In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending)

to influence the economy.[1] The two main instruments of fiscal policy are government taxation and changes in the level and composition of taxation and government spending can affect the following variables in the economy:

Aggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

Fiscal policy refers to the use of the government budget to influence economic activity.

Stances of fiscal policy

The three main stances of fiscal policy are:

Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

Taxation Seigniorage, the benefit from printing money Borrowing money from the population or from abroad Consumption of fiscal reserves Sale of fixed assets (e.g., land)

Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed; notice, additional debt is not needed. For this to happen, the marginal propensity to save needs to be strictly positive.

Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending & increasing taxes after the economic boom begins. Keynesians argue this method be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal. Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices. Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal. Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View[citation needed], which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.

In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.[2] Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

Fiscal straitjacket
The concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing, to limit or regulate the budget deficit over a time period. The term probably originated from the definition of straitjacket (anything that severely confines, constricts, or hinders).[3] Various states in the United States have various forms of self-imposed fiscal straitjackets.
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory.[1] Neoclassical economics dominates microeconomics, and together with Keynesian economics forms the neoclassical synthesis which dominates mainstream economics today.[2] Although neoclassical economics has gained widespread acceptance by contemporary economists, there have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory as awareness of economic criteria changes.

The term was originally introduced by Thorstein Veblen in 1900, in his article 'Preconceptions of Economic Science', to distinguish marginalists in the tradition of Alfred Marshall from those in the Austrian School.[3][4] "No attempt will here be made even to pass a verdict on the relative claims of the recognized two or three main "schools" of theory, beyond the somewhat obvious finding that, for the purpose in

hand, the so-called Austrian school is scarcely distinguishable from the neo-classical, unless it be in the different distribution of emphasis. The divergence between the modernized classical views, on the one hand, and the historical and Marxist schools, on the other hand, is wider, so much so, indeed, as to bar out a consideration of the postulates of the latter under the same head of inquiry with the former." - Veblen[5] It was later used by John Hicks, George Stigler, and others[6] to include the work of Carl Menger, William Stanley Jevons, John Bates Clark and many others.[3] Today it is usually used to refer to mainstream economics, although it has also been used as an umbrella term encompassing a number of other schools of thought,[7] notably excluding institutional economics, various historical schools of economics, and Marxian economics, in addition to various other heterodox approaches to economics. Neoclassical economics is characterized by several assumptions common to many schools of economic thought. There is not a complete agreement on what is meant by neoclassical economics, and the result is a wide range of neoclassical approaches to various problem areas and domainsranging from neoclassical theories of labor to neoclassical theories of demographic changes. As expressed by E. Roy Weintraub, neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:[8] 1. People have rational preferences among outcomes that can be identified and associated with a value. 2. Individuals maximize utility and firms maximize profits. 3. People act independently on the basis of full and relevant information. From these three assumptions, neoclassical economists have built a structure to understand the allocation of scarce resources among alternative endsin fact understanding such allocation is often considered the definition of economics to neoclassical theorists. Here's how William Stanley Jevons presented "the problem of Economics". "Given, a certain population, with various needs and powers of production, in possession of certain lands and other sources of material: required, the mode of employing their labour which will maximize the utility of their produce."[9] From the basic assumptions of neoclassical economics comes a wide range of theories about various areas of economic activity. For example, profit maximization lies behind the neoclassical theory of the firm, while the derivation of demand curves leads to an understanding of consumer goods, and the supply curve allows an analysis of the factors of production. Utility maximization is the source for the neoclassical theory of consumption, the derivation of demand curves for consumer goods, and the derivation of labor supply curves and reservation demand.[10] Market supply and demand are aggregated across firms and individuals. Their interactions determine equilibrium output and price. The market supply and demand for each factor of production is derived analogously to those for market final output to determine equilibrium income and the income distribution. Factor demand incorporates the marginal-productivity relationship of that factor in the output market. [6] [11][12][13]

Neoclassical economics emphasizes equilibria, where equilibria are the solutions of agent maximization problems. Regularities in economies are explained by methodological individualism, the position that economic phenomena can be explained by aggregating over the behavior of agents. The emphasis is on microeconomics. Institutions, which might be considered as prior to and conditioning individual behavior, are de-emphasized. Economic subjectivism accompanies these emphases. See also general equilibrium.

Origins
This section does not cite any references or sources. Please help improve this section by adding citations to reliable sources. Unsourced material may be challenged and removed. (August 2011) Classical economics, developed in the 18th and 19th centuries, included a value theory and distribution theory. The value of a product was thought to depend on the costs involved in producing that product. The explanation of costs in Classical economics was simultaneously an explanation of distribution. A landlord received rent, workers received wages, and a capitalist tenant farmer received profits on their investment. This classic approach included the work of Adam Smith and David Ricardo. However, some economists gradually began emphasizing the perceived value of a good to the consumer. They proposed a theory that the value of a product was to be explained with differences in utility (usefulness) to the consumer. (In England, economists tended to conceptualize utility in keeping with the Utilitarianism of Jeremy Bentham and later of John Stuart Mill.) The third step from political economy to economics was the introduction of marginalism and the proposition that economic actors made decisions based on margins. For example, a person decides to buy a second sandwich based on how full they are after the first one, a firm hires a new employee based on the expected increase in profits the employee will bring. This differs from the aggregate decision making of classical political economy in that it explains how vital goods such as water can be cheap, while luxuries can be expensive.

The marginal revolution

The change in economic theory from neoclassical economics has been called the 'marginal revolution', although it has been argued that the process was slower than the term suggests.[14] It is frequently dated from William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Lon Walras's Elements of Pure Economics (18741877). Historians of economics and economists have debated:

Whether utility or marginalism was more essential to this revolution (whether the noun or the adjective in the phrase "marginal utility" is more important)

Whether there was a revolutionary change of thought or merely a gradual development and change of emphasis from their predecessors Whether grouping these economists together disguises differences more important than their similarities.[15]

In particular, Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general equilibrium theory. Menger did not embrace this hedonic conception, explained diminishing marginal utility in terms of subjective prioritization of possible uses, and emphasized disequilibrium and the discrete; further Menger had an objection to the use of mathematics in economics, while the other two modeled their theories after 19th century mechanics.[16] Walras' conception of utility, like that of Menger, was that of usefulness in general,[17] rather than the hedonic conception of Bentham or of Mill; and Walras was more interested in the interaction of markets than in explaining the individual psyche.[15] Alfred Marshall's textbook, Principles of Economics (1890), was the dominant textbook in England a generation later. Marshall's influence extended elsewhere; Italians would compliment Maffeo Pantaleoni by calling him the "Marshall of Italy". Marshall thought classical economics attempted to explain prices by the cost of production. He asserted that earlier marginalists went too far in correcting this imbalance by overemphasizing utility and demand. Marshall thought that "We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production". Marshall explained price by the intersection of supply and demand curves. The introduction of different market "periods" was an important innovation of Marshalls:

Market period. The goods produced for sale on the market are taken as given data, e.g. in a fish market. Prices quickly adjust to clear markets. Short period. Industrial capacity is taken as given. The level of output, the level of employment, the inputs of raw materials, and prices fluctuate to equate marginal cost and marginal revenue, where profits are maximized. Economic rents exist in short period equilibrium for fixed factors, and the rate of profit is not equated across sectors. Long period. The stock of capital goods, such as factories and machines, is not taken as given. Profit-maximizing equilibria determine both industrial capacity and the level at which it is operated. Very long period. Technology, population trends, habits and customs are not taken as given, but allowed to vary in very long period models.

Marshall took supply and demand as stable functions and extended supply and demand explanations of prices to all runs. He argued supply was easier to vary in longer runs, and thus became a more important determinant of price in the very long run.

Further developments

An important change in neoclassical economics occurred around 1933. Joan Robinson and Edward H. Chamberlin, with the near simultaneous publication of their respective books, The Economics of Imperfect Competition (1933) and The Theory of Monopolistic Competition (1933), introduced models of imperfect competition. Theories of market forms and industrial organization grew out of this work. They also emphasized certain tools, such as the marginal revenue curve. Joan Robinson's work on imperfect competition, at least, was a response to certain problems of Marshallian partial equilibrium theory highlighted by Piero Sraffa. Anglo-American economists also responded to these problems by turning towards general equilibrium theory, developed on the European continent by Walras and Vilfredo Pareto. J. R. Hicks's Value and Capital (1939) was influential in introducing his English-speaking colleagues to these traditions. He, in turn, was influenced by the Austrian School economist Friedrich Hayek's move to the London School of Economics, where Hicks then studied. These developments were accompanied by the introduction of new tools, such as indifference curves and the theory of ordinal utility. The level of mathematical sophistication of neoclassical economics increased. Paul Samuelson's Foundations of Economic Analysis (1947) contributed to this increase in mathematical modelling. The interwar period in American economics has been argued to have been pluralistic, with neoclassical economics and institutionalism competing for allegiance. Frank Knight, an early Chicago school economist attempted to combine both schools. But this increase in mathematics was accompanied by greater dominance of neoclassical economics in Anglo-American universities after World War II. Hicks' book, Value and Capital had two main parts. The second, which was arguably not immediately influential, presented a model of temporary equilibrium. Hicks was influenced directly by Hayek's notion of intertemporal coordination and paralleled by earlier work by Lindhal. This was part of an abandonment of disaggregated long run models. This trend probably reached its culmination with the Arrow-Debreu model of intertemporal equilibrium. The ArrowDebreu model has canonical presentations in Grard Debreu's Theory of Value (1959) and in Arrow and Hahn's "General Competitive Analysis" (1971). Many of these developments were against the backdrop of improvements in both econometrics, that is the ability to measure prices and changes in goods and services, as well as their aggregate quantities, and in the creation of macroeconomics, or the study of whole economies. The attempt to combine neo-classical microeconomics and Keynesian macroeconomics would lead to the neoclassical synthesis[18] which has been the dominant paradigm of economic reasoning in English-speaking countries since the 1950s. Hicks and Samuelson were for example instrumental in mainstreaming Keynesian economics. Macroeconomics influenced the neoclassical synthesis from the other direction, undermining foundations of classical economic theory such as Say's Law, and assumptions about political economy such as the necessity for a hard-money standard. These developments are reflected in

neoclassical theory by the search for the occurrence in markets of the equilibrium conditions of Pareto optimality and self-sustainability.

Criticisms
Main article: Criticisms of neoclassical economics Neoclassical economics is sometimes criticized for having a normative bias. In this view, it does not focus on explaining actual economies, but instead on describing a "utopia" in which Pareto optimality applies. The assumption that individuals act rationally may be viewed as ignoring important aspects of human behavior. Many see the "economic man" as being quite different from real people. Many economists, even contemporaries, have criticized this model of economic man. Thorstein Veblen put it most sardonically. Neoclassical economics assumes a person to be, "a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift about the area, but leave him intact."[19] Large corporations might perhaps come closer to the neoclassical ideal of profit maximization, but this is not necessarily viewed as desirable if this comes at the expense of neglect of wider social issues. The response to this is that neoclassical economics is descriptive and not normative. It addresses such problems with concepts of private versus social utility. Problems exist with making the neoclassical general equilibrium theory compatible with an economy that develops over time and includes capital goods. This was explored in a major debate in the 1960sthe "Cambridge capital controversy"about the validity of neoclassical economics, with an emphasis on the economic growth, capital, aggregate theory, and the marginal productivity theory of distribution. There were also internal attempts by neoclassical economists to extend the Arrow-Debreu model to disequilibrium investigations of stability and uniqueness. However a result known as the Sonnenschein-Mantel-Debreu theorem suggests that the assumptions that must be made to ensure that the equilibrium is stable and unique are quite restrictive. Neoclassical economics is also often seen as relying too heavily on complex mathematical models, such as those used in general equilibrium theory, without enough regard to whether these actually describe the real economy. Many see an attempt to model a system as complex as a modern economy by a mathematical model as unrealistic and doomed to failure. A famous answer to this criticism is Milton Friedman's claim that theories should be judged by their ability to predict events rather than by the realism of their assumptions.[20] Mathematical models also include those in game theory, linear programming, and econometrics. Critics of neoclassical economics are divided into those who think that highly mathematical method is inherently wrong and those who think that mathematical method is potentially good even if contemporary methods have problems.

In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards neoclassical economics. It is fair to say that many (but not all) of these criticisms can only be directed towards a subset of the neoclassical models (for example, there are many neoclassical models where unregulated markets fail to achieve Pareto-optimality and there has recently been an increased interest in modeling non-rational decision making). Alfred Marshall (26 July 1842 13 July 1924) was one of the most influential economists of his time. His book, Principles of Economics (1890), was the dominant economic textbook in England for many years. It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent whole. He is known as one of the founders of economics. Marshall was born in Clapham, England, July 26, 1842. His father was a bank cashier and a devout Evangelical. Marshall grew up in the London suburb of Clapham and was educated at the Merchant Taylors' School and St John's College, Cambridge, where he demonstrated an aptitude in mathematics, achieving the rank of Second Wrangler in the 1865 Cambridge Mathematical Tripos.[1][2] Marshall experienced a mental crisis that led him to abandon physics and switch to philosophy. He began with metaphysics, specifically "the philosophical foundation of knowledge, especially in relation to theology.".[3] Metaphysics led Marshall to ethics, specifically a Sidgwickian version of utilitarianism; ethics, in turn, led him to economics, because economics played an essential role in providing the preconditions for the improvement of the working class. Even as he turned to economics, his ethical views continued to be a dominant force in his thinking. Marshall took a broad approach to social science in which economics plays an important but limited role. He recognized that in the real world, economic life is tightly bound up with ethical, social and political currentscurrents he felt economists should not ignore. Marshall envisioned dramatic social change involving the elimination of poverty and a sharp reduction of inequality. He saw the duty of economics was to improve material conditions, but such improvement would occur, Marshall believed, only in connection with social and political forces. His interest in liberalism, socialism, trade unions, women's education, poverty and progress reflect the influence of his early social philosophy to his later activities and writings. Marshall was elected in 1865 to a fellowship at St John's College at Cambridge, and became lecturer in the moral sciences in 1868. In 1885 he became professor of political economy at Cambridge, where he remained until his retirement in 1908. Over the years he interacted with many British thinkers including Henry Sidgwick, W.K. Clifford, Benjamin Jowett, William Stanley Jevons, Francis Ysidro Edgeworth, John Neville Keynes and John Maynard Keynes. Marshall founded the "Cambridge School" which paid special attention to increasing returns, the theory of the firm, and welfare economics; after his retirement leadership passed to Arthur Cecil Pigou and John Maynard Keynes.

Economics
He desired to improve the mathematical rigor of economics and transform it into a more scientific profession. In the 1870s he wrote a small number of tracts on international trade and the problems of protectionism. In 1879, many of these works were compiled into a work entitled

The Theory of Foreign Trade: The Pure Theory of Domestic Values. In the same year (1879) he published The Economics of Industry with his wife Mary Paley. Although Marshall took economics to a more mathematically rigorous level, he did not want mathematics to overshadow economics and thus make economics irrelevant to the layman. Accordingly, Marshall tailored the text of his books to laymen and put the mathematical content in the footnotes and appendices for the professionals. In a letter to A. L. Bowley, he laid out the following system: (1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you cant succeed in 4, burn 3. This I do often."[4] Marshall had been Mary Paley's professor of political economy at Cambridge and the two were married in 1877, forcing Marshall to leave his position as a Fellow (college) of St John's College, Cambridge in order to comply with celibacy rules at the university. He became the first principal at University College, Bristol, which was the institution that later became the University of Bristol, again lecturing on political economy and economics. He perfected his Economics of Industry while at Bristol, and published it more widely in England as an economic curriculum; its simple form stood upon sophisticated theoretical foundations. Marshall achieved a measure of fame from this work, and upon the death of William Jevons in 1882, Marshall became the leading British economist of the scientific school of his time. Marshall returned to Cambridge, via a brief period at Balliol College, Oxford during 18834, to take the seat as Professor of Political Economy in 1884 on the death of Henry Fawcett. At Cambridge he endeavored to create a new tripos for economics, a goal which he would only achieve in 1903. Until that time, economics was taught under the Historical and Moral Sciences Triposes which failed to provide Marshall the kind of energetic and specialized students he desired.

Principles of Economics (1890)

Main article: Principles of Economics (Marshall) Marshall began his economic work, the Principles of Economics, in 1881, and spent much of the next decade at work on the treatise. His plan for the work gradually extended to a two-volume compilation on the whole of economic thought. The first volume was published in 1890 to worldwide acclaim that established him as one of the leading economists of his time. The second volume, which was to address foreign trade, money, trade fluctuations, taxation, and collectivism, was never published. Principles of Economics established his worldwide reputation. It appeared in 8 editions, starting at 750 pages and growing to 870 pages. It decisively shaped the teaching of economics in English-speaking countries. Its main technical contribution was a masterful analysis of the issues of elasticity, consumer surplus, increasing and diminishing returns, short and long terms, and

marginal utility; many of the ideas were original with Marshall, others were improved version of ideas by W. S. Jevons and others. In a broader sense Marshall hoped to reconcile the classical and modern theories of value. John Stuart Mill had examined the relationship between the value of commodities and their production costs, on the theory that value depends on effort expended in manufacture. Jevons and the Marginal Utility theorists had elaborated a theory of value based on the idea of maximizing utility, holding that value depends on demand. Marshall's work used both these approaches, but he focused more on costs. He noted that, in the short run, supply cannot be changed and market value depends mainly on demand. In an intermediate time period, production can be expanded by existing facilities, such as buildings and machinery; but since these do not require renewal within this intermediate period their costs (called fixed, overhead, or supplementary costs) have little influence on the sale price of the product. Marshall pointed out that it is the prime or variable costs, which constantly recur, that influence the sale price most in this period. In a still longer period, machines and buildings wear out and have to be replaced, so that the sale price of the product must be high enough to cover such replacement costs. This classification of costs into fixed and variable and the emphasis given to the element of time probably represent one of Marshall's chief contributions to economic theory. He was committed to partial equilibrium models over general equilibrium on the grounds that the inherently dynamical nature of economics made the former more practically useful.

Alfred Marshall's supply and demand graph. Much of the success of Marshall's teaching and Principles book derived from his effective use of diagrams, which were soon emulated by other teachers worldwide.[5] Alfred Marshall was the first to develop the standard supply and demand graph demonstrating a number of fundamentals regarding supply and demand including the supply and demand curves, market equilibrium, the relationship between quantity and price in regards to supply and demand,

law of marginal utility, law diminishing returns, and the ideas of consumer and producer surpluses. This model is now used by economists in various forms using different variables to demonstrate several other economic principles. Marshall's model allowed a visual representation of complex economic fundamentals where before all the ideas and theories were only capable of being explained through words. These models are now critical throughout the study of economics because it allows a clear and concise representation of the fundamentals or theories being explained.

Later career
He served as President of the first day of the 1889 Co-operative Congress.[6] Over the next two decades he worked to complete the second volume of his Principles, but his unyielding attention to detail and ambition for completeness prevented him from mastering the work's breadth. The work was never finished and many other, lesser works he had begun work on - a memorandum on trade policy for the Chancellor of the Exchequer in the 1890s, for instance - were left incomplete for the same reasons. His health problems had gradually grown worse since the 1880s, and in 1908 he retired from the university. He hoped to continue work on his Principles but his health continued to deteriorate and the project had continued to grow with each further investigation. The outbreak of the First World War in 1914 prompted him to revise his examinations of the international economy and in 1919 he published Industry and Trade at the age of 77. This work was a more empirical treatise than the largely theoretical Principles, and for that reason it failed to attract as much acclaim from theoretical economists. In 1923, he published Money, Credit, and Commerce, a broad amalgam of previous economic ideas, published and unpublished, stretching back a half-century. From 1890 to 1924 he was the respected father of the economic profession and to most economists for the half-century after his death, the venerable grandfather. He had shied away from controversy during his life in a way that previous leaders of the profession had not, although his even-handedness drew great respect and even reverence from fellow economists, and his home at Balliol Croft in Cambridge had no shortage of distinguished guests. His students at Cambridge became leading figures in economics, including John Maynard Keynes and Arthur Cecil Pigou. His most important legacy was creating a respected, academic, scientifically founded profession for economists in the future that set the tone of the field for the remainder of the 20th century. Having died aged 81 at his home in Cambridge, Marshall is buried in the Ascension Parish Burial Ground. [7] The library of the Department of Economics at Cambridge University (The Marshall Library of Economics), the Economics society at Cambridge (The Marshall Society)[8] as well as the University of Bristol Economics department are named for him. His home, Balliol Croft, was renamed Marshall House in 1991 in his honour when it was bought by Lucy Cavendish College, Cambridge.[9]

Theoretical contributions
Marshall is considered to be one of the most influential economists of his time, largely shaping mainstream economic thought for the next fifty years, and being one of the founders of the school of neoclassical economics. Although his economics was advertised as extensions and refinements of the work of Adam Smith, David Ricardo, Thomas Robert Malthus and John Stuart Mill, he extended economics away from its classical focus on the market economy and instead popularized it as a study of human behavior. He downplayed the contributions of certain other economists to his work, such as Lon Walras, Vilfredo Pareto and Jules Dupuit, and only grudgingly acknowledged the influence of Stanley Jevons himself. Marshall's influence on codifying economic thought is difficult to deny. He popularized the use of supply and demand functions as tools of price determination (previously discovered independently by Cournot); modern economists owe the linkage between price shifts and curve shifts to Marshall. Marshall was an important part of the "marginalist revolution;" the idea that consumers attempt to adjust consumption until marginal utility equals the price was another of his contributions. The price elasticity of demand was presented by Marshall as an extension of these ideas. Economic welfare, divided into producer surplus and consumer surplus, was contributed by Marshall, and indeed, the two are sometimes described eponymously as 'Marshallian surplus.' He used this idea of surplus to rigorously analyze the effect of taxes and price shifts on market welfare. Marshall also identified quasi-rents. Marshall's brief references to the social and cultural relations in the "industrial districts" of England were used as a starting point for late twentieth-century work in economic geography and institutional economics on clustering and learning organizations. Gary Becker (b. 1930), the 1992 Nobel prize winner in economics, has mentioned that Milton Friedman and Alfred Marshall were the two greatest influences on his work. Another contribution that Marshall made was differentiating concepts of internal and external economies of scale. That is that when costs of input factors of production go down, it's a positive externality for all the firms in the market place, outside the control of any of the firms.[10]

The Marshallian industrial district

A concept based on a pattern of organization that was common in late nineteenth century Britain in which firms concentrating on the manufacture of certain products were geographically clustered. Comments made by Marshall in Book 4, Chapter 10 of Principles of Economics[11] have been used by economists and economic geographers to discuss this phenomenon. The two dominant characteristics of a Marshallian industrial district[12] are high degrees of vertical and horizontal specialisation and a very heavy reliance on market mechanism for exchange. Firms tend to be small and to focus on a single function in the production chain. Firms located in industrial districts are highly competitive in the neoclassical sense, and in many cases there is little product differentiation. The major advantages of Marshallian industrial districts

arise from simple propinquity of firms, which allows easier recruitment of skilled labour and rapid exchanges of commercial and technical information through informal channels. They illustrate competitive capitalism at its most efficient, with transaction costs reduced to a practical minimum; but they are feasible only when economies of scale are limited.

Works

The Pure Theory of Foreign Trade: The Pure Theory of Domestic Values. Principles of Economics. The Economics of Industry (with Mary Paley Marshall) Industry and Trade. Sir John Richard Hicks (8 April 1904 20 May 1989) was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model (1937), which summarised a Keynesian view of macroeconomics. His book Value and Capital (1939) significantly extended general-equilibrium and value theory. The compensated demand function is named the Hicksian demand function in memory of him. In 1972 he received the Nobel Memorial Prize in Economic Sciences (jointly) for his pioneering contribution to general equilibrium theory and welfare theory.[1]

Early life
Hicks was born in 1904 at Warwick, England. His father was a journalist at a local newspaper. He was educated at Clifton College (191722) and at Balliol College, Oxford (192226), financed by mathematical scholarships. During his school days, and in his first year at Oxford, he specialised in mathematics but also had interests in literature and history. In 1923, he moved to Philosophy, Politics and Economics, the "new school" just being started at Oxford, graduating with second-class honors and, so he states, "no adequate qualification in any of the subjects" that he had studied.[2]

Career, influences, and honors

From 1926 to 1935 Hicks lectured at the London School of Economics and Political Science.[3] He started as a labour economist and did descriptive work on industrial relations but gradually he moved over to the analytical side, where his mathematics background returned to the fore. Hick's influences included Lionel Robbins and such associates as Friedrich von Hayek, R.G.D. Allen, Nicholas Kaldor, and Abba Lerner - and Ursula Webb, who, in 1935, became his wife. From 1935 to 1938, he lectured at Cambridge where he was also a fellow of Gonville & Caius College. He was mainly occupied in writing Value and Capital, which was based on the work he had done in London. From 1938 to 1946, he was Professor at the University of Manchester. It was there that he did his main work on welfare economics, with its application to social accounting.

In 1946 he returned to Oxford, first as a research fellow of Nuffield College (194652), then as Drummond Professor of Political Economy (195265), and finally as a research fellow of All Souls College (196571) where he continued writing after retirement. He was also an honorary fellow of Linacre College, Oxford . He died in 1989. Hicks was knighted in 1964 and was co-recipient of the Nobel Prize in Economic Sciences (with Kenneth J. Arrow) in 1972. He donated the Nobel Prize to the London School of Economics and Political Science's Library Appeal in 1973.[3]

Contributions to economic analysis

Hicks's early work as a labour economist culminated in The Theory of Wages (1932, 2nd ed. 1963), still considered standard in the field. He collaborated with R.G.D. Allen in two seminal papers on value theory published in 1934. His magnum opus is Value and Capital published in 1939. The book built on ordinal utility and mainstreamed the now-standard distinction between the substitution effect and the income effect for an individual in demand theory for the 2-good case. It generalised the analysis to the case of one good and a composite good, that is, all other goods. It aggregated individuals and businesses through demand and supply across the economy. It anticipated the aggregation problem, most acutely for the stock of capital goods. It introduced general equilibrium theory to an Englishspeaking audience, refined the theory for dynamic analysis, and for the first time attempted a rigorous statement of stability conditions for general equilibrium. In the course of analysis Hicks formalised comparative statics. In the same year, he also developed the famous "compensation" criterion called Kaldor-Hicks efficiency for welfare comparisons of alternative public policies or economic states. Hicks's most familiar contribution in macroeconomics was the Hicks-Hansen IS-LM model,[4] which formalised an interpretation of the theory of John Maynard Keynes (see Keynesianism). The model describes the economy as a balance between three commodities: money, consumption and investment. Hicks himself did not embrace the theory as he interpreted it; and, in a paper published in 1980, Hicks asserted that it had omitted some crucial components of Keynes's arguments, especially those related to uncertainty.[5] George Joseph Stigler (January 17, 1911 December 1, 1991) was a U.S. economist. He won the Nobel Memorial Prize in Economic Sciences in 1982, and was a key leader of the Chicago School of Economics, along with his close friend Milton Friedman. While at Chicago, he was greatly influenced by Frank Knight, his dissertation supervisor. Friedman, a friend for over sixty years, comments upon it as remarkable since only three or four students ever managed to complete their PhD dissertation under Knight in his 28 years at Chicago. Jacob Viner and Henry Simons also influenced him and, among his students, W. Allen Wallis and Milton Friedman. Stigler is best known for developing the Economic Theory of Regulation, also known as capture, which says that interest groups and other political participants will use the regulatory and

coercive powers of government to shape laws and regulations in a way that is beneficial to them. This theory is a component of the public choice field of economics. He also carried out extensive research in the history of economic thought. Stigler's most important contribution to economics was disseminated in his landmark article titled "The Economics of Information".[1] According to Friedman, Stigler "essentially created a new area of study for economists." In this article, Stigler stressed the importance of information by writing, "One should hardly have to tell academicians that information is a valuable resource: knowledge is power. And yet it occupies a slum dwelling in the town of economics."[2] His 1962 article "Information in the Labor Market" developed the theory of search unemployment.[3] He was known for his sharp sense of humor, and wrote a number of spoof essays. In his book The Intellectual and the Marketplace, for instance, he proposed Stigler's Law of Demand and Supply Elasticities, that "all demand curves are inelastic and all supply curves are inelastic too." The essay referenced studies that found many goods and services to be inelastic over the long run, as well as offering a supposed theoretical proof; he ended by announcing that his next essay would demonstrate that the price system does not exist. Another essay, on "Truth in Teaching," described the consequences of a (fictional) set of court decisions that held universities legally responsible for the consequences of teaching errors.[4] The Stigler diet was named after him. Stigler was born in Seattle, Washington, graduated from the University of Washington in 1931 with a B.A and then spent a year at Northwestern University from which he obtained his M.B.A in 1932. It was during his studies at Northwestern that Stigler developed an interest in economics and decided on an academic career.[2] Due to a tuition scholarship that he received from the University of Chicago, Stigler enrolled at the university in 1933 to study economics and went on to earn his Ph.D. in economics from the University of Chicago in 1938. His teaching experience began in 1936 at Iowa State College where he taught until 1938. He spent much of World War II at Columbia University, performing mathematical and statistical research for the Manhattan Project. He then spent one year at Brown University. He served on the Columbia faculty from 1947 to 1958. Stigler was a founding member of the Mont Pelerin Society, and was president from 1976 to 1978. He also received National Medal of Science in 1987. Carl Menger (February 23, 1840 February 26, 1921) was the founder of the Austrian School of economics, famous for contributing to the development of the theory of marginal utility, which contested the cost-of-production theories of value, developed by the classical economists such as Adam Smith and David Ricardo. Menger was born in Nowy Scz in Austrian Galicia, now in Poland. He was the son of a wealthy family of minor nobility; his father, Anton, was a

lawyer. His mother, Caroline, was the daughter of a wealthy Bohemian merchant. He had two brothers, Anton and Max, both prominent as lawyers. After attending Gymnasium he studied law at the Universities of Prague and Vienna and later received a doctorate in jurisprudence from the Jagiellonian University in Krakw. In the 1860s Menger left school and enjoyed a stint as a journalist reporting and analyzing market news, first at the Lemberger Zeitung in Lww, Ukraine and later at the Wiener Zeitung in Vienna. During the course of his newspaper work he noticed a discrepancy between what the classical economics he was taught in school said about price determination and what real world market participants believed. In 1867 Menger began a study of political economy which culminated in 1871 with the publication of his Principles of Economics (Grundstze der Volkswirtschaftslehre), thus becoming the father of the Austrian School of economic thought. It was in this work that he challenged classical cost-based theories of value with his theory of marginality - that price is determined at the margin. In 1872 Menger was enrolled into the law faculty at the University of Vienna and spent the next several years teaching finance and political economy both in seminars and lectures to a growing number of students. In 1873 he received the university's chair of economic theory at the very young age of 33. In 1876 Menger began tutoring Archduke Rudolf von Habsburg, the Crown Prince of Austria in political economy and statistics. For two years Menger accompanied the prince in his travels, first through continental Europe and then later through the British Isles.[1] He is also thought to have assisted the crown prince in the composition of a pamphlet, published anonymously in 1878, which was highly critical of the higher Austrian aristocracy. His association with the prince would last until Rudolf's suicide in 1889 (see the Mayerling Affair). In 1878 Rudolf's father, Emperor Franz Josef, appointed Menger to the chair of political economy at Vienna. The title of Hofrat was conferred on him, and he was appointed to the Austrian Herrenhaus in 1900. Ensconced in his professorship he set about refining and defending the positions he took and methods he utilized in Principles, the result of which was the 1883 publication of Investigations into the Method of the Social Sciences with Special Reference to Economics (Untersuchungen ber die Methode der Socialwissenschaften und der politischen Oekonomie insbesondere). The book caused a firestorm of debate, during which members of the Historical school of economics began to derisively call Menger and his students the "Austrian School" to emphasize their departure from mainstream economic thought in Germany the term was specifically used in an unfavorable review by Gustav von Schmoller. In 1884 Menger responded with the pamphlet The Errors of Historicism in German Economics and launched the infamous Methodenstreit, or methodological debate, between the Historical School and the Austrian School. During this time Menger began to attract like-minded disciples who would go on to make their own mark on the field of economics, most notably Eugen von Bhm-Bawerk, and Friedrich von Wieser. In the late 1880s Menger was appointed to head a commission to reform the Austrian monetary system. Over the course of the next decade he authored a plethora of articles which would

revolutionize monetary theory, including "The Theory of Capital" (1888) and "Money" (1892).[2] Largely due to his pessimism about the state of German scholarship, Menger resigned his professorship in 1903 to concentrate on study.

Economics
Menger used his subjective theory of value to arrive at one of the most powerful insights in economics: both sides gain from exchange. Unlike William Jevons, Menger did not believe that goods provide utils, or units of utility. Rather, he wrote, goods are valuable because they serve various uses whose importance differs. Menger also came up with an explanation of how money develops that is still accepted today. If people barter, he pointed out, then they can rarely get what they want in one or two transactions. If they have lamps and want chairs, for example, they will not necessarily be able to trade lamps for chairs but may instead have to make a few intermediate trades. This is a hassle. But people notice that the hassle is much less when they trade what they have for some good that is widely accepted, and then use this good to buy what they want. The good that is widely accepted eventually becomes money.[3]

John Bates Clark (January 26, 1847 March 21, 1938) was an American neoclassical economist. He was one of the pioneers of the marginalist revolution and opponent to the Institutionalist school of economics, and spent most of his career teaching at Columbia University. Biography
Clark was born and raised in Providence, Rhode Island, and graduated from Amherst College, in Massachusetts, at the age of 25. From 1872 to 1875, he attended the University of Zurich and the University of Heidelberg where he studied under Karl Knies (a leader of the German Historical School). Early in his career Clark's writings reflected his German Socialist background and showed him as a critic of capitalism. During his time as a professor at Columbia University however, his views gradually shifted to support of capitalism and he later became known as a leading advocate of the capitalist system.

Theoretical work
After his return from 1877 onward Clark published several articles most of them edited later in The Philosophy of Wealth (1886). There he formulated an original version of marginal utility theory, principle already published by Jevons (1871), Menger (1871), and Walras (1878). Until 1886 Clark was a Christian socialist reflecting the view of his German teachers that competition is no universal remedy especially not for fixing wages. Clark writes:[1] It is a dangerous mistake to extol competition, as such too highly, and regard all attacks upon it as revolutionary. We do not eat men but we do it by such indirect and refined methods that it does not generally occur to us that we are cannibals.

He hoped that communism could be combatted by suppression and reform:[2] Among the adherents of Communism there is a large element that is simply murderous, and this deserves only the murderer's fate. ... It is possible that an indefinitely large proportion of declared communists in this country may be of worthless or criminal character. According to Clark only if "...the union of capital necessitates the union of labour" just wages will come about and may be fixed by arbitration.[3] This view on fair wages changed in 1886: "Clark himself, it will be remembered has song down the doom of competition in The Philosophy of Wealth. But now he has reversed his position and build[s] up a body of economic laws based on competition"[4] writes Homan (1928) and Everett (1946) finds: "Soon after writing The Philosophy of Wealth, however, Clark started to make defences for the competitive system. What caused the change is unknown. This much we can say. By the time he wrote The Distribution of Wealth he was convinced that pure competition was the natural and normal law by which the economic order obtained justice."[5] One cause that prompted this reorientation could be the Haymarket Riot (1886) in Chicago when some strikers were shot and others hanged. In the US it resulted in a cleansing of higher education from socialist reformers and the ruin of the Knights of Labor. In 1888, Clark wrote Capital and its Earnings. Frank A. Fetter later reflected on Bates' motivation for writing this work:[6] The probable source from which immediate stimulation came to Clark was the contemporary single tax discussion. ... Events were just at that time crowding each other fast in the single tax propaganda. [ Henry George's ] Progress and Poverty... had a larger sale than any other book ever written by an American. ... No other economic subject at the time was comparable in importance in the public eye with the doctrine of Progress and Poverty. Capital and its Earnings "... wears the mien of pure theory .... But ... one can hardly fail to see on almost every page the reflections of the contemporary single-tax discussion. In the brief preface is expressed the hope that 'it may be found that these principles settle questions of agrarian socialism.' Repeatedly the discussion turns to 'the capital that vests itself in land,'... The foundation of Clark's further work was competition: "If nothing suppresses competition, progress will continue forever".[7] Clark: "The science adapted is economic Darwinism. Though the process was savage, the outlook which it afforded was not wholly evil. The survival of crude strength was, in the long run, desirable".[8] This was the fundament to develop the theory which made him famous: Given competition and homogeneous factors of production labor and capital, the repartition of the social product will be according to the productivity of the last physical input of units of labor and capital. This theorem is a cornerstone of neoclassical micro-economics. Clark stated it in 1881[9] and more elaborated 1899 in The Distribution of Wealth.[10] The same theorem was formulated later independently by John Atkinson Hobson (1891) and Philip Wicksteed (1894). The political message of this theorem is: "[W]hat a social class gets is, under natural law, what it contributes to the general output of industry."[11]

Clark's conclusion rests upon the productive contribution of the last unit of physical labour one hour unqualified labour and the last unit of physical capital. To him heterogeneous capital goods have a second, a social form as homogeneous capital[12] (called jelly as a street can be moulded into an engine) and the productivity of the last unit of jelly determines profit. This retakes Karl Marx's view that commodities have a heterogeneous natural form (Naturalform) and also opposed to it a homogenous value-form (Wertform),[13] jelly. Clark might have known this Marxian construction from his German time and was reproached for this similarity.[14] Clark's capital are not produced means of production each with a different production structure. It is an abstract, always existing and never perishing one great tool in the hand of working humanity[15] similar to a field or a waterfall, also considered capital by Clark. The arguable sides of Clark's notion of capital helped to give rise to the Cambridge capital controversy from 1954 to 1965 between the departments of economics at Cambridge University, England, and at MIT in Cambridge, Massachusetts. Paul A. Samuelson's 1947 textbook Economics divulged Clark's capital concept worldwide. J. B. Clark was the father of John Maurice Clark. Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on the one side and the "ceremonial" sphere of society on the other. Its name and core elements trace back to a 1919 American Economic Review article by Walton H. Hamilton.[1][2] Institutional economics emphasizes a broader study of institutions and views markets as a result of the complex interaction of these various institutions (e.g. individuals, firms, states, social norms). The earlier tradition continues today as a leading heterodox approach to economics.[3] A significant variant is the new institutional economics from the later 20th century, which integrates later developments of neoclassical economics into the analysis. Law and economics has been a major theme since the publication of the Legal Foundations of Capitalism by John R. Commons in 1924. Behavioral economics is another hallmark of institutional economics based on what is known about psychology and cognitive science, rather than simple assumptions of economic behavior.

