legal (minimum) reserve ratio, and the observed currency–deposit ratio from an assumed model one. Note that in this case the reserve–deposit ratio and currency–deposit ratio are outputs of observations, and fluctuate over time. If one then uses these observed ratios as model parameters (inputs) for the predictions of effects of monetary policy and assumes that they remain constant, computing a constant multiplier, the resulting predictions are valid only if these ratios do not in fact change. Sometimes this holds, and sometimes it does not; for example, increases in central bank money may result in increases in commercial bank money – and will, if these ratios (and thus multiplier) stay constant – or may result in increases in excess reserves but little or no change in commercial bank money, in which case the reserve–deposit ratio will grow and the multiplier will fall.
Mechanism
There are two suggested mechanisms for how money creation occurs in a fractional-reserve banking system: either reserves are first injected by the central bank, and then lent on by the commercial banks, or loans are first extended by commercial banks, and then backed by reserves borrowed from the central bank. The "reserves first" model is that taught in mainstream economics textbooks, while the "loans first" model is advanced by endogenous money theorists.
Reserves first model
In the "reserves first" model of money creation, a given reserve is lent out by a bank, then deposited at a bank (possibly different), which is then lent out again, the process repeating and the ultimate result being a geometric series.




Formula
The money multiplier, m, is the inverse of the reserve requirement,RR:

This formula stems from the fact that the sum of the "amount loaned out" column above can be expressed mathematically as a geometric series with a common ratio of
To correct for currency drain (a lessening of the impact of monetary policy due to peoples' desire to hold some currency in the form of cash) and for banks' desire to hold reserves in excess of the required amount, the formula:

can be used, where Currency Drain Ratio is the percentage of money that people want to hold as cash and the Desired Reserve Ratio is the sum of the Required Reserve Ratio and the Excess Reserve Ratio.

The formula above is derived from the following procedure. Let the monetary base be normalized to unity. Define the legal reserve ratio, , the excess reserves ratio, , the currency drain ratio with respect to deposits, ; suppose the demand for funds is unlimited; then the theoretical superior limit for deposits is defined by the following series:



Analogously, the theoretical superior limit for the money held by public is defined by the following series:



and the theoretical superior limit for the totale loans lent in the market is defined by the following series:



By summing up the two quantities, the theoretical money multiplier is defined as




where and

The process described above by the geometric series can be represented in the following table, where

loans at stage are a function of the deposits at the precedent stage:

publicly held money at stage is a function of the deposits at the precedent stage:

deposits at stage are the difference between additional loans and publicly held money relative to the same stage:
Process of money multiplicationDepositsLoansPublicly Held Money

- -







… … … …



… … … …



Total Deposits: Total Loans: Total Publicly Held Money:


Table
 This re-lending process (with no currency drain) can be depicted as follows, assuming a 20% reserve ratio and a $100 initial deposit:
Table SourceIndividual BankAmount DepositedLent OutReserves

A 100.00 80.00 20.00

B 80.00 64.00 16.00

C 64.00 51.20 12.80

D 51.20 40.96 10.24

E 40.96 32.77 8.19

F 32.77 26.21 6.55

G 26.21 20.97 5.24

H 20.97 16.78 4.19

I 16.78 13.42 3.36

J 13.42 10.74 2.68

K 10.74
Total Reserves:
89.26

Total Amount of Deposits: Total Amount Lent Out: Total Reserves + Last Amount Deposited:

457.05 357.05 100.00

For example, with the reserve ratio of 20 percent, this reserve ratio, RR, 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.

Another way to look at the monetary multiplier is derived from the concept of money supply and money base. It is the number of dollars of money supply that can be created for every dollar of monetary base. Money supply, denoted by M, is the stock of money held by public. It is measured by the amount of currency and deposits. Money Base, denoted by B, is the summation of currency and reserves. Currency and Reserves are monetary policy that can be affected by the Federal Reserve. For example, the Federal Reserve can increase currency by printing more money and they can similarly increase reserve by requiring a higher percentage of deposits to be stored in the Federal Reserve.

Mathematically:

M=Money Supply

C=Currency

D=Deposits

B=Money Base

R=Reserve
So that money supply over money base:

Multiply the right side by . Since this equals to 1, it is mathematically justified to multiply it to only the right side.

Then multiple the right side of the equation by the Money Base

So we get:

is the multiplier. Therefore, if money base is held constant, the ratio of D/R and D/C affects the money supply. When the ratio of deposits to reserves (D/R) reduces, the multiplier reduces. Similarly, if the ratio of deposits to currency (D/C) falls, the multiplier falls as well.