Institutional economics
Institutional economics focuses on learning, bounded rationality, and evolution (rather than assume stable preferences, rationality and equilibrium). It was a central part of American economics in the first part of the 20th century, including such famous but diverse economists as Thorstein Veblen, Wesley Mitchell, and John R. Commons.[4] Some institutionalists see Karl Marx as belonging to the institutionalist tradition, because he described capitalism as a historically-bounded social system; other institutionalist economists disagree with Marx's definition of capitalism, instead seeing defining features such as markets, money and the private

ownership of production as indeed evolving over time, but as a result of the purposive actions of individuals. "Traditional" institutionalism [1] rejects the reduction of institutions to simply tastes, technology, and nature (see naturalistic fallacy). Tastes, along with expectations of the future, habits, and motivations, not only determine the nature of institutions but are limited and shaped by them. If people live and work in institutions on a regular basis, it shapes their world-views. Fundamentally, this traditional institutionalism (and its modern counterpart institutionalist political economy) emphasizes the legal foundations of an economy (see John R. Commons) and the evolutionary, habituated, and volitional processes by which institutions are erected and then changed (see John Dewey, Thorstein Veblen, and Daniel Bromley.) The vacillations of institutions are necessarily a result of the very incentives created by such institutions, and are thus endogenous. Emphatically, traditional institutionalism is in many ways a response to the current economic orthodoxy; its reintroduction in the form of institutionalist political economy is thus an explicit challenge to neoclassical economics, since it is based on the fundamental premise that neoclassicists oppose: that economics cannot be separated from the political and social system within which it is embedded. Some of the authors associated with this school include Robert H. Frank, Warren Samuels, Mark Tool, Geoffrey Hodgson, Daniel Bromley, Jonathan Nitzan, Shimshon Bichler, Elinor Ostrom, Anne Mayhew, John Kenneth Galbraith and Gunnar Myrdal, but even the sociologist C. Wright Mills was highly influenced by the institutionalist approach in his major studies.

Thorstein Veblen
Main articles: Thorstein Veblen and The Theory of the Leisure Class

Thorstein Veblen came from rural Mid-western America and Norwegian immigrant family Thorstein Veblen (18571929) wrote his first and most influential book while he was at the University of Chicago, on The Theory of the Leisure Class (1899).[5] In it he analyzed the motivation in capitalism to conspicuously consume their riches as a way of demonstrating

success. Conspicuous leisure was another focus of Veblen's critique. The concept of conspicuous consumption was in direct contradiction to the neoclassical view that capitalism was efficient. In The Theory of Business Enterprise (1904) Veblen distinguished the motivations of industrial production for people to use things from business motivations that used, or misused, industrial infrastructure for profit, arguing that the former is often hindered because businesses pursue the latter. Output and technological advance are restricted by business practices and the creation of monopolies. Businesses protect their existing capital investments and employ excessive credit, leading to depressions and increasing military expenditure and war through business control of political power. These two books, focusing on criticism first of consumerism, and second of profiteering, did not advocate change. Through the 1920s and after the Wall Street Crash of 1929 Thorstein Veblen's warnings of the tendency for wasteful consumption and the necessity of creating sound financial institutions seemed to ring true. Veblen remains a leading critic, which cautions against the excesses of "the American way". Thorstein Veblen wrote in 1898 an article entitled "Why is Economics Not an Evolutionary Science"[6] and he became the precursor of current evolutionary economics.

John R. Commons
Main article: John R. Commons John R. Commons (18621945) also came from mid-Western America. Underlying his ideas, consolidated in Institutional Economics (1934) was the concept that the economy is a web of relationships between people with diverging interests. There are monopolies, large corporations, labour disputes and fluctuating business cycles. They do however have an interest in resolving these disputes. Government, thought Commons, ought to be the mediator between the conflicting groups. Commons himself devoted much of his time to advisory and mediation work on government boards and industrial commissions.

Wesley Mitchell
Main article: Wesley Mitchell Wesley Clair Mitchell (August 5, 1874 October 29, 1948) was an American economist known for his empirical work on business cycles and for guiding the National Bureau of Economic Research in its first decades. Mitchells teachers included economists Thorstein Veblen and J. L. Laughlin and philosopher John Dewey.

Clarence Ayres
Main article: Clarence Edwin Ayres Clarence Ayres (May 6, 1891 July 24, 1972) was the principal thinker of what some has called the Texas school of institutional economics. Ayres developed on the ideas of Thorstein Veblen

with a dichotomy of "technology" and "institutions" to separate the inventive from the inherited aspects of economic structures. He claimed that technology was always one step ahead of the socio-cultural institutions. Indeed, it can be argued that Ayres was not an "institutionalist" in any normal sense of the term; since he identified institutions with sentiments and superstition and in consequence institutions only played a kind of residual role in this theory of development which core center was that of technology. Indeed, Ayres was under strong influence of Hegel and institutions for Ayres had the same function as "Schein" (with the connotation of deception, and illusion) for Hegel. A more appropriate name for Ayres' position would be that of a "technobehaviorist" rather than an institutionalist.

Adolf Berle
Main article: Adolf Berle

Adolf Augustus Berle, Jr. Adolf A. Berle (18951971) was one of the first authors to combine legal and economic analysis, and his work stands as a founding pillar of thought in modern corporate governance. Like Keynes, Berle was at the Paris Peace Conference, 1919, but subsequently resigned from his diplomatic job dissatisfied with the Versailles Treaty terms. In his book with Gardiner C. Means, The Modern Corporation and Private Property (1932), he detailed the evolution in the contemporary economy of big business, and argued that those who controlled big firms should be better held to account. Directors of companies are held to account to the shareholders of companies, or not, by the rules found in company law statutes. This might include rights to elect and fire the management, require for regular general meetings, accounting standards, and so on. In 1930s America, the typical company laws (e.g. in Delaware) did not clearly mandate such rights. Berle argued that the unaccountable directors of companies were therefore apt to funnel the fruits of enterprise profits into their own pockets, as well as manage in their own interests. The ability to do this was supported by the fact that the majority of shareholders in big public companies were single individuals, with scant means of communication, in short, divided and conquered. Berle served in President Franklin Delano Roosevelt's administration through the depression, and was a key member of the so-called "Brain trust" developing many of the New

Deal policies. In 1967, Berle and Means issued a revised edition of their work, in which the preface added a new dimension. It was not only the separation of controllers of companies from the owners as shareholders at stake. They posed the question of what the corporate structure was really meant to achieve. Stockholders toil not, neither do they spin, to earn [dividends and share price increases]. They are beneficiaries by position only. Justification for their inheritance... can be founded only upon social grounds... that justification turns on the distribution as well as the existence of wealth. Its force exists only in direct ratio to the number of individuals who hold such wealth. Justification for the stockholder's existence thus depends on increasing distribution within the American population. Ideally the stockholder's position will be impregnable only when every American family has its fragment of that position and of the wealth by which the opportunity to develop individuality becomes fully actualized.[7]

John Kenneth Galbraith

Main article: John Kenneth Galbraith John Kenneth Galbraith (19082006) worked in the New Deal administration of Franklin Delano Roosevelt. Although he wrote later, and was more developed than the earlier institutional economists, Galbraith was critical of orthodox economics throughout the late twentieth century. In The Affluent Society (1958), Galbraith argues voters reaching a certain material wealth begin to vote against the common good. He coins the term "conventional wisdom" to refer to the orthodox ideas that underpin the resulting conservative consensus.[8] In an age of big business, it is unrealistic to think only of markets of the classical kind. Big businesses set their own terms in the marketplace, and use their combined resources for advertising programmes to support demand for their own products. As a result, individual preferences actually reflect the preferences of entrenched corporations, a "dependence effect", and the economy as a whole is geared to irrational goals.[9] In The New Industrial State Galbraith argues that economic decisions are planned by a private bureaucracy, a technostructure of experts who manipulate is marketing and public relations channels. This hierarchy is selfserving, profits are no longer the prime motivator, and even managers are not in control. Because they are the new planners, corporations detest risk, requiring steady economic and stable markets. They recruit governments to serve their interests with fiscal and monetary policy. While the goals of an affluent society and complicit government serve the irrational technostructure, public space is simultaneously impoverished. Galbraith paints the picture of stepping from penthouse villas on to unpaved streets, from landscaped gardens to unkempt public parks. In Economics and the Public Purpose (1973) Galbraith advocates a "new socialism" (social democracy) as the solution, with nationalization of military production and public services such as health care, plus disciplined salary and price controls to reduce inequality.

New institutional economics

Main article: New institutional economics

With the new developments in the economic theory of organizations, information, property rights,[10] and transaction costs,[11] an attempt was made to integrate institutionalism into more recent developments in mainstream economics, under the title new institutional economics.[12][13]

Institutionalism today
The earlier approach was a central element in American economics in the interwar years after 1919 but was marginalized to a relatively minor role as to mainstream economics in the postwar period with the ascendence of neoclassical and Keynesian approaches. It continued, however, as a leading heterodox approach in critiquing neoclassical economics and as an alternative research program in economics.[citation needed] The leading Swedish economist Lars Plsson Syll is a believer in institutional economics.[14] He is an outspoken opponent to all kinds of social constructivism and postmodern relativism.[15]

Criticism
Critics of institutionalism have maintained that the concept of "institution" is so central for all social science that it is senseless to use it as a buzzword for a particular theoretical school. And as a consequence the elusive meaning of the concept of "institution" has resulted in a bewildering and never-ending dispute about which scholars are "institutionalists" or notand a similar confusion about what is supposed to be the core of the theory. In other words, institutional economics have become so popular because it means all things to all people, which in the end of the day is the meaning of nothing. Indeed, it can be argued that the term "institutionalists" was misplaced from the very beginning, since Veblen, Hamilton and Ayres were preoccupied with the evolutionary (and "objectifying") forces of technology and institutions had a secondary place within their theories. Institutions were almost a kind of "anti-stuff," their key concern was on technology and not on institutions. Rather than being "institutional," Veblen, Hamilton and Ayres position is anti-institutional.[16]

See also

History of economic thought Institutional logic Institutionalist political economy Constitutional economics Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill. Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical economics. The school was active into the mid 19th century and was followed by neoclassical economics in Britain beginning around 1870, or, in Marx's definition by "vulgar political economy" from the 1830s. The definition of classical economics is debated, particularly the period 183070 and the connection to neoclassical economics. The term "classical economics" was coined by Karl Marx to refer to Ricardian economics the economics of David Ricardo and James Mill and their

predecessors but usage was subsequently extended to include the followers of Ricardo.[1] Classical economists claimed that free markets regulate themselves, when free of any intervention. Adam Smith referred to a so-called invisible hand, which will move markets towards their natural equilibrium, without requiring any outside intervention. As opposed to Keynesian economics, classical economics assumes flexible prices both in the case of goods and wages. Another main assumption is based on Say's Law: supply creates its own demand - that is, aggregate production will generate an income enough to purchase all the output produced; this implicitly assumes, in contrast to Keynes, that there will be net saving or spending of cash or financial instruments. Another postulate of classical economics is the equality of savings and investment, assuming that flexible interest rates will always maintain equilibrium.

History
The classical economists produced their "magnificent dynamics"[2] during a period in which capitalism was emerging from feudalism and in which the industrial revolution was leading to vast changes in society. These changes raised the question of how a society could be organized around a system in which every individual sought his or her own (monetary) gain. Classical political economy is popularly associated with the idea that free markets can regulate themselves.[3] Classical economists and their immediate predecessors reoriented economics away from an analysis of the ruler's personal interests to broader national interests. Adam Smith, and also physiocrat Francois Quesnay, for example, identified the wealth of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as produced by labour, land, and capital. With property rights to land and capital held by individuals, the national income is divided up between labourers, landlords, and capitalists in the form of wages, rent, and interest or profits.

Modern legacy
Classical economics is generally agreed (but see section Debates on the definition of classical economics below) to have developed into neoclassical economics as the name suggests or to at least be most closely represented in the modern age by neoclassical economics, and many of its ideas remain fundamental in economics. Other ideas, however, have either disappeared from neoclassical discourse or been replaced by Keynesian economics in the Keynesian revolution and neoclassical synthesis. Some classical ideas are represented in various schools of heterodox economics, notably Marxian economics Marx being a contemporary of the classical economists and their immediate successors and Austrian economics, which split from neoclassical economics in the late 19th century.

Classical theories of growth and development

Analyzing the growth in the wealth of nations and advocating policies to promote such growth was a major focus of classical economists. John Hicks & Samuel Hollander,[4] Nicholas Kaldor,[5] Luigi L. Pasinetti,[6][7] and Paul A. Samuelson[8][9] have presented formal models as part of their respective interpretations of classical political economy.

Value theory
Classical economists developed a theory of value, or price, to investigate economic dynamics. William Petty introduced a fundamental distinction between market price and natural price to facilitate the portrayal of regularities in prices. Market prices are jostled by many transient influences that are difficult to theorize about at any abstract level. Natural prices, according to Petty, Smith, and Ricardo, for example, capture systematic and persistent forces operating at a point in time. Market prices always tend toward natural prices in a process that Smith described as somewhat similar to gravitational attraction. The theory of what determined natural prices varied within the Classical school. Petty tried to develop a par between land and labour and had what might be called a land-and-labour theory of value. Smith confined the labour theory of value to a mythical pre-capitalist past. Others may interpret Smith believed in value as derived from labour.[10] He stated that natural prices were the sum of natural rates of wages, profits (including interest on capital and wages of superintendence) and rent. Ricardo also had what might be described as a cost of production theory of value. He criticized Smith for describing rent as price-determining, instead of pricedetermined, and saw the labour theory of value as a good approximation. Some historians of economic thought, in particular, Sraffian economists,[11][12] see the classical theory of prices as determined from three givens: 1. The level of outputs at the level of Smith's "effectual demand", 2. technology, and 3. wages. From these givens, one can rigorously derive a theory of value. But neither Ricardo nor Marx, the most rigorous investigators of the theory of value during the Classical period, developed this theory fully. Those who reconstruct the theory of value in this manner see the determinants of natural prices as being explained by the Classical economists from within the theory of economics, albeit at a lower level of abstraction. For example, the theory of wages was closely connected to the theory of population. The Classical economists took the theory of the determinants of the level and growth of population as part of Political Economy. Since then, the theory of population has been seen as part of Demography. In contrast to the Classical theory, the determinants of the neoclassical theory value: 1. tastes 2. technology, and 3. endowments are seen as exogenous to neoclassical economics.

Classical economics tended to stress the benefits of trade. Its theory of value was largely displaced by marginalist schools of thought which sees "use value" as deriving from the marginal utility that consumers finds in a good, and "exchange value" (i.e. natural price) as determined by the marginal opportunity- or disutility-cost of the inputs that make up the product. Ironically, considering the attachment of many classical economists to the free market, the largest school of economic thought that still adheres to classical form is the Marxian school.

Monetary theory
British classical economists in the 19th century had a well-developed controversy between the Banking and the Currency school. This parallels recent debates between proponents of the theory of endogeneous money, such as Nicholas Kaldor, and monetarists, such as Milton Friedman. Monetarists and members of the currency school argued that banks can and should control the supply of money. According to their theories, inflation is caused by banks issuing an excessive supply of money. According to proponents of the theory of endogenous money, the supply of money automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans are made .

Debates on the definition of classical economics

The theory of value is currently a contested subject. One issue is whether classical economics is a forerunner of neoclassical economics or a school of thought that had a distinct theory of value, distribution, and growth. Sraffians, who emphasize the discontinuity thesis, see classical economics as extending from Petty's work in the 17th century to the break-up of the Ricardian system around 1830. The period between 1830 and the 1870s would then be dominated by "vulgar political economy", as Karl Marx characterized it. Sraffians argue that: the wages fund theory; Senior's abstinence theory of interest, which puts the return to capital on the same level as returns to land and labour; the explanation of equilibrium prices by well-behaved supply and demand functions; and Say's law, are not necessary or essential elements of the classical theory of value and distribution. Perhaps Schumpeter's view that John Stuart Mill put forth a half-way house between classical and neoclassical economics is consistent with this view. Sraffians generally see Marx as having rediscovered and restated the logic of classical economics, albeit for his own purposes. Others, such as Schumpeter, think of Marx as a follower of Ricardo. Even Samuel Hollander[13] has recently explained that there is a textual basis in the classical economists for Marx's reading, although he does argue that it is an extremely narrow set of texts. Another position is that neoclassical economics is essentially continuous with classical economics. To scholars promoting this view, there is no hard and fast line between classical and neoclassical economics. There may be shifts of emphasis, such as between the long run and the short run and between supply and demand, but the neoclassical concepts are to be found

confused or in embryo in classical economics. To these economists, there is only one theory of value and distribution. Alfred Marshall is a well-known promoter of this view. Samuel Hollander is probably its best current proponent. Still another position sees two threads simultaneously being developed in classical economics. In this view, neoclassical economics is a development of certain exoteric (popular) views in Adam Smith. Ricardo was a sport, developing certain esoteric (known by only the select) views in Adam Smith. This view can be found in W. Stanley Jevons, who referred to Ricardo as something like "that able, but wrong-headed man" who put economics on the "wrong track". One can also find this view in Maurice Dobb's Theories of Value and Distribution Since Adam Smith: Ideology and Economic Theory (1973), as well as in Karl Marx's Theories of Surplus Value. The above does not exhaust the possibilities. John Maynard Keynes thought of classical economics as starting with Ricardo and being ended by the publication of Keynes' own General Theory of Employment Interest and Money. The defining criterion of classical economics, on this view, is Say's law which is disputed by Keynesian economics. One difficulty in these debates is that the participants are frequently arguing about whether there is a non-neoclassical theory that should be reconstructed and applied today to describe capitalist economies. Some, such as Terry Peach,[14] see classical economics as of antiquarian interest. Sometimes the definition of classical economics is expanded to include the earlier 17th century English economist William Petty and the contemporary early 19th century German economist Johann Heinrich von Thnen.

Monetization is the process of converting or establishing something into legal tender. It usually refers to the coining of currency or the printing of banknotes by central banks. Things such as gold, diamonds and emeralds generally do have intrinsic value based on their rarity or quality and thus provide a premium not associated with fiat currency unless that currency is "promissory": That is the currency promises to deliver a given amount of a recognized commodity of a universally (globally) agreed to rarity and value, providing the currency with the foundation of legitimacy or value. Though rarely the case with paper currency, even intrinsically relatively worthless items or commodities can be made into money, so long as they are difficult to make or acquire. Monetization may also refer to exchanging securities for currency, selling a

possession, charging for something that used to be free or making money on goods or services that were previously unprofitable. Monetizing debt
In many countries the government has assigned exclusive power to issue or print its national currency to a central bank. The government treasury must pay off government debt either with money it already holds or by financing it by issuing new bonds which are sold to either the public directly or the central bank, in order to raise the funds required to repay bonds that have come due. The central bank may purchase government bonds by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process. If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may 'borrow' money without needing to repay it. This process of financing government spending is called 'monetizing the debt'.[1] Central banks are usually forbidden by law from purchasing debt directly from the government. For example, the Maastricht Treaty (article 104) expressly forbids EU central banks' direct purchase of debt of EU public bodies such as national governments. Their debt purchases have to be from the secondary markets. Monetizing debt is thus a two-step process where the government issues debt to finance its spending and the central bank purchases the debt, holding it till it comes due, and leaving the system with an increased supply of money.

Effects on inflation
When government deficits are financed through this method of debt monetization the outcome is an increase in the monetary base, the money supply. If a budget deficit persists for a substantial period of time, the monetary base will also increase, shifting the aggregate-demand curve to the right leading to a rise in the price level.[2] When governments intentionally do this, they devalue existing stockpiles of fixed income cash flows of anyone who is holding assets based in that currency. This does not reduce the value of floating or hard assets, and has an uncertain (and potentially beneficial) impact on some equities. It benefits debtors at the expense of creditors and will result in an increase in the nominal price of real estate. This wealth transfer is clearly not a Pareto improvement but can act as a stimulus to economic growth and employment in an economy overburdened by private debt[citation needed]. It is in essence a "tax" and a simultaneous redistribution to debtors as the overall value of creditors' fixed income assets drop (and as the debt burden to debtors correspondingly decreases). If the beneficiaries of this transfer are more likely to spend their gains (due to lower income and asset levels) this can stimulate demand and increase liquidity. It also decreases the value of the currency - potentially stimulating exports and decreasing imports - improving the balance of trade. Foreign owners of local currency and debt also lose money, Fixed income creditors experience decreased wealth due to a loss in spending power. This is known as "inflation tax" (or "inflationary debt relief"). Conversely, tight monetary policy which favors creditors over debtors even at the expense of reduced economic growth can also be considered a wealth transfer to holders of fixed assets from people with debt or with mostly human capital to trade (a "deflation tax").

A deficit can be the source of sustained inflation only if it is persistent rather than temporary, and if the government finances it by creating money (through monetizing the debt), rather than leaving bonds in the hands of the public.[3]

Revenue from business operations

In some[which?] industry sectors, monetization is a buzzword for adapting non-revenue-generating assets to generate revenue. Failure to monetize web sites was a problem that caused many businesses to fold during the dot-com bust. Web sites that do generate revenue are often monetized via advertisements or subscription fees. A previously free product may have premium options added thus becoming freemium.

Monetization of non-monetary benefits

Monetization is also used to refer to the process of converting some benefit received in nonmonetary form (such as milk) into a monetary payment. The term is used in social welfare reform when converting in-kind payments (such as food stamps or other free benefits) into some "equivalent" cash payment. From the point of view of economics and efficiency, it is usually considered better to give someone a monetary equivalent of some benefit than the benefit (say, a liter of milk) in kind.

Inefficiency: in the latter situation people who may not need milk cannot get something of equivalent value (without subsequently trading or selling the milk). Black market growth: people who need something other than milk may sell it. In many circumstances, this action may be illegal and considered fraudulent. For example, Moscow pensioners (see below for details) often give their personal cards that allow free usage of local transport to relatives who use public transport more frequently. Changes on the market: supply of milk to the market is reduced by the amount distributed to the privileged group, so the price and availability of milk may change. Corruption: firms that should give this benefit have an advantage as they have guaranteed consumers and the quality of the goods supplied is controlled only administratively, not by market competition. So, bribes to the body that choose such firms and/or maintain control can take place.

Russian social welfare monetization of 2005

In 2005, Russia transformed most of its in-kind benefits into monetary compensation. Before this reform there were a large system of preferences: free/reduced price of travels on local transport, free supply of drugs, free health resort treatment, etc. for diverse categories of society: military personnel, the disabled, and separately, persons disabled due to WWII, Chernobyl disaster "liquidators," inhabitants of Leningrad during the siege, former political prisoners, and

just for all pensioners (women 55+, men 60+). This system was a legacy of the Soviet Union, but it was heavily extended by populist laws of central and regional authorities during the 1990s. By the law 122- of 22 August 2004 this system was converted into cash payments by various means:

abolition of preference, compensated by raising of wage (e.g. free use of local transport for military personnel) or pension (e.g. different preferences for Chernobyl liquidators) for three most important preferences (free local transport, 50%-price suburban rail transport, free supply of drugs): a choice between this preference and some extra money.

The main causes of friction in the reform were the following:

technical and bureaucratic problems (e.g. for usage of 50% discount for suburban rail transport a person should present a paper from local State Pension Fund office stating that he/she doesn't choose monetary compensation); separation of all preference-recipients into federal and regional accordingly to the body issuing a preference legislation. The largest group, that is pensioners, was regional. It was the main cause of problems: o In poor regions local government had to abolish these preferences with small or zero compensation. o Even if these preferences were retained, they could apply only to pensioners of this region, so, e.g. Moscow Oblast pensioners cannot use Moscow metro and buses freely. (Later these problems would be generally solved by a series of bilateral agreements between neighboring regions.)

The wave of protests emerged in various parts of Russia in the beginning of 2005 as this law started to work. But government measures (raising of compensations, normalization of bureaucratic mechanisms, etc.) eventually neutralized opposition. The long-term effects of the monetization reform varied for various groups. Some people received compensation in excess of the services they received (e.g. in rural areas without any local transport, the free transport benefit was of little value), some have found that the compensation is insufficient to cover the cost of the benefits needed. Transport companies and railroad have obvious benefits from monetization as they receive higher cash receipts when these categories use their services (previously in some regions more than a half of passengers did not pay for municipal transport, without sufficient compensation to the companies from the government). Effects on medical system are controversial. Doctors and nurses have to use their time to fill in many forms to justify free receipts, thus reducing time spent on services.

United States agricultural policy

In United States agricultural policy, "monetization" is a P.L. 480 provision (section 203) first included in the Food Security Act of 1985 (P.L. 99-198) that allows private voluntary organizations and cooperatives to sell a percentage of donated P.L. 480 commodities in the recipient country or in countries in the same region. Under section 203, private voluntary

organizations or cooperatives are permitted to sell (i.e., monetize) for local currencies or dollars an amount of commodities equal to not less than 15% of the total amount of commodities distributed in any fiscal year in a country. The currency generated by these sales can then be used: to finance internal transportation, storage, or distribution of commodities; to implement development projects; or to invest and with the interest earned used to finance distribution costs or projects.[4] Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation.[1] Paper currency and coins are common forms of legal tender in many countries. The origin of the term "legal tender" is from Middle English tendren, French tendre (verb form), meaning to offer. The Latin root is tendere (to stretch out), and the sense of tender as an offer is related to the etymology of the English word extend (to hold outward).[2] The noun form of a tender as an offering is a back-formation of the noun from the verb.[citation needed] Legal tender is variously defined in different jurisdictions. Formally, it is anything which when offered in payment extinguishes the debt. Thus, personal cheques, credit cards, debit cards, and similar non-cash methods of payment are not usually legal tender. The law does not relieve the debt obligation until payment is accepted. Coins and banknotes are usually defined as legal tender. Some jurisdictions may forbid or restrict payment made other than by legal tender. For example, such a law might outlaw the use of foreign coins and bank notes or require a license to perform financial transactions in a foreign currency. In some jurisdictions legal tender can be refused as payment if no debt exists prior to the time of payment (where the obligation to pay may arise at the same time as the offer of payment). For example vending machines and transport staff do not have to accept the largest denomination of banknote. Shopkeepers may reject large banknotes: this is covered by the legal concept known as invitation to treat. However, restaurants that do not collect payment until after a meal is served must accept that legal tender for the debt incurred in purchasing the meal. The right, in many jurisdictions, of a trader to refuse to do business with any person means a purchaser may not insist on making a purchase and so declaring a legal tender in law, as anything other than an offered payment for debts already incurred would not be effective. Coins and banknotes may cease to be legal tender if new notes of the same currency substitute them or if a new currency is introduced replacing the former one.[3] Examples of this are:

The United Kingdom, adopting decimal currency in place of pounds, shillings, and pence in 1971. Banknotes remained unchanged (except for the replacement of the 10 shilling note by the 50 pence coin). In 1968 and 1969 decimal coins which had precise equivalent values in the old currency (5p, 10p, 50p) were introduced, while decimal coins with no precise equivalent (p, 1p, 2p) were introduced on 15 February 1971. The smallest and largest non-decimal circulating coins, the half penny and half crown, were withdrawn in 1969, and the other non-decimal coins with no precise equivalent in the new currency (1d, 3d) were withdrawn later in 1971. Nondecimal coins with precise decimal equivalents (6d ( = 2p), 1 and 2 shillings) remained legal tender either until the coins no longer circulated (1980 in the case of the 6d), or the equivalent decimal coins were reduced in size in the early 1990s. The 6d coin was permitted to remain in

large circulation throughout the United Kingdom due to the London Underground committee's large investment in coin-operated ticketing machines that used it.[citation needed] Old coins returned to the Royal Mint through the UK banking system will be redeemed for legal tender without time limits, but coins issued before 1947 have a higher value for their silver content than for their monetary value.[citation needed] The successor states of the Soviet Union replacing the Soviet ruble in the 1990s.[citation needed] Currencies used in the Eurozone before being replaced by the euro are not legal tender, but all banknotes are redeemable for euros for a minimum of 10 years (for certain notes, there is no time limit).[citation needed]

Individual coins or banknotes can be demonetised and cease to be legal tender (for example, the pre-decimal United Kingdom farthing or the Bank of England 1 pound note), but the Bank of England does redeem all Bank of England banknotes for legal tender at its counters in London (or by post) regardless of how old they are. Banknotes issued by retail banks in the UK are not legal tender, but one of the criteria for legal protection under the Forgery and Counterfeiting Act is that banknotes must be payable on demand, therefore withdrawn notes remain a liability of the issuing bank without any time limits.[citation needed] In the case of the euro, coins and banknotes of former national currencies were considered as legal tender from 1 January 1999 until 28 February 2002 (in some cases). Legally, those coins and banknotes were considered non-decimal sub-divisions of the euro.[citation needed] When the Iraqi Swiss dinar ceased to be legal tender in Iraq, it still circulated in the northern Kurdish regions, and despite lacking government backing, it had a stable market value for more than a decade. This example is often cited to demonstrate that the value of a currency is not derived purely from its legal status[citation needed] (but this currency would not be legal tender). This is also true of the paper money issued by the Confederate States of America during the American Civil War. Although Confederate currency became worthless by its own terms after the war, since it could only be redeemed a stated number of years after a peace treaty was signed between the Confederacy and the United States (which never happened as the Confederacy was defeated and dissolved), the value of Confederate currency today as a historical and collectible item is usually much greater than its face value.[citation needed] Demonetisation is currently prohibited in the United States and the Coinage Act of 1965 applies to all US coins and currency regardless of age. The closest historical equivalent in the US, other than Confederate money, was from 1933 to 1974, when the government banned most private ownership of gold bullion, including gold coins held for non-numismatic purposes. Now, however, even surviving pre-1933 gold coins are legal tender under the 1964 act.[citation needed]

Withdrawal from circulation

Banknotes and coins may be withdrawn from circulation, but remain legal tender. United States banknotes issued at any date remain legal tender even after they are withdrawn from circulation. Canadian 1- and 2-dollar bills remain legal tender even if they have been withdrawn and replaced by coins, but Canadian $1000 bills remain legal tender even if they are removed from

circulation as they arrive at a bank. However, Bank of England notes that are withdrawn from circulation generally cease to be legal tender but remain redeemable for current currency at the Bank of England itself or by post. All paper and polymer issues of New Zealand banknotes issued from 1967 onwards (and 1- and 2-dollar notes until 1993) are still legal tender; however, 1- and 2-cent coins are no longer used in Australia and New Zealand.

Commemorative issues
Sometimes currency issues such as commemorative coins or transfer bills may be issued that are not intended for public circulation but are nonetheless legal tender. An example of such currency is Maundy money. Some currency issuers, particularly the Scottish banks, issue special commemorative banknotes which are intended for ordinary circulation. As well, some standard coins are minted on higher-quality dies as 'uncirculated' versions of the coin, for collectors to purchase at a premium; these coins are nevertheless legal tender. Some countries issue preciousmetal coins which have a currency value indicated on them which is far below the value of the metal the coin contains: these coins are known as "non-circulating legal tender" or "NCLT".

Legal tender status by country

Australia
In Australia, the creation of legal tender, in the form of notes and base metal coins, is the exclusive right of the Commonwealth Government. According to the Australian Constitution, s 115[4] which states: "A State shall not coin money, nor make anything but gold and silver coin a legal tender in payment of debts." Under this provision the Perth Mint, owned by the Western Australian Government, still produces gold and silver coins with legal tender status, the Australian Gold Nugget and Australian Silver Kookaburra. These, however, although having the status of legal tender, are almost never circulated or used in payment of debts, and are mostly considered bullion coins. Australian notes are legal tender, as established by the Reserve Bank Act 1959[5] for all amounts. Australian coins for general circulation, now produced at the Royal Australian Mint in Canberra, are also legal tender, under the provisions of the Currency Act 1965,[6] but only for the following amounts:

not exceeding 20 if 1 and/or 2 coins are offered; not exceeding $5 if any of 5, 10, 20 and 50 coins are offered; not exceeding 10 times the face value if coins in the range 50 to $10 inclusive are offered; to any value if face value is greater than $10 are offered.

The one cent and two cent coins have been withdrawn from circulation since February 1992 but remain legal tender. According to the Reserve Bank of Australia,[7] the legal framework[8] for legal tender in Australia is somewhat unclear. The Reserve Bank Act 1959[5] and Currency Act 1965[6] establish that it is

not legally required to accept legal tender, even for an existing debt, although failure to do so may be prejudicial in future legal proceedings. In Australia, except for when sending items via Registered Post, Australia Post prohibits the sending of coins or banknotes, for any country, in the post.
History

In 1901, notes in circulation in Australia consisted of bank notes payable in gold coin and issued by the trading banks, and Queensland Treasury notes. Bank notes circulated in all States except Queensland, but were not legal tender except for a brief period in 1893 in New South Wales. There were, however, some restrictions on their issue or other provisions for the protection of the public. Queensland Treasury notes were issued by the Queensland Government and were legal tender in that State. Notes of both categories continued in circulation until 1910, when the Australian Notes Act 1910 and Bank Notes Tax Act 1910 were passed by the Commonwealth Parliament. The Australian Notes Act 1910 prohibited the circulation of state notes as money, and the Bank Notes Tax Act 1910 imposed a tax of ten per cent per annum on 'all bank notes issued or re-issued by any bank in the Commonwealth after the commencement of this Act, and not redeemed'. These Acts effectively put an end to the issue of notes by the trading banks and the Queensland Treasury. The Reserve Bank Act 1959[5] expressly prohibits persons and states from issuing 'a bill or note for the payment of money payable to bearer on demand and intended for circulation'.

Canada
Canadian dollar banknotes issued by the Bank of Canada are legal tender in Canada. However, commercial transactions may legally be settled in any manner agreed by the parties involved with the transactions. For example, convenience stores may refuse $100 bank notes if they feel that would put them at risk of being counterfeit victims; however, official policy suggests that the retailers should evaluate the impact of that approach. In the case that no mutually acceptable form of payment can be found for the tender, the parties involved should seek legal advice.[9] As outlined in the Currency Act, there is a limit the value of a transaction for which you can use only coins.[10] A payment in coins is legal tender for no more than the following amounts for the following denominations of coins:
1. 2. 3. 4. 5. forty dollars if the denomination is two dollars or greater but does not exceed ten dollars; twenty-five dollars if the denomination is one dollar; ten dollars if the denomination is ten cents or greater but less than one dollar; five dollars if the denomination is five cents; and twenty-five cents if the denomination is one cent.

Eurozone
Euro coins and banknotes became legal tender in most countries of the Eurozone on January 1, 2002. Although one side of the coins is used for different national marks for each country, all

coins and all banknotes are legal tender throughout the eurozone. Therefore, it is possible to find Irish euro coins in Greece and Finnish euro coins in Portugal, for instance. Although some eurozone countries do not put 1 cent and 2 cent coins into general circulation (prices in those countries are by general understanding always rounded to whole multiples of 5 cent), 1 cent and 2 cent coins from other eurozone countries remain legal tender in those countries. European Regulation EC 974/98 limits the number of coins that can be offered for payment to fifty.[11] National laws may also impose restrictions as to maximal amounts that can be settled by coins or notes.

France
Legal tender was enacted the first time in 1870 for all notes and coins of the Banque de France. Anyone refusing such monies for their whole value would be prosecuted (French Penal Code art. R. 642-3).

Republic of Ireland
See also: Coinage of the Republic of Ireland

According to the Economic and Monetary Union Act, 1998 of the Republic of Ireland which replaced the legal tender provisions that had been re-enacted in Irish legislation from previous British enactments, No person, other than the Central Bank of Ireland and such persons as may be designated by the Minister by order, shall be obliged to accept more than 50 coins denominated in euro or in cent in any single transaction.
Irish history

The Decimal Currency Act, 1970 governed legal tender prior to the adoption of the euro and laid down the analogous provisions as in United Kingdom legislation (all inherited from previous British law), namely: coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, coins denominated not more than 10 pence became legal tender for payment not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence.

India
The Indian rupee is the de facto legal tender currency in India. The Indian rupee is also legal tender in Nepal and Bhutan, but the Nepalese rupee and Bhutanese ngultrum are not legal tender in India. Both the Nepalese rupee and Bhutanese ngultrum are pegged with the Indian rupee.[12] The Indian rupee used to be an official currency of other countries, including the Straits Settlements (now Singapore and parts of Malaysia), Kuwait, Bahrain, Qatar, and the Trucial States (now the UAE).

In 1837, the Indian rupee was made the sole official currency of the Straits Settlements, as it was administered as a part of India. In 1845, the British replaced the Indian rupee with the Straits dollar after administration of the Straits Settlements separated from India earlier in that same year. After partition of India and Pakistan in 1947, the Pakistani rupee came into existence, initially using Indian coins and Indian currency notes simply overstamped with the word "Pakistan". New coins and banknotes were issued in 1948. The Gulf rupee, also known as the Persian Gulf rupee (XPGR), was introduced by the Government of India as a replacement for the Indian rupee for circulation exclusively outside the country with the Reserve Bank of India Amendment Act of 1 May 1959. This creation of a separate currency was an attempt to reduce the strain put on India's foreign reserves by gold smuggling. Two states, Kuwait and Bahrain eventually replaced the Gulf rupee with their own currencies (the Kuwaiti dinar and the Bahraini dinar) after gaining independence from Britain in 1961 and 1965, respectively. On 6 June 1966, India devalued the rupee. To avoid following this devaluation, several of the states using the rupee adopted their own currencies. Qatar and most of the Trucial States adopted the Qatar and Dubai riyal, whilst Abu Dhabi adopted the Bahraini dinar. Only Oman continued to use the Gulf rupee until 1970, with the government backing the currency at its old peg to the pound. Oman later replaced the Gulf rupee with its own rial in 1970.

New Zealand
New Zealand has a complex history of legal tender. At the creation of the colony after the signing of the Treaty of Waitangi in 1840 there was no legal tender in New Zealand, because although the Treaty authorised the British Crown to govern, the laws of Great Britain had not been formally adopted by the new colony. The British Laws Act 1858 retrospectively adopted the laws of Great Britain, and through the UK's Coinage Act 1816, British coins were confirmed as legal tender in New Zealand. Unusually, until 1989, the Reserve Bank did not have the right to issue coins as legal tender. Coins had to be issued by the Minister of Finance. The history of bank notes was considerably more complex. In 1840, the Union Bank started issuing bank notes under provisions of British law, but these were not automatically legal tender. In 1844, ordinances were passed making the Union Bank banknotes legal tender and authorising the government to issue debentures in small denominations, thus creating two sets of legal tender. These debentures were circulated but were traded at a discount to their face value because of distrust of the colonial government by the settler population. In 1845, the Ordinance was disallowed by the British Colonial office and they were recalled, not without first causing a panic among holders of the debentures.

In 1847, the Colonial Bank of Issue became the only issuer of legal tender. In 1856, however the Colonial Bank of Issue was disbanded and through the Paper Currency Act 1856, the Union Bank was confirmed once again as an issuer of legal tender. The Act also authorised the Oriental Bank to issue legal tender but this bank ceased operations in 1861. Between 1861 and 1874, a number of other banks including the Bank of New Zealand, Bank of New South Wales, National Bank of New Zealand and Colonial Bank of New Zealand were created by Acts of Parliament and authorised to issue bank notes backed by gold, however these notes were not legal tender. The 1893 Bank Note Issue Act allowed the government to declare a bank's right to issue legal tender. This enabled the government to make such a declaration to assist the Bank of New Zealand when in 1895 the bank encountered financial difficulties that could have led to its failure. In 1914, the Banking Amendment Act gave legal tender status to bank notes from any issuer and removed the requirement that banks authorised to issue bank notes must redeem them on demand for gold (the gold standard). In 1933, the Coinage Act created a specific New Zealand coinage and removed legal tender status from British coins. In the same year the Reserve Bank of New Zealand was established. The bank was given a monopoly on the issue of legal tender. The Reserve Bank also provided a mechanism through which the other issuers of legal tender could phase out their bank notes. These banknotes were convertible into British legal tender on demand at the Reserve Bank and remained so until the 1938 Sterling Exchange Suspension Notice that suspended provisions of a 1936 amendment of the 1933 Reserve Bank of New Zealand Act. In 194?, the Reserve Bank of New Zealand Act restated that only notes issued by the Reserve Bank were legal tender. The Act also ended the right of individuals to redeem their bank notes for coin, effectively ending the distinction between coin and notes in New Zealand. The Act came into force in 1967 establishing as legal tender all New Zealand dollar five dollars banknotes and greater, all decimal coins, the pre-decimal sixpence, the shilling, and the florin. Also passed in 1964 was the Decimal Currency Act, which created the basis for a decimal currency, introduced in 1967. As of 2005, banknotes were legal tender for all payments, and $1 and $2 coins were legal tender for payments up to $100, and 10c, 20c, and 50c silver coins were legal tender for payments up to $5. These older style silver coins were legal tender until October 2006, after which only the new 10c, 20c and 50c coins, introduced in August 2006, are legal.[13]

Norway
The Norwegian krone (NOK) is legal tender in Norway according to the Central Bank (Norwegian: Sentralbankloven) of 1985-05-24,[14] However, no-one is obliged to accept more than 25 coins of each denomination (of which currently 1, 5, 10 and 20 NOK denominations are in common circulation).

Singapore and Brunei

The Singapore dollar is legal tender in Brunei since a Currency Interchangeability Agreement was signed on 1967-06-12. Brunei dollar banknotes (but not coins) are widely accepted throughout Singapore and represent a "customary tender".[15]

Switzerland and Liechtenstein

Main article: Swiss franc

The Swiss franc is the only legal tender in Switzerland. Any payment consisting of up to 100 Swiss coins is legal tender; banknotes are legal tender for any amount.[16] The sixth series of Swiss bank notes from 1976, recalled by the National Bank in 2000, is no longer legal tender, but can be exchanged in banks for current notes until April 2020. The Swiss franc is also the legal tender of the Principality of Liechtenstein, which is joined to Switzerland in a customs union. The Swiss franc is also the currency used for administrative and accounting purposes by most of the numerous international organisations that are headquartered in Switzerland.

Taiwan
Main article: New Taiwan dollar

The New Taiwan dollar issued by the Central Bank of the Republic of China (Taiwan) is legal tender for all payments within the territory of the Republic of China, Taiwan.[17] However, candidates to become civil servants in elections in the Republic of China may not pay the deposits in coinage.[18]

United Kingdom
Legal tender is solely for the guaranteed settlement of debts and does not affect any party's right of refusal of service in any transaction.[19] In the 19th century, gold coins were legal tender to any amount, but silver coins were not legal tender for sums over 2 pounds as well as bronze for sums over 1 shilling. This provision was retained in revised form at the introduction of decimal currency, and the Coinage Act 1971 laid down that coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, non-bronze coins denominated not more than 10 pence became legal tender for payment not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence. Throughout the United Kingdom, coins valued 1 pound, 2 pounds, and 5 pounds Sterling are legal tender in unlimited amounts. Twenty pence pieces and fifty pence pieces are legal tender in

amounts up to 10 pounds; five pence pieces and ten pence pieces are legal tender in amounts up to 5 pounds; and pennies and two pence coins are legal tender in amounts up to 20 pence.[20] In accordance with the Coinage Act 1971,[21] gold sovereigns are also legal tender for any amount. Although it is not specifically mentioned on them, the face values of gold coins are 50p; 1; 2; and 5, a mere fraction of their worth as bullion. Maundy money is legal tender but may not be accepted by retailers and is worth much more than face value due to its rarity value and silver content. Bank of England notes are legal tender in England and Wales and are issued in the denominations of 5, 10, 20 and 50. English banknotes can always be redeemed at the Bank of England even if discontinued. Banknotes issued by Scottish and Northern Irish banks are not legal tender anywhere in England and Wales but can still be accepted with agreement between parties.[22] Whilst Banknotes issued by the Scottish banks are legal currency, that is approved by the UK Parliament, no banknotes issued by Scottish banks, Northern Ireland banks nor the Bank of England are legal tender in Scotland. Thus legal tender in Scotland is limited to coin as noted above.

United States
Before the Civil War (1861 to 1865), silver coins were legal tender only up to the sum of $5. Before 1853, when US silver coins were reduced in weight 7%, coins had exactly their value in metal (from 1830 to 1852). Two silver 50 cent coins had exactly $1 worth of silver. A gold US Dollar of 1849 had $1 worth of gold. With the flood of gold coming out of the California mines in the early 1850s, the price of silver rose (gold went down). Thus, 50 cent coins of 1840 to 1852 were worth 53 cents if melted down. The government could increase the value of the gold coins (expensive) or reduce the size of all US silver coins. With the reduction of 1853, a 50-cent coin now had only 48 cents of silver. This is the reason for the $5 limit of silver coins as legal tender; paying somebody $100 in the new silver coins would be giving them $96 worth of silver. Most people preferred bank check or gold coins for large purchases. During the early American Civil War, the federal government first issued United States Notes (the first greenback notes) which were not redeemable in gold and silver coins but could be used to pay "all dues" to the Federal Government. Since land purchases and duties on imports were payable only in gold or the new Demand Notes, the Demand Notes were bought by importers and land speculators for about 97 cents on the gold dollar and never lost value. 1862 greenbacks (Legal Tender Notes) at first traded for 97 cents on the dollar but gained/lost value depending on fortunes of the Union army. The value of Legal Tender Greenbacks swung wildly but trading was from 85 to 33 cents on the gold dollar. This resulted in a situation in which the greenback "Legal Tender" notes of 1862 were fiat, and so gold and silver were held and paper circulated at a discount because of Gresham's Law. The 1861 Demand Notes were a huge success but robbed the customs house of much needed gold coin (interest on most bonds back then was paid in gold). A money-strapped Congress which had to pay for the war eventually adopted the Legal Tender Act of 1862, issuing United States Notes

backed only by treasury securities, and compelled the people to accept the new notes at a discount; prices rose except for those who had gold and/or silver coins. Litigation resulted from debts incurred before the Civil War (when gold coins were common) and 5 years later, the debtor wanted to pay the debt in full with "Legal Tender" (worth only 55 cents on the gold dollar). Bank deposits were often in "current funds (paper money)" or gold coin. Checks were written to be cashed in "gold coin" or "current funds." The United States Supreme Court, with Salmon P. Chase (former Secretary of the Treasury) ruled the practice of legal tender unconstitutional in Hepburn v. Griswold in 1869, but later reversed its ruling within a month when confusion in the markets caused everybody not to accept "Legal Tender" notes at all. The Court held that paper money, even that not backed by specie such as the United States Notes can be legal tender, in the Legal Tender Cases, ranging from 1871 to 1884. On the other hand, coins made of gold or silver may not necessarily be legal tender, if they are not fiat money in the jurisdiction where they are preferred as payment. The Coinage Act of 1965 states (in part):
United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes and dues. Foreign gold or silver coins are not legal tender for debts. 31 U.S.C. 5103

There is, however, no federal statute that a private business, a person, or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.[23] On May 27, 2011, Jason West in Vernal, Utah dumped 2500 loose pennies onto the counter of Basin Clinic when disputing a bill.[24] The police there cited him with disorderly conduct for causing unnecessary alarm when the dumped pennies were strewn about the counter and the floor, but paying in pennies itself was not the reason to cite him.[25] Coins and banknotes may cease to be legal tender if new notes of the same currency substitute them or if a new currency is introduced replacing the former one.[3] Examples of this are:

The United Kingdom, adopting decimal currency in place of pounds, shillings, and pence in 1971. Banknotes remained unchanged (except for the replacement of the 10 shilling note by the 50 pence coin). In 1968 and 1969 decimal coins which had precise equivalent values in the old currency (5p, 10p, 50p) were introduced, while decimal coins with no precise equivalent (p, 1p, 2p) were introduced on 15 February 1971. The smallest and largest non-decimal circulating coins, the half penny and half crown, were withdrawn in 1969, and the other non-decimal coins

with no precise equivalent in the new currency (1d, 3d) were withdrawn later in 1971. Nondecimal coins with precise decimal equivalents (6d ( = 2p), 1 and 2 shillings) remained legal tender either until the coins no longer circulated (1980 in the case of the 6d), or the equivalent decimal coins were reduced in size in the early 1990s. The 6d coin was permitted to remain in large circulation throughout the United Kingdom due to the London Underground committee's large investment in coin-operated ticketing machines that used it.[citation needed] Old coins returned to the Royal Mint through the UK banking system will be redeemed for legal tender without time limits, but coins issued before 1947 have a higher value for their silver content than for their monetary value.[citation needed] The successor states of the Soviet Union replacing the Soviet ruble in the 1990s.[citation needed] Currencies used in the Eurozone before being replaced by the euro are not legal tender, but all banknotes are redeemable for euros for a minimum of 10 years (for certain notes, there is no time limit).[citation needed]

Individual coins or banknotes can be demonetised and cease to be legal tender (for example, the pre-decimal United Kingdom farthing or the Bank of England 1 pound note), but the Bank of England does redeem all Bank of England banknotes for legal tender at its counters in London (or by post) regardless of how old they are. Banknotes issued by retail banks in the UK are not legal tender, but one of the criteria for legal protection under the Forgery and Counterfeiting Act is that banknotes must be payable on demand, therefore withdrawn notes remain a liability of the issuing bank without any time limits.[citation needed] In the case of the euro, coins and banknotes of former national currencies were considered as legal tender from 1 January 1999 until 28 February 2002 (in some cases). Legally, those coins and banknotes were considered non-decimal sub-divisions of the euro.[citation needed] When the Iraqi Swiss dinar ceased to be legal tender in Iraq, it still circulated in the northern Kurdish regions, and despite lacking government backing, it had a stable market value for more than a decade. This example is often cited to demonstrate that the value of a currency is not derived purely from its legal status[citation needed] (but this currency would not be legal tender). This is also true of the paper money issued by the Confederate States of America during the American Civil War. Although Confederate currency became worthless by its own terms after the war, since it could only be redeemed a stated number of years after a peace treaty was signed between the Confederacy and the United States (which never happened as the Confederacy was defeated and dissolved), the value of Confederate currency today as a historical and collectible item is usually much greater than its face value.[citation needed] Demonetisation is currently prohibited in the United States and the Coinage Act of 1965 applies to all US coins and currency regardless of age. The closest historical equivalent in the US, other than Confederate money, was from 1933 to 1974, when the government banned most private ownership of gold bullion, including gold coins held for non-numismatic purposes. Now, however, even surviving pre-1933 gold coins are legal tender under the 1964 act.[citation needed]

Withdrawal from circulation

Banknotes and coins may be withdrawn from circulation, but remain legal tender. United States banknotes issued at any date remain legal tender even after they are withdrawn from circulation. Canadian 1- and 2-dollar bills remain legal tender even if they have been withdrawn and replaced by coins, but Canadian $1000 bills remain legal tender even if they are removed from circulation as they arrive at a bank. However, Bank of England notes that are withdrawn from circulation generally cease to be legal tender but remain redeemable for current currency at the Bank of England itself or by post. All paper and polymer issues of New Zealand banknotes issued from 1967 onwards (and 1- and 2-dollar notes until 1993) are still legal tender; however, 1- and 2-cent coins are no longer used in Australia and New Zealand.

Commemorative issues
Sometimes currency issues such as commemorative coins or transfer bills may be issued that are not intended for public circulation but are nonetheless legal tender. An example of such currency is Maundy money. Some currency issuers, particularly the Scottish banks, issue special commemorative banknotes which are intended for ordinary circulation. As well, some standard coins are minted on higher-quality dies as 'uncirculated' versions of the coin, for collectors to purchase at a premium; these coins are nevertheless legal tender. Some countries issue preciousmetal coins which have a currency value indicated on them which is far below the value of the metal the coin contains: these coins are known as "non-circulating legal tender" or "NCLT".

Legal tender status by country

Australia
In Australia, the creation of legal tender, in the form of notes and base metal coins, is the exclusive right of the Commonwealth Government. According to the Australian Constitution, s 115[4] which states: "A State shall not coin money, nor make anything but gold and silver coin a legal tender in payment of debts." Under this provision the Perth Mint, owned by the Western Australian Government, still produces gold and silver coins with legal tender status, the Australian Gold Nugget and Australian Silver Kookaburra. These, however, although having the status of legal tender, are almost never circulated or used in payment of debts, and are mostly considered bullion coins. Australian notes are legal tender, as established by the Reserve Bank Act 1959[5] for all amounts. Australian coins for general circulation, now produced at the Royal Australian Mint in Canberra, are also legal tender, under the provisions of the Currency Act 1965,[6] but only for the following amounts:

not exceeding 20 if 1 and/or 2 coins are offered; not exceeding $5 if any of 5, 10, 20 and 50 coins are offered; not exceeding 10 times the face value if coins in the range 50 to $10 inclusive are offered; to any value if face value is greater than $10 are offered.

The one cent and two cent coins have been withdrawn from circulation since February 1992 but remain legal tender. According to the Reserve Bank of Australia,[7] the legal framework[8] for legal tender in Australia is somewhat unclear. The Reserve Bank Act 1959[5] and Currency Act 1965[6] establish that it is not legally required to accept legal tender, even for an existing debt, although failure to do so may be prejudicial in future legal proceedings. In Australia, except for when sending items via Registered Post, Australia Post prohibits the sending of coins or banknotes, for any country, in the post.
History

In 1901, notes in circulation in Australia consisted of bank notes payable in gold coin and issued by the trading banks, and Queensland Treasury notes. Bank notes circulated in all States except Queensland, but were not legal tender except for a brief period in 1893 in New South Wales. There were, however, some restrictions on their issue or other provisions for the protection of the public. Queensland Treasury notes were issued by the Queensland Government and were legal tender in that State. Notes of both categories continued in circulation until 1910, when the Australian Notes Act 1910 and Bank Notes Tax Act 1910 were passed by the Commonwealth Parliament. The Australian Notes Act 1910 prohibited the circulation of state notes as money, and the Bank Notes Tax Act 1910 imposed a tax of ten per cent per annum on 'all bank notes issued or re-issued by any bank in the Commonwealth after the commencement of this Act, and not redeemed'. These Acts effectively put an end to the issue of notes by the trading banks and the Queensland Treasury. The Reserve Bank Act 1959[5] expressly prohibits persons and states from issuing 'a bill or note for the payment of money payable to bearer on demand and intended for circulation'.

Canada
Canadian dollar banknotes issued by the Bank of Canada are legal tender in Canada. However, commercial transactions may legally be settled in any manner agreed by the parties involved with the transactions. For example, convenience stores may refuse $100 bank notes if they feel that would put them at risk of being counterfeit victims; however, official policy suggests that the retailers should evaluate the impact of that approach. In the case that no mutually acceptable form of payment can be found for the tender, the parties involved should seek legal advice.[9] As outlined in the Currency Act, there is a limit the value of a transaction for which you can use only coins.[10] A payment in coins is legal tender for no more than the following amounts for the following denominations of coins:
1. 2. 3. 4. 5. forty dollars if the denomination is two dollars or greater but does not exceed ten dollars; twenty-five dollars if the denomination is one dollar; ten dollars if the denomination is ten cents or greater but less than one dollar; five dollars if the denomination is five cents; and twenty-five cents if the denomination is one cent.

Eurozone
Euro coins and banknotes became legal tender in most countries of the Eurozone on January 1, 2002. Although one side of the coins is used for different national marks for each country, all coins and all banknotes are legal tender throughout the eurozone. Therefore, it is possible to find Irish euro coins in Greece and Finnish euro coins in Portugal, for instance. Although some eurozone countries do not put 1 cent and 2 cent coins into general circulation (prices in those countries are by general understanding always rounded to whole multiples of 5 cent), 1 cent and 2 cent coins from other eurozone countries remain legal tender in those countries. European Regulation EC 974/98 limits the number of coins that can be offered for payment to fifty.[11] National laws may also impose restrictions as to maximal amounts that can be settled by coins or notes.

France
Legal tender was enacted the first time in 1870 for all notes and coins of the Banque de France. Anyone refusing such monies for their whole value would be prosecuted (French Penal Code art. R. 642-3).

Republic of Ireland
See also: Coinage of the Republic of Ireland

According to the Economic and Monetary Union Act, 1998 of the Republic of Ireland which replaced the legal tender provisions that had been re-enacted in Irish legislation from previous British enactments, No person, other than the Central Bank of Ireland and such persons as may be designated by the Minister by order, shall be obliged to accept more than 50 coins denominated in euro or in cent in any single transaction.
Irish history

The Decimal Currency Act, 1970 governed legal tender prior to the adoption of the euro and laid down the analogous provisions as in United Kingdom legislation (all inherited from previous British law), namely: coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, coins denominated not more than 10 pence became legal tender for payment not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence.

India
The Indian rupee is the de facto legal tender currency in India. The Indian rupee is also legal tender in Nepal and Bhutan, but the Nepalese rupee and Bhutanese ngultrum are not legal tender in India. Both the Nepalese rupee and Bhutanese ngultrum are pegged with the Indian rupee.[12]

The Indian rupee used to be an official currency of other countries, including the Straits Settlements (now Singapore and parts of Malaysia), Kuwait, Bahrain, Qatar, and the Trucial States (now the UAE). In 1837, the Indian rupee was made the sole official currency of the Straits Settlements, as it was administered as a part of India. In 1845, the British replaced the Indian rupee with the Straits dollar after administration of the Straits Settlements separated from India earlier in that same year. After partition of India and Pakistan in 1947, the Pakistani rupee came into existence, initially using Indian coins and Indian currency notes simply overstamped with the word "Pakistan". New coins and banknotes were issued in 1948. The Gulf rupee, also known as the Persian Gulf rupee (XPGR), was introduced by the Government of India as a replacement for the Indian rupee for circulation exclusively outside the country with the Reserve Bank of India Amendment Act of 1 May 1959. This creation of a separate currency was an attempt to reduce the strain put on India's foreign reserves by gold smuggling. Two states, Kuwait and Bahrain eventually replaced the Gulf rupee with their own currencies (the Kuwaiti dinar and the Bahraini dinar) after gaining independence from Britain in 1961 and 1965, respectively. On 6 June 1966, India devalued the rupee. To avoid following this devaluation, several of the states using the rupee adopted their own currencies. Qatar and most of the Trucial States adopted the Qatar and Dubai riyal, whilst Abu Dhabi adopted the Bahraini dinar. Only Oman continued to use the Gulf rupee until 1970, with the government backing the currency at its old peg to the pound. Oman later replaced the Gulf rupee with its own rial in 1970.

New Zealand
New Zealand has a complex history of legal tender. At the creation of the colony after the signing of the Treaty of Waitangi in 1840 there was no legal tender in New Zealand, because although the Treaty authorised the British Crown to govern, the laws of Great Britain had not been formally adopted by the new colony. The British Laws Act 1858 retrospectively adopted the laws of Great Britain, and through the UK's Coinage Act 1816, British coins were confirmed as legal tender in New Zealand. Unusually, until 1989, the Reserve Bank did not have the right to issue coins as legal tender. Coins had to be issued by the Minister of Finance. The history of bank notes was considerably more complex. In 1840, the Union Bank started issuing bank notes under provisions of British law, but these were not automatically legal tender. In 1844, ordinances were passed making the Union Bank banknotes legal tender and authorising the government to issue debentures in small denominations, thus creating two sets of legal

tender. These debentures were circulated but were traded at a discount to their face value because of distrust of the colonial government by the settler population. In 1845, the Ordinance was disallowed by the British Colonial office and they were recalled, not without first causing a panic among holders of the debentures. In 1847, the Colonial Bank of Issue became the only issuer of legal tender. In 1856, however the Colonial Bank of Issue was disbanded and through the Paper Currency Act 1856, the Union Bank was confirmed once again as an issuer of legal tender. The Act also authorised the Oriental Bank to issue legal tender but this bank ceased operations in 1861. Between 1861 and 1874, a number of other banks including the Bank of New Zealand, Bank of New South Wales, National Bank of New Zealand and Colonial Bank of New Zealand were created by Acts of Parliament and authorised to issue bank notes backed by gold, however these notes were not legal tender. The 1893 Bank Note Issue Act allowed the government to declare a bank's right to issue legal tender. This enabled the government to make such a declaration to assist the Bank of New Zealand when in 1895 the bank encountered financial difficulties that could have led to its failure. In 1914, the Banking Amendment Act gave legal tender status to bank notes from any issuer and removed the requirement that banks authorised to issue bank notes must redeem them on demand for gold (the gold standard). In 1933, the Coinage Act created a specific New Zealand coinage and removed legal tender status from British coins. In the same year the Reserve Bank of New Zealand was established. The bank was given a monopoly on the issue of legal tender. The Reserve Bank also provided a mechanism through which the other issuers of legal tender could phase out their bank notes. These banknotes were convertible into British legal tender on demand at the Reserve Bank and remained so until the 1938 Sterling Exchange Suspension Notice that suspended provisions of a 1936 amendment of the 1933 Reserve Bank of New Zealand Act. In 194?, the Reserve Bank of New Zealand Act restated that only notes issued by the Reserve Bank were legal tender. The Act also ended the right of individuals to redeem their bank notes for coin, effectively ending the distinction between coin and notes in New Zealand. The Act came into force in 1967 establishing as legal tender all New Zealand dollar five dollars banknotes and greater, all decimal coins, the pre-decimal sixpence, the shilling, and the florin. Also passed in 1964 was the Decimal Currency Act, which created the basis for a decimal currency, introduced in 1967. As of 2005, banknotes were legal tender for all payments, and $1 and $2 coins were legal tender for payments up to $100, and 10c, 20c, and 50c silver coins were legal tender for payments up to $5. These older style silver coins were legal tender until October 2006, after which only the new 10c, 20c and 50c coins, introduced in August 2006, are legal.[13]

Norway

The Norwegian krone (NOK) is legal tender in Norway according to the Central Bank (Norwegian: Sentralbankloven) of 1985-05-24,[14] However, no-one is obliged to accept more than 25 coins of each denomination (of which currently 1, 5, 10 and 20 NOK denominations are in common circulation).

Singapore and Brunei

The Singapore dollar is legal tender in Brunei since a Currency Interchangeability Agreement was signed on 1967-06-12. Brunei dollar banknotes (but not coins) are widely accepted throughout Singapore and represent a "customary tender".[15]

Switzerland and Liechtenstein

Main article: Swiss franc

The Swiss franc is the only legal tender in Switzerland. Any payment consisting of up to 100 Swiss coins is legal tender; banknotes are legal tender for any amount.[16] The sixth series of Swiss bank notes from 1976, recalled by the National Bank in 2000, is no longer legal tender, but can be exchanged in banks for current notes until April 2020. The Swiss franc is also the legal tender of the Principality of Liechtenstein, which is joined to Switzerland in a customs union. The Swiss franc is also the currency used for administrative and accounting purposes by most of the numerous international organisations that are headquartered in Switzerland.

Taiwan
Main article: New Taiwan dollar

The New Taiwan dollar issued by the Central Bank of the Republic of China (Taiwan) is legal tender for all payments within the territory of the Republic of China, Taiwan.[17] However, candidates to become civil servants in elections in the Republic of China may not pay the deposits in coinage.[18]

United Kingdom
Legal tender is solely for the guaranteed settlement of debts and does not affect any party's right of refusal of service in any transaction.[19] In the 19th century, gold coins were legal tender to any amount, but silver coins were not legal tender for sums over 2 pounds as well as bronze for sums over 1 shilling. This provision was retained in revised form at the introduction of decimal currency, and the Coinage Act 1971 laid down that coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, non-bronze coins denominated not more than 10 pence became legal tender for payment

not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence. Throughout the United Kingdom, coins valued 1 pound, 2 pounds, and 5 pounds Sterling are legal tender in unlimited amounts. Twenty pence pieces and fifty pence pieces are legal tender in amounts up to 10 pounds; five pence pieces and ten pence pieces are legal tender in amounts up to 5 pounds; and pennies and two pence coins are legal tender in amounts up to 20 pence.[20] In accordance with the Coinage Act 1971,[21] gold sovereigns are also legal tender for any amount. Although it is not specifically mentioned on them, the face values of gold coins are 50p; 1; 2; and 5, a mere fraction of their worth as bullion. Maundy money is legal tender but may not be accepted by retailers and is worth much more than face value due to its rarity value and silver content. Bank of England notes are legal tender in England and Wales and are issued in the denominations of 5, 10, 20 and 50. English banknotes can always be redeemed at the Bank of England even if discontinued. Banknotes issued by Scottish and Northern Irish banks are not legal tender anywhere in England and Wales but can still be accepted with agreement between parties.[22] Whilst Banknotes issued by the Scottish banks are legal currency, that is approved by the UK Parliament, no banknotes issued by Scottish banks, Northern Ireland banks nor the Bank of England are legal tender in Scotland. Thus legal tender in Scotland is limited to coin as noted above.

United States
Before the Civil War (1861 to 1865), silver coins were legal tender only up to the sum of $5. Before 1853, when US silver coins were reduced in weight 7%, coins had exactly their value in metal (from 1830 to 1852). Two silver 50 cent coins had exactly $1 worth of silver. A gold US Dollar of 1849 had $1 worth of gold. With the flood of gold coming out of the California mines in the early 1850s, the price of silver rose (gold went down). Thus, 50 cent coins of 1840 to 1852 were worth 53 cents if melted down. The government could increase the value of the gold coins (expensive) or reduce the size of all US silver coins. With the reduction of 1853, a 50-cent coin now had only 48 cents of silver. This is the reason for the $5 limit of silver coins as legal tender; paying somebody $100 in the new silver coins would be giving them $96 worth of silver. Most people preferred bank check or gold coins for large purchases. During the early American Civil War, the federal government first issued United States Notes (the first greenback notes) which were not redeemable in gold and silver coins but could be used to pay "all dues" to the Federal Government. Since land purchases and duties on imports were payable only in gold or the new Demand Notes, the Demand Notes were bought by importers and land speculators for about 97 cents on the gold dollar and never lost value. 1862 greenbacks (Legal Tender Notes) at first traded for 97 cents on the dollar but gained/lost value depending on fortunes of the Union army. The value of Legal Tender Greenbacks swung wildly but trading was from 85 to 33 cents on the gold dollar.

This resulted in a situation in which the greenback "Legal Tender" notes of 1862 were fiat, and so gold and silver were held and paper circulated at a discount because of Gresham's Law. The 1861 Demand Notes were a huge success but robbed the customs house of much needed gold coin (interest on most bonds back then was paid in gold). A money-strapped Congress which had to pay for the war eventually adopted the Legal Tender Act of 1862, issuing United States Notes backed only by treasury securities, and compelled the people to accept the new notes at a discount; prices rose except for those who had gold and/or silver coins. Litigation resulted from debts incurred before the Civil War (when gold coins were common) and 5 years later, the debtor wanted to pay the debt in full with "Legal Tender" (worth only 55 cents on the gold dollar). Bank deposits were often in "current funds (paper money)" or gold coin. Checks were written to be cashed in "gold coin" or "current funds." The United States Supreme Court, with Salmon P. Chase (former Secretary of the Treasury) ruled the practice of legal tender unconstitutional in Hepburn v. Griswold in 1869, but later reversed its ruling within a month when confusion in the markets caused everybody not to accept "Legal Tender" notes at all. The Court held that paper money, even that not backed by specie such as the United States Notes can be legal tender, in the Legal Tender Cases, ranging from 1871 to 1884. On the other hand, coins made of gold or silver may not necessarily be legal tender, if they are not fiat money in the jurisdiction where they are preferred as payment. The Coinage Act of 1965 states (in part):
United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes and dues. Foreign gold or silver coins are not legal tender for debts. 31 U.S.C. 5103

There is, however, no federal statute that a private business, a person, or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.[23] On May 27, 2011, Jason West in Vernal, Utah dumped 2500 loose pennies onto the counter of Basin Clinic when disputing a bill.[24] The police there cited him with disorderly conduct for causing unnecessary alarm when the dumped pennies were strewn about the counter and the floor, but paying in pennies itself was not the reason to cite him.[25]

An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary

means of implementing monetary policy. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementationProcess
Since most money now exists in the form of electronic records rather than in the form of paper, open market operations are conducted simply by electronically increasing or decreasing (crediting or debiting) the amount of base money that a bank has in its reserve account at the central bank. Thus, the process does not literally require new currency. However, this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance. When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money. The central bank goes to the open market to buy a financial asset, such as government bonds, foreign currency, gold, or seemingly nonvolatile (until the 2008 financial fallout) MBS's [3] (Mortgage Backed Securities). To pay for these assets, bank reserves in the form of new base money (for example newly printed cash) are transferred to the seller's bank and the seller's account is credited. Thus, the total amount of base money in the economy is increased. Conversely, if the central bank sells these assets in the open market, the amount of base money held by the buyer's bank is decreased, effectively destroying base money.

Possible targets

Under inflation targeting, open market operations target a specific short term interest rate in the debt markets. This target is changed periodically to achieve and maintain an inflation rate within a target range. However, other variants of monetary policy also often target interest rates: the US Federal Reserve, the Bank of England and the European Central Bank use variations on interest rate targets to guide open market operations. Besides interest rate targeting there are other possible targets of open markets operations. A second possible target is the contraction of the money supply, as was the case in the U.S. in the late 1970s through the early 1980s under Fed Chairman Paul Volcker. Under a currency board open market operations would be used to achieve and maintain a fixed exchange rate with relation to some foreign currency.

Under a gold standard, notes would be convertible to gold, so there would be no open market operations. However, open market operations could be used to keep the value of a fiat currency constant relative to gold. A central bank can also use a mixture of policy settings that change depending on circumstances. A central bank may peg its exchange rate (like a currency board) with different levels or forms of commitment. The looser the exchange rate peg, the more latitude the central bank has to target other variables (such as interest rates). It may instead target a basket of foreign currencies rather than a single currency. In some instances it is empowered to use additional means other than open market operations, such as changes in reserve requirements or capital controls, to achieve monetary outcomes.

How open market operations are conducted

United States
Further information: Monetary policy of the United States In the United States, as of 2006, the Federal Reserve sets an interest rate target for the Federal funds (overnight bank reserves) market. When the actual Federal funds rate is higher than the target, the New York Reserve Bank will usually increase the money supply via a repo (effectively borrowing from the dealers' perspective; lending for the Reserve Bank). When the actual Federal funds rate is less than the target, the Bank will usually decrease the money supply via a reverse repo (effectively lending from the dealers' perspective; borrowing for the Reserve Bank). In the U.S., the Federal Reserve most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money, which offset temporary changes in the level of bank reserves.[4] The Federal Reserve also makes outright purchases and sales of securities through the System Open Market Account (SOMA) with its manager over the Trading Desk at the New York Reserve Bank. The trade of securities in the SOMA changes the balance of bank reserves, which also affects short term interest rates. The SOMA manager is responsible for trades that result in a short term interest rate near the target rate set by the Federal Open Market Committee (FOMC), or create money by the outright purchase of securities.[5] More rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 (currently 18 as an immediate aftermath of 08/09 credit crisis) banks or bond dealers that are called primary dealers. Money is created or destroyed by changing the reserve account of the bank with the Federal Reserve. The Federal Reserve has conducted open market operations in this manner since the 1920s, through the Open Market Desk at the Federal Reserve Bank of New York, under the direction of the Federal Open Market Committee. The open market operation is also a means through which inflation can be controlled because when treasury bills are sold to commercial banks these banks can no longer give out loans to the public for the period and therefore money is being reduced from circulation.

Eurozone
The European Central Bank has similar mechanisms for their operations; it describes its methods as a four-tiered approach with different goals: beside its main goal of steering and smoothing Eurozone interest rates while managing the liquidity situation in the market the ECB also has the aim of signalling the stance of monetary policy with its operations. Broadly speaking, the ECB controls liquidity in the banking system via Refinancing Operations, which are basically repurchase agreements,[6] i.e. banks put up acceptable collateral with the ECB and receive a cash loan in return. These are the following main categories of refinancing operations that can be employed depending on the desired outcome:

The regular weekly main refinancing operations (MRO) with maturity of one week and, The monthly longer-term refinancing operations (LTRO) provide liquidity to the financial sector, while ad-hoc "Fine-tuning operations" (in the form of reverse or outright transactions, foreign exchange swaps and the collection of fixed-term deposits) aim to smooth interest rates caused by liquidity fluctuations in the market and "Structural operations" are used to adjust the central banks' longer-term structural positions vis-a-vis the financial sector.

Refinancing operations are conducted via an auction mechanism. The ECB specifies the amount of liquidity it wishes to auction (called the allotted amount) and asks banks for expressions of interest. In a fixed rate tender the ECB also specifies the interest rate at which it is willing to lend money; alternatively, in a variable rate tender the interest rate is not specified and banks bid against each other (subject to a minimum bid rate specified by the ECB) to access the available liquidity. MRO auctions are held on Mondays, with settlement (i.e. disbursal of the funds) occurring the following Wednesday. For example at its auction on 2008 October 6, the ECB made available 250 million in EUR on October 8 at a minimum rate of 4.25%. It received 271 million in bids, and the allotted amount (250) was awarded at an average weighted rate of 4.99%. Since mid-October 2008, however, the ECB has been following a different procedure on a temporary basis, the fixed rate MRO with full allottment. In this case the ECB specifies the rate but not the amount of credit made available, and banks can request as much as they wish (subject as always to being able to provide sufficient collateral). This procedure was made necessary by the financial crisis of 2008 and is expected to end at some time in the future. Though the ECB's main refinancing operations (MRO) are from repo auctions with a (bi)weekly maturity and monthly maturation, Long Term Refinancing Operations (LTROs) are also issued, which traditionally mature after three months; since 2008, tenders are now offered for six months, 12 months and 36 months. [7]

Switzerland

The Swiss National Bank currently targets the 3 month Swiss franc LIBOR rate. The primary way the SNB influences the 3 month Swiss franc LIBOR rate is through open market operations, with the most important monetary policy instrument being repo transactions.[8]

India
Indias Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are much different than those in the other developed countries. Thus Reserve Bank Of India, being the Central Bank of the country, has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBIs major source of funding and control over credit and interest rates was the CRR (Cash reserve ratio) and the SLR (Statutory Liquidity Ratio). But after the reforms, the use of CRR as an effective tool was de-emphasized and the use of open market operations increased. OMOs are more effective in adjusting market liquidity. The two traditional type of OMOs used by RBI: 1. Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent). 2. Repurchase agreement (REPO): Is short term, and are subject to repurchase.[9] However, even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus, on the recommendations of the Narshiman Committee Report (1998), The RBI brought together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI also help in determining other market interest rates.[10] India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus, on the recommendations of the Working Group of RBI on instruments of Sterilization (December, 2003), a new scheme known as the Market stabilization scheme (MSS) was set up. The LAF and the OMOs were dealing with day to day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.[11] According to this scheme, the RBI issues additional T-bills and securities to absorb the liquidity. And the money goes into the Market Stabilization scheme Account (MSSA). The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. The Government, in collaboration with the RBI, fixes a ceiling amount on the issue of these instruments.[12] But for an open market operation instrument to be effective, there has to be an active securities market for RBI to make any kind of effect on the liquidity and rates of interest. In economics, the monetary base (also base money, money base, high-powered money, reserve money, or, in

the UK, narrow money) is a term relating to (but not being equivalent to) the money supply (or money stock), the amount of money in the economy. The monetary base is highly liquid money that consists of coins, paper money (both as bank vault cash and as currency circulating in the public), and commercial banks' reserves with the central bank. Measures of money are typically classified as levels of M, where the monetary base is smallest and lowest M-level: M0. Base money can be described as the most acceptable (or liquid) form of final payment. Broader measures of the money supply also include money that does not count as base money, such as demand deposits (included in M1), and other deposit accounts like the less liquid savings accounts (included in M2) etc. (The narrow money supply is an earlier term used in the U.S to describe currency held by the non-bank public and demand deposits of banks, M1). "Open market operations" are monetary policy tools that affect directly the monetary base; the monetary base can be expanded or contracted using an Expansionary monetary policy or a Contractionary monetary policy. The monetary base is typically controlled by the institution in a country that controls monetary policy. This is usually either the finance ministry or the central bank. These institutions change the monetary base through open market transactions (i.e., the buying and selling of government bonds). These institutions also typically have the ability to influence banking activities by manipulating interest rates and changing bank reserve requirements (how much money banks must keep on hand instead of loaning out to borrowers). The monetary base is called high-powered because an increase in the monetary base (M0) will typically result in a much larger increase in the supply of demand deposits through banks' loanmaking activities (an effect often referred to as the money multiplier.)[1] Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1][2] The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.[3]

Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a

variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. 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 instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market 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 or else relative to gold. 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; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (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).