The multiplier effect is relevant to considering monetary and fiscal policies, as well how the banking system works. For example, the deposit, the monetary amount a customer deposits at a bank, is used by the bank to loan out to others, thereby generating the money supply. Most banks are FDIC insured (Federal Deposit Insurance Corporation), so that customers are assured that their savings, up to a certain amount, is insured by the federal government. Banks are required to reserve a certain ratio of the customer's deposits in reserve, either in the form of vault cash or of a deposit maintained by a Federal Reserve Bank.. Therefore, if the Federal Reserve Bank (and hence its monetary policy) requires a higher percentage of reserve, then it lowers the bank's financial ability to loan.

Loans first model

In the alternative model of money creation, loans are first extended by commercial banks – say, $1,000 of loans (following the example above), which may then require that the bank borrow $100 of reserves either from depositors (or other private sources of financing), or from the central bank. However it is also possible that the loan is used to pay another bank customer who deposits it back with the bank, thus negating the need for any form of reserve to be borrowed by the bank. This view is advanced in endogenous money theories, such as the Post-Keynesian school of monetary circuit theory, as advanced by such economists as Basil Moore and Steve Keen.

Implications for monetary policy

The multiplier plays a key role in monetary policy, and the distinction between the multiplier being the maximum amount of commercial bank money created by a given unit of central bank money and approximately equal to the amount created has important implications in monetary policy.

If banks maintain low levels of excess reserves, as they did in the US from 1959 to August 2008, then central banks can finely control broad (commercial bank) money supply by controlling central bank money creation, as the multiplier gives a direct and fixed connection between these.

If, on the other hand, banks accumulate excess reserves, as occurs in some financial crises such as the Great Depression and theFinancial crisis of 2007–2010, then this relationship breaks down and central banks can force the broad money supply to shrink, but not force it to grow:

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.

Restated, increases in central bank money may not result in commercial bank money because the money is not required to be lent out – it may instead result in a growth of unlent reserves (excess reserves). This situation is referred to as "pushing on a string": withdrawal of central bank money compels commercial banks to curtail lending (one can pull money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot push via this mechanism).

This described growth in excess reserves has indeed occurred in the Financial crisis of 2007–2010, US bank excess reserves growing over 500-fold, from under $2 billion in August 2008 to over $1,000 billion in November 2009.

Types of money

Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins. As economies developed, commodity money was eventually replaced by representative money, such as the gold standard, as traders found the physical transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years, especially since the breakup of the Bretton Woods system in the early 1970s.Many items have been used as commodity money such as naturally scarce precious metals,conch shells, barley, beads etc., as well as many other things that are thought of as havingvalue. Commodity money value comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity. Examples of commodities that have been used as mediums of exchange include gold, silver, copper, rice, salt, peppercorns, large stones, decorated belts, shells, alcohol, cigarettes, cannabis, candy, etc. These items were sometimes used in a metric of perceived value in conjunction to one another, in various commodity valuation or Price System economies. Use of commodity money is similar to barter, but a commodity money provides a simple and automatic unit of account for the commodity which is being used as money. Although some gold coins such as the Krugerrand are considered legal tender, there is no record of their face value on either side of the coin. The rationale for this is that emphasis is laid on their direct link to the prevailing value of their fine gold content. American Eagles are imprinted with their gold content and legal tender face value.

Representative money

In 1875 economist William Stanley Jevons described what he called "representative money," i.e., money that consists of token coins, or other physical tokens such as certificates, that can be reliably exchanged for a fixed quantity of a commodity such as goldor silver. The value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity

Fiat money

Fiat money or fiat currency is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins from a central bank, such as the Federal Reserve System in the U.S.) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.

Some bullion coins such as the Australian Gold Nugget and American Eagle are legal tender, however, they trade based on themarket price of the metal content as a commodity, rather than their legal tender face value (which is usually only a small fraction of their bullion value).

Fiat money, if physically represented in the form of currency (paper or coins) can be accidentally damaged or destroyed. However, fiat money has an advantage over representative or commodity money, in that the same laws that created the money can also define rules for its replacement in case of damage or destruction. For example, the U.S. government will replace mutilated Federal Reserve notes (U.S. fiat money) if at least half of the physical note can be reconstructed, or if it can be otherwise proven to have been destroyed. By contrast, commodity money which has been lost or destroyed cannot be recovered.