Theory

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices.[citation needed] Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wagesetting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail. Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to

meet targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued[4] that to prevent some pathologies related to the time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessarily tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.[5]

History of monetary policy

Monetary policy is associated with interest rates and availabilility of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base.[6] For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium.

In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[7] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other goldbacked currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 18701920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[8] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output.[9] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[10] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[11] Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.[12][13][14] Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rates; credit quality; bonds and equities (corporate ownership and debt); government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people, primarily libertarians and Constitutionalists,[15] advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and

these risks will result in drastic harm to the populace should monetary policy fail. Others[who?] see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt. In fact, many economists [16] disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 20082009.[17]

Trends in central banking

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[18] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists {[19] which argues that central bank monetary policy aggravates the business cycle, creating malinvestment and maladjustments in the economy which then cause downcycle corrections, but most economists fall into either the Keynesian or neoclassical camps on this issue.

Developing countries
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation. Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting Price Level Targeting Monetary

Target Market Variable: Long Term Objective: Interest rate on overnight A given rate of change in the CPI debt Interest rate on overnight A specific CPI number debt The growth in money supply A given rate of change in the CPI

Aggregates Fixed Exchange Rate Gold Standard Mixed Policy

The spot price of the currency The spot price of gold Usually interest rates

The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

Inflation targeting
Main article: Inflation targeting Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[20] The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years. Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and workers, and undermines any information that can be gained from relative prices, as it is more difficult for firms to determine if a change in the price of a good or service is because of inflation or other factors, such as an increase in the efficiency of factors of production, if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money and increases transaction costs and shoe leather costs.

Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation. Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency. Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy). These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors. See also: List of fixed currencies

Gold standard
Main article: Gold standard The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971.[21] Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their money supply.[22] The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each

unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

Policy of various nations

Bangladesh - Inflation targeting Australia Inflation targeting Brazil Inflation targeting Canada Inflation targeting Chile Inflation targeting China Monetary targeting and targets a currency basket Czech Republic Inflation targeting Colombia Inflation targeting Hong Kong Currency board (fixed to US dollar) India Multiple indicator approach New Zealand Inflation targeting Norway Inflation targeting Singapore Exchange rate targeting South Africa Inflation targeting Sri Lanka Monetary targeting Switzerland Inflation targeting [23] Turkey Inflation targeting United Kingdom[24] Inflation targeting, alongside secondary targets on 'output and employment'. United States[25] Mixed policy dedicated to maximum employment and stable prices (and since the 1980s it is well described by the "Taylor rule," which maintains that the Fed funds rate responds to shocks in inflation and output) Further information: Monetary policy of the USA

Monetary policy tools

Monetary base
Monetary policy can be implemented by changing the size of the monetary base. Central banks use open market operations to change the monetary base. The central bank buys or sells reserve assets (usually financial instruments such as bonds) in exchange for money on deposit at the

central bank. Those deposits are convertible to currency. Together such currency and deposits constitute the monetary base which is the general liabilities of the central bank in its own monetary unit. Usually other banks can use base money as a fractional reserve and expand the circulating money supply by a larger amount.

Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

Discount window lending

Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), thereby affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Interest rates
Main article: Interest rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a

monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board
Main article: currency board A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are threefold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization). In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency. The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners. Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).

Currency boards have advantages for small, open economies that would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

Unconventional monetary policy at the zero bound

This section requires expansion. (February 2010) Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, and signaling. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an extended period, and the Bank of Canada made a conditional commitment to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010. Fiscal policy and monetary policy are the two tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. The celebrated IS/LM model is one of the models used to depict the effect of interaction on aggregate output and interest rates. The fiscal policies have an impact on the goods market and the monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables output and interest rates, the policies interact while influencing the output or the interest rates. Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals as the two were perceived to aim at mutually inconsistent targets. But in recent years, owing to the transfer of control with respect to monetary policy formulation to Central Banks, formation of monetary unions (like European Monetary Union formed via the Stability and Growth Pact) and attempts being made to form fiscal unions,there has been a significant structural change in the way in which fiscal-monetary policies interact. There is a dilemma as to whether these two policies are complementary, or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker's expansionary (contractionary) policies are countered by another policy maker's contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other. The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely

dominates the policy making and no interaction worthy of analysis would arise.Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.

Active and passive monetary

and fiscal policies

Professor Eric Leeper has defined[1] :

Passive fiscal policy is one in which the authority raises or reduces taxes to balance the budget intertemporally. Active fiscal policy is one in which the tax and spending levels are determined independent of intertemporal budget consideration. Active monetary policy is one that pursues its inflation target independent of fiscal policies. Passive monetary policy is one that sets interest rates to accommodate fiscal policies.

In case of an active fiscal policy and a passive monetary policy, the economy faces an expansionary fiscal shock that raises the price levels and money growth as monetary authority is forced to accommodate these shocks. But in case both the authorities are active, then the expansionary pressures created by the fiscal authority is contained to some extent by the monetary policies.

Supply shock
During a negative supply shock, the fiscal and monetary authorities are seen to follow conflicting policies as the fiscal authorities would follow expansionary policies to bring the output at its original state while the monetary authorities would follow contractionary policies so as to reduce the inflation created due to shortage in output caused by the supply shock.

Demand shock
During a demand shock (a sudden significant rise or fall in aggregate demand due to external factors) without a corresponding change in output that results in inflation or deflation which can also be termed as inflation or a deflation shock, it is observed that the two policies work in harmony. Both the authorities would follow expansionary policies in case of a negative demand shock in order to bring back the demand at its original state while they would follow contractionary policies during a positive demand shock in order to reduce the excess aggregate demand and bring inflation under control.

Cost push shocks

A cost-push shock is defined as a change in inflation that is not a result of pressures in the economy.[2] The macroeconomic goal under such a situation is to optimise between reducing inflation and reducing the gap between the actual output and the desired level of output. A

contractionary monetary policy under such a scenario raises the real interest rates which in turn not only reduces consumption thereby dampening aggregate demand and inflation but also raises the labour supply as workers are willing to sacrifice current leisure along with current consumption. This further dampens the inflation rates. On the other hand, changes in government spending is able to influence aggregate demand alone and hence is less effective in comparison to monetary policy. Moreover a deviation from the given level of government spending has an impact on optimal provision of public goods which then has direct welfare costs. Hence the optimal fiscal policy is to keep the government spending gap (i.e. the gap between the actual and the socially desired levels of government spending) close to zero. Thus, when an economy is hit by a cost push shock and given that the only policy instrument in the hand of fiscal authority is public spending (ignoring the impacts of taxes and debt), the monetary policy dominates fiscal policies in reviving the economy. But this holds true only when the economy has zero government debt. Once government debt becomes positive, then a non zero government spending gap becomes essential to absorb any repercussions of cost push shocks or monetary policy responses.This is because the rise in real interest rates raises the cost of debt which then requires the fiscal authority to deviate from its natural rate of public spending so as to nullify the impact of increasing interest rates.

Fiscal shock and policy rate shock

In case of a positive fiscal shock i.e. increase in fiscal deficits, the aggregate output rises beyond the potential output thus raising the aggregate demand. Subsequently, this leads to dissavings and lowering of investments which further depresses output in the long run. Monetary authorities react in a countercyclical way to this and in the long run adopts quantitative easing to counter the fall in output caused due to fiscal expansion. In case of policy shocks, caused by a sudden positive (negative) changes in policy rates such as statutory liquidity ratio, cash reserve ratio or the repo rates, the fiscal authority initially reacts by following expansionary (contractionary) policy subsequently narrows down (expands up)

Presence of monetary union

When an economy is a part of a monetary union, its monetary authority is no longer able to conduct its monetary policies independently as per the requirements of the economy. Under such situation the interaction between fiscal and monetary policies undergo certain changes. Generally, the monetary union follows policies to keep the overall inflation at such levels so as to keep the overall gap between the actual aggregate consumption and desired consumption close to zero. Fiscal polices are then used to minimise the country specific welfare losses arising out of such policies. Also, fiscal policies are used to stabilise the terms of trade and maintain them at their natural levels. Given the common monetary policies and the price levels for all the nations under

the union, the fiscal authority of the home country is led to follow contractionary policies in case of deterioration in terms of trade.

Effect of price rigidities

In case of a supply shock,while the weighted average inflation is at optimum levels,the inflation levels of the nations hit by such a shock is far from optimum. In such a scenario, given that the degree of price rigidities in all the nations are equal, then the fiscal policies would achieve the dual goal of attaining optimum public spending and maintaining the natural levels of terms of trade only when the shocks hitting the nations under the union are perfectly correlated else either of the objective is achieved at the cost of other as monetary policies fail to influence the terms of trade owing to equality of the degree of price rigidities amongst the nations. But in case of varying degrees of price rigidities amongst the nations, terms of trade is no longer insulated from monetary policies. This is so because, the monetary policies would be directed towards keeping the inflation of the nations with higher degree of price rigidities at optimum levels so as to reduce their terms of trade losses and the fiscal policies of the rest of the countries would assume a relatively effective role in stabilising the national inflation as the price levels would respond to the change in public spendings. In short, lower the degree of price rigidities in an economy belonging to a monetary union, greater would be the relative role of fiscal policies in economic stabilisation and vice versa.

Fiscal monetary Interaction in European Monetary Union

The European Central Bank was created in December 1998 and from 1999 onwards the Euro became the official currency of the member nations of the European Monetary Union and a single monetary policy was adopted under the European Central Bank. To ensure that the member nations meet the optimum currency area, potential member nations were asked to commit to the below-mentioned convergence criteria as spelled out in the Maastricht Treaty:

Central Bank independence A stability-oriented monetary policy with the primary objective of maintaining price stability Obligations of the member states to treat the economic policies, in particular, fiscal policies as a matter of common concern.[3]

In addition to the above requirements, members were to maintain exchange rates within specific band and bring inflation, long term interest rates and budget deficits to levels specified in the Treaty. Meeting these criteria forced the member nations to restrict the adoption of stabilising fiscal policies and concentrate of inflation races to bring them down to the levels spelled out in the Treaty. This led to change in the structure of monetary fiscal interaction in the member nations. Unemployment (or joblessness) occurs when people are without work and actively seeking work.[1] The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals

currently in the labor force. During periods of recession, an economy usually experiences a relatively high unemployment rate.[2] In a 2011 news story, BusinessWeek reported, "More than 200 million people globally are out of work, a record high, as almost two-thirds of advanced economies and half of developing countries are experiencing a slowdown in employment growth".[3] There remains considerable theoretical debate regarding the causes, consequences and solutions for unemployment. Classical economics, New classical economics, and the Austrian School of economics argue that market mechanisms are reliable means of resolving unemployment. These theories argue against interventions imposed on the labor market from the outside, such as unionization, minimum wage laws, taxes, and other regulations that they claim discourage the hiring of workers. Keynesian economics emphasizes the cyclical nature of unemployment and recommends interventions it claims will reduce unemployment during recessions. This theory focuses on recurrent shocks that suddenly reduce aggregate demand for goods and services and thus reduce demand for workers. Keynesian models recommend government interventions designed to increase demand for workers; these can include financial stimuli, publicly funded job creation, and expansionist monetary policies. In addition to these comprehensive theories of unemployment, there are a few categorizations of unemployment that are used to more precisely model the effects of unemployment within the economic system. The main types of unemployment include structural unemployment which focuses on structural problems in the economy and inefficiencies inherent in labour markets including a mismatch between the supply and demand of laborers with necessary skill sets. Structural arguments emphasize causes and solutions related to disruptive technologies and globalization. Discussions of frictional unemployment focus on voluntary decisions to work based on each individuals' valuation of their own work and how that compares to current wage rates plus the time and effort required to find a job. Causes and solutions for frictional unemployment often address barriers to entry and wage rates. Behavioral economists highlight individual biases in decision making and often involve problems and solutions concerning sticky wages and efficiency wages.

Definitions, types, and theories

"Driver looking for work" Unemployed German laborer in 1949 Economists distinguish between various overlapping types of and theories of unemployment, including cyclical or Keynesian unemployment, frictional unemployment, structural unemployment and classical unemployment.[4] Some additional types of unemployment that are occasionally mentioned are seasonal unemployment, hardcore unemployment, and hidden unemployment. The U.S. BLS measures six types of unemployment, U1U6. A recent alternative classification is into obstructional, developmental, and contractional unemployment.[5] Though there have been several definitions of voluntary and involuntary unemployment in the economics literature, a simple distinction is often applied. Voluntary unemployment is attributed to the individual's decisions, whereas involuntary unemployment exists because of the socioeconomic environment (including the market structure, government intervention, and the level of aggregate demand) in which individuals operate. In these terms, much or most of frictional unemployment is voluntary, since it reflects individual search behavior. Voluntary unemployment includes workers who reject low wage jobs whereas involuntary unemployment includes workers fired due to an economic crisis, industrial decline, company bankruptcy, or organizational restructuring. On the other hand, cyclical unemployment, structural unemployment, and classical unemployment are largely involuntary in nature. However, the existence of structural unemployment may reflect choices made by the unemployed in the past, while classical (natural) unemployment may result from the legislative and economic choices made by labour unions or political parties. So, in practice, the distinction between voluntary and involuntary unemployment is hard to draw. The clearest cases of involuntary unemployment are those where there are fewer job vacancies than unemployed workers even when wages are allowed to adjust, so that even if all vacancies were to be filled, some unemployed workers would still remain. This happens with cyclical unemployment, as macroeconomic forces cause microeconomic unemployment which can boomerang back and exacerbate these macroeconomic forces.

Classical unemployment

Graph of Labor Market

Classical or real-wage unemployment occurs when real wages for a job are set above the marketclearing level, causing the number of job-seekers to exceed the number of vacancies. Many economists have argued that unemployment increases the more the government intervenes into the economy to try to improve the conditions of those without jobs.[citation needed] For example, minimum wage laws raise the cost of laborers with few skills to above the market equilibrium, resulting in people who wish to work at the going rate but cannot as wage enforced is greater than their value as workers becoming unemployed.[6][7] Laws restricting layoffs made businesses less likely to hire in the first place, as hiring becomes more risky, leaving many young people unemployed and unable to find work.[7] However, this argument is criticized for ignoring numerous external factors and overly simplifying the relationship between wage rates and unemployment in other words, that other factors may also affect unemployment.[8][9][10][11][12] Some, such as Murray Rothbard,[13] suggest that even social taboos can prevent wages from falling to the market clearing level. In Out of Work: Unemployment and Government in the Twentieth-Century America, economists Richard Vedder and Lowell Gallaway argue that the empirical record of wages rates, productivity, and unemployment in American validates the classical unemployment theory. Their data shows a strong correlation between the adjusted real wage and unemployment in the United States from 1900 to 1990. However, they maintain that their data does not take into account exogenous events.[14]

Cyclical unemployment

The IS-LM Model is used to analyze the effect of demand shocks on the economy. Cyclical or Keynesian unemployment, also known as deficient-demand unemployment, occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. Demand for most goods and services falls, less production is needed and consequently fewer workers are needed, wages are sticky and do not fall to meet the equilibrium level, and mass unemployment results.[15] Its name is derived from the frequent shifts in the business cycle although unemployment can also be persistent as occurred during the Great

Depression of the 1930s. With cyclical unemployment, the number of unemployed workers exceeds the number of job vacancies, so that even if full employment were attained and all open jobs were filled, some workers would still remain unemployed. Some associate cyclical unemployment with frictional unemployment because the factors that cause the friction are partially caused by cyclical variables. For example, a surprise decrease in the money supply may shock rational economic factors and suddenly inhibit aggregate demand. In some industries, this results in high number of Liquid employees who can only find temporary work and are forced to move from company to company. Keynesian economists on the other hand see the lack of demand for jobs as potentially resolvable by government intervention. One suggested interventions involves deficit spending to boost employment and demand. Another intervention involves an expansionary monetary policy that increases the demand of money which should reduce interest rates which should lead to an increase in non-governmental spending.[16]

Marxian theory of unemployment

It is in the very nature of the capitalist mode of production to overwork some workers while keeping the rest as a reserve army of unemployed paupers. Marx, Theory of Surplus Value, [17] According to Karl Marx, unemployment is inherent within the unstable capitalist system and periodic crises of mass unemployment are to be expected. The function of the proletariat within the capitalist system is to provide a "reserve army of labour" that creates downward pressure on wages. This is accomplished by dividing the proletariat into surplus labour (employees) and under-employment (unemployed).[18] This reserve army of labour fight among themselves for scarce jobs at lower and lower wages. At first glance, unemployment seems inefficient since unemployed workers do not increase profits. However, unemployment is profitable within the global capitalist system because unemployment lowers wages which are costs from the perspective of the owners. From this perspective low wages benefit the system by reducing economic rents. Yet, it does not benefit workers. Capitalist systems unfairly manipulate the market for labour by perpetuating unemployment which lowers laborers' demands for fair wages. Workers are pitted against one another at the service of increasing profits for owners. According to Marx, the only way to permanently eliminate unemployment would be to abolish capitalism and the system of forced competition for wages and then shift to a socialist or communist economic system. For contemporary Marxists, the existence of persistent unemployment is proof of the inability of capitalism to ensure full employment.[19]

Full employment
Main article: Full employment

Short-Run Phillips Curve before and after Expansionary Policy, with Long-Run Phillips Curve (NAIRU) In demand-based theory, it is possible to abolish cyclical unemployment by increasing the aggregate demand for products and workers. However, eventually the economy hits an "inflation barrier" imposed by the four other kinds of unemployment to the extent that they exist. Some demand theory economists see the inflation barrier as corresponding to the natural rate of unemployment. The "natural" rate of unemployment is defined as the rate of unemployment that exists when the labour market is in equilibrium and there is pressure for neither rising inflation rates nor falling inflation rates. An alternative technical term for this rate is the NAIRU or the Non-Accelerating Inflation Rate of Unemployment. No matter what its name, demand theory holds that this means that if the unemployment rate gets "too low," inflation will get worse and worse (accelerate) in the absence of wage and price controls (incomes policies). One of the major problems with the NAIRU theory is that no one knows exactly what the NAIRU is (while it clearly changes over time). The margin of error can be quite high relative to the actual unemployment rate, making it hard to use the NAIRU in policy-making. Another, normative, definition of full employment might be called the ideal unemployment rate. It would exclude all types of unemployment that represent forms of inefficiency. This type of "full employment" unemployment would correspond to only frictional unemployment (excluding that part encouraging the McJobs management strategy) and would thus be very low. However, it would be impossible to attain this full-employment target using only demand-side Keynesian stimulus without getting below the NAIRU and suffering from accelerating inflation (absent incomes policies). Training programs aimed at fighting structural unemployment would help here. To the extent that hidden unemployment exists, it implies that official unemployment statistics provide a poor guide to what unemployment rate coincides with "full employment".

Structural unemployment
Main article: Structural unemployment

Okun's Law interprets unemployment as a function of growth in GDP Structural unemployment occurs when a labour market is unable to provide jobs for everyone who wants one because there is a mismatch between the skills of the unemployed workers and the skills needed for the available jobs. Structural unemployment is hard to separate empirically from frictional unemployment, except to say that it lasts longer. As with frictional unemployment, simple demand-side stimulus will not work to easily abolish this type of unemployment. Structural unemployment may also be encouraged to rise by persistent cyclical unemployment: if an economy suffers from long-lasting low aggregate demand, it means that many of the unemployed become disheartened, while their skills (including job-searching skills) become "rusty" and obsolete. Problems with debt may lead to homelessness and a fall into the vicious circle of poverty. This means that they may not fit the job vacancies that are created when the economy recovers. Some economists see this scenario as occurring under British Prime Minister Margaret Thatcher during the 1970s and 1980s. The implication is that sustained high demand may lower structural unemployment. This theory of persistence in structural unemployment has been referred to as an example of path dependence or "hysteresis". Much technological unemployment,[20] due to the replacement of workers by machines, might be counted as structural unemployment. Alternatively, technological unemployment might refer to the way in which steady increases in labour productivity mean that fewer workers are needed to produce the same level of output every year. The fact that aggregate demand can be raised to deal with this problem suggests that this problem is instead one of cyclical unemployment. As indicated by Okun's Law, the demand side must grow sufficiently quickly to absorb not only the growing labour force but also the workers made redundant by increased labour productivity. Seasonal unemployment may be seen as a kind of structural unemployment, since it is a type of unemployment that is linked to certain kinds of jobs (construction work, migratory farm work). The most-cited official unemployment measures erase this kind of unemployment from the statistics using "seasonal adjustment" techniques. The resulting in substantial, permanent structural unemployment.

Frictional unemployment

Main article: Frictional unemployment

Beveridge curve of 2004 job vacancy and unemployment rate from the United States Bureau of Labour Statistics Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment is always present in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment, which means that increases or decreases in unemployment are normally under-represented in the simple statistics.[21] Frictional unemployment exists because both jobs and workers are heterogeneous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to skills, payment, work-time, location, seasonal industries, attitude, taste, and a multitude of other factors. New entrants (such as graduating students) and re-entrants (such as former homemakers) can also suffer a spell of frictional unemployment. Workers as well as employers accept a certain level of imperfection, risk or compromise, but usually not right away; they will invest some time and effort to find a better match. This is in fact beneficial to the economy since it results in a better allocation of resources. However, if the search takes too long and mismatches are too frequent, the economy suffers, since some work will not get done. Therefore, governments will seek ways to reduce unnecessary frictional unemployment through multiple means including providing education, advice, training, and assistance such as daycare centers. The frictions in the labour market are sometimes illustrated graphically with a Beveridge curve, a downward-sloping, convex curve that shows a correlation between the unemployment rate on one axis and the vacancy rate on the other. Changes in the supply of or demand for labour cause movements along this curve. An increase (decrease) in labour market frictions will shift the curve outwards (inwards).

Hidden unemployment

United States mean duration of unemployment (19502010) Hidden, or covered, unemployment is the unemployment of potential workers that is not reflected in official unemployment statistics, due to the way the statistics are collected. In many countries only those who have no work but are actively looking for work (and/or qualifying for social security benefits) are counted as unemployed. Those who have given up looking for work (and sometimes those who are on Government "retraining" programs) are not officially counted among the unemployed, even though they are not employed. The same applies to those who have taken early retirement to avoid being laid off, but would prefer to be working. The statistic also does not count the "underemployed" those working fewer hours than they would prefer or in a job that doesn't make good use of their capabilities. In addition, those who are of working age but are currently in full-time education are usually not considered unemployed in government statistics. Traditional unemployed native societies who survive by gathering, hunting, herding, and farming in wilderness areas, may or may not be counted in unemployment statitics. Official statistics often underestimate unemployment rates because of hidden unemployment.

Long-term unemployment
This is normally defined, for instance in European Union statistics, as unemployment lasting for longer than one year. It is an important indicator of social exclusion. The United States Bureau of Labor Statistics (BLS) reports this as 27 weeks or longer. Long-term unemployment can result in older workers taking early retirement; in the United States, taking reduced social security benefits at age 62.[22]

Measurement
There are also different ways national statistical agencies measure unemployment. These differences may limit the validity of international comparisons of unemployment data.[23] To some degree these differences remain despite national statistical agencies increasingly adopting the definition of unemployment by the International Labour Organization.[24] To facilitate international comparisons, some organizations, such as the OECD, Eurostat, and International Labor Comparisons Program, adjust data on unemployment for comparability across countries. Though many people care about the number of unemployed individuals, economists typically focus on the unemployment rate. This corrects for the normal increase in the number of people employed due to increases in population and increases in the labour force relative to the population. The unemployment rate is expressed as a percentage, and is calculated as follows:

As defined by the International Labour Organization, "unemployed workers" are those who are currently not working but are willing and able to work for pay, currently available to work, and have actively searched for work.[25] Individuals who are actively seeking job placement must make the effort to: be in contact with an employer, have job interviews, contact job placement agencies, send out resumes, submit applications, respond to advertisements, or some other means of active job searching within the prior four weeks. Simply looking at advertisements and not responding will not count as actively seeking job placement. Since not all unemployment may be "open" and counted by government agencies, official statistics on unemployment may not be accurate.[26] In the United States, for example, the unemployment rate does not take into consideration those individuals who are not actively looking for employment, such as those still attending college.[27] The ILO describes 4 different methods to calculate the unemployment rate:[28]

Labour Force Sample Surveys are the most preferred method of unemployment rate calculation since they give the most comprehensive results and enables calculation of unemployment by different group categories such as race and gender. This method is the most internationally comparable. Official Estimates are determined by a combination of information from one or more of the other three methods. The use of this method has been declining in favor of Labour Surveys. Social Insurance Statistics such as unemployment benefits, are computed base on the number of persons insured representing the total labour force and the number of persons who are insured that are collecting benefits. This method has been heavily criticized due to the expiration of benefits before the person finds work. Employment Office Statistics are the least effective being that they only include a monthly tally of unemployed persons who enter employment offices. This method also includes unemployed who are not unemployed per the ILO definition.

The primary measure of unemployment, U3, allows for comparisons between countries. Unemployment differs from country to country and across different time periods. For example, during the 1990s and 2000s, the United States had lower unemployment levels than many countries in the European Union,[29] which had significant internal variation, with countries like the UK and Denmark outperforming Italy and France. However, large economic events such as the Great Depression can lead to similar unemployment rates across the globe.

European Union (Eurostat)

Unemployment in the regions of the European Union in 2010, according to Eurostat.

Unemployment rates from 19932009 for United States and European Union. Eurostat, the statistical office of the European Union, defines unemployed as those persons age 15 to 74 who are not working, have looked for work in the last four weeks, and ready to start work within two weeks, which conform to ILO standards. Both the actual count and rate of unemployment are reported. Statistical data are available by member state, for the European Union as a whole (EU27) as well as for the euro area (EA16). Eurostat also includes a long-term unemployment rate. This is defined as part of the unemployed who have been unemployed for an excess of 1 year.[30] The main source used is the European Union Labour Force Survey (EU-LFS). The EU-LFS collects data on all member states each quarter. For monthly calculations, national surveys or national registers from employment offices are used in conjunction with quarterly EU-LFS data. The exact calculation for individual countries, resulting in harmonized monthly data, depend on the availability of the data.[31]

United States Bureau of Labor statistics

Unemployment rate in the U.S. by county in 2008.[32] 1.23% 5.16% 8.19% 11.113% 3.14% 6.17% 9.110% 13.122.9% 4.15% 7.18% 10.111% The Bureau of Labor Statistics measures employment and unemployment (of those over 15 years of age) using two different labour force surveys[33] conducted by the United States Census Bureau (within the United States Department of Commerce) and/or the Bureau of Labor Statistics (within the United States Department of Labor) that gather employment statistics monthly. The Current Population Survey (CPS), or "Household Survey", conducts a survey based on a sample of 60,000 households. This Survey measures the unemployment rate based on the ILO definition.[34] The Current Employment Statistics survey (CES), or "Payroll Survey", conducts a survey based on a sample of 160,000 businesses and government agencies that represent 400,000 individual employers.[35] This survey measures only nonagricultural, nonsupervisory employment; thus, it does not calculate an unemployment rate, and it differs from the ILO unemployment rate definition. These two sources have different classification criteria, and usually produce differing results. Additional data are also available from the government, such as the unemployment insurance weekly claims report available from the Office of Workforce Security, within the U.S. Department of Labor Employment & Training Administration.[36] The Bureau of Labor Statistics provides up-to-date numbers via a PDF linked here.[37] The BLS also provides a readable concise current Employment Situation Summary, updated monthly.[38]

U1U6 from 19502010, as reported by the Bureau of Labor Statistics The Bureau of Labor Statistics also calculates six alternate measures of unemployment, U1 through U6, that measure different aspects of unemployment:[39]

U1:[40] Percentage of labor force unemployed 15 weeks or longer. U2: Percentage of labor force who lost jobs or completed temporary work. U3: Official unemployment rate per the ILO definition occurs when people are without jobs and they have actively looked for work within the past four weeks.[1] U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them. U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently. U6: U5 + Part-time workers who want to work full-time, but cannot due to economic reasons (underemployment).

Note: "Marginally attached workers" are added to the total labour force for unemployment rate calculation for U4, U5, and U6. The BLS revised the CPS in 1994 and among the changes the measure representing the official unemployment rate was renamed U3 instead of U5.[41] Statistics for the U.S. economy as a whole hide variations among groups. For example, in January 2008 U.S. unemployment rates were 4.4% for adult men, 4.2% for adult women, 4.4% for Caucasians, 6.3% for Hispanics or Latinos (all races), 9.2% for African Americans, 3.2% for Asian Americans, and 18.0% for teenagers.[35] Also, the U.S. unemployment rate would be at least 2% higher if prisoners and jail inmates were counted.[42][43] The unemployment rate is included in a number of major economic indexes including the United States' Conference Board's Index of Leading Indicators a macroeconomic measure of the state of the economy.

Estimated U.S. Unemployment rate from 18001890. All data are estimates based on data compiled by Lebergott.[44] See limitations section below regarding how to interpret unemployment statistics in self-employed, agricultural economies. See image info for complete data.

Estimated U.S. Unemployment rate from 18902011. 18901930 data are from Romer.[45] 1930 1940 data are from Coen.[46] 19402011 data are from Bureau of Labor Statistics.[47][48] See image info for complete data.

Alternatives
Limitations of the unemployment definition Some critics believe that current methods of measuring unemployment are inaccurate in terms of the impact of unemployment on people as these methods do not take into account the 1.5% of the available working population incarcerated in U.S. prisons (who may or may not be working while incarcerated), those who have lost their jobs and have become discouraged over time from actively looking for work, those who are self-employed or wish to become self-employed, such as tradesmen or building contractors or IT consultants, those who have retired before the official retirement age but would still like to work (involuntary early retirees), those on disability pensions who, while not possessing full health, still wish to work in occupations suitable for their medical conditions, those who work for payment for as little as one-hour per week but would like to work full-time.[49] These people are "involuntary part-time" workers, those who are underemployed, e.g., a computer programmer who is working in a retail store until he can find a permanent job, involuntary stay-at-home mothers who would prefer to work, and graduate and Professional school students who were unable to find worthwhile jobs after they graduated with their Bachelor's degrees.

Government unemployment office with job listings, Berlin, Germany.

Internationally, some nations' unemployment rates are sometimes muted or appear less severe due to the number of self-employed individuals working in agriculture.[50] Small independent farmers are often considered self-employed; so, they cannot be unemployed. The impact of this is that in non-industrialized economies, such as the United States and Europe during the early 19th century, overall unemployment was approximately 3% because so many individuals were self-employed, independent farmers; yet, unemployment outside of agriculture was as high as 80%.[51] Many economies industrialize and experience increasing numbers of non-agricultural workers. For example, the United States' non-agricultural labour force increased from 20% in 1800, to 50% in 1850, to 97% in 2000.[52] The shift away from self-employment increases the percentage of the population who are included in unemployment rates. When comparing unemployment rates between countries or time periods, it is best to consider differences in their levels of industrialization and self-employment. Additionally, the measures of employment and unemployment may be "too high". In some countries, the availability of unemployment benefits can inflate statistics since they give an incentive to register as unemployed. People who do not really seek work may choose to declare themselves unemployed so as to get benefits; people with undeclared paid occupations may try to get unemployment benefits in addition to the money they earn from their work.[53] However, in countries such as the United States, Canada, Mexico, Australia, Japan and the European Union, unemployment is measured using a sample survey (akin to a Gallup poll).[24] According to the BLS, a number of Eastern European nations have instituted labour force surveys as well. The sample survey has its own problems because the total number of workers in the economy is calculated based on a sample rather than a census. It is possible to be neither employed nor unemployed by ILO definitions, i.e., to be outside of the "labour force."[26] These are people who have no job and are not looking for one. Many of these are going to school or are retired. Family responsibilities keep others out of the labour force. Still others have a physical or mental disability which prevents them from participating in labour force activities. And of course some people simply elect not to work, preferring to be dependent on others for sustenance. Typically, employment and the labour force include only work done for monetary gain. Hence, a homemaker is neither part of the labour force nor unemployed. Nor are full-time students nor prisoners considered to be part of the labour force or unemployment.[49] The latter can be important. In 1999, economists Lawrence F. Katz and Alan B. Krueger estimated that increased incarceration lowered measured unemployment in the United States by 0.17% between 1985 and the late 1990s.[49] In particular, as of 2005, roughly 0.7% of the U.S. population is incarcerated (1.5% of the available working population). Additionally, children, the elderly, and some individuals with disabilities are typically not counted as part of the labour force in and are correspondingly not included in the unemployment statistics. However, some elderly and many disabled individuals are active in the labour market In the early stages of an economic boom, unemployment often rises.[15] This is because people join the labour market (give up studying, start a job hunt, etc.) because of the improving job market, but until they have actually found a position they are counted as unemployed. Similarly,

during a recession, the increase in the unemployment rate is moderated by people leaving the labour force or being otherwise discounted from the labour force, such as with the selfemployed. For the fourth quarter of 2004, according to OECD, (source Employment Outlook 2005 ISBN 92-64-01045-9), normalized unemployment for men aged 25 to 54 was 4.6% in the U.S. and 7.4% in France. At the same time and for the same population the employment rate (number of workers divided by population) was 86.3% in the U.S. and 86.7% in France. This example shows that the unemployment rate is 60% higher in France than in the U.S., yet more people in this demographic are working in France than in the U.S., which is counterintuitive if it is expected that the unemployment rate reflects the health of the labour market.[54][55] Due to these deficiencies, many labour market economists prefer to look at a range of economic statistics such as labour market participation rate, the percentage of people aged between 15 and 64 who are currently employed or searching for employment, the total number of full-time jobs in an economy, the number of people seeking work as a raw number and not a percentage, and the total number of person-hours worked in a month compared to the total number of personhours people would like to work. In particular the NBER does not use the unemployment rate but prefer various employment rates to date recessions.[56] Participation rate

United States Labor Force Participation Rate by gender 19482011. Men are represented in light blue, women in pink, and the total in black. The labor force participation rate is the ratio between the labor force and the overall size of their cohort (national population of the same age range). In the West during the later half of the 20th century, the labor force participation rate increased significantly, largely due to the increasing number of women entering the workplace. In the United States, there were three significant stages of women's increased participation in the labor force. During the late 19th century through the 1920s, very few women worked. They were young single women who typically withdrew from labor force at marriage unless family needed two incomes. These women worked primarily in the textile manufacturing industry or as domestic workers. This profession empowered women and allowed them to earn a living wage. At times, they were a financial help to their families. Between 1930 and 1950, women labor

force participation has increased primarily due to the increased demand for office workers, women participation in the high school movement, and due to electrification which reduced the time spent on household chores. In the 1950s to the 1970s, most women were secondary earners working mainly as secretaries, teachers, nurses, and librarians (pink-collar jobs). Claudia Goldin and others, specifically point that by the mid-1970s there was a period of revolution of women in the labor force brought on by a source of different factors. Women more accurately planned for their future in the work force, investing in more applicable majors in college that prepared them to enter and compete in the labor market. In the United States, the labor force participation rate rose from approximately 59% in 1948 to 66% in 2005,[57] with participation among women rising from 32% to 59%[58] and participation among men declining from 87% to 73%.[59][60] A common theory in modern economics claims that the rise of women participating in the U.S. labor force in the late 1960s was due to the introduction of a new contraceptive technology, birth control pills, and the adjustment of age of majority laws. The use of birth control gave women the flexibility of opting to invest and advance their career while maintaining a relationship. By having control over the timing of their fertility, they were not running a risk of thwarting their career choices. However, only 40% of the population actually used the birth control pill. This implies that other factors may have contributed to women choosing to invest in advancing their careers. One factor may be that more and more men delayed the age of marriage, allowing women to marry later in life without worrying about the quality of older men. Other factors include the changing nature of work, with machines replacing physical labor, eliminating many traditional male occupations, and the rise of the service sector, where many jobs are gender neutral. Another factor that may have contributed to the trend was the The Equal Pay Act of 1963, which aimed at abolishing wage disparity based on sex. Such legislation diminished sexual discrimination and encouraged more women to enter the labor market by receiving fair remuneration to help raising families and children. The labor force participation rate can decrease when the rate of growth of the population outweighs that of the employed and unemployed together. The labor force participation rate is a key component in long-term economic growth, almost as important as productivity. Participation rates are defined as follows: Pop = total population LFpop = labor force population (generally defined as all men and women aged 15 64) E = number employed U = number of unemployed LF = labor force = U + E p = participation rate = LF / LFpop e = rate of employment = E / LF u = rate of unemployment = U / LF

The labor force participation rate explains how an increase in the unemployment rate can occur simultaneously with an increase in employment. If a large amount of new workers enter the labor

force but only a small fraction become employed, then the increase in the number of unemployed workers can outpace the growth in employment.[61]

Effects
Costs
Individual

Migrant Mother, Dorothea Lange, 1936 Unemployed individuals are unable to earn money to meet financial obligations. Failure to pay mortgage payments or to pay rent may lead to homelessness through foreclosure or eviction.[62] Across the United States the growing ranks of people made homeless in the foreclosure crisis are generating tent cities.[63] Unemployment increases susceptibility to malnutrition, illness, mental stress, and loss of self-esteem, leading to depression. According to a study published in Social Indicator Research, even those who tend to be optimistic find it difficult to look on the bright side of things when unemployed. Using interviews and data from German participants aged 16 to 94 including individuals coping with the stresses of real life and not just a volunteering student population the researchers determined that even optimists struggled with being unemployed.[64] Dr. M. Brenner conducted a study in 1979 on the "Influence of the Social Environment on Psychology." Brenner found that for every 10% increase in the number of unemployed there is an increase of 1.2% in total mortality, a 1.7% increase in cardiovascular disease, 1.3% more cirrhosis cases, 1.7% more suicides, 4.0% more arrests, and 0.8% more assaults reported to the police.[65] A more recent study by Christopher Ruhm[66] on the effect of recessions on health found that several measures of health actually improve during recessions. As for the impact of an economic downturn on crime, during the Great Depression the crime rate did not decrease. The unemployed in the U.S. often use welfare programs such as Food Stamps or accumulating debt

because unemployment insurance in the U.S. generally does not replace a majority of the income one received on the job (and one cannot receive such aid indefinitely). Not everyone suffers equally from unemployment. In a prospective study of 9570 individuals over four years, highly conscientious people suffered more than twice as much if they became unemployed.[67] The authors suggested this may be due to conscientious people making different attributions about why they became unemployed, or through experiencing stronger reactions following failure. Some hold that many of the low-income jobs are not really a better option than unemployment with a welfare state (with its unemployment insurance benefits). But since it is difficult or impossible to get unemployment insurance benefits without having worked in the past, these jobs and unemployment are more complementary than they are substitutes. (These jobs are often held short-term, either by students or by those trying to gain experience; turnover in most low-paying jobs is high.) Another cost for the unemployed is that the combination of unemployment, lack of financial resources, and social responsibilities may push unemployed workers to take jobs that do not fit their skills or allow them to use their talents. Unemployment can cause underemployment, and fear of job loss can spur psychological anxiety. As well as anxiety, it can cause depression, lack of confidence, and huge amounts of stress. They will begin to lose social contacts, and good social skills. Social

Demonstration against unemployment in Kerala, India An economy with high unemployment is not using all of the resources, specifically labour, available to it. Since it is operating below its production possibility frontier, it could have higher output if all the workforce were usefully employed. However, there is a trade-off between economic efficiency and unemployment: if the frictionally unemployed accepted the first job they were offered, they would be likely to be operating at below their skill level, reducing the economy's efficiency.[68] During a long period of unemployment, workers can lose their skills, causing a loss of human capital. Being unemployed can also reduce the life expectancy of workers by about 7 years.[69]

High unemployment can encourage xenophobia and protectionism as workers fear that foreigners are stealing their jobs.[70] Efforts to preserve existing jobs of domestic and native workers include legal barriers against "outsiders" who want jobs, obstacles to immigration, and/or tariffs and similar trade barriers against foreign competitors. High unemployment can also cause social problems such as crime; if people have less disposable income than before, it is very likely that crime levels within the economy will increase. Socio-political

Unemployment rate in Germany in 2003 by states. High levels of unemployment can be causes of civil unrest, in some cases leading to revolution, and particularly totalitarianism. The fall of the Weimar Republic in 1933 and Adolf Hitler's rise to power, which culminated in World War II and the deaths of tens of millions and the destruction of much of the physical capital of Europe, is attributed to the poor economic conditions in Germany at the time, notably a high unemployment rate[71] of above 20%; see Great Depression in Central Europe for details. Note that the hyperinflation in the Weimar Republic is not directly blamed for the Nazi rise the Inflation in the Weimar Republic occurred primarily in the period 192123, which was contemporary with Hitler's Beer Hall Putsch of 1923, and is blamed for damaging the credibility of democratic institutions, but the Nazis did not assume government until 1933, ten years after the hyperinflation but in the midst of high unemployment. Rising unemployment has traditionally been regarded by the public and media in any country as a key guarantor of electoral defeat for any government which oversees it. This was very much the consensus in the United Kingdom until 1983, when Margaret Thatcher's Conservative

government won a landslide in the general election, despite overseeing a rise in unemployment from 1,500,000 to 3,200,000 since its election four years earlier.[72]

Benefits
Main article: Full employment The primary benefit of unemployment is that people are available for hire, without being headhunted away from their existing employers. This permits new and old businesses to take on staff. Unemployment is argued[citation needed] to be "beneficial" to the people who are not unemployed in the sense that it averts inflation, which itself has damaging effects, by providing (in Marxian terms) a reserve army of labour, that keeps wages in check. However the direct connection between full local employment and local inflation has been disputed by some due to the recent increase in international trade that supplies low-priced goods even while local employment rates rise to full employment.[73]

In the Shapiro-Stiglitz model of efficiency wages, workers are paid at a level that dissuades shirking. This prevents wages from dropping to market clearing levels. Full employment cannot be achieved because workers would shirk if they were not threatened with the possibility of unemployment. The curve for the no-shirking condition (labeled NSC) goes to infinity at full employment as a result. The inflation-fighting benefits to the entire economy arising from a presumed optimum level of unemployment has been studied extensively.[74] The Shapiro-Stiglitz model suggests that wages are not bid down sufficiently to ever reach 0% unemployment.[75] This occurs because employers know that when wages decrease, workers will shirk and expend less effort. Employers avoid shirking by preventing wages from decreasing so low that workers give up and become unproductive. These higher wages perpetuate unemployment while the threat of unemployment reduces shirking. Before current levels of world trade were developed, unemployment was demonstrated to reduce inflation, following the Phillips curve, or to decelerate inflation, following the NAIRU/natural rate of unemployment theory, since it is relatively easy to seek a new job without losing one's current one. And when more jobs are available for fewer workers (lower unemployment), it may allow workers to find the jobs that better fit their tastes, talents, and needs.

As in the Marxian theory of unemployment, special interests may also benefit: some employers may expect that employees with no fear of losing their jobs will not work as hard, or will demand increased wages and benefit. According to this theory, unemployment may promote general labour productivity and profitability by increasing employers' rationale for their monopsony-like power (and profits).[17] Optimal unemployment has also been defended as an environmental tool to brake the constantly accelerated growth of the GDP to maintain levels sustainable in the context of resource constraints and environmental impacts.[76] However the tool of denying jobs to willing workers seems a blunt instrument for conserving resources and the environment it reduces the consumption of the unemployed across the board, and only in the short term. Full employment of the unemployed workforce, all focused toward the goal of developing more environmentally efficient methods for production and consumption might provide a more significant and lasting cumulative environmental benefit and reduced resource consumption.[77] If so the future economy and workforce would benefit from the resultant structural increases in the sustainable level of GDP growth. Some critics of the "culture of work" such as anarchist Bob Black see employment as overemphasized culturally in modern countries. Such critics often propose quitting jobs when possible, working less, reassessing the cost of living to this end, creation of jobs which are "fun" as opposed to "work," and creating cultural norms where work is seen as unhealthy. These people advocate an "anti-work" ethic for life.[78]

Decline in work hours

As a result of productivity the work week declined considerably over the 19th century.[79][80] By the 1920s in the U.S. the average work week was 49 hours, but the work week was reduced to 40 hours (after which overtime premium was applied) as part of the National Industrial Recovery Act of 1933. At the time of the Great Depression of the 1930s it was understood that with the enormous productivity gains due to electrification, mass production and agricultural mechanization, there was no need for a large number of previously employed workers.[20][81]

Controlling or reducing unemployment

United States Families on Relief (in 1,000's)[82] 1936 1937 1938 1939 1940 1941 Workers employed WPA CCC and NYA Other federal work projects 1,995 2,227 1,932 2,911 1,971 1,638 712 554 801 663 643 452 793 488 877 468 919 681

Cases on public assistance Social security programs General relief 602 1,306 1,852 2,132 2,308 2,517 2,946 1,484 1,611 1,647 1,570 1,206 Totals Total families helped 5,886 5,660 5,474 6,751 5,860 5,167

Unemployed workers (BLS) 9,030 7,700 10,390 9,480 8,120 5,560 Coverage (cases/unemployed) 65% 74% 53% 71% 72% 93%

Societies try a number of different measures to get as many people as possible into work, and various societies have experienced close to full employment for extended periods, particularly during the Post-World War II economic expansion. The United Kingdom in the 1950s and 60s averaged 1.6% unemployment,[83] while in Australia the 1945 White Paper on Full Employment in Australia established a government policy of full employment, which policy lasted until the 1970s when the government ran out of money. However, mainstream economic discussions of full employment since the 1970s suggest that attempts to reduce the level of unemployment below the natural rate of unemployment will fail, resulting only in less output and more inflation.

Demand side solutions

Many countries aid the unemployed through social welfare programs. These unemployment benefits include unemployment insurance, unemployment compensation, welfare and subsidies to aid in retraining. The main goal of these programs is to alleviate short-term hardships and, more importantly, to allow workers more time to search for a job. A direct demand-side solution to unemployment is government-funded employment of the ablebodied poor. This was notably implemented in Britain from the 17th century until 1948 in the institution of the workhouse, which provided jobs for the unemployed with harsh conditions and poor wages to dissuade their use. A modern alternative is a job guarantee, where the government guarantees work at a living wage. Temporary measures can include public works programs such as the Works Progress Administration. Government-funded employment is not widely advocated as a solution to unemployment, except in times of crisis; this is attributed to the public sector jobs' existence depending directly on the tax receipts from private sector employment.

Supply-side economics proposes that lower taxes lead to employment growth. Historical state data from the United States shows a heterogeneous result. In the U.S. the unemployment insurance allowance one receives is based solely on previous income (not time worked, family size, etc.) and usually compensates for one-third of one's previous income. To qualify, one must reside in their respective state for at least a year and, of course, work. The system was established by the Social Security Act of 1935. Although 90% of citizens are covered by unemployment insurance, less than 40% apply for and receive benefits.[84] However, the number applying for and receiving benefits increases during recessions. In cases of highly seasonal industries the system provides income to workers during the off seasons, thus encouraging them to stay attached to the industry.

Tax decreases on high income earners (top 10%) are not correlated with employment growth, however, tax decreases on lower income earners (bottom 90%) are correlated with employment growth.[85][85] According to classical economic theory, markets reach equilibrium where supply equals demand; everyone who wants to sell at the market price can. Those who do not want to sell at this price do not; in the labour market this is classical unemployment. Increases in the demand for labour will move the economy along the demand curve, increasing wages and employment. The demand for labour in an economy is derived from the demand for goods and services. As such, if the demand for goods and services in the economy increases, the demand for labour will increase, increasing employment and wages. Monetary policy and fiscal policy can both be used to increase short-term growth in the economy, increasing the demand for labour and decreasing unemployment.

Supply-side solutions

However, the labour market is not 100% efficient: It does not clear, though it may be more efficient than bureaucracy. Some argue that minimum wages and union activity keep wages from falling, which means too many people want to sell their labour at the going price but cannot. This assumes perfect competition exists in the labour market, specifically that no single entity is large enough to affect wage levels. Advocates of supply-side policies believe those policies can solve this by making the labour market more flexible. These include removing the minimum wage and reducing the power of unions. Supply-siders argue the reforms increase long-term growth. This increased supply of goods and services requires more workers, increasing employment. It is argued that supply-side policies, which include cutting taxes on businesses and reducing regulation, create jobs and reduce unemployment. Other supply-side policies include education to make workers more attractive to employers.

History
There are relatively limited historical records on unemployment because it has not always been acknowledged or measured systematically. Industrialization involves economies of scale that often prevent individuals from having the capital to create their own jobs to be self-employed. An individual who cannot either join an enterprise or create a job is unemployed. As individual farmers, ranchers, spinners, doctors and merchants are organized into large enterprises, those who cannot join or compete become unemployed. Recognition of unemployment occurred slowly as economies across the world industrialized and bureaucratized. Before this, traditional self sufficient native societies have no concept of unemployment. The recognition of the concept of "unemployment" is best exemplified through the well documented historical records in England. For example, in 16th century England no distinction was made between vagrants and the jobless; both were simply categorized as "sturdy beggars", to be punished and moved on.[86] The closing of the monasteries in the 1530s increased poverty, as the church had helped the poor. In addition, there was a significant rise in enclosure during the Tudor period. Also the population was rising. Those unable to find work had a stark choice: starve or break the law. In 1535, a bill was drawn up calling for the creation of a system of public works to deal with the problem of unemployment, to be funded by a tax on income and capital. A law passed a year later allowed vagabonds to be whipped and hanged.[87] In 1547, a bill was passed that subjected vagrants to some of the more extreme provisions of the criminal law, namely two years servitude and branding with a "V" as the penalty for the first offense and death for the second.[88] During the reign of Henry VIII, as many as 72,000 people are estimated to have been executed.[89] In the 1576 Act each town was required to provide work for the unemployed.[90] The Elizabethan Poor Law of 1601, one of the world's first government-sponsored welfare programs, made a clear distinction between those who were unable to work and those ablebodied people who refused employment.[91] Under the Poor Law systems of England and Wales, Scotland and Ireland a workhouse was a place where people who were unable to support themselves, could go to live and work.[92]

Industrial Revolution to late 19th century

Poverty was a highly visible problem in the eighteenth century, both in cities and in the countryside. In France and Britain by the end of the century, an estimated 10 percent of the people depended on charity or begging for their food. Jackson J. Spielvogel (2008), Cengage Learning. p.566. ISBN 0-495-50287-1 By 1776 some 1,912 parish and corporation workhouses had been established in England and Wales, housing almost 100,000 paupers. A description of the miserable living standards of the mill workers in England in 1844 was given by Fredrick Engels in The Condition of the Working-Class in England in 1844.[93] In the preface to the 1892 edition Engels notes that the extreme poverty he wrote about in 1844 had largely disappeared. David Ames Wells also noted that living conditions in England had improved near the end of the 19th century and that unemployment was low. The scarcity and high price labor in the U.S. during the 19th century was well documented by contemporary accounts, as in the following: "The laboring classes are comparatively few in number, but this is counterbalanced by, and indeed, may be one of the causes of the eagerness by which they call in the use of machinery in almost every department of industry. Wherever it can be applied as a substitute for manual labor, it is universally and willingly resorted to .It is this condition of the labor market, and this eager resort to machinery wherever it can be applied, to which, under the guidance of superior education and intelligence, the remarkable prosperity of the United States is due."[94] Joseph Whitworth, 1854 Scarcity of labor was a factor in the economics of slavery in the U.S. As new territories were opened and Federal land sales conducted, land had to be cleared and new homesteads established. Hundreds of thousands of immigrants annually came to the U.S. and found jobs digging canals and building railroads. Almost all work during most of the 19th century was done by hand or with horses, mules, or oxen, because there was very little mechanization. The workweek during most of the 19th century was 60 hours. Unemployment at times was between one and two percent. The tight labor market was a factor in productivity gains allowing workers to maintain or increase their nominal wages during the secular deflation that caused real wages to rise at various times in the 19th century, especially in the final decades.[95]

20th century

"Industrious young man looking for work" Unemployed German laborer in 1928

Unemployed men, marching for jobs during the Great Depression in Canada, 1930 There were labor shortages during WW I.[20] Ford Motor Co. doubled wages to reduce turnover. After 1925 unemployment began to gradually rise.[96] The decade of the 1930s saw the Great Depression impact unemployment across the globe. One Soviet trading corporation in New York averaged 350 applications a day from Americans seeking jobs in the Soviet Union.[97] In Germany the unemployment rate reached nearly 25% in 1932.[98] In some towns and cities in the north east of England, unemployment reached as high as 70%; the national unemployment level peaked at more than 22% in 1932.[99] Unemployment in Canada reached 27% at the depth of the Depression in 1933.[100] In 1929, the U.S. unemployment rate averaged 3%.[101] In 1933, 25% of all American workers and 37% of all nonfarm workers were unemployed.[102] In Cleveland, Ohio, the unemployment rate was 60%; in Toledo, Ohio, 80%.[103] There were two million homeless people migrating across the United States.[103] Over 3 million unemployed young men were taken out of the cities and placed into 2600+ work camps managed by the CCC.[104]

Unemployment in the United Kingdom fell later in the 1930s as the depression eased, and remained low (in six figures) after World War II. Fredrick Mills found that in the U.S., 51% of the decline in work hours was due to the fall in production and 49% was from increased productivity.[105] By 1972 unemployment in the UK had crept back up above 1,000,000, and was even higher by the end of the decade, with inflation also being high. Although the monetarist economic policies of Margaret Thatcher's Conservative government saw inflation reduced after 1979, unemployment soared in the early 1980s, exceeding 3,000,000 a level not seen for some 50 years by 1982. This represented one in eight of the workforce, with unemployment exceeding 20% in some parts of the United Kingdom which had relied on the now-declining industries such as coal mining.[106] However, this was a time of high unemployment in all major industrialised nations. By the spring of 1983, unemployment in the United Kingdom had risen by 6% in the previous 12 months; compared to 10% in Japan, 23% in the United States of America and 34% in West Germany (seven years before reunification).[107] Unemployment in the United Kingdom remained above 3,000,000 until the spring of 1987, by which time the economy was enjoying a boom.[106] By the end of 1989, unemployment had fallen to 1,600,000. However, inflation had reached 7.8% and the following year it reached a nine-year high of 9.5%; leading to increased interest rates.[108] Another recession began during 1990 and lasted until 1992. Unemployment began to increase and by the end of 1992 nearly 3,000,000 in the United Kingdom were unemployed. Then came a strong economic recovery.[106] With inflation down to 1.6% by 1993, unemployment then began to fall rapidly, standing at 1,800,000 by early 1997.[109]

Unemployment rate for Japan 19532006 The official unemployment rate in the 16 EU countries that use the euro rose to 10% in December 2009 as a result of another recession.[110] Latvia had the highest unemployment rate in EU at 22.3% for November 2009.[111] Europe's young workers have been especially hard hit.[112] In November 2009, the unemployment rate in the EU27 for those aged 1524 was 18.3%. For those under 25, the unemployment rate in Spain was 43.8%.[113] Unemployment has risen in twothirds of European countries since 2010.[114]

Into the 21st century, unemployment in the United Kingdom remained low and the economy remaining strong, while at this time several other European economies namely, France and Germany (reunified a decade earlier) experienced a minor recession and a substantial rise in unemployment.[115] In 2008, when the recession brought on another increase in the United Kingdom, after 15 years of economic growth and no major rises in unemployment.[116] Early in 2009, unemployment passed the 2,000,000 mark, by which time economists were predicting it would soon reach 3,000,000.[117] However, the end of the recession was declared in January 2010[118] and unemployment peaked at nearly 2,700,000 in 2011,[119] appearing to ease fears of unemployment reaching 3,000,000.[120] The unemployment rate of Britain's young black people was 47.4% in 2011.[121] A flood of inexpensive consumer goods from China has recently encountered criticism from Europe, the United States and some African countries.[122] As of 26 April 2005 Asia Times article notes that, "In regional giant South Africa, some 300,000 textile workers have lost their jobs in the past two years due to the influx of Chinese goods".[123] The increasing U.S. trade deficit with China has cost 2.4 million American jobs between 2001 and 2008, according to a study by the Economic Policy Institute (EPI).[124] From 2000 to 2007, the United States had lost a total of 3.2 million manufacturing jobs.[125] About 25 million people in the world's 30 richest countries will have lost their jobs between the end of 2007 and the end of 2010 as the economic downturn pushes most countries into recession.[126] In April 2010, the U.S. unemployment rate was 9.9%, but the government's broader U-6 unemployment rate was 17.1%.[127] There are six unemployed people, on average, for each available job.[128] In April 2012, the unemployment rate was 4.6% in Japan.[129] In a 2012 news story, the Financial Post reported, "Nearly 75 million youth are unemployed around the world, an increase of more than 4 million since 2007. In the European Union, where a debt crisis followed the financial crisis, the youth unemployment rate rose to 18% last year from 12.5% in 2007, the ILO report shows."[130] Monetary economics is a branch of economics that historically prefigured and remains integrally linked to macroeconomics.[1] Monetary economics provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good.[2] It examines the effects of monetary systems, including regulation of money and associated financial institutions[3] and international aspects.[4] Modern analysis has attempted to provide a micro-based formulation of the demand for money[5] and to distinguish valid nominal and real monetary relationships for micro or macro uses, including their influence on the aggregate demand for output.[6] Its methods include deriving and testing the implications of money as a substitute for other assets[7] and as based on explicit frictions.[8] Research areas have included:

empirical determinants and measurement of the money supply, whether narrowly-, broadly-, or index-aggregated, in relation to economic activity[9] debt-deflation and balance-sheet theories, which hypothesize that over-extension of credit associated with a subsequent asset-price fall generate business fluctuations through the wealth effect on net worth.[10] and the relationship between the demand for output and the demand for money[11] monetary implications of the asset-price/macroeconomic relation[12] the quantity theory of money,[13] monetarism,[14] and the importance and stability of the relation between the money supply and interest rates, the price level, and nominal and real output of an economy.[15] monetary impacts on interest rates and the term structure of interest rates[16] lessons of monetary/financial history[17] transmission mechanisms of monetary policy as to the macroeconomy[18] the monetary/fiscal policy relationship to macroeconomic stability[19] neutrality of money vs. money illusion as to a change in the money supply, price level, or inflation on output[20] tests, testability, and implications of rational-expectations theory as to changes in output or inflation from monetary policy[21] monetary implications of imperfect and asymmetric information[22] and fraudulent finance[23] game theory as a modeling paradigm for monetary and financial institutions[24] the political economy of financial regulation and monetary policy[25] possible advantages of following a monetary-policy rule to avoid inefficiencies of time inconsistency from discretionary policy[26] "anything that central bankers should be interested in."[27]

Current state of monetary economics

Since 1990, the classical form of monetarism has been questioned. This is because of events which many economists interpret as inexplicable in monetarist terms, especially the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period. Alan Greenspan, former chairman of the Federal Reserve, argued that the 1990s decoupling may be explained by a virtuous cycle of productivity and investment on one hand, and a certain degree of "irrational exuberance" in the investment sector. Economist Robert Solow of MIT suggested that the 2001-2003 failure of the expected economic recovery should be attributed not to monetary policy failure, but rather to the breakdown in productivity growth in crucial sectors of the economy, most particularly retail trade. He noted that five sectors produced all of the productivity gains of the 1990s, and that while the growth of retail and wholesale trade produced the smallest growth, they were by far the largest sectors of the economy experiencing net increase of productivity. "2% may be peanuts, but being the single largest sector of the economy, that's an awful lot of peanuts."

The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. There are distinct kinds of "gold standards". First, the gold specie standard is a system in which the monetary unit is associated with circulating gold coins, or with the unit of value defined in terms of one particular circulating gold coin in conjunction with subsidiary coinage made from a less valuable metal. Similarly, the gold exchange standard typically does not involve the circulation of gold coins. Rather, it uses notes or coins made of silver or other metals, but where the authorities guarantee a fixed exchange rate with another country that is on the gold standard. This creates a de facto gold standard, in that the value of the silver coins has a fixed external value in terms of gold that is independent of the inherent silver value. Finally, the gold bullion standard is a system in which gold coins do not circulate, but in which the authorities have agreed to sell gold bullion on demand at a fixed price in exchange for circulating currency. No country currently uses the gold standard as the basis of its monetary system, although several hold substantial gold reserves At first, the gold specie standard was not designed or mandated. Rather, it arose spontaneously from the widespread voluntary acceptance of gold as currency.[1] When commodities compete for the role of money, the one that over time loses the least value takes on the role.[2] The use of gold as money dates back thousands of years.[3] During the Middle Ages, the Byzantine gold Solidus, commonly known as the Bezant, circulated throughout Europe and the Mediterranean. However, as the Byzantine Empire's economic influence declined, the European world tended to see silver, rather than gold, as the currency of choice, leading to the development of a silver standard. Silver pennies, based on the Roman Denarius, became the staple coin of Britain around the time of King Offa, circa AD 796, and similar coins, including Italian denari, French deniers, and Spanish dineros circulated throughout Europe. Following the Spanish discovery of silver deposits at Potos in Bolivia and in Mexico during the 16th century, international trade came to depend on coins such as the Spanish dollar, the Maria Theresa thaler, and, in the 1870s, the United States Trade dollar. In modern times the British West Indies was one of the first regions to adopt a gold specie standard. Following Queen Anne's proclamation of 1704, the British West Indies gold standard was a de facto gold standard based on the Spanish gold doubloon coin. In the year 1717, the master of the Royal Mint Sir Isaac Newton established a new mint ratio between silver and gold that had the effect of driving silver out of circulation and putting Britain on a gold standard. However, only in 1821, following the introduction of the gold sovereign coin by the new Royal Mint at Tower Hill in the year 1816, it was the United Kingdom who formally put on a gold specie standard, the first of the great industrial powers to do so. Soon to follow was Canada in 1853, Newfoundland in 1865, the USA and Germany de jure in 1873. The USA used the Eagle as its unit, and Germany introduced the new gold mark, while Canada adopted a dual system based on both the American Gold Eagle and the British Gold Sovereign.

Australia and New Zealand adopted the British gold standard, as did the British West Indies, while Newfoundland was the only British Empire territory to introduce its own gold coin as a standard. Royal Mint branches were established in Sydney, New South Wales, Melbourne, Victoria, and Perth, for the purpose of minting gold sovereigns from Australia's rich gold deposits.

The crisis of silver currency and bank notes (17501870)

In the late 18th century, wars within Europe as well as an ongoing trade deficit with China (which sold to Europe but had little use for European goods) drained silver from the economies of Western Europe and the United States. Coins were struck in smaller and smaller numbers, and there was a proliferation of bank and stock notes used as money.
United Kingdom

In the 1790s, the United Kingdom, suffering a massive shortage of silver coinage, ceased to mint larger silver coins and issued "token" silver coins and overstruck foreign coins. With the end of the Napoleonic Wars, the United Kingdom began the massive recoinage programme that created standard gold sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821. The recoinage of silver in United Kingdom after a long drought produced a burst of coins: the United Kingdom struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3 million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the date for resumption of convertibility, reached instead by 1821. Throughout the 1820s, small notes were issued by regional banks, which were finally restricted in 1826, while the Bank of England was allowed to set up regional branches. In 1833, however, Bank of England notes were made legal tender, and redemption by other banks was discouraged. In 1844 the Bank Charter Act established that Bank of England notes, fully backed by gold, became the legal standard. According to the strict interpretation of the gold standard, this 1844 act marks the establishment of a full gold standard for British money.
United States

The United States adopted a silver standard based on the Spanish milled dollar in 1785. This was codified in the 1792 Mint and Coinage Act, and by the Federal Government's use of the "Bank of the United States" to hold its reserves, as well as establish a fixed ratio of gold to the U.S. dollar. This was, in effect, a derivative silver standard, since the bank was not required to keep silver to back all of its currency. This began a long series of attempts by the USA to create a bi-metallic standard for the U.S. Dollar, which would continue until the 1920s. Gold and silver coins were legal tender, including the Spanish real. Because of the huge debt taken on by the U.S. Federal Government to finance the Revolutionary War, silver coins struck by the government left circulation, and in 1806 President Jefferson suspended the minting of silver coins.

The U.S. Treasury was put on a strict hard-money standard, doing business only in gold or silver coin as part of the Independent Treasury Act of 1848, which legally separated the accounts of the Federal Government from the banking system. However, the fixed rate of gold to silver overvalued silver in relation to the demand for gold to trade or borrow from England. The drain of gold in favor of silver led to a search for gold, including the California Gold Rush of 1849. Following Gresham's law, silver poured into the USA, which traded with other silver nations, and gold moved out. In 1853, the USA reduced the silver weight of coins to keep them in circulation, and in 1857 removed legal tender status from foreign coinage. In 1857 the final crisis of the free banking era of international finance began as American banks suspended payment in silver, rippling through the very young international financial system of central banks. In 1861 the U.S. government suspended payment in gold and silver, effectively ending the attempts to form a silver standard basis for the dollar.
International

Through the 18601871 period, various attempts to resurrect bi-metallic standards were made, including one based on the gold and silver franc; however, with the rapid influx of silver from new deposits, the expectation of scarcity of silver ended. The interaction between central banking and currency basis formed the primary source of monetary instability during this period. The combination that produced economic stability was a restriction of supply of new notes, a government monopoly on the issuance of notes directly and, indirectly, a central bank and a single unit of value. Attempts to avoid these conditions produced periodic monetary crises. As notes devalued, or silver ceased to circulate as a store of value, there was a depression. Governments, demanding specie as payment, drained the circulating medium out of the economy. At the same time, there was a dramatically expanded need for credit and large banks were being chartered in various states, including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a rapid acceptance of the gold standard in the period that followed.
Japan

By way of example, and following Germany's decision after the Franco-Prussian War (1870 1871) to extract reparations to facilitate a move to the gold standard, Japan gained the needed reserves after the Sino-Japanese War of 18941895. Whether the gold standard provides a government sufficient bona fides when it seeks to borrow abroad is debated. For Japan, moving to gold was considered vital for gaining access to Western capital markets.[4]

The gold exchange standard (18701914)

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2010)

Towards the end of the 19th century, some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d. Around the start of the 20th century, the Philippines pegged the silver peso/dollar to the U.S. dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time with the silver peso of Mexico and the silver yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard. When adopting the gold standard, many European nations changed the name of their currency from Daler (Sweden and Denmark) or Gulden (Austria-Hungary) to Crown, since the former names were traditionally associated with silver coins and the latter with gold coins.

Impact of World War I (191425)

Governments faced with the need to fund high levels of expenditure, but with limited sources of tax revenue, suspended convertibility of currency into gold on a number of occasions in the 19th century. The British government suspended convertibility (that is to say, it went off the gold standard) during the Napoleonic wars and the U.S. government during the US Civil War. In both cases, convertibility was resumed after the war.[citation needed] The real test, however, came in the form of World War I, a test which "it failed utterly" according to economist Richard Lipsey.[1] In order to finance the cost of war, most belligerent countries went off the gold standard during the war, and suffered drastic inflation. Because inflation levels varied between states, when they returned to the standard after the war at price they determined themselves (some, for example, chose to enter at pre-war prices), some countries' goods were undervalued and some overvalued.[1] Ultimately, the system as it stood could not deal quickly enough with the large deficits and surpluses created in the balance of payments; this has previously been attributed to increasing rigidity of wages (particularly in terms of wage cuts) brought about by the advent of unionized labor, but is now more likely thought of as an inherent fault with the system which came to light under the pressures of war and rapid technological change. In any case, prices had not reached equilibrium by the time of the Great Depression, which served only to kill off the system completely.[1] For example, Germany had gone off the gold standard in 1914, and could not effectively return to it as that country had lost much of its remaining gold reserves because of reparations. The German central bank issued unbacked marks virtually without limit to buy foreign currency for further reparations and to support workers during the Occupation of the Ruhr, finally leading to hyperinflation in the 1920s.

The gold bullion standard and the decline of the gold standard (192531)
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(August 2011)

William McKinley ran for president on the basis of the gold standard.

The gold specie standard ended in the United Kingdom and the rest of the British Empire at the outbreak of World War I. Treasury notes replaced the circulation of the gold sovereigns and gold half sovereigns. Legally, the gold specie standard was not repealed. The end of the gold standard was successfully effected by the Bank of England through appeals to patriotism urging citizens not to redeem paper money for gold specie. It was only in 1925, when Britain returned to the gold standard in conjunction with Australia and South Africa that the gold specie standard was officially ended. The British Gold Standard Act 1925 both introduced the gold bullion standard and simultaneously repealed the gold specie standard. The new gold bullion standard did not envisage any return to the circulation of gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at a fixed price, but only in the form of bars containing approximately four hundred troy ounces of fine gold.[5] This gold bullion standard lasted until 1931 when speculative attacks on the pound forced Britain off the gold standard.[6] Loans from American and French Central Banks of 50,000,000, were insufficient and exhausted in a matter of weeks.[7]

On September 19, 1931, the United Kingdom left the revised gold standard,[8] forced to suspend the gold bullion standard due to large outflows of gold across the Atlantic Ocean. The British benefited from this departure. They could now use monetary policy to stimulate the economy through the lowering of interest rates. Australia and New Zealand had already been forced off the gold standard by the same pressures connected with the Great Depression which forced British Colonies such as Canada to quickly followed suit with Britain's innovation. The interwar partially backed gold standard was inherently unstable, because of the conflict between (a) the expansion of sterling and dollar liabilities to foreign central banks and (b) the resulting deterioration in the reserve ratio of the Bank of England, and U.S. Treasury and Federal Reserve Banks.[9] This instability was enhanced by gold flows out of England, with its overvalued pound, to other countries such as France, which was attempting to make Paris a world class financial center, in competition with London and New York.[10] It was destabilizing speculation, emanating from lack of confidence in authorities' commitment to currency convertibility that ended the interwar gold standard. In May 1931 there was a run on Austria's largest commercial bank, and the bank failed. The run spread to Germany, where the central bank also collapsed. The countries' central banks lost substantial reserves; international financial assistance was too late, and in July 1931 Germany adopted exchange control, followed by Austria in October. These countries were definitively off the gold standard. The Austrian and German experiences, as well as British budgetary and political difficulties, were among the factors that destroyed confidence in sterling, which occurred in mid-July 1931. Runs on sterling ensued, and the Bank of England lost much of its reserves. Loans from abroad were insufficient, and in any event taken as a sign of weakness. The gold standard was abandoned in September, and the pound quickly and sharply depreciated on the foreignexchange market, as overvaluation of the pound would imply.[11]

Depression and World War II (193246)

Prolongation of the Great Depression

Some economic historians, such as American professor Barry Eichengreen, blame the gold standard of the 1920s for prolonging the Great Depression.[12] Adherence to the gold standard prevented the Federal Reserve from expanding the money supply in order to stimulate the economy, fund insolvent banks and fund government deficits which could "prime the pump" for an expansion. Once the US went off the gold standard, it became free to engage in such money creation. The gold standard limited the flexibility of the central banks' monetary policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates. In the US, the Federal Reserve was required by law to have 40% gold backing of its Federal Reserve demand notes, and thus, could not expand the money supply beyond what was allowed by the gold reserves held in their vaults.[13] Others including Federal Reserve Chairman Ben Bernanke and Nobel Prize winning economist Milton Friedman place most or all of the blame for the severity of the Great Depression at the feet of the Federal Reserve, mostly due to the deliberate tightening of monetary policy.[14] The US economic contraction in 1937, the last gasp of the Great Depression, is blamed on tightening of monetary policy by the Federal Reserve

resulting in a higher cost of capital and weaker securities markets, a reduced net government contribution to income, the undistributed profits tax, and higher labor costs.[15] As a result of the tighter monetary policy, the money supply peaked in March 1937, with a trough in May 1938.[16] Higher interest rates intensified the deflationary pressure on the dollar and reduced investment in U.S. banks. Commercial banks also converted Federal Reserve Notes to gold in 1931, reducing the Federal Reserve's gold reserves, and forcing a corresponding reduction in the amount of Federal Reserve Notes in circulation.[17] This speculative attack on the dollar created a panic in the U.S. banking system. Fearing imminent devaluation of the dollar, many foreign and domestic depositors withdrew funds from U.S. banks to convert them into gold or other assets.[17] As people pulled money from the banking system due to bank panics, a reverse multiplier effect caused a contraction in the money supply.[18] Additionally the New York Fed had loaned over $150 million (over 240 tons) to European Central Banks to help them out with their difficulties. This transfer of gold out of the US acted to contract the US money supply. These loans became questionable once England, Germany, Austria and other European countries went off the gold standard in 1931 and weakened confidence in the dollar.[19] The forced contraction of the money supply caused by people removing funds from the banking system during the bank panics resulted in deflation; and even as nominal interest rates dropped, inflation-adjusted real interest rates remained high, rewarding those that held onto money instead of spending it, causing a further slowdown in the economy.[20] Recovery in the United States was slower than in Britain, in part due to Congressional reluctance to abandon the gold standard and float the U.S. currency as Britain had done.[21] In the early 1930s, the Federal Reserve defended the fixed price of dollars in respect to the gold standard by raising interest rates, trying to increase the demand for dollars. Its commitment and adherence to the gold standard explain why the U.S. did not engage in expansionary monetary policy. To compete in the international economy, the U.S. maintained high interest rates. This helped attract international investors who bought foreign assets with gold.[17] Congress passed the Gold Reserve Act on 30 January 1934; the measure nationalized all gold by ordering the Federal Reserve banks to turn over their supply to the U.S. Treasury. In return the banks received gold certificates to be used as reserves against deposits and Federal Reserve notes. The act also authorized the president to devalue the gold dollar so that it would have no more than 60 percent of its existing weight. Under this authority the president, on 31 January 1934, changed the value of the dollar from $20.67 to the troy ounce to $35 to the troy ounce, a devaluation of over 40%. Other factors in the prolongation of the Great Depression include trade wars and the reduction in international trade caused by trade barriers such as Smoot-Hawley Tarriff in the US and the Imperial Preference policies of Great Britain,[22] the failure of central banks to act responsibly,[23] government policies designed to prevent wages from falling, such as the Davis-Bacon Act of 1931, during the deflationary period resulting in production costs dropping slower then sales prices and thereby injuring business profitability [24] and increases in taxes to reduce budget deficits and to support new programs such as Social Security. The US top marginal income tax rate went from 25% to 63% in 1932 and to 79% in 1936[25] while the bottom rate increased over

10 fold from .375% in 1929 to 4% in 1932[26] Successful attacks on partially backed currencies which forced many countries off the gold standard and reduced confidence in the financial system, and a financial system, further damaged by the bank panics of the 1930s were also factors, as was inclement weather such as the drought resulting in the US Dust Bowl. Milton Friedman stated that "the severity of each of the major contractions 1920-1, 1929-33 and 1937-8 is directly attributable to acts of commission and omission by the Reserve authorities"[27] He further believes that the US got out of the Great Depression because of the "natural resiliency of the economy and WW2, and not due to any acts of government, which in general were "very destructive" and extended the Great Depression.[28] Barry Eichengreen believes that the Austrian School view that the Great Depression was the result of a credit bust.[29] Alan Greenspan wrote that the bank failures of the 1930s were sparked by Great Britain dropping the gold standard in 1931. This act "tore asunder" any remaining confidence in the banking system.[30] Financial historian Niall Ferguson writes that what made the Great Depression truly 'great' was the European banking crisis of 1931.[31] According to Fed Chairman M. Eccles, the root cause of the Great Depression was a concentration of wealth resulting in a stagnating or reduction in the standard of living for the poor and middle class. In an attempt to maintain and/or improve their standard of living these classes went into debt, resulting in the credit explosion of the 1920s. Eventually the debt load grew so heavy that it could not be sustained, resulting in the massive defaults and financial panics of the 1930s.[32]
British hesitate to return to gold standard

John Maynard Keynes, who had argued against such a gold standard, proposed to put the power to print money in the hands of the privately owned Bank of England. Keynes, in warning about the menaces of inflation, said, "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some".[33] Quite possibly because of this, the 1944 Bretton Woods Agreement established the International Monetary Fund and an international monetary system based on convertibility of the various national currencies into a U.S. dollar that was in turn convertible into gold.