Currency
urrency refers to physical objects generally accepted as a medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of bank deposits (sometimes called deposit money), ownership of which can be transferred by means of cheques, debit cards, or other forms of money transfer. Deposit money and currency are money in the sense that both are acceptable as a means of payment.

Money in the form of currency has predominated throughout most of history. Usually (gold or silver) coins of intrinsic value (commodity money) have been the norm. However, nearly all contemporary money systems are based on fiat money – modern currency has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins issued by the central bank) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.

Commercial bank money

Commercial bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by check or cashwithdrawal without giving the bank or financial institution any prior notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or 'at call'). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using automatic teller machines (ATMs), or through online banking.

Commercial bank money is created through fractional-reserve banking, the banking practice where banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand. Commercial bank money differs from commodity and fiat money in two ways, firstly it is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions, and secondly, there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent. The process of fractional-reserve banking has a cumulative effect ofmoney creation by commercial banks, as it expands money supply (cash and demand deposits) beyond what it would otherwise be. Because of the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators.

The money supply of a country is usually held to be the total amount of currency in circulation plus the total amount of checking and savings deposits in the commercial banks in the country. In modern economies, relatively little of the money supply is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money.

Digital money

Digital currencies gained momentum in before the 2000 tech bubble. Flooz and Beenz were particularly advertised as an alternative form of money. While the tech bubble caused them to be short lived, many new digital currencies have reached some, albeit generally small userbases.

Most digital currencies are simply fiat currencies parleyed across a digital medium. However, protocols like Bitcoin allow money to only exist in cyberspace which allows for some classic limitations to be lifted. Never in the history of time has the sending of money across a geographical divide not required the trust of a 3rd party which of course then is susceptible to regulatory capture. Analogous to the printing press having allowed the free exchange knowledge which was highly regulated by the Christian church (who unsuccessfully tried to impose the death penalty for publishing after the printing press came to Europe), new forms of currency coming to fruition this very day allow for the free exchange of wealth across distances.

Monetary policy

When gold and silver are used as money, the money supply can grow only if the supply of these metals is increased by mining. This rate of increase will accelerate during periods of gold rushes and discoveries, such as when Columbus discovered the New World and brought back gold and silver to Spain, or when gold was discovered in California in 1848. This causes inflation, as the value of gold goes down. However, if the rate of gold mining cannot keep up with the growth of the economy, gold becomes relatively more valuable, and prices (denominated in gold) will drop, causing deflation. Deflation was the more typical situation for over a centurywhen gold and paper money backed by gold were used as money in the 18th and 19th centuries.

Modern day monetary systems are based on fiat money and are no longer tied to the value of gold. The control of the amount of money in the economy is known as monetary policy. Monetary policy is the process by which a government, central bank, ormonetary authority manages the money supply to achieve specific goals. Usually the goal of monetary policy is to accommodateeconomic growth in an environment of stable prices. For example, it is clearly stated in the Federal Reserve Act that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

A failed monetary policy can have significant detrimental effects on an economy and the society that depends on it. These includehyperinflation, stagflation, recession, high unemployment, shortages of imported goods, inability to export goods, and even total monetary collapse and the adoption of a much less efficient barter economy. This happened in Russia, for instance, after the fall of the Soviet Union.

Governments and central banks have taken both regulatory and free market approaches to monetary policy. Some of the tools used to control the money supply include:

§ changing the interest rate at which the central bank loans money to (or borrows money from) the commercial banks

§ currency purchases or sales

§ increasing or lowering government borrowing

§ increasing or lowering government spending

§ manipulation of exchange rates

§ raising or lowering bank reserve requirements

§ regulation or prohibition of private currencies

§ taxation or tax breaks on imports or exports of capital into a country
In the US, the Federal Reserve is responsible for controlling the money supply, while in the Euro area the respective institution is theEuropean Central Bank. Other central banks with significant impact on global finances are the Bank of Japan, People's Bank of China and the Bank of England.
For many years much of monetary policy was influenced by an economic theory known as monetarism. Monetarism is an economic theory which argues that management of the money supply should be the primary means of regulating economic activity. The stability of the demand for money prior to the 1980s was a key finding of Milton Friedman and Anna Schwartz supported by the work of David Laidler, and many others. The nature of the demand for money changed during the 1980s owing to technical, institutional, and legal factors] and the influence of monetarism has since decreased.