Post-war international gold-dollar standard (19461971)

Main article: Bretton Woods system

After the Second World War, a system similar to a Gold Standard and sometimes described as a "gold exchange standard" was established by the Bretton Woods Agreements. Under this system, many countries fixed their exchange rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at approximately $35 per ounce. Implicitly, then, all currencies pegged to the dollar also had a fixed value in terms of gold.[1]

Starting under the administration of the French President Charles de Gaulle and continuing until 1970, France reduced its dollar reserves, trading them for gold from the U.S. government, thereby reducing U.S. economic influence abroad. This, along with the fiscal strain of federal expenditures for the Vietnam War and persistent balance of payments deficits, led President Richard Nixon to end the direct convertibility of the dollar to gold on August 15, 1971, resulting in the system's breakdown (the "Nixon Shock").

Theory
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Commodity money is inconvenient to store and transport. Furthermore, it does not allow a government to manipulate or restrict the flow of commerce within its dominion with the same ease that a fiat currency does. As such, commodity money gave way to representative money, and gold and other specie were retained as its backing. Gold was a common form of money due to its rarity, durability, divisibility, fungibility, and ease of identification,[4] often in conjunction with silver. Silver was typically the main circulating medium, with gold as the metal of monetary reserve. The gold standard variously specified how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself is just paper and so has no intrinsic value, but is accepted by traders because it can be redeemed any time for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver. Representative money and the gold standard protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. That system eventually collapsed in 1971, at which time nearly all nations had switched to full fiat money. According to Keynesian analysis, the earliness with which a country left the gold standard reliably predicted its economic recovery from the great depression. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer. Countries such as China, which had a silver standard, almost avoided the depression entirely. The connection between leaving the gold standard as a strong predictor of that country's severity of its depression and the length of time in its recovery has been shown to be consistent for dozens of countries, predominantly in developing countries. This may explain why the experience and length of the depression differed between national economies.[34]

Differing definitions

A 100%-reserve gold standard, or a full gold standard, exists when a monetary authority holds sufficient gold to convert all of the representative money it has issued into gold at the promised exchange rate. It is sometimes referred to as the gold specie standard to more easily identify it from other forms of the gold standard that have existed at various times. Opponents of a 100%reserve standard consider a 100%-reserve standard difficult to implement, saying that the quantity of gold in the world is too small to sustain current worldwide economic activity at current gold prices; implementation would entail a many-fold increase in the price of gold.[citation needed] However, proponents of the gold standard have said that any amount of gold can serve as the reserve: "Once a money is established, any stock of money becomes compatible with any amount of employment and real income."[35] According to them the prices of goods and services will adjust to the supply of gold.[36] In an international gold-standard system (which is necessarily based on an internal gold standard in the countries concerned),[37] gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, when exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level. International gold standards often limit which entities have the right to redeem currency for gold.

Advantages

Long-term price stability has been described as the great virtue of the gold standard.[38] The gold standard makes it difficult for governments to inflate prices through issuance of paper currency.[39] Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases.[39] Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare,[39] as gold supply for monetary use is limited by the available gold that can be minted into coin.[39] High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available.[39] In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South,[40] while the California Gold Rush made large amounts of gold available for minting.[41] However, an examination of actual historical data shows that inflation (and deflation) magnitudes were actually far higher under the gold standard.[42] The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade.[39] Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the "price specie flow mechanism."[39] Gold used to pay for imports reduces the money supply of importing nations, causing deflation and a reduction in the general price level for goods and services, making them more competitive, while the importation of gold by net exporters serves to increase the money supply, causes inflation and an increase in the general price level, making them less competitive.[43] A gold standard cannot be used for what some economists call, financial repression.[44] Newly printed money can be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.[45][46] In

1966 Alan Greenspan wrote "Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."[47] Per John Maynard Keynes "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens".[48] Financial repression negatively affects economic growth.[49] In the US and United Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per year on average.[50]

Disadvantages

Gold prices (US$ per ounce) from 1968 to 2010, in nominal US$ and inflation adjusted US$.

The unequal distribution of gold as a natural resource makes the gold standard much more advantageous in terms of cost and international economic empowerment for those countries that produce gold.[51] In 2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and Russia.[52] The country with the largest reserves is Australia.[53] The gold standard acts as a limit on economic growth.[54] As an economys productive capacity grows, then so should its money supply. Because a gold standard requires that money be backed in the metal, then the scarcity of the metal constrains the ability of the economy to produce more capital and grow.[54] Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.[55] Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession.[56] Such reason is often employed to in part blame the gold standard for the Great Depression, citing that the Federal Reserve couldn't expand credit at a fast enough rate to offset the deflationary forces at work in the market.[57] Although the gold standard has brought long-run price stability, it has also historically been associated with high short-run price volatility.[58][59] It has been argued by, among others, Anna

Schwartz, that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt.[60] The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons[61] and arguments have been made that this amount is too small to serve as a monetary base. The value of this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share of the world economy, stands at $2.7 trillion at the end of 2011.[62] Murray Rothbard argues that the amount of gold available is not a bar to a gold standard since the free market will determine the purchasing power of gold money based on its supply.[63] Deflation punishes debtors.[64][65] Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all.[66] The overall amount of expenditure is therefore likely to fall.[66] Monetary policy would essentially be determined by the rate of gold production.[67] Fluctuations in the amount of gold that is mined could cause inflation if there is an increase, or deflation if there is a decrease.[58][67] Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.[68][69] James Hamilton contended that the gold standard may be susceptible to speculative attacks when a government's financial position appears weak, although others contend that this very threat discourages governments' engaging in risky policy (see Moral Hazard).[69] For example, some believe that the United States was forced to contract the money supply and raise interest rates in September 1931 to defend the dollar after speculators forced Great Britain off the gold standard[69][70][71] If a country wanted to devalue its currency, a gold standard would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation.[72] Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but primarily because they believe that central banks still have some role to play in dampening fluctuations in output and unemployment. Central banks can more safely play that role when a positive rate of inflation gives them room to tighten money growth without inducing price declines.[73] It is difficult to manipulate a gold standard to tailor to an economys demand for money, providing practical constraints against the measures that central banks might otherwise use to respond to economic crises.[74] The demand for money always equals the supply of money. Creation of new money reduces interest rates and thereby increases demand for new lower cost debt, raising the demand for money.[75]

Advocates of a renewed gold standard

The return to the gold standard is supported by many followers of the Austrian School of Economics, Objectivists, free-market libertarians[76] and, in the United States, by strict constitutionalists largely because they object to the role of the government in issuing fiat currency through central banks. A significant number of gold-standard advocates also call for a mandated end to fractional-reserve banking.[citation needed]

Few politicians[77] today advocate a return to the gold standard, other than adherents of the Austrian school and some supply-siders. However, some prominent economists have expressed sympathy with a hard-currency basis, and have argued against politically-controlled fiat money, including former U.S. Federal Reserve Chairman Alan Greenspan (himself a former Objectivist), and macro-economist Robert Barro.[78] Greenspan famously argued the case for returning to a 'pure' gold standard in his 1966 paper "Gold and Economic Freedom", in which he described supporters of fiat currencies as "welfare statists" intending to use monetary policies to finance deficit spending.[79] Barro argues in favor of adopting some form of "monetary constitution" that will provide stability to monetary policy rather than allowing decisions about monetary policy to be made on the basis of politics. He suggests that what form this constitution takesfor example, a gold standard, some other commodity-based standard, or a fiat currency with fixed rules for determining the quantity of moneyis considerably less important.[78] U.S. Congressman Ron Paul has continually argued for the reinstatement of the gold standard, but is no longer a strict advocate, instead supporting a basket of commodities that emerges on the free markets.[80] For the time being, the global monetary system continues to rely on the U.S. dollar as a reserve currency by which major transactions, such as the price of gold itself, are measured.[81] A host of alternatives has been suggested, including energy-based currencies, and market baskets of currencies or commodities, gold being one of the alternatives. In 2001, Malaysian Prime Minister Mahathir bin Mohamad proposed a new currency that would be used initially for international trade among Muslim nations. The currency he proposed was called the Islamic gold dinar and it was defined as 4.25 grams of pure (24-carat) gold. Mahathir Mohamad promoted the concept on the basis of its economic merits as a stable unit of account and also as a political symbol to create greater unity between Islamic nations. The purported purpose of this move would be to reduce dependence on the United States dollar as a reserve currency, and to establish a non-debt-backed currency in accord with Islamic law against the charging of interest.[82] However, to date, Mahathir's proposed gold-dinar currency has failed to take hold. In 2011, the legislature of the state of Utah passed a bill to accept federally issued gold and silver coins as legal tender to pay taxes.[83][84] Similar legislation is under consideration in other US states.

Gold as a reserve today

Main article: Gold reserve

The Swiss Franc was based on a 40% legal gold-reserve requirement from 1936, when it ended gold convertibility,[85] until 2000. Gold reserves are held in significant quantity by many nations as a means of defending their currency, and hedging against the U.S. Dollar, which forms the bulk of liquid currency reserves. [86] Both gold coins and gold bars are traded in liquid markets and serve as a private store of wealth.

Economic growth is the increase in the amount of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP[1]. Growth is usually calculated in real terms, i.e. inflationadjusted terms, in order to obviate the distorting effect of inflation on the price of the goods produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment". As an area of study, economic growth is generally distinguished from development economics. The former is primarily the study of how countries can advance their economies. The latter is the study of the economic aspects of the development process in low-income countries. See also Economic development. Since economic growth is measured as the annual percent change of gross domestic product (GDP), it has all the advantages and drawbacks of that measure.

Definitions and history

Economic growth versus the business cycle
Economists distinguish between short-run economic changes in production and long-run economic growth. Short-run variation in economic growth is termed the business cycle. The business cycle is made up of booms and drops in production that occur over a period of months or years. Generally, economists attribute the ups and downs in the business cycle to fluctuations in aggregate demand. In contrast, the topic of economic growth is concerned with the long-run trend in production due to strucural causes such as technological growth and factor accumulation. The business cycle moves up and down, creating fluctuations around the long-run trend in economic growth.

Historical sources of economic growth

Main article: Productivity improving technologies (historical) Economic growth has traditionally been attributed to the accumulation of human and physical capital, and increased productivity arising from technological innovation.[2] Economic growth was also the result of developing new products and services, which have been described as "demand creating".[3] Increases in productivity are a major factor responsible for per capita economic growth - this has been especially evident since the mid-19th century. Most of the economic growth in the 20th century was due to reduced inputs of labor, materials, energy, and land per unit of economic output (less input per widget). The balance of growth has come from using more inputs overall because of the growth in output (more widgets or alternately more value added), including new kinds of goods and services (innovations).[4]

During colonial times, what ultimately mattered for economic growth were the institutions and systems of government imported through colonization. There is a clear reversal of fortune between poor and wealthy countries, which is evident when comparing the method of colonialism in a region. Geography and endowments of natural resources are not the sole determinants of GDP. In fact, those that were blessed with good factor endowments experienced colonial extraction which only provided limited rapid growth; whereas, countries that were less fortunate in their original endowments experienced European settlement, relative equality, and demand for the rule of law. These initially poor colonies end up developing an open franchise, equality, and broad public education, which helps them experience greater economic growth than the colonies that had exploited their economies of scale. During the Industrial Revolution, mechanization began to replace hand methods in manufacturing and new processes were developed to make chemicals, iron, steel and other products.[5] Machine tools made the economical production of metal parts possible, so that parts could be interchangeable.[6] See: Interchangeable parts. During the Second Industrial Revolution, a major factor of productivity growth was the substitution of energy from human and animal labor, to water and wind power with electrification and internal combustion.[5] Since that replacement, the great expansion of total power was driven by continuous improvements in energy conversion efficiency.[7] Other major historical sources of productivity were automation, transportation infrastructures (canals, railroads, and highways),[8][9] new materials (steel) and power, which includes steam and internal combustion engines and electricity. Other productivity improvements included mechanized agriculture and scientific agriculture including chemical fertilizers and livestock and poultry management, and the Green Revolution. Interchangeable parts made with machine tools powered by electric motors evolved into mass production, which is universally used today.[10]

Productivity lowered the cost of most items in terms of work time required to purchase. Real food prices fell due to improvements in transportation and trade, mechanized agriculture, fertilizers, scientific farming and the Green Revolution. Great sources of productivity improvement in the late 19th century were railroads, steam ships, horse-pulled reapers and combine harvesters, and steam-powered factories.[11][12] The invention

of processes for making cheap steel were important for many forms of mechanization and transportation. By the late 19th century prices, as well as weekly work hours, fell because less labor, materials, and energy were required to produce and transport goods. However, real wages rose, allowing workers to improve their diet, buy consumer goods and afford better housing.[11] Mass production of the 1920s created overproduction, which was arguably one of several causes of the Great Depression of the 1930s.[13] Following the Great Depression, economic growth resumed, aided in part by demand for entirely new goods and services, such as telephones, radio, television, automobiles, and household appliances, air conditioning, and commercial aviation (after 1950), creating enough new demand to stabilize the work week.[14] The building of highway infrastructures also contributed to post World War II growth, as did capital investments in manufacturing and chemical industries. The post World War II economy also benefited from the discovery of vast amounts of oil around the world, particularly in the Middle East. Economic growth in Western nations slowed down after 1973. In contrast growth in Asia has been strong since then, starting with Japan and spreading to Korea, China, the Indian subcontinent and other parts of Asia. In 1957 South Korea had a lower per capita GDP than Ghana,[15] and by 2008 it was 17 times as high as Ghana's.[16] The Japanese economic growth has slackened considerably since the late 1980s.

Economic growth per capita

The concern about economic growth often focuses on the desire to improve a country's standard of living the level of goods and services that, on average, individuals purchase or otherwise gain access to. It should be noted that if the population grows along with economic production, increases in GDP do not necessarily result in an improvement in the standard of living. When the focus is on standard of living, economic growth is expressed on a per capita basis.[17] A high savings rate is also linked to the standard of living. Increased saving will in the long run lead to a permanently higher output (income) per capita as capital accumulation per individual also increases.[citation needed]

Measuring economic growth

Economic growth is measured as a percentage change in the Gross Domestic Product (GDP) or Gross National Product (GNP). These two measures, which are calculated slightly differently, total the amounts paid for the goods and services that a country produced. As an example of measuring economic growth, a country which creates $9,000,000,000 in goods and services in 2010 and then creates $9,090,000,000 in 2011, has a nominal economic growth rate of 1% for 2011. In order to compare per capita economic growth among countries, the total sales of the respected countries may be quoted in a single currency. This requires converting the value of currencies of various countries into a selected currency, for example U.S. dollars. One way to do this conversion is to rely on exchange rates among currencies, for example how many Mexican pesos buy a single U.S. dollar? Another approach is to use the purchasing power parity method. This

method is based on how much consumers must pay for the same "basket of goods" in each country. Inflation or deflation can make it difficult to measure economic growth. If GDP, for example, goes up in a country by 1% in a year, was this due solely to rising prices (inflation), or because more goods and services were produced and saved? To express real growth rather than changes in prices for the same goods, statistics on economic growth are often adjusted for inflation or deflation. For example, a table may show changes in GDP in the period from 1990 to 2000, as expressed in 1990 U.S. dollars. This means that the single currency being used is the U.S. dollar with the purchasing power it had in the U.S. in 1990. The table might mention that the figures are "inflation-adjusted" or real. If no adjustment were made for inflation, the table might make no mention of inflation-adjustment or might mention that the prices are nominal.

The power of annual growth

Over long periods of time, even small rates of growth, like a 2% annual increase, will have large effects. For example, the United Kingdom experienced a 1.97% average annual increase in its inflation-adjusted GDP between 1830 and 2008.[18] In 1830, the GDP was 41,373 million pounds. It grew to 1,330,088 million pounds by 2008. (Figures are adjusted for inflation and stated in 2005 values for the pound.) A growth rate which averaged 1.97% over 178 years resulted in a 32-fold increase in GDP by 2008. The large impact of a relatively small growth rate over a long period of time is due to the power of compounding (also see exponential growth). A growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years, whilst a growth rate of 8% per annum (an average exceeded by China between 2000 and 2010) leads to a doubling of GDP within 10 years. Thus, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

Theories of economic growth

Classical growth theory

Adam Smith wrote The Wealth of Nations The modern conception of economic growth began with the critique of Mercantilism, especially by the physiocrats and with the Scottish Enlightenment thinkers such as David Hume and Adam Smith, and the foundation of the discipline of modern political economy. David Ricardo argued that trade was a benefit to a country, because if one could buy a good more cheaply from abroad, it meant that there was more profitable work to be done here. This theory of "comparative advantage" would be the central basis for arguments in favor of free trade as an essential component of growth.[19]

The neoclassical growth model

The notion of growth as increased stocks of capital goods (means of production) was codified as the Solow-Swan Growth Model, which involved a series of equations which showed the relationship between labor-time, capital goods, output, and investment. According to this view, the role of technological change became crucial, even more important than the accumulation of capital. This model, developed by Robert Solow[20] and Trevor Swan[21] in the 1950s, was the first attempt to model long-run growth analytically. This model assumes that countries use their resources efficiently and that there are diminishing returns to capital and labor increases. From these two premises, the neoclassical model makes three important predictions. First, increasing capital relative to labor creates economic growth, since people can be more productive given more capital. Second, poor countries with less capital per person will grow faster because each investment in capital will produce a higher return than rich countries with ample capital. Third, because of diminishing returns to capital, economies will eventually reach a point at which any increase in capital will no longer create economic growth. This point is called a "steady state". The model also notes that countries can overcome this steady state and continue growing by inventing new technology. In the long run, output per capital depends on the rate of saving, but the rate of output growth should be equal for any saving rate. In this model, the process by which countries continue growing despite the diminishing returns is "exogenous" and represents the creation of new technology that allows production with fewer resources. Technology improves, the steady state level of capital increases, and the country invests and grows. The data does not support some of this model's predictions, in particular, that all countries grow at the same rate in the long run, or that poorer countries should grow faster until they reach their steady state. Also, the data suggests the world has slowly increased its rate of growth. However, modern economic research shows that the baseline version of the neoclassical model of economic growth is not supported by the evidence.[citation needed]

Salter cycle
According to the Salter cycle, economic growth is enabled by increases in productivity, which lowers the inputs (labour, capital, material, energy, etc.) for a given amount of product (output).[22] Lowered cost increases demand for goods and services, which also results in capital

investment to increase capacity. New capacity is more efficient because of new technology, improved methods and economies of scale. This leads to further price reductions, which further increases demand, until markets become saturated due to diminishing marginal utility.[23][24]

Endogenous growth theory

Main article: Endogenous growth theory

World map of the 20082009 Global Competitiveness Index. Growth theory advanced again with theories of economist Paul Romer and Robert Lucas, Jr. in the late 1980s and early 1990s. Unsatisfied with Solow's explanation, economists worked to "endogenize" technology in the 1980s. They developed the endogenous growth theory that includes a mathematical explanation of technological advancement.[25][26] This model also incorporated a new concept of human capital, the skills and knowledge that make workers productive. Unlike physical capital, human capital has increasing rates of return. Therefore, overall there are constant returns to capital, and economies never reach a steady state. Growth does not slow as capital accumulates, but the rate of growth depends on the types of capital a country invests in. Research done in this area has focused on what increases human capital (e.g. education) or technological change (e.g. innovation).[27]

Energy and energy efficiency theories

The importance of energy to economic growth was emphasized by William Stanley Jevons in The Coal Question in which he described the rebound effect based on the observation that increasing energy efficiency resulted in more use of energy. (See: Jevons paradox) In the 1980s, the economists Daniel Khazzoom and Leonard Brookes independently put forward ideas about energy consumption and behavior that argue that increased energy efficiency paradoxically tends to lead to increased energy consumption. In 1992, the US economist Harry Saunders dubbed this hypothesis the KhazzoomBrookes postulate, and showed that it was true under neo-classical growth theory over a wide range of assumptions.[28] The importance of electricity to economic growth has been recognized by economists, prominent businessmen,[29] economic historians[30] and various engineering, technical and science organizations[31] and government agencies. Conclusions of a report prepared for Los Alamos National Laboratory for the United States Department of Energy and the National Academy of Sciences stated:

"Electricity use and gross national product have been, and probably will be, strongly correlated".[32] The report's conclusion went on to say that the energy intensity of the U.S. economy (electricity consumed per dollar of GDP) had been declining for a number of years. All approaches to the inclusion energy into the theory of production are known as the energy theory of value, which, nevertheless, does not have an accurate and complete formulation. For example, Ayres and Warr have presented a model that aims to address deficiencies in the neoclassical and endogenous growth models. It claims that physical and chemical work performed by energy, or more correctly exergy, has historically been a very important driver of economic growth.[7] [33] Key support for this theory is a mathematical model showing that the efficiency of a composite indicator using electrical generation and other energy efficiencies is a good proxy for the Solow residual, or technological progress, that is, the portion of economic growth that is not attributable to capital or labor.[34][35] The proper role of energy in production processes was elucidated by technological theory of social production. Energy growth theory economists have criticized orthodox economics for neglecting the role of energy and natural resources. Ayres and Warr's model relates the slowing of economic growth to energy conversion efficiencies approaching thermodynamic limits, and cautions that declining resource quality could bring an end to economic growth in a few decades.[36] Hall et al. 2001 state: "Although the first and second laws of thermodynamics are the most thoroughly tested and validated laws of nature [..] the basic neoclassical economic model is a perpetual motion machine, with no required inputs or limits."[37]

Unified growth theory

Unified growth theory was developed by Oded Galor and his co-authors to address the inability of endogenous growth theory to explain key empirical regularities in the growth processes of individual economies and the world economy as a whole. Endogenous growth theory was satisfied with accounting for empirical regularities in the growth process of developed economies over the last hundred years. As a consequence, it was not able to explain the qualitatively different empirical regularities that characterized the growth process over longer time horizons in both developed and less developed economies. Unified growth theories are endogenous growth theories that are consistent with the entire process of development, and in particular the transition from the epoch of Malthusian stagnation that had characterized most of the process of development to the contemporary era of sustained economic growth.[38]

The big push

In theories of economic growth, the mechanisms that let it take place and its main determinants are abundant. One popular theory in the 1940s, for example, was that of the "Big Push" which suggested that countries needed to jump from one stage of development to another through a virtuous cycle, in which large investments in infrastructure and education coupled with private investments would move the economy to a more productive stage, breaking free from economic paradigms appropriate to a lower productivity stage.[39]

Schumpeterian Growth
Schumpeterian growth is an economic theory named after the 20th century Austrian economist Joseph Schumpeter. Unlike other economic growth theories, his approach explains growth by innovation as a process of creative destruction, which captures the dual nature of technological progress: in terms of creation, entrepreneurs introduce new products or processes in the hope that they will enjoy temporary monopoly-like profits as they capture markets. In doing so, they make old technologies or products obsolete: this is the destruction[disambiguation needed] referred to by Schumpeter, that could also be referred to as the annulment of previous technologies which makes them obsolete, and "which destroys the rents generated by previous innovations" (Aghion 855).[40] A major model that illustrates Schumpeterian growth is the Aghion-Howitt model.[41]

Institutions and growth

According to Acemolu, Simon Johnson and James Robinson, the positive correlation between high income and cold climate is a by-product of history. Europeans adopted very different colonization policies in different colonies, with different associated institutions. In places where these colonizers faced high mortality rates (e.g., due to the presence of tropical diseases), they could not settle permanently, and they were thus more likely to establish extractive institutions, which persisted after independence; in places where they could settle permanently (e.g. those with temperate climates), they established institutions with this objective in mind and modeled them after those in their European homelands. In these 'neo-Europes' better institutions in turn produced better development outcomes. Thus, although other economists focus on the identity or type of legal system of the colonizers to explain institutions, these authors look at the environmental conditions in the colonies to explain institutions. For instance, former colonies have inherited corrupt governments and geo-political boundaries (set by the colonizers) that are not properly placed regarding the geographical locations of different ethnic groups, creating internal disputes and conflicts which in turn hinder development. In another example, societies that emerged in colonies without solid native populations established better property rights and incentives for long-term investment than those where native populations were large.[17][42]

Human capital and growth

One ubiquitous element of both theoretical and empirical analyses of economic growth is the role of human capital. The skills of the population enter into both neoclassical and endogenous growth models.[43] The most commonly used measure of human capital is the level of school attainment in a country, building upon the data development of Robert Barro and Jong-Wha Lee.[44] This measure of human capital, however, requires the strong assumption that what is learned in a year of schooling is the same across all countries. It also presumes that human capital is only developed in formal schooling, contrary to the extensive evidence that families, neighborhoods, peers, and health also contribute to the development of human capital. In order to measure human capital more accurately, Eric Hanushek and Dennis Kimko introduced measures of mathematics and science skills from international assessments into growth analysis.[45] They found that quality of human capital was very significantly related to economic growth. This

approach has been extended by a variety of authors, and the evidence indicates that economic growth is very closely related to the cognitive skills of the population.[46]

Inequality and economic growth

Percentage changes in GDP growth spell length as each factor moves from 50th to 60th percentile and all other factors are held constant. Income distribution is measured by the Gini coefficient. Political institutions are measured by the Polity IV Project scale. Exchange rate competitiveness is measured by rate deviation from purchasing power parity adjusted for per capita income.[47] Initial[when?] theories incorrectly stated that inequality had a positive effect on economic development. The marginal propensity to save was thought[who?] to increase with wealth and inequality increases savings and capital accumulation.[48] However, it was[who?] determined much later[when?] that the analysis based on comparing yearly equality figures to yearly growth rates was flawed and misleading because it takes several years for the effects of equality changes to manifest in economic growth changes.[47] The credit market imperfection approach, developed by Galor and Zeira (1993), demonstrates that inequality in the presence of credit market imperfections has a long lasting detrimental effect on human capital formation and economic development.[49] The political economy approach, developed by Alesian and Rodrik (1994) and Persson and Tabellini (1994), argues that inequality is harmful for economic development because inequality generates a pressure to adopt redistributive policies that have an adverse effect on investment and economic growth.[50]

Evidence
A study by Perotti (1996) examines of the channels through which inequality may affect economic growth. He shows that in accordance with the credit market imperfection approach, inequality is associated with lower level of human capital formation (education, experience, apprenticeship) and higher level of fertility, while lower level of human capital is associated with lower growth and lower levels of economic growth. In contrast, his examination of the political economy channel refutes the political economy mechanism. He demonstrates that inequality is associated with lower levels of taxation, while lower levels of taxation, contrary to the theories, are associated with lower level of economic growth[51]

A 2011 note for the International Monetary Fund by Andrew G. Berg and Jonathan D. Ostry found a strong association between lower levels of inequality in developing countries and sustained periods of economic growth. Developing countries with high inequality have "succeeded in initiating growth at high rates for a few years" but "longer growth spells are robustly associated with more equality in the income distribution."[52] Disputing the claim of a Washington Post editorialist that "Western Europes recent history suggests that flat income distribution accompanies flat economic growth," journalist Timothy Noah, points out that redistribution policies in Europe do not seem to be correlated to economic problems of the late twenty-oughts. With the exception of Ireland, the countries at risk of default in 2011 (Greece, Italy, Spain, Portugal) were notable for their high Gini-measured levels of income inequality compared to other European countries. As measured by the Gini index, Greece as of 2008 had more income inequality than the economically healthy Germany.[53]

Quality of life
Happiness has been shown to increase with a higher GDP per capita, at least up to a level of $15,000 per person.[54] Economic growth has the indirect potential to alleviate poverty, as a result of a simultaneous increase in employment opportunities and increase labour productivity.[55] A study by researchers at the Overseas Development Institute (ODI) of 24 countries that experienced growth found that in 18 cases, poverty was alleviated.[55] However, employment is no guarantee of escaping poverty, the International Labour Organisation (ILO) estimates that as many as 40% of workers as poor, not earning enough to keep their families above the $2 a day poverty line.[55] For instance, in India most of the chronically poor are wage earners in formal employment, because their jobs are insecure and low paid and offer no chance to accumulate wealth to avoid risks.[55] This appears to be the result of a negative relationship between employment creation and increased productivity, when a simultaneous positive increase is required to reduced poverty. According to the UNRISD, increasing labour productivity appears to have a negative impact on job creation: in the 1960s, a 1% increase in output per worker was associated with a reduction in employment growth of 0.07%, by the first decade of this century the same productivity increase implies reduced employment growth by 0.54%.[55] Increases in employment without increases in productivity leads to a rise in the number of "working poor", which is why some experts are now promoting the creation of "quality" and not "quantity" in labour market policies.[55] This approach does highlight how higher productivity has helped reduce poverty in East Asia, but the negative impact is beginning to show.[55] In Vietnam, for example, employment growth has slowed while productivity growth has continued.[55] Furthermore, productivity increases do not always lead to increased wages, as can be seen in the United States, where the gap between productivity and wages has been rising since the 1980s.[55] The ODI study showed that other sectors were just as important in reducing unemployment, as manufacturing.[55] The services sector is most effective at translating productivity growth into employment growth. Agriculture provides a safety net for jobs and economic buffer when other sectors are struggling.[55] This study suggests a more nuanced understanding of economic growth and quality of life and poverty alleviation.

Negative effects of economic growth

A number of arguments have been raised against economic growth.[56] It may be that economic growth improves the quality of life up to a point, after which it doesn't improve the quality of life, but rather obstructs sustainable living.[57]

Resource depletion
Many earlier predictions of resource depletion, such as Thomas Malthus' 1798 predictions about approaching famines in Europe, The Population Bomb (1968),[58][59][60] Limits to Growth (1972),[58][59][60] and the SimonEhrlich wager (1980) [61] did not materialize, nor has diminished production of most resources occurred so far, one reason being that advancements in technology and science have allowed some previously unavailable resources to be produced.[61] In some cases, substitution of more abundant materials, such as plastics for cast metals, lowered growth of usage for some metals. In the case of the limited resource of land, famine was relieved firstly by the revolution in transportation caused by railroads and steam ships, and later by the Green Revolution and chemical fertilizers, especially the Haber process for ammonia synthesis.[62][63]

M. King Hubbert's prediction of world petroleum production rates. Virtually all economic sectors rely heavily on petroleum. In the case of minerals, lower grades of mineral resources are being extracted, requiring higher inputs of capital and energy for both extraction and processing.[64] An example is natural gas from shale and other low permeability rock, which can be developed with much higher inputs of energy, capital, and materials than conventional gas in previous decades. Another example is offshore oil and gas, which has exponentially increasing cost as water depth increases. Some "Malthusians", such as William R. Catton, Jr., author of the 1980 book "Overshoot," are skeptical of these various advancements in technology which make available previously inaccessible or lower grade resources. The counter-argument is that such advances as well as increases in efficiency merely accelerate the drawing down of finite resources. Catton has referred to the contemporary increases in rates of resource extraction as "stealing ravenously from the future."[65] The apparent and temporary "increase" of resource extraction with the use of new technology leads to the popular perception that resources are infinite or can be substituted without limit, but this perception fails to consider that ultimately, even lower quality resources

are finite and become uneconomic to extract when the ore quality is too low. Because of cultural lag, the perception of infinite resources and substitutes may linger on for generations, and may not change, since the inevitable resource bankruptcy is passed on to posterity. Catton has called the faith in technology a form of "cargoism," which takes its meaning from various "Cargo Cults" in Melanesia and Micronesia. Furthermore, Joseph Tainter, anthropologist, historian and author of the book "The Collapse of Complex Societies," has pointed out that each new addition of complexity to technology can only be sustained if there is a good enough return to justify the technology, and that over time, increases in complexity have improved productivity at an ever decreasing rate. As an example, in the early 20th century when much of the world's oil was untapped, it was sufficient to drill a few metres into the ground and install inexpensive rigs to extract oil at rapid rates. At the beginning of the 21st century, in order to achieve the same flowrates or less, oilfields must be drilled much deeper and managed with sophisticated techniques and equipment costing many hundreds of millions of dollars. If such trends continue, there may arrive a time when it becomes uneconomic to increase complexity in order to access lower grade resources with no net improvement in productivity.

Environmental impact

Forest in Indonesia being cut for palm oil plantation. Some critics[who?] argue that a narrow view of economic growth, combined with globalization, is creating a scenario where we could see a systemic collapse of our planet's natural resources.[66] Other critics draw on archaeology to cite examples of cultures they claim have disappeared because they grew beyond the ability of their ecosystems to support them.[67] Concerns about possible negative effects of growth on the environment and society led some to advocate lower levels of growth, from which comes the ideas of uneconomic growth and de-growth, and Green parties which argue that economies are part of a global society and a global ecology and cannot outstrip their natural growth without damaging them. Those more optimistic about the environmental impacts of growth believe that, although localized environmental effects may occur, large-scale ecological effects are minor. The argument as stated by commentators Julian Lincoln Simon states that if these global-scale ecological effects exist, human ingenuity will find ways of adapting to them.[68]

Equitable growth

While acknowledging the central role economic growth can potentially play in human development, poverty reduction and the achievement of the Millennium Development Goals, it is becoming widely understood amongst the development community that special efforts must be made to ensure poorer sections of society are able to participate in economic growth.[69] For instance, with low inequality a country with a growth rate of 2% per head and 40% of its population living in poverty, can halve poverty in ten years, but a country with high inequality would take nearly 60 years to achieve the same reduction.[70] In the words of the Secretary General of the United Nations Ban Ki-Moon: While economic growth is necessary, it is not sufficient for progress on reducing poverty.[69] Researchers at the Overseas Development Institute compares situations such as in Uganda, where during a period of annual growth of 2.5% between 2000 and 2003, the percentage of people living in poverty actually increased by 3.8%.[69] The ODI thus emphasises the need to ensure social protection is extended to allow universal access and that policies are introduced to encourage the private sector to create new jobs as the economy grows (as opposed to jobless growth) and seek to employ people from disadvantaged groups.[69]

Implications of global warming

see Economics of global warming Up to the present there are close correlations of economic growth with carbon dioxide emissions across nations, although there is also a considerable divergence in carbon intensity (carbon emissions per GDP).[71] The Stern Review notes that the prediction that "under business as usual, global emissions will be sufficient to propel greenhouse gas concentrations to over 550ppm CO2e by 2050 and over 650700ppm by the end of this century is robust to a wide range of changes in model assumptions". The scientific consensus is that planetary ecosystem functioning without incurring dangerous risks requires stabilization at 450550 ppm.[72] As a consequence, growth-oriented environmental economists propose massive government intervention into switching sources of energy production, favouring wind, solar, hydroelectric, and nuclear. This would largely confine use of fossil fuels to either domestic cooking needs (such as for kerosene burners) or where carbon capture and storage technology can be costeffective and reliable.[73] The Stern Review, published by the United Kingdom Government in 2006, concluded that an investment of 1% of GDP would be sufficient to avoid the worst effects of climate change, and that failure to do so could risk climate-related costs equal to 20% of GDP. Because carbon capture and storage is as yet widely unproven, and its long term effectiveness (such as in containing carbon dioxide 'leaks') unknown, and because of current costs of alternative fuels, these policy responses largely rest on faith of technological change. On the other hand, Nigel Lawson claimed that people in a hundred years' time would be "seven times as well off as we are today", therefore it is not reasonable to impose sacrifices on the "much poorer present generation".[74]

Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods". More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to persist over time due to increases in supply, unless the economy is already at a full employment level. The term demand-pull inflation is mostly associated with Keynesian economics. According to Keynesian theory, the more firms will employ people, the more people that are employed, the higher aggregate demand (AD) will become. This greater demand will make firms employ more people in order to output more. Due to capacity constraints, this increase in output will eventually become so small that the price of the good will rise. At first, unemployment will go down, shifting AD1 to AD2, which increases demand (noted as "Y") by (Y2 - Y1). This increase in demand means more workers are needed, and then AD will be shifted from AD2 to AD3, but this time much less is produced than in the previous shift, but the price level has risen from P2 to P3, a much higher increase in price than in the previous shift. This increase in price is called inflation. Demand-pull inflation is in contrast with cost-push inflation, when price and wage increases are being transmitted from one sector to another. However, these can be considered as different aspects of an overall inflationary process: demand-pull inflation explains how price inflation starts, and cost-push inflation demonstrates why inflation once begun is so difficult to stop.[1] Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available. A situation that has been often cited of this was the oil crisis of the 1970s, which some economists see as a major cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC. Since petroleum is so important to industrialised economies, a large increase in its price can lead to the increase in the price of most products, raising the inflation rate. This can raise the normal or built-in inflation rate, reflecting adaptive expectations and the price/wage spiral, so that a supply shock can have persistent effects. Keynesians argue that in a modern industrial economy, many prices are sticky downward or downward inflexible, so that instead of prices for non-oil-related goods falling in this story, a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation. They also note that though there was no deflation in the 1980s, there was a definite fall in the inflation rate during this period. Actual deflation was prevented because supply shocks are not the only cause of inflation; in terms of the modern triangle model of inflation, supply-driven deflation was counteracted by demand-pull inflation and built-in inflation resulting from adaptive expectations and the price/wage spiral.

Monetarist economists such as Milton Friedman argue against the concept of cost-push inflation because increases in the cost of goods and services do not lead to inflation without the government and its central bank cooperating in increasing the money supply. The argument is that if the money supply is constant, increases in the cost of a good or service will decrease the money available for other goods and services, and therefore the price of some those goods will fall and offset the rise in price of those goods whose prices have increased. One consequence of this is that monetarist economists do not believe that the rise in the cost of oil was a direct cause of the inflation of the 1970s. They argue that although the price of oil went back down in the 1980s, there was no corresponding deflation. In economics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable. For example, suppose a one-unit change in some variable x causes another variable y to change by M units. Then the multiplier is M.

Common uses
Two multipliers are commonly discussed in introductory macroeconomics.

Money multiplier
Main article: Money multiplier See also: Fractional reserve banking In monetary macroeconomics and banking, the money multiplier measures how much the money supply increases in response to a change in the monetary base. The multiplier may vary across countries, and will also vary depending on what measures of money are considered. For example, consider M2 as a measure of the U.S. money supply, and M0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10.

Fiscal multipliers
Main article: Fiscal multiplier Multipliers can be calculated to analyze the effects of fiscal policy, or other exogenous changes in spending, on aggregate output. For example, if an increase in German government spending by 100, with no change in taxes, causes German GDP to increase by 150, then the spending multiplier is 1.5. Other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes (such as lump-sum taxes or proportional taxes).

Keynesian and Hansen-Samuelson multipliers

Keynesian economists often calculate multipliers that measure the effect on aggregate demand only. (To be precise, the usual Keynesian multiplier formulas measure how much the IS curve shifts left or right in response to an exogenous change in spending.) American Economist Paul Samuelson credited Alvin Hansen for the inspiration behind his seminal 1939 contribution. The original Samuelson multiplier-accelerator model (or, as he belatedly baptised it, the "Hansen-Samuelson" model) relies on a multiplier mechanism that is based on a simple Keynesian consumption function with a Robertsonian lag:

so present consumption is a function of past income (with c as the marginal propensity to consume). Investment, in turn, is assumed to be composed of three parts:

The first part is autonomous investment, the second is investment induced by interest rates and the final part is investment induced by changes in consumption demand (the "acceleration" principle). It is assumed that 0 < b . As we are concentrating on the income-expenditure side, let us assume I(r) = 0 (or alternatively, constant interest), so that:

Now, assuming away government and foreign sector, aggregate demand at time t is:

assuming goods market equilibrium (so

), then in equilibrium:

But we know the values of and are merely respectively, then substituting these in:

and

or, rearranging and rewriting as a second order linear difference equation:

The solution to this system then becomes elementary. The equilibrium level of Y (call it particular solution) is easily solved by letting , or:

, the

so:

The complementary function, is also easy to determine. Namely, we know that it will have the form where and are arbitrary constants to be defined and where and are the two eigenvalues (characteristic roots) of the following characteristic equation:

Thus, the entire solution is written as Opponents of Keynesianism have sometimes argued that Keynesian multiplier calculations are misleading; for example, according to the theory of Ricardian equivalence, it is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future.[citation needed]

General method
The general method for calculating long-run multipliers is called comparative statics. That is, comparative statics calculates how much one or more endogenous variables change in the long run, given a permanent change in one or more exogenous variables. The comparative statics method is an application of the Implicit Function Theorem. Dynamic multipliers can also be calculated. That is, one can ask how a change in some exogenous variable in year t affects endogenous variables in year t, in year t+1, in year t+2, and so forth.[1] A graph showing the impact on some endogenous variable, over time (that is, the multipliers for times t, t+1, t+2, etcetera), is called an impulse-response function.[2] The general method for calculating impulse response functions is sometimes called comparative dynamics.

History

Illustration of the original visualisation of the tableau conomique by Quesnay, 1759. The tableau conomique (Economic Table) of Franois Quesnay (1759), which lay the foundation of the Physiocrats economic theory, is credited as the "first precise formulation" of interdependent systems in economics and the origin of multiplier theory.[3] In the tableau conomique, one sees variables in one period (time t) feeding into variables in the next period (time t+1), and a constant rate of flow yields geometric series, which computes a multiplier. The modern theory of the multiplier was developed in the 1930s, by Kahn, Keynes, Giblin, and others,[4] following earlier work in the 1890s by the Australian economist Alfred De Lissa, the Danish economist Julius Wulff, and the German-American economist N. A. J. L. Johannsen.[5]

Critiques
Economist Robert Barro believes that the Keynesian multiplier is close to zero. For every dollar the government borrows and spends, spending elsewhere in the economy falls by almost the same amount.[6] In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency.[1] For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange

rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.

Retail exchange market

People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveller can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveller's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveller has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com.[3] This studied consumer banks in the U.S., and Travelex, showed that the credit card networks save travellers about 8% relative to banks and roughly 15% relative to airport companies.[3]

Quotations

Exchange rates display in Thailand Main article: Currency pair A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars. There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR GBP AUD NZD USD others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.

Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective)[4] and are used by most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone. Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places. In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform.[5] The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this system.

Exchange rate regime

Main article: Exchange rate regime Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid. If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. [1] But

that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes. Still, some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued[by whom?] that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)[citation needed]

Purchasing power of currency

The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries ( ), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.

Bilateral vs. effective exchange rate

Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies (US Dollar, Euro, Japanese Yen, Chinese Renmenbi, Swiss Franks, Pound Sterling Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

Uncovered interest rate parity

See also: Interest rate parity#Uncovered interest rate parity Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite, appreciation, quite frequently happens in the short-term, as explained below). The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium. UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.

Balance of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Asset market model

See also: Capital asset pricing model and Net Capital Outflow The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.[6] The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities. Like the stock exchange, money can be made (or lost) on the foreign exchange market by investors and speculators buying and selling at the right (or wrong) times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates

Manipulation of exchange rates

Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low, typically by the national central bank engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time. In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.[7] Purchasing power parity (PPP) is an economic theory and a technique used to determine the relative value of currencies, estimating the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power.[1] It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same purchasing power in different countries. Among other uses, PPP rates facilitate international comparisons of income, as market exchange rates are often volatile, are affected by political and financial factors that do not lead to immediate

changes in income and tend to systematically understate the standard of living in poor countries, due to the BalassaSamuelson effect. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918.[2][3] The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.[4] Another interpretation is that the difference in the rate of change in prices at home and abroad the difference in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate. Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP-adjusted" and converted into common units. The best-known purchasing power adjustment is the GearyKhamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the BalassaSamuelson theorem. There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[5] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[6]considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,704.063[7] while on a PPP basis it is about US$3,608.196.[8] At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is US$37,304.

Measurement
The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.[citation needed] Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from that of another; Americans eat more bread, Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. Additional statistical difficulties arise with

multilateral comparisons when (as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs can provide a more stable multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was USD 0.91, and in Norway the price was USD 6.27.[9] The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

Law of one price

Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.[4] The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent.

Big Mac Index

Big Mac hamburgers, like this one from Japan, are similar worldwide. Main article: Big Mac Index An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which looks at the prices of a Big Mac burger in

McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known food whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government regulations, product differentiation, and prices of nonfood inputs.[4][10] Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few substitutes for the Big Mac allows McDonald's to have market power. Countries like Argentina that have abundant beef resources see a structural underpricing in the Big Mac.

Starbucks tall latte index

The Starbucks tall latte index is a variant of the Big Mac Index; it can give information regarding exchange rates similar to the Big Mac Index. The tall latte index was compiled in 2004, during which time both a Big Mac and tall latte cost $2.80. The measures told the same story in most cases with the notable exception of Asia. According to the Big Mac index, the yen was 12% undervalued against the dollar, whereas it was 13% overvalued according to the tall latte index. Furthermore, the Chinese yuan was 56% undervalued based on the Big Mac index but neither significantly undervalued nor overvalued according to the Starbucks index.[11] The following table, based on data from The Economist's 2004 calculations, shows the under (-) and over (+) valuation of the local currency against the dollar in %, according to the Starbucks tall latte index and the Big Mac index. Country Starbucks tall latte index McDonald's Big Mac Index Australia -4 -17 United Kingdom +17 +23 Canada -16 -16 China -1 -56 Eurozone +33 +24 Hong Kong +15 -45 Japan +13 -12 Malaysia -25 -53 Mexico -15 -21 New Zealand -12 -4 Singapore +2 -31

Country South Korea Switzerland Taiwan Thailand Turkey

Starbucks tall latte index McDonald's Big Mac Index +6 0 +62 +82 -5 -21 -31 -46 +6 +5

OECD comparative price levels

Each month, the Organisation for Economic Co-operation and Development measures the difference in price levels between its member countries by calculating the ratios of PPPs for private final consumption expenditure to exchange rates. The OECD table below indicates the number of US dollars needed, as of June 2012, in each of the countries listed to buy the same representative basket of consumer goods and services that would cost 100 USD in the United States. According to the table, an American living in Switzerland on an income denominated in US dollars would find that country (in November 2012) to be the most expensive of the group, having to spend 76% more US dollars to maintain a standard of living comparable to the USA in terms of consumption. Country Australia Austria Belgium Canada Chile Czech Republic Denmark Estonia Finland France Germany Greece Hungary Iceland Ireland Israel Italy Japan Korea Luxembourg Price level (USA = 100)[12] 164 114 120 132 78 84 152 87 130 117 109 102 74 122 128 116 101 150 83 127

Country Price level (USA = 100)[12] Mexico 70 Netherlands 114 New Zealand 132 Norway 168 Poland 63 Portugal 100 Slovak Republic 78 Slovenia 93 Spain 105 Sweden 138 Switzerland 176 Turkey 56 United Kingdom 137 United States 100

Measurement issues
In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The International Comparison Program, which PPP estimates are based on, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories. Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian laborer who lives on teff with the Thai laborer who lives on rice, because teff is not commercially available in Thailand and rice is not in Ethiopia, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison. PPP levels will also vary based on the formula used to calculate price matrices. Different possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages. Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which do not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.

Need for adjustments to GDP

Gross domestic product (by purchasing power parity) in 2006 The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. For example, if the value of the Mexican peso falls by half compared to the US dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem. PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases, a PPP exchange rate is likely the most realistic basis for economic comparison.

Updating PPP rates for GDP

Since global PPP estimates such as those provided by the ICP are not calculated annually, but for a single year, PPP exchange rates for years other than the benchmark year need to be updated. This is done using the country's GDP deflator. To calculate a country's PPP exchange rate in GearyKhamis dollars for a particular year, the calculation proceeds in the following manner:

Where PPPrateX,i is the PPP exchange rate of country X for year i, PPPrateX,b is the PPP exchange rate of country X for the benchmark year, PPPrateU,b is the PPP exchange rate of the United States (US) for the benchmark year (equal to 1), GDPdefX,i is the GDP deflator of country X for year i, GDPdefX,b is the GDP deflator of country X for the benchmark year, GDPdefU,i is the GDP deflator of the US for year i, and GDPdefU,b is the GDP deflator of the US for the benchmark year.

Difficulties
There are a number of reasons that different measures do not perfectly reflect standards of living.

Range and quality of goods

The goods that the currency has the "power" to purchase are a basket of goods of different types: 1. Local, non-tradable goods and services (like electric power) that are produced and sold domestically. 2. Tradable goods such as non-perishable commodities that can be sold on the international market (like diamonds). The more that a product falls into category 1, the more that its price will be from the currency exchange rate, moving towards the PPP exchange rate. Conversely, category 2 products tend to trade close to the currency exchange rate. (See also Penn effect). More processed and expensive products are likely to be tradable, falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it won't buy three times as much of internationally traded goods like steel, cars and microchips, but nontraded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the Balassa-Samuelson effect and gives a big cost advantage to labour intensive production of tradable goods in low income countries (like Ethiopia), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes farther in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent cost benefit comes from non-traded goods that can be sourced

locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a cheaper factor of production than is available to factories in richer countries. The Bhagwati-Kravis-Lipsey view provides a somewhat different explanation from the BalassaSamuelson theory. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive.[4] PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.

Trade barriers and nontradables

The law of one price, the underlying mechanism behind PPP, is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price. As transport costs increase, the larger the range of exchange rate fluctuations. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country."[4] They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago, which is certainly not the case. Nontradables are primarily services and the output of the construction industry. Nontradables also lead to deviations in PPP because the prices of nontradables are not linked internationally. The prices are determined by domestic supply and demand, and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of nontradables rise, the purchasing power of any given currency will fall in that country.[4]

Departures from free competition

Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of inter-country differences in conditions on both the demand side (e.g., virtually no demand for pork or alcohol in Islamic states) and the supply side (e.g., whether the existing market for a prospective entrant's product features few suppliers or instead is already near-saturated). According to Krugman and Obstfeld, this occurrence of product differentiation and segmented markets results in violations of the law of one price and absolute PPP. Overtime, shifts in market structure and demand will occur, which may invalidate relative PPP.[4]

Differences in price level measurement

Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.[4]

Global poverty line

The global poverty line is a worldwide count of people who live below an international poverty line, referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the world's poorest countries, expressed in international dollars. These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP.

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted national income (NNI* adjusted for natural resource depletion). All are specially concerned with counting the total amount of goods and services produced within some "boundary". The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted. For instance, some measures count only goods and services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them. National accounts
Main article: National accounts

Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century,[2] the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression

and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as well-informed as possible.

Market value
Main article: Market value

In order to count a good or service, it is necessary to assign value to it. The value that the measures of national income and output assign to a good or service is its market value the price it fetches when bought or sold. The actual usefulness of a product (its use-value) is not measured assuming the use-value to be any different from its market value. Three strategies have been used to obtain the market values of all the goods and services produced: the product (or output) method, the expenditure method, and the income method. The product method looks at the economy on an industry-by-industry basis. The total output of the economy is the sum of the outputs of every industry. However, since an output of one industry may be used by another industry and become part of the output of that second industry, to avoid counting the item twice we use not the value output by each industry, but the value-added; that is, the difference between the value of what it puts out and what it takes in. The total value produced by the economy is the sum of the values-added by every industry. The expenditure method is based on the idea that all products are bought by somebody or some organisation. Therefore we sum up the total amount of money people and organisations spend in buying things. This amount must equal the value of everything produced. Usually expenditures by private individuals, expenditures by businesses, and expenditures by government are calculated separately and then summed to give the total expenditure. Also, a correction term must be introduced to account for imports and exports outside the boundary. The income method works by summing the incomes of all producers within the boundary. Since what they are paid is just the market value of their product, their total income must be the total value of the product. Wages, proprieter's incomes, and corporate profits are the major subdivisions of income.

The output approach

The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in total output. This avoids an issue often called 'double counting', wherein the total value of a good is included several times in national output, by counting it repeatedly in several stages of production. In the example of meat production, the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be $60, not the sum of all those numbers, $100. The values added at each stage of production over the previous

stage are respectively $10, $20, and $30. Their sum gives an alternative way of calculating the value of final output. Formulae: GDP(gross domestic product) at market price = value of output in an economy in a particular year - intermediate consumption NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from abroad) - net indirect taxes[3]

The income approach

The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation. The main types of factor income are:

Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits); Interest received net of interest paid; Rental income (mainly for the use of real estate) net of expenses of landlords; Royalties paid for the use of intellectual property and extractable natural resources.

All remaining value added generated by firms is called the residual or profit. If a firm has stockholders, they own the residual, some of which they receive as dividends. Profit includes the income of the entrepreneur - the businessman who combines factor inputs to produce a good or service. Formulae: NDP at factor cost = Compensation of employees + Net interest + Rental & royalty income + Profit of incorporated and unincorporated NDP at factor cost

The expenditure approach

The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output takes all the different areas in which money is spent within the region, and then combines them to find the total output.

Where: C = household consumption expenditures / personal consumption expenditures I = gross private domestic investment G = government consumption and gross investment expenditures

X = gross exports of goods and services M = gross imports of goods and services Note: (X - M) is often written as XN, which stands for "net exports"

Definitions
The names of the measures consist of one of the words "Gross" or "Net", followed by one of the words "National" or "Domestic", followed by one of the words "Product", "Income", or "Expenditure". All of these terms can be explained separately.
"Gross" means total product, regardless of the use to which it is subsequently put. "Net" means "Gross" minus the amount that must be used to offset depreciation ie., wearand-tear or obsolescence of the nation's fixed capital assets. "Net" gives an indication of how much product is actually available for consumption or new investment. "Domestic" means the boundary is geographical: we are counting all goods and services produced within the country's borders, regardless of by whom. "National" means the boundary is defined by citizenship (nationality). We count all goods and services produced by the nationals of the country (or businesses owned by them) regardless of where that production physically takes place. The output of a French-owned cotton factory in Senegal counts as part of the Domestic figures for Senegal, but the National figures of France. "Product", "Income", and "Expenditure" refer to the three counting methodologies explained earlier: the product, income, and expenditure approaches. However the terms are used loosely. "Product" is the general term, often used when any of the three approaches was actually used. Sometimes the word "Product" is used and then some additional symbol or phrase to indicate the methodology; so, for instance, we get "Gross Domestic Product by income", "GDP (income)", "GDP(I)", and similar constructions. "Income" specifically means that the income approach was used. "Expenditure" specifically means that the expenditure approach was used.

Note that all three counting methods should in theory give the same final figure. However, in practice minor differences are obtained from the three methods for several reasons, including changes in inventory levels and errors in the statistics. One problem for instance is that goods in inventory have been produced (therefore included in Product), but not yet sold (therefore not yet included in Expenditure). Similar timing issues can also cause a slight discrepancy between the value of goods produced (Product) and the payments to the factors that produced the goods

(Income), particularly if inputs are purchased on credit, and also because wages are collected often after a period of production.

GDP and GNP

Main articles: GDP and GNP

Gross domestic product (GDP) is defined as "the value of all final goods and services produced in a country in 1 year".[4] Gross National Product (GNP) is defined as "the market value of all goods and services produced in one year by labour and property supplied by the residents of a country."[5] As an example, the table below shows some GDP and GNP, and NNI data for the United States:[6]
National income and output (Billions of dollars) Period Ending Gross national product Net U.S. income receipts from rest of the world U.S. income receipts U.S. income payments Gross domestic product Private consumption of fixed capital Government consumption of fixed capital Statistical discrepancy National Income 2003 11,063.3 55.2 329.1 -273.9 11,008.1 1,135.9 218.1 25.6 9,679.7

NDP: Net domestic product is defined as "gross domestic product (GDP) minus depreciation of capital",[7] similar to NNP. GDP per capita: Gross domestic product per capita is the mean value of the output produced per person, which is also the mean income.

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National income and welfare

GDP per capita (per person) is often used as a measure of a person's welfare. Countries with higher GDP may be more likely to also score highly on other measures of welfare, such as life expectancy. However, there are serious limitations to the usefulness of GDP as a measure of welfare:

Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as childcare. This leads to distortions; for example, a paid nanny's income contributes to GDP, but an unpaid parent's time spent caring for children will not, even though they are both carrying out the same economic activity. GDP takes no account of the inputs used to produce the output. For example, if everyone worked for twice the number of hours, then GDP might roughly double, but this does not necessarily mean that workers are better off as they would have less leisure time. Similarly, the impact of economic activity on the environment is not measured in calculating GDP. Comparison of GDP from one country to another may be distorted by movements in exchange rates. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services, for example subsistence farming. GDP does not measure factors that affect quality of life, such as the quality of the environment (as distinct from the input value) and security from crime. This leads to distortions - for example, spending on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss of clean beaches) is not measured. GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed income distribution may have a relatively high per-capita GDP while the majority of its citizens have a relatively low level of income, due to concentration of wealth in the hands of a small fraction of the population. See Gini coefficient.

Because of this, other measures of welfare such as the Human Development Index (HDI), Index of Sustainable Economic Welfare (ISEW), Genuine Progress Indicator (GPI), gross national happiness (GNH), and sustainable national income (SNI) are used.

Difficulties in Measurement of National Income

There are many difficulties when it comes to measuring national income, however these can be grouped into conceptual difficulties and practical difficulties.
Conceptual Difficulties

Inclusion of Services: There has been some debate about whether to include services in the counting of national income, and if it counts as output. Marxian economists are of the belief that services should be excluded from national income, most other economists though are in agreement that services should be included. Identifying Intermediate Goods: The basic concept of national income is to only include final goods, intermediate goods are never included, but in reality it is very hard to draw a clear cut

line as to what intermediate goods are. Many goods can be justified as intermediate as well as final goods depending on their use. Identifying Factor Incomes: Separating factor incomes and non factor incomes is also a huge problem. Factor incomes are those paid in exchange for factor services like wages, rent, interest etc. Non factor are sale of shares selling old cars property etc., but these are made to look like factor incomes and hence are mistakenly included in national income. Services of Housewives and other similar services: National income includes those goods and services for which payment has been made, but there are scores of jobs, for which money as such is not paid, also there are jobs which people do themselves like maintain the gardens etc., so if they hired someone else to do this for them, then national income would increase, the argument then is why are these acts not accounted for now, but the bigger issue would be how to keep a track of these activities and include them in national income.

Practical Difficulties

Unreported Illegal Income: Sometimes, people don't provide all the right information about their incomes to evade taxes so this obviously causes disparities in the counting of national income. Non Monetized Sector: In many developing nations, there is this issue that goods and services are traded through barter, i.e. without any money. Such goods and services should be included in accounting of national income, but the absence of data makes this inclusion difficult.

The Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product (GDP) conversion at market exchange rates. It has been a consistent econometric result for at least fifty years. The "Balassa-Samuelson effect" is a model cited as the principal cause of the Penn effect by neo-classical economics, as well as being a synonym of "Penn effect"

History
Classical economics made simple predictions about exchange rates; it was said that a basket of goods would cost roughly the same amount everywhere in the world, when paid for in some common currency (like gold)1. This is called the purchasing power parity (PPP) hypothesis, also expressed as saying that the real exchange rate (RER) between goods in various countries should be close to one. Fluctuations over time were expected by this theory but were predicted to be small and non-systematic. Pre-1940, the PPP hypothesis found econometric support, but some time after the Second World War, a series of studies by a Penn team documented a modern relationship: countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices), relative to prices of goods included in the exchange rate. In 1964 the modern theoretical interpretation was set down as the Balassa-Samuelson effect, with studies since then consistently confirming the original Penn effect. However, subsequent analysis has provided many other mechanisms through which the Penn effect can arise, and historical cases where it is expected, but not found. Up until 1994 the PPPdeviation tended to be known as the "Balassa-Samuelson effect", but in his review of progress "Facets of Balassa-Samuelson Thirty Years Later" Paul Samuelson acknowledged the debt that his theory owed to the Penn World Tables data-gatherers, by

coining the term "Penn effect" to describe the "basic fact" they uncovered, when he wrote: The Penn effect is an important phenomenon of actual history, but not an inevitable fact of life.

Understanding the Penn effect

Further information: Big Mac Index Most things are cheaper in poor (low income) countries than in rich ones. Someone from a "first world" country on vacation in a "third world" country will usually find their money going a lot further abroad than at home. For instance, the same Big Mac cost $5.46 in Switzerland, and $1.49 in Russia in December 2004, at the prevailing USD exchange rate into the local currencies. To avoid confusion arising from money prices the nominal exchange rates are usually ignored, with only the 'real exchange rate' (RER) being considered. (Here, 3.66 Russian meals to one Swiss.)

The effect's challenge to simple open economy models

The (nave form of the) purchasing power parity hypothesis argues that the BalassaSamuelson effect shouldn't occur. A simple open economy model treating Big Macs as commodity goods implies that international price competition will force Swiss, Russian, and U.S. burger prices to converge in price. The Penn effect denies this convergence; it is clear evidence that the general price level is much higher where (dollar) incomes are high, with no tendency to match the cheaper prices in poorer countries.

How identical products can be sold at consistently different prices in different places
The law of one price says that the same item cannot sustain two different sale prices in the same market (since everyone would buy only at the lower price). By reversing this law, we can infer that different countries do not share an efficient common market from the fact that prices for the same good are different. If a McDonalds patron in Zurich were able to eat in an identical Moscow restaurant at one quarter the price they would do so, and price competition would then equalize the Big Mac price throughout the world. Of course, someone can only eat out locally, so regional price differentials can persist; the Moscow and Zurich branches are not in competition. If the Moscow McDonalds starts giving away burgers the price in Zurich will be unaffected, since one is unlikely to dine in Moscow if starting the evening in Zurich.

The price level

Measuring 'the' price level involves looking at goods other than burgers, but most goods in a consumer price index (CPI) show the same pattern; equivalent things tend to cost more in high income countries. Most services, perishable goods like the Big Mac, and housing cannot be purchased very far from the point of consumption (where the consumer happens to live). These items form the typical consumer shopping list, and therefore the CPI level can vary from country to country, just like the burger price.

The international development implications

The PPP-deviation allows rural Indians to survive on an income below the absolute subsistence level in the rich world. If the money income levels are taken as given, then ceteris paribus, the Penn effect is a very good thing. If it did not apply, millions of the

world's poorest people would find that their income was below the survival threshold. However, the effect implies that the money income level disparity as measured by international exchange rates is an illusion, because these exchange rates only apply to traded goods, a small proportion of consumption. If the genuine income differential (taking local prices into account) is exaggerated by the RER, so the real difference in the standard of living between rich and poor countries is less than GDP per capita figures would suggest. To make a more significant comparison, economists divide a country's average income by its consumer price index.

The term security was originally used to describe financial instruments secured by physical assets, but in North America, its meaning evolved to include all instruments irrespective of whether they offer security or not. Other English speaking countries have adopted the term as a synonym for the term financial instrument.[1] Securities are broadly categorized into:

debt securities (such as banknotes, bonds and debentures), equity securities, e.g., common stocks; and, derivative contracts, such as forwards, futures, options and swaps.

The company or other entity issuing the security is called the issuer. A country's regulatory structure determines what qualifies as a security. For example, private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions. Securities may be represented by a certificate or, more typically, "non-certificated", that is in electronic or "book entry" only form. Certificates may be bearer, meaning they entitle the holder to rights under the security merely by holding the security, or registered, meaning they entitle the holder to rights only if he appears on a security register maintained by the issuer or an intermediary. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, limited partnership units, and various other formal investment instruments that are negotiable and fungible.

Classification
Securities may be classified according to many categories or classification systems:

Currency of denomination Ownership rights Term to maturity Degree of liquidity Income payments Tax treatment Credit rating Industrial sector or "industry". ("Sector" often refers to a higher level or broader category, such as Consumer Discretionary, whereas "industry" often refers to a lower level classification, such as Consumer Appliances. See Industry for a discussion of some classification systems.)

Region or country (such as country of incorporation, country of principal sales/market of its products or services, or country in which the principal securities exchange where it trades is located) Market capitalization State (typically for municipal or "tax-free" bonds in the U.S.)

New capital
Securities are the traditional way that commercial enterprises raise new capital. These may be an attractive alternative to bank loans depending on their pricing and market demand for particular characteristics. Another disadvantage of bank loans as a source of financing is that the bank may seek a measure of protection against default by the borrower via extensive financial covenants. Through securities, capital is provided by investors who purchase the securities upon their initial issuance. In a similar way, a government may issue securities to when it needs to increase government debt.

Repackaging
In recent decades, securities have been issued to repackage existing assets. In a traditional securitization, a financial institution may wish to remove assets from its balance sheet to achieve regulatory capital efficiencies (the informal ratio of output divided by capital expenditure) or to accelerate its receipt of cash flow from the original assets. Alternatively, an intermediary may wish to make a profit by acquiring financial assets and repackaging them in a way more attractive to investors. In other words, a basket of assets is typically contributed or placed into a separate legal entity such as a trust or SPV, which subsequently issues shares of equity interest to investors. This allows the sponsor entity to more easily raise capital for these assets as opposed to finding buyers to purchase directly such assets.

Type of holder
Investors in securities may be retail, i.e. members of the public investing other than by way of business. The greatest part of investment, in terms of volume, is wholesale, i.e. by financial institutions acting on their own account, or on behalf of clients. Important institutional investors include investment banks, insurance companies, pension funds and other managed funds.
Investment

The traditional economic function of the purchase of securities is investment, with the view to receiving income and/or achieving capital gain. Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth. Equity investment may also offer control of the business of the issuer. Debt holdings may also offer some measure of control to the investor if the company is a fledgling start-up or an old giant undergoing 'restructuring'. In these cases, if interest payments are missed, the creditors may take control of the company and liquidate it to recover some of their investment.

Collateral

The last decade has seen an enormous growth in the use of securities as collateral. Purchasing securities with borrowed money secured by other securities or cash itself is called "buying on margin". Where A is owed a debt or other obligation by B, A may require B to deliver property rights in securities to A, either at inception (transfer of title) or only in default (non-transfer-oftitle institutional). For institutional loans, property rights are not transferred but nevertheless enable A to satisfy its claims in the event that B fails to make good on its obligations to A or otherwise becomes insolvent. Collateral arrangements are divided into two broad categories, namely security interests and outright collateral transfers. Commonly, commercial banks, investment banks, government agencies and other institutional investors such as mutual funds are significant collateral takers as well as providers. In addition, private parties may utilize stocks or other securities as collateral for portfolio loans in securities lending scenarios. On the consumer level, loans against securities have grown into three distinct groups over the last decade: 1) Standard Institutional Loans, generally offering low loan-to-value with very strict call and coverage regimens, akin to standard margin loans; 2) Transfer-of-Title (ToT) Loans, typically provided by private parties where borrower ownership is completely extinguished save for the rights provided in the loan contract; and 3) Non-Transfer-of-Title Credit Line facilities where shares are not sold and they serve as assets in a standard lien-type line of cash credit. Of the three, transfer-of-title loans have fallen into the very high-risk category as the number of providers has dwindled as regulators have launched an industry-wide crackdown on transfer-oftitle structures where the private lender may sell or sell short the securities to fund the loan. See sell short. Institutionally managed consumer securities-based loans, on the other hand, draw loan funds from the financial resources of the lending institution, not from the sale of the securities.

Debt and equity

Securities are traditionally divided into debt securities and equities (see also derivatives).

Debt
Debt securities may be called debentures, bonds, deposits, notes or commercial paper depending on their maturity and certain other characteristics. The holder of a debt security is typically entitled to the payment of principal and interest, together with other contractual rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term. Debt securities may be protected by collateral or may be unsecured, and, if they are unsecured, may be contractually "senior" to other unsecured debt meaning their holders would have a priority in a bankruptcy of the issuer. Debt that is not senior is "subordinated". Corporate bonds represent the debt of commercial or industrial entities. Debentures have a long maturity, typically at least ten years, whereas notes have a shorter maturity. Commercial paper is a simple form of debt security that essentially represents a post-dated check with a maturity of not more than 270 days.

Money market instruments are short term debt instruments that may have characteristics of deposit accounts, such as certificates of deposit, and certain bills of exchange. They are highly liquid and are sometimes referred to as "near cash". Commercial paper is also often highly liquid. Euro debt securities are securities issued internationally outside their domestic market in a denomination different from that of the issuer's domicile. They include eurobonds and euronotes. Eurobonds are characteristically underwritten, and not secured, and interest is paid gross. A euronote may take the form of euro-commercial paper (ECP) or euro-certificates of deposit. Government bonds are medium or long term debt securities issued by sovereign governments or their agencies. Typically they carry a lower rate of interest than corporate bonds, and serve as a source of finance for governments. U.S. federal government bonds are called treasuries. Because of their liquidity and perceived low risk, treasuries are used to manage the money supply in the open market operations of non-US central banks. Sub-sovereign government bonds, known in the U.S. as municipal bonds, represent the debt of state, provincial, territorial, municipal or other governmental units other than sovereign governments. Supranational bonds represent the debt of international organizations such as the World Bank, the International Monetary Fund, regional multilateral development banks and others.

Equity
An equity security is a share of equity interest in an entity such as the capital stock of a company, trust or partnership. The most common form of equity interest is common stock, although preferred equity is also a form of capital stock. The holder of an equity is a shareholder, owning a share, or fractional part of the issuer. Unlike debt securities, which typically require regular payments (interest) to the holder, equity securities are not entitled to any payment. In bankruptcy, they share only in the residual interest of the issuer after all obligations have been paid out to creditors. However, equity generally entitles the holder to a pro rata portion of control of the company, meaning that a holder of a majority of the equity is usually entitled to control the issuer. Equity also enjoys the right to profits and capital gain, whereas holders of debt securities receive only interest and repayment of principal regardless of how well the issuer performs financially. Furthermore, debt securities do not have voting rights outside of bankruptcy. In other words, equity holders are entitled to the "upside" of the business and to control the business.

Stock

Hybrid
Hybrid securities combine some of the characteristics of both debt and equity securities. Preference shares form an intermediate class of security between equities and debt. If the issuer is liquidated, they carry the right to receive interest and/or a return of capital in priority to

ordinary shareholders. However, from a legal perspective, they are capital stock and therefore may entitle holders to some degree of control depending on whether they contain voting rights. Convertibles are bonds or preferred stock that can be converted, at the election of the holder of the convertibles, into the common stock of the issuing company. The convertibility, however, may be forced if the convertible is a callable bond, and the issuer calls the bond. The bondholder has about 1 month to convert it, or the company will call the bond by giving the holder the call price, which may be less than the value of the converted stock. This is referred to as a forced conversion. Equity warrants are options issued by the company that allow the holder of the warrant to purchase a specific number of shares at a specified price within a specified time. They are often issued together with bonds or existing equities, and are, sometimes, detachable from them and separately tradeable. When the holder of the warrant exercises it, he pays the money directly to the company, and the company issues new shares to the holder. Warrants, like other convertible securities, increases the number of shares outstanding, and are always accounted for in financial reports as fully diluted earnings per share, which assumes that all warrants and convertibles will be exercised.

The securities markets

Primary and secondary market
Public securities markets are either primary or secondary markets. In the primary market, the money for the securities is received by the issuer of the securities from investors, typically in an initial public offering (IPO). In the secondary market, the securities are simply assets held by one investor selling them to another investor, with the money going from one investor to the other. An initial public offering is when a company issues public stock newly to investors, called an "IPO" for short. A company can later issue more new shares, or issue shares that have been previously registered in a shelf registration. These later new issues are also sold in the primary market, but they are not considered to be an IPO but are often called a "secondary offering". Issuers usually retain investment banks to assist them in administering the IPO, obtaining SEC (or other regulatory body) approval of the offering filing, and selling the new issue. When the investment bank buys the entire new issue from the issuer at a discount to resell it at a markup, it is called a firm commitment underwriting. However, if the investment bank considers the risk too great for an underwriting, it may only assent to a best effort agreement, where the investment bank will simply do its best to sell the new issue. For the primary market to thrive, there must be a secondary market, or aftermarket that provides liquidity for the investment securitywhere holders of securities can sell them to other investors for cash. Otherwise, few people would purchase primary issues, and, thus, companies and governments would be restricted in raising equity capital (money) for their operations. Organized exchanges constitute the main secondary markets. Many smaller issues and most debt securities trade in the decentralized, dealer-based over-the-counter markets.

In Europe, the principal trade organization for securities dealers is the International Capital Market Association.[2] In the U.S., the principal trade organization for securities dealers is the Securities Industry and Financial Markets Association,[3] which is the result of the merger of the Securities Industry Association and the Bond Market Association. The Financial Information Services Division of the Software and Information Industry Association (FISD/SIIA)[4] represents a round-table of market data industry firms, referring to them as Consumers, Exchanges, and Vendors.In india the equivalent organisation is the securities exchange board of india(SEBI)

Public offer and private placement

In the primary markets, securities may be offered to the public in a public offer. Alternatively, they may be offered privately to a limited number of qualified persons in a private placement. Sometimes a combination of the two is used. The distinction between the two is important to securities regulation and company law. Privately placed securities are not publicly tradable and may only be bought and sold by sophisticated qualified investors. As a result, the secondary market is not nearly as liquid as it is for public (registered) securities. Another category, sovereign bonds, is generally sold by auction to a specialized class of dealers.

Listing and OTC dealing

Securities are often listed in a stock exchange, an organized and officially recognized market on which securities can be bought and sold. Issuers may seek listings for their securities to attract investors, by ensuring there is a liquid and regulated market that investors can buy and sell securities in. Growth in informal electronic trading systems has challenged the traditional business of stock exchanges. Large volumes of securities are also bought and sold "over the counter" (OTC). OTC dealing involves buyers and sellers dealing with each other by telephone or electronically on the basis of prices that are displayed electronically, usually by commercial information vendors such as SuperDerivatives, Reuters and Bloomberg. There are also eurosecurities, which are securities that are issued outside their domestic market into more than one jurisdiction. They are generally listed on the Luxembourg Stock Exchange or admitted to listing in London. The reasons for listing eurobonds include regulatory and tax considerations, as well as the investment restrictions.

Market
London is the centre of the eurosecurities markets. There was a huge rise in the eurosecurities market in London in the early 1980s. Settlement of trades in eurosecurities is currently effected through two European computerized clearing/depositories called Euroclear (in Belgium) and Clearstream (formerly Cedelbank) in Luxembourg.

The main market for Eurobonds is the EuroMTS, owned by Borsa Italiana and Euronext. There are ramp up market in Emergent countries, but it is growing slowly.

Physical nature of securities

Certificated securities
Securities that are represented in paper (physical) form are called certificated securities. They may be bearer or registered.

DRS securities
Securities may also be held in the Direct Registration System (DRS), which is a method of recording shares of stock in book-entry form. Book-entry means the company's transfer agent maintains the shares on the owner's behalf without the need for physical share certificates. Shares held in un-certificated book-entry form have the same rights and privileges as shares held in certificated form.
Bearer securities

Bearer securities are completely negotiable and entitle the holder to the rights under the security (e.g. to payment if it is a debt security, and voting if it is an equity security). They are transferred by delivering the instrument from person to person. In some cases, transfer is by endorsement, or signing the back of the instrument, and delivery. Regulatory and fiscal authorities sometimes regard bearer securities negatively, as they may be used to facilitate the evasion of regulatory restrictions and tax. In the United Kingdom, for example, the issue of bearer securities was heavily restricted firstly by the Exchange Control Act 1947 until 1953. Bearer securities are very rare in the United States because of the negative tax implications they may have to the issuer and holder.
Registered securities

In the case of registered securities, certificates bearing the name of the holder are issued, but these merely represent the securities. A person does not automatically acquire legal ownership by having possession of the certificate. Instead, the issuer (or its appointed agent) maintains a register in which details of the holder of the securities are entered and updated as appropriate. A transfer of registered securities is effected by amending the register.

Non-certificated securities and global certificates

Modern practice has developed to eliminate both the need for certificates and maintenance of a complete security register by the issuer. There are two general ways this has been accomplished.

Non-certificated securities

In some jurisdictions, such as France, it is possible for issuers of that jurisdiction to maintain a legal record of their securities electronically. In the United States, the current "official" version of Article 8 of the Uniform Commercial Code permits non-certificated securities. However, the "official" UCC is a mere draft that must be enacted individually by each U.S. state. Though all 50 states (as well as the District of Columbia and the U.S. Virgin Islands) have enacted some form of Article 8, many of them still appear to use older versions of Article 8, including some that did not permit non-certificated securities.[5]
Global certificates, book entry interests, depositories

To facilitate the electronic transfer of interests in securities without dealing with inconsistent versions of Article 8, a system has developed whereby issuers deposit a single global certificate representing all the outstanding securities of a class or series with a universal depository. This depository is called The Depository Trust Company, or DTC. DTC's parent, Depository Trust & Clearing Corporation (DTCC), is a non-profit cooperative owned by approximately thirty of the largest Wall Street players that typically act as brokers or dealers in securities. These thirty banks are called the DTC participants. DTC, through a legal nominee, owns each of the global securities on behalf of all the DTC participants. All securities traded through DTC are in fact held, in electronic form, on the books of various intermediaries between the ultimate owner, e.g. a retail investor, and the DTC participants. For example, Mr. Smith may hold 100 shares of Coca Cola, Inc. in his brokerage account at local broker Jones & Co. brokers. In turn, Jones & Co. may hold 1000 shares of Coca Cola on behalf of Mr. Smith and nine other customers. These 1000 shares are held by Jones & Co. in an account with Goldman Sachs, a DTC participant, or in an account at another DTC participant. Goldman Sachs in turn may hold millions of Coca Cola shares on its books on behalf of hundreds of brokers similar to Jones & Co. Each day, the DTC participants settle their accounts with the other DTC participants and adjust the number of shares held on their books for the benefit of customers like Jones & Co. Ownership of securities in this fashion is called beneficial ownership. Each intermediary holds on behalf of someone beneath him in the chain. The ultimate owner is called the beneficial owner. This is also referred to as owning in "Street name". Among brokerages and mutual fund companies, a large amount of mutual fund share transactions take place among intermediaries as opposed to shares being sold and redeemed directly with the transfer agent of the fund. Most of these intermediaries such as brokerage firms clear the shares electronically through the National Securities Clearing Corp. or "NSCC", a subsidiary of DTCC.
Other depositories: Euroclear and Clearstream

Besides DTC, two other large securities depositories exist, both in Europe: Euroclear and Clearstream.

Divided and undivided security

The terms "divided" and "undivided" relate to the proprietary nature of a security. Each divided security constitutes a separate asset, which is legally distinct from each other security in the same issue. Pre-electronic bearer securities were divided. Each instrument constitutes the separate covenant of the issuer and is a separate debt. With undivided securities, the entire issue makes up one single asset, with each of the securities being a fractional part of this undivided whole. Shares in the secondary markets are always undivided. The issuer owes only one set of obligations to shareholders under its memorandum, articles of association and company law. A share represents an undivided fractional part of the issuing company. Registered debt securities also have this undivided nature.

Fungible and non-fungible security

The terms "fungible" and "non-fungible" are a feature of assets. If an asset is fungible, this means that if such an asset is lent, or placed with a custodian, it is customary for the borrower or custodian to be obliged at the end of the loan or custody arrangement to return assets equivalent to the original asset, rather than the specific identical asset. In other words, the redelivery of fungibles is equivalent and not in specie. In other words, if an owner of 100 shares of IBM transfers custody of those shares to another party to hold for a purpose, at the end of the arrangement, the holder need simply provide the owner with 100 shares of IBM identical to those received. Cash is also an example of a fungible asset. The exact currency notes received need not be segregated and returned to the owner. Undivided securities are always fungible by logical necessity. Divided securities may or may not be fungible, depending on market practice. The clear trend is towards fungible arrangements.

Regulation
In the US, the public offer and sale of securities must be either registered pursuant to a registration statement that is filed with the U.S. Securities and Exchange Commission (SEC) or are offered and sold pursuant to an exemption therefrom. Dealing in securities is regulated by both federal authorities (SEC) and state securities departments. In addition, the brokerage industry is supposedly self policed by Self Regulatory Organizations (SROs), such as the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (or NASD) or the MSRB. With respect to investment schemes that do not fall within the traditional categories of securities listed in the definition of a security (Sec. 2(a)(1) of the 33 act and Sec. 3(a)(10) of the 34 act) the US Courts have developed a broad definition for securities that must then be registered with the SEC. When determining if there a is an "investment contract" that must be registered the courts look for an investment of money, a common enterprise and expectation of profits to come primarily from the efforts of others. See SEC v. W.J. Howey Co. and SEC v. Turner."

A financial instrument is a tradable asset of any kind; either cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument. According to IAS 32 and 39, it is defined as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity

Categorization
Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments:

Cash instruments are financial instruments whose value is determined directly by the markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. Derivative instruments are financial instruments which derive their value from the value and characteristics of one or more underlying entities such as an asset, index, or interest rate. They can be divided into exchange-traded derivatives and over-the-counter (OTC) derivatives.

Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category.

A table
Combining the above methods for categorization, the main instruments can be organized into a table as follows: Instrument Type Asset Class Securities Other cash Exchange-traded derivatives Bond futures Options on bond futures Short term interest OTC derivatives Interest rate swaps Interest rate caps and floors Interest rate options Exotic instruments Forward rate

Debt (Long Term) >1 year Debt (Short

Bonds

Loans

Bills, e.g. T-

Deposits

Term) <=1 year

Bills Commercial paper Stock

Certificates of deposit

rate futures

agreements

Equity

N/A

Stock options Equity futures

Stock options Exotic instruments Foreign exchange options Outright forwards Foreign exchange swaps Currency swaps

Foreign Exchange

N/A

Spot foreign exchange

Currency futures

Some instruments defy categorization into the above matrix, for example repurchase agreements.

Measuring Financial Instrument's Gain or Loss

The table below shows how to measure a financial instrument's gain or loss: Instrument Type

Categories Loans and receivables Available for sale financial assets

Measurement

Gains and losses Net income when asset is derecognized or impaired (foreign exchange and impairment recognized in net income immediately)

Assets

Amortized costs

Assets

Deposit account - Other comprehensive income (impairment Fair value recognized in net income immediately)

A currency (from Middle English curraunt, meaning in circulation) in the most specific use of the word refers to money in any form when in actual use or circulation, as a medium of exchange, especially circulating paper money. This use is synonymous with banknotes, or (sometimes) with banknotes plus coins, meaning the physical tokens used for money by a government.[1][2] A much more general use of the word currency is anything that is used in any circumstances, as a medium of exchange. In this use, "currency" is a synonym for the concept of money.[3] A definition of intermediate generality is that a currency is a system of money (monetary units) in common use, especially in a nation.[4] Under this definition, British pounds, U.S. dollars, and European euros are different types of currency, or currencies. Currencies in this definition need not be physical objects, but as stores of value are subject to trading between nations in foreign exchange markets, which determine the relative values of the different currencies.[5] Currencies

in the sense used by foreign exchange markets, are defined by governments, and each type has limited boundaries of acceptance. The former definitions of the term "currency" are discussed in their respective synonymous articles banknote, coin, and money. The latter definition, pertaining to the currency systems of nations, is the topic of this article Currency evolved from two basic innovations, both of which had occurred by 2000 BC. Originally money was a form of receipt, representing grain stored in temple granaries in Sumer in ancient Mesopotamia, then Ancient Egypt. This first stage of currency, where metals were used to represent stored value, and symbols to represent commodities, formed the basis of trade in the Fertile Crescent for over 1500 years. However, the collapse of the Near Eastern trading system pointed to a flaw: in an era where there was no place that was safe to store value, the value of a circulating medium could only be as sound as the forces that defended that store. Trade could only reach as far as the credibility of that military. By the late Bronze Age, however, a series of treaties had established safe passage for merchants around the Eastern Mediterranean, spreading from Minoan Crete and Mycenae in the northwest to Elam and Bahrain in the southeast. Although it is not known what functioned as a currency to facilitate these exchanges, it is thought that ox-hide shaped ingots of copper, produced in Cyprus may have functioned as a currency. It is thought that the increase in piracy and raiding associated with the Bronze Age collapse, possibly produced by the Peoples of the Sea, brought this trading system to an end. It was only with the recovery of Phoenician trade in the ninth and tenth centuries BC that saw a return to prosperity, and the appearance of real coinage, possibly first in Anatolia with Croesus of Lydia and subsequently with the Greeks and Persians. In Africa many forms of value store have been used including beads, ingots, ivory, various forms of weapons, livestock, the manilla currency, ochre and other earth oxides, and so on. The manilla rings of West Africa were one of the currencies used from the 15th century onwards to buy and sell slaves. African currency is still notable for its variety, and in many places various forms of barter still apply.

Coinage
Main article: Coin These factors led to the shift of the store of value being the metal itself: at first silver, then both silver and gold, at one point there was bronze as well. Now we have copper coins and other nonprecious metals as coins. Metals were mined, weighed, and stamped into coins. This was to assure the individual taking the coin that he was getting a certain known weight of precious metal. Coins could be counterfeited, but they also created a new unit of account, which helped lead to banking. Archimedes' principle provided the next link: coins could now be easily tested for their fine weight of metal, and thus the value of a coin could be determined, even if it had been shaved, debased or otherwise tampered with (see Numismatics). In most major economies using coinage, copper, silver and gold formed three tiers of coins. Gold coins were used for large purchases, payment of the military and backing of state activities.

Silver coins were used for midsized transactions, and as a unit of account for taxes, dues, contracts and fealty, while copper coins represented the coinage of common transaction. This system had been used in ancient India since the time of the Mahajanapadas. In Europe, this system worked through the medieval period because there was virtually no new gold, silver or copper introduced through mining or conquest.[citation needed] Thus the overall ratios of the three coinages remained roughly equivalent.

Paper money
Main article: Banknote In premodern China, the need for credit and for circulating a medium that was less of a burden than exchanging thousands of copper coins led to the introduction of paper money, commonly known today as banknotes. This economic phenomenon was a slow and gradual process that took place from the late Tang Dynasty (618907) into the Song Dynasty (9601279). It began as a means for merchants to exchange heavy coinage for receipts of deposit issued as promissory notes from shops of wholesalers, notes that were valid for temporary use in a small regional territory. In the 10th century, the Song Dynasty government began circulating these notes amongst the traders in their monopolized salt industry. The Song government granted several shops the sole right to issue banknotes, and in the early 12th century the government finally took over these shops to produce state-issued currency. Yet the banknotes issued were still regionally valid and temporary; it was not until the mid 13th century that a standard and uniform government issue of paper money was made into an acceptable nationwide currency. The already widespread methods of woodblock printing and then Pi Sheng's movable type printing by the 11th century was the impetus for the massive production of paper money in premodern China.

Song Dynasty Jiaozi, the world's earliest paper money At around the same time in the medieval Islamic world, a vigorous monetary economy was created during the 7th12th centuries on the basis of the expanding levels of circulation of a stable high-value currency (the dinar). Innovations introduced by Muslim economists, traders and merchants include the earliest uses of credit,[6] cheques, promissory notes,[7] savings accounts, transactional accounts, loaning, trusts, exchange rates, the transfer of credit and debt,[8] and banking institutions for loans and deposits.[8] In Europe, paper money was first introduced in Sweden in 1661. Sweden was rich in copper, thus, because of copper's low value, extraordinarily big coins (often weighing several kilograms) had to be made. The advantages of paper currency were numerous: it reduced transport of gold and silver, and thus lowered the risks; it made loaning gold or silver at interest easier, since the specie (gold or silver) never left the possession of the lender until someone else redeemed the note; and it allowed for a division of currency into credit and specie backed forms. It enabled the sale of stock in joint stock companies, and the redemption of those shares in paper. However, these advantages held within them disadvantages. First, since a note has no intrinsic value, there was nothing to stop issuing authorities from printing more of it than they had specie to back it with. Second, because it increased the money supply, it increased inflationary pressures, a fact observed by David Hume in the 18th century. The result is that paper money would often lead to an inflationary bubble, which could collapse if people began demanding hard money, causing the demand for paper notes to fall to zero. The printing of paper money was also

associated with wars, and financing of wars, and therefore regarded as part of maintaining a standing army. For these reasons, paper currency was held in suspicion and hostility in Europe and America. It was also addictive, since the speculative profits of trade and capital creation were quite large. Major nations established mints to print money and mint coins, and branches of their treasury to collect taxes and hold gold and silver stock. At this time both silver and gold were considered legal tender, and accepted by governments for taxes. However, the instability in the ratio between the two grew over the course of the 19th century, with the increase both in supply of these metals, particularly silver, and of trade. This is called bimetallism and the attempt to create a bimetallic standard where both gold and silver backed currency remained in circulation occupied the efforts of inflationists. Governments at this point could use currency as an instrument of policy, printing paper currency such as the United States Greenback, to pay for military expenditures. They could also set the terms at which they would redeem notes for specie, by limiting the amount of purchase, or the minimum amount that could be redeemed. By 1900, most of the industrializing nations were on some form of gold standard, with paper notes and silver coins constituting the circulating medium. Private banks and governments across the world followed Gresham's Law: keeping gold and silver paid, but paying out in notes. This did not happen all around the world at the same time, but occurred sporadically, generally in times of war or financial crisis, beginning in the early part of the 20th century and continuing across the world until the late 20th century, when the regime of floating fiat currencies came into force. One of the last countries to break away from the gold standard was the United States in 1971. No country anywhere in the world today has an enforceable gold standard or silver standard currency system.

Banknote era
Main articles: Banknote and Fiat currency A banknote (more commonly known as a bill in the United States and Canada) is a type of currency, and commonly used as legal tender in many jurisdictions. With coins, banknotes make up the cash form of all money. Banknotes are mostly paper, but Australia's Commonwealth Scientific and Industrial Research Organisation developed the world's first polymer currency in the 1980s that went into circulation on the nation's bicentenary in 1988. Now used in some 22 countries (over 40 if counting commemorative issues), polymer currency dramatically improves the life span of banknotes and prevents counterfeiting.

Modern currencies
Main article: Tables of historical exchange rates to the USD

Currencies exchange logo To find out which currency is used in a particular country, check list of circulating currencies. Currency use is based on the concept of lex monetae; that a sovereign state decides which currency it shall use. Currently, the International Organization for Standardization has introduced a three-letter system of codes (ISO 4217) to define currency (as opposed to simple names or currency signs), in order to remove the confusion that there are dozens of currencies called the dollar and many called the franc. Even the pound is used in nearly a dozen different countries, all, of course, with wildly differing values. In general, the three-letter code uses the ISO 3166-1 country code for the first two letters and the first letter of the name of the currency (D for dollar, for instance) as the third letter. United States currency, for instance is globally referred to as USD. It is also possible for a currency to be internet-based and digital, for instance, Bitcoin,[9] the Ripple Pay system or MintChip, and not tied to any specific country. The International Monetary Fund uses a variant system when referring to national currencies.

Control and production

In most cases, a central bank has monopoly control over emission of coins and banknotes (fiat money) for its own area of circulation (a country or group of countries); it regulates the production of currency by banks (credit) through monetary policy. In order to facilitate trade between these currency zones, there are different exchange rates, which are the prices at which currencies (and the goods and services of individual currency zones) can be exchanged against each other. Currencies can be classified as either floating currencies or fixed currencies based on their exchange rate regime. In cases where a country does have control of its own currency, that control is exercised either by a central bank or by a Ministry of Finance. In either case, the institution that has control of monetary policy is referred to as the monetary authority. Monetary authorities have varying degrees of autonomy from the governments that create them. In the United States, the Federal Reserve System operates without direct oversight by the legislative or executive branches. A

monetary authority is created and supported by its sponsoring government, so independence can be reduced by the legislative or executive authority that creates it. Several countries can use the same name for their own distinct currencies (for example, dollar in Australia, Canada and the United States). By contrast, several countries can also use the same currency (for example, the euro), or one country can declare the currency of another country to be legal tender. For example, Panama and El Salvador have declared U.S. currency to be legal tender, and from 17911857, Spanish silver coins were legal tender in the United States. At various times countries have either re-stamped foreign coins, or used currency board issuing one note of currency for each note of a foreign government held, as Ecuador currently does. Each currency typically has a main currency unit (the dollar, for example, or the euro) and a fractional currency, often valued at 1100 of the main currency: 100 cents = 1 dollar, 100 centimes = 1 franc, 100 pence = 1 pound, although units of 110 or 11000 are also common. Some currencies do not have any smaller units at all, such as the Icelandic krna. Mauritania and Madagascar are the only remaining countries that do not use the decimal system; instead, the Mauritanian ouguiya is divided into 5 khoums, while the Malagasy ariary is divided into 5 iraimbilanja. In these countries, words like dollar or pound "were simply names for given weights of gold."[10] Due to inflation khoums and iraimbilanja have in practice fallen into disuse. (See non-decimal currencies for other historic currencies with non-decimal divisions).

Currency convertibility
Convertibility of a currency determines the ability of an individual, corporate or government to convert its local currency to another currency or vice versa with or without central bank/government intervention. Based on the above restrictions or free and readily conversion features currencies are classified as:

Fully Convertible - When there are no restrictions or limitations on the amount of currency that can be traded on the international market, and the government does not artificially impose a fixed value or minimum value on the currency in international trade. The US dollar is an example of a fully convertible currency and for this reason, US dollars are one of the major currencies traded in the FOREX[11] market. Partially Convertible - Central Banks control international investments flowing in and out of the country, while most domestic trade transactions are handled without any special requirements, there are significant restrictions on international investing and special approval is often required in order to convert into other currencies. The Indian Rupee is an example of a partially convertible currency. Nonconvertible - Neither participate in the international FOREX market nor allow conversion of these currencies by individuals or companies. As a result, these currencies are known as blocked currencies. e.g.: North Korean Won and the Cuban Peso

Local currencies

Main article: Local currency In economics, a local currency is a currency not backed by a national government, and intended to trade only in a small area. Advocates such as Jane Jacobs argue that this enables an economically depressed region to pull itself up, by giving the people living there a medium of exchange that they can use to exchange services and locally produced goods (In a broader sense, this is the original purpose of all money.) Opponents of this concept argue that local currency creates a barrier which can interfere with economies of scale and comparative advantage, and that in some cases they can serve as a means of tax evasion. Local currencies can also come into being when there is economic turmoil involving the national currency. An example of this is the Argentinian economic crisis of 2002 in which IOUs issued by local governments quickly took on some of the characteristics of local currencies. One of the best examples of a local currency is the original LETS currency, founded on Vancouver Island in the early 1980s. In 1982 the Canadian Central Banks lending rates ran up to 14% which drove chartered bank lending rates as high as 19%. The resulting currency and credit scarcity left island residents with few options other than to create a local currency.[12] What is full convertibility of rupee on capital account? Is the Indian economy ready to switch over to such full convertibility? Convertibility of the domestic currency is one of the prerequisite for complete globalisation of any economy. Along with de-controls, freer movement of goods and services, removal of tariff and non-tariff restrictions and easier mobility of the workforce, convertibility is one of the important cornerstones of the process of globalisation and economic reforms. Current account convertibility is already there and the stringent controls of pre-nineties over the foreign exchange have also been relaxed to a great extent. The stringent Foreign Exchange Regulation Act (FERA) was replaced by a relaxed Act called Foreign Exchange Management Act (FEMA), making the movement of foreign exchange easier. Resident Indians and companies now have access to foreign exchange for various purposes, including education and travel. They can also receive and make payments in foreign currencies on trade account. Full convertibility implies that the existing restrictions on the capital account would also be withdrawn. Corollary of this step would be that the domestic assets, including the real estate and stocks, could be sold to the foreigners and the payments in foreign currency could be received in the country without prior regulatory clearances. Some steps have already been taken to facilitate the full capital account convertibility in the country. Foreign exchange has been allowed to flow into Indian stock markets through registered institutional investors. In addition, many categories of the resident Indians have been allowed to open foreign currency accounts abroad. Indian companies have also been making overseas acquisitions for which they have been given access to foreign currency resources. It would, however, be wrong to presume that full convertibility on the capital account would

result in lifting of all the restrictions. Even the developed countries like the USA block foreign investment in some of the sectors. Despite the government decision in this regard, it has not been easy for the non-resident Indians to acquire property and real estate in the country. The government of India, though has allowed Direct Foreign Investment (FDI) in most of the fields, yet certain caps have been put by the government on the FDI in some of the sectors. Most of these restrictions may continue even after the capital account convertibility is introduced. Benefits would be in terms of more flow of foreign capital into the economy, resulting in higher investment and the resultant growth rate. Further, the financial and capital markets would bring more profits to the domestic investors. There are certain prerequisites for introduction of capital account full convertibility. The economy must be nearer to the global standards in the matter of fiscal deficit, inflation rate, interest rates, foreign exchange reserves, etc. It is said that the economy can be said to be ripe for capital account convertibility only if interest rates are low and de-regulated and the inflation rate in the three consecutive years had been around three per cent. In addition, fiscal deficit should be low at around 3 per cent and foreign exchange reserves should be reasonably high. Further, the economy has to be in good shape, as full convertibility would result in bringing in the instabilities and fluctuations of the outside world into the economy, as it gets more connected to the outside world. Further, imperfections in the economy, like the urban-rural dichotomy and difference in the growth rates in various sectors like agriculture and industries, as well as services, must be removed. Considering the above prerequisites it appears that the Indian economy is not yet prepared for switching over to the capital account convertibility. The only requisites which have been met are reasonably high level of foreign exchange reserves, mostly deregulated interest rates and relatively good condition of the economy as a whole. In most of the other areas there is lot more to be done. Interest rates as well as the inflation rate are higher than the required levels. Further, the imperfections of the economy are glaring as the services and industrial sectors are booming, but the agricultural sector which employs over 65 per cent of the total work force, is growing at a much lower rate of 2 to 3 per cent per annum.

Capital account convertibility is a feature of a nation's financial regime that centers on the ability to conduct transactions of local financial assets into foreign financial assets freely and at country determined exchange rates.[1] It is sometimes referred to as capital asset liberation or CAC. In layman's terms, full capital account convertibility allows local currency to be exchanged for foreign currency without any restriction on the amount.[citation needed] This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions.[citation needed] CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.[2]

History
CAC was first coined as a theory by the Reserve Bank of India in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World countries transition to globalized market economies.[3] However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 90's. Article VIII of the IMFs Articles of Agreement is agreed by most economists to have been the basis for CAC, although it notably failed to anticipate problems with the concept in regard to outflows of currency. However, before the formalization of CAC, there were problems with the theory. Free flow of assets was required to work in both directions. Although CAC freely enabled investment in the country, it also enabled quick liquidation and removal of capital assets from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.[4] As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 90's. In Malaysia, for example, there were heavy losses in overseas investments of at least one bank, in the magnitude of hundreds of millions of dollars. These were not realized and identified until a reform system strengthened regulatory and accounting controls.[5] This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation and stringent controls.[4]

Tenets
CAC has 5 basic statements designed as points of action:[6]

All types of liquid capital assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates. The amounts must be a significant amount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. Institutional investors should not use CAC to manipulate fiscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.

Application
In most traditional theories of international trade, the reasoning for capital account convertibility was so that foreign investors could invest without barriers. Prior to its implementation, foreign investment was hindered by uneven exchange rates due to corrupt officials, local businessmen had no convenient way to handle large cash transactions, and national banks were disassociated from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those few local companies that wished to do business abroad.

Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments.[7] When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with jobs and factories going overseas is a direct result of the foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e., investing in long term government bonds, etc.) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.

Controversy
Despite changes in wording over the years, and additional safeguards, there is still criticism of CAC by some economists. American economists, in particular, find the restriction on inflows to Third World countries being invested in improvements as negative, since they would rather see such transactions put to direct use in growing capital.[4][2 A market economy is an economy in which decisions regarding investment, production and distribution are based on supply and demand,[1] and prices of goods and services are determined in a free price system.[2] The major defining characteristic of a market economy is that decisions regarding investments and the allocation of producer goods is accomplished primarily through markets.[3] This is contrasted with a planned economy, where investment and production decisions are embodied in a plan of production. Market economies can range from hypothetical laissez-faire and free market variants to regulated markets and interventionist variants. In reality market economies do not exist in pure form, since societies and governments regulate them to varying degrees.[4][5] Most existing market economies include a degree of economic planning or state-directed activity, and are thus classified as mixed economies. The term free-market economy is sometimes used synonymously with market economy, but it may also refer to laissez-faire or Free-market anarchism.[6] Market economies do not logically presuppose the existence of private property in the means of production; a market economy can consist of various types of cooperatives, collectives or autonomous state agencies that buy and sell capital goods with each other in a free price system.[7] In addition to capitalist market economies, there are many variations of market socialism that involve employee-owned enterprises based on self-management that operate in markets. Another form of market socialism involves public ownership of the means of production, where goods and services are distributed through markets.[8] The term market economy used by itself can be somewhat misleading. For example, the United States constitutes a mixed economy (substantial market regulation, agricultural subsidies, extensive government-funded research and development, Medicare/Medicaid), yet at the same time it is foundationally rooted in a market economy. Different perspectives exist as to how

strong a role the government should have in both guiding the market economy and addressing the inequalities the market produces. Capitalism generally refers to economic system in which the means of production are largely or entirely privately owned and operated for a profit, structured on the process of capital accumulation. In general, investments, distribution, income, and pricing is determined by markets. There are different variations of capitalism and these different variations have different relationships to markets. In free-market and Laissez-faire forms of capitalism, markets are utilized most extensively with minimal or no regulation over the pricing mechanism. In interventionist, Keynesian and mixed economies, markets continue to play a dominant role but are regulated to some extent by government in order to correct market failures or to promote social welfare. In state capitalist systems, markets are relied upon the least, and the state relies heavily on either indirect economic planning and/or state-owned enterprises to accumulate capital. Capitalism has been dominant in the Western world since the end of feudalism, but most feel[who?] that the term "mixed economies" more precisely describes most contemporary economies, due to their containing both private-owned and state-owned enterprises. In capitalism, prices are decided by the demand-supply scale. For example, higher demand for certain goods and services lead to higher prices and lower demand for certain goods lead to lower prices.

Anglo-Saxon model
Main article: Anglo-Saxon economy

Anglo-Saxon capitalism refers to the form of capitalism that is predominant in Anglophone countries and typified by the economy of the United States, as contrasted with European models of capitalism such as the continental Social market model and the Nordic model. It refers to a common macroeconomic policy regime and capital market structure among these economies. The Anglo-Saxon model features lower rates of taxation, more open financial markets, and a less generous welfare state eschewing collective bargaining schemes found in continental and northern European models of capitalism.

Laissez-faire
Main article: Laissez-faire

Laissez-faire is synonymous with what was referred to as strict capitalist free market economy during the early and mid-19th century as an ideal to achieve. It is generally understood that the necessary components for the functioning of an idealized free market include the complete absence of government regulation, subsidies, artificial price pressures and government-granted monopolies (usually classified as coercive monopoly by free market advocates) and no taxes or

tariffs other than what is necessary for the government to provide protection from coercion and theft and maintaining peace, and property rights.

Social market economy

Main articles: Social market economy and Rhine Capitalism

This model was implemented by Alfred Mller-Armack and Ludwig Erhard after World War II in West Germany. The social market economic model is based upon the idea of realizing the benefits of a free market economy, especially economic performance and high supply of goods, while avoiding disadvantages such as market failure, destructive competition, concentration of economic power and anti-social effects of market processes. The aim of the social market economy is to realize greatest prosperity combined with best possible social security. As a difference to the free market economy the state is not passive, but actively takes regulative measures.[9] The social policy objectives include employment, housing and education policies, as well as a socio-politically motivated balancing of the distribution of income growth. Characteristics of social market economies are a strong competition policy and a contractionary monetary policy. The philosophical background is Neoliberalism or Ordoliberalism[10]

Market socialism
Main article: Market socialism
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Market socialism refers to various types of economic systems where the means of production and dominant economic institutions are either publicly-owned or cooperatively-owned but operated according to the rules of supply and demand. This type of market economy has its roots in classical economics and in the works of Adam Smith, the Ricardian socialists and Mutualist philosophers.[11] The distinguishing feature between non-market socialism and market socialism is the existence of a market for factors of production and the criteria of profitability for enterprises. Profits derived from the public enterprises can either be used to reinvest in production or finance government and social services directly and/or be distributed to the workforce or public at large through a social dividend.

Public ownership models

In Oskar Lange's model of market socialism, the Lange theorem, prices would be determined by a public body (Central planning board) through a trial-and-error approach until they equaled the marginal cost of production so to achieve perfect competition and pareto optimality. In this model, firms would be state-owned and managed by their employees and the profits would be disbursed among the population in a social dividend. A more contemporary model of market socialism is that put forth by John Roemer, referred to as Economic democracy, where social ownership is achieved through public ownership of equity in a market economy. In this model, a Bureau of Public Ownership (BPO) would own controlling shares in publicly-listed firms, and profits would be used for public finance and the provision of a basic income.

Cooperative socialism
Libertarian socialists and left-anarchists often promote a form of market socialism in which enterprises are owned and managed cooperatively by the workers so that the profits directly

remunerate the employee-owners. These cooperative enterprises would compete with each other in the same way private companies compete in a capitalist market. An example would be mutualism, as promoted by early anarchists. Self-managed market socialism was promoted in Yugoslavia by economists Branko Horvat and Jaroslav Vanek. In the self-managed model, firms would be directly owned by their employees and management would be elected by employees. These cooperative firms would compete with each other in a market in both capital goods and for consumer goods.

Socialist market economy

Following the 1978 reforms, the People's Republic of China instituted what it calls a "socialist market economy", in which most of the economy is under state ownership, but the state enterprises are reorganized into joint-stock companies where various government agencies own controlling shares through a shareholder system. Prices are set by a largely free-price system and the state-owned enterprises are not subjected to micromanagement by a government planning agency. A similar system called "socialist-oriented market economy" has been implemented in Vietnam following the i Mi reforms in 1986. However, this system is usually characterized as state capitalism instead of market socialism because there is no meaningful degree of employee self-management in firms, the state enterprises retain their profits instead of distributing them to the workforce or government, and many function as de facto private enterprises. The profits neither finance a social dividend to benefit the population at large, nor do they accrue to their employees. Robin Hahnel and Michael Albert claim that "markets inherently produce class division."[12] Albert states that even if everyone started out with a balanced job complex (doing a mix of roles of varying creativity, responsibility and empowerment) in a market economy, class divisions would arise. "(...) Without taking the argument that far, it is evident that in a market system with uneven distribution of empowering work, such as Economic Democracy, some workers will be more able than others to capture the benefits of economic gain. For example, if one worker designs cars and another builds them, the designer will use his cognitive skills more frequently than the builder. In the long term, the designer will become more adept at conceptual work than the builder, giving the former greater bargaining power in a firm over the distribution of income. A conceptual worker who is not satisfied with his income can threaten to work for a company that will pay him more. The effect is a class division between conceptual and manual laborers, and ultimately managers and workers, and a de facto labor market for conceptual workers (...)".[12] David McNally argues that the logic of the market is inherently inequitable and based on unequal exchanges, and that Adam Smith's moral intent and moral philosophy of equal exchange was undermined by the practice of the free markets he championed. The development of the market economy involved coercion, exploitation and violence that Adam Smith's moral philosophy could not countenance. McNally also criticizes market socialists for believing in the possibility of fair markets based on equal exchanges achieved by purging "parasitical" elements, such as

private ownership of the means of production, from the equation. McNally argues that market socialism is an oxymoron when socialism implies an end to wage-based labor.[13]

India has been relentlessly moving on the path towards liberalization, opening up its markets and
loosening its controls over many economic matters so as to integrate with the global economy.

Despite the opposition to globalization from some quarters, India has been quite watchful in its approach to embracing global economy. The issue of capital account convertibility is one such where the nation has tread very cautiously. A high-level committee to look into this matter, appointed by the Reserve Bank of India [ Get Quote ], on Friday recommended that India move to fuller capital account convertibility over the next five years and has laid down the roadmap for the move. So what is capital account convertibility? To put is simply, capital account convertibility (CAC) -- or a floating exchange rate -- means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. This means that capital account convertibility allows anyone to freely move from local currency into foreign currency and back. It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the financial system. A capital account refers to capital transfers and acquisition or disposal of non-produced, nonfinancial assets, and is one of the two standard components of a nation's balance of payments. The other being the current account, which refers to goods and services, income, and current transfers. How are capital a/c convertibility and current a/c convertibility different? Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments -- receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc. Why capital account convertibility? Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as they can re-convert local currency into foreign currency anytime they want to and take their money away.

At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. At the moment, India has current account convertibility. This means one can import and export goods or receive or make payments for services rendered. However, investments and borrowings are restricted. But economists say that jumping into capital account convertibility game without considering the downside of the step could harm the economy. The East Asian economic crisis is cited as an example by those opposed to capital account convertibility. Even the World Bank has said that embracing capital account convertibility without adequate preparation could be catastrophic. But India is now on firm ground given its strong financial sector reform and fiscal consolidation, and can now slowly but steadily move towards fuller capital account convertibility. What is the Tarapore Committee? The Reserve Bank of India has appointed a committee to set out the framework for fuller Capital Account Convertibility. The Committee, chaired by former RBI governor S S Tarapore, was set up by the Reserve Bank of India in consultation with the Government of India to revisit the subject of fuller capital account convertibility in the context of the progress in economic reforms, the stability of the external and financial sectors, accelerated growth and global integration. Economists Surjit S Bhalla, M G Bhide, R H Patil, A V Rajwade and Ajit Ranade were the members of the Committee. The Reserve Bank of India has also constituted an internal task force to re-examine the extant regulations and make recommendations to remove the operational impediments in the path of liberalisation already in place. The task force will make its recommendations on an ongoing basis and the processes are expected to be completed by December 4, 2006. The Task Force has been set up following a recommendation of the Committee. The Task Force will be convened by Salim Gangadharan, chief general manager, in-charge, foreign exchange department, Reserve Bank of India, and will have the following terms of reference:

Undertake a review of the extant regulations that straddle current and capital accounts, especially items in one account that have implication for the other account, and iron out inconsistencies in such regulations. Examine existing repatriation/surrender requirements in the context of current account convertibility and management of capital account. Identify areas where streamlining and simplification of procedure is possible and remove the operational impediments, especially in respect of the ease with which transactions at the level of authorized entities are conducted, so as to make liberalisation more meaningful. Ensure that guidelines and regulations are consistent with regulatory intent.

Review the delegation of powers on foreign exchange regulations between Central Office and Regional offices of the RBI and examine, selectively, the efficacy in the functioning of the delegation of powers by RBI to Authorised Dealers (banks). Consider any other matter of relevance to the above.

The Task Force is empowered to devise its work procedure, constitute working groups in various areas, co-opt permanent/special invitees and meet various trade associations, representative bodies or individuals to facilitate its work. It will make recommendations on an ongoing basis to rectify the anomalies and remove operational impediments. The processes are expected to be completed by December 4, 2006. How does capital a/c convertibility affect you? As most of us know, resident Indians cannot move their money abroad freely. That is, one has to operate within the limits specified by the Reserve Bank of India and obtain permission from RBI for anything concerning foreign currency. For example, the annual limit for the amount you are allowed to carry on a private visit abroad is $10,000: of which only $5,000 can be in cash. For business travel, the yearly limit is $25,000. Similarly, you can gift or donate up to $5,000 in a year. The RBI limit raises the limit if you are going abroad for employment, or are emigrating to another country, or are going for studies abroad: the limit in both these cases is $100,000. You are also allowed to invest into foreign stock markets up to the extent of $25,000 in a year. For the average Indian, these 'limits' seem generous and might not affect him at all. But for heavy spenders and those with visions of buying a house abroad or a Van Gogh painting, it will mean a lot. . . But with the markets opening up further with the advent of capital account convertibility, one would be able to look forward to more and better goods and services. And how will it affect Non-Resident Indians? Capital account convertibility may NRIs as it will help remove all shackles on movement of their funds. Currently, NRIs have to produce a whole lot of documents and certificates if they want to buy a house in India (for which the lock-in period is 10 years, meaning they can't take their money back overseas if they sell the house after having owned it for less than 10 years), or send money to India from their overseas accounts. NRIs: Tax benefits may be removed

However, the Tarapore Committee on fuller capital account convertibility has recommended bringing foreign individuals on par with Non-Resident Indians in terms of convertibility and tax treatment. The committee has proposed that the government must review tax benefits offered to NRIs for investments in foreign currency non-resident (banks) and non-resident (external) rupee account deposit schemes, while suggesting that foreign individuals be allowed to invest in these deposit schemes but without any tax concessions. The committee said a movement towards capital account convertibility implied that all nonresidents (corporates and individuals) should get equal treatment. This means that the tax benefits extended to NRIs under these schemes should be removed. The committee recommends that these deposit schemes should be extended to non-residents (other than NRIs), in two phases. In Phase I, non-residents could first be provided the FCNR (B) deposit facility, without tax benefits, subject to know-your-customer (customer identification) and financial action task force's (FATF) anti-money laundering norms. Similarly, in Phase II, the NR(E)RA deposit scheme, with cheque writing facility, could also be extended to non-residents. With respect to the capital market, at present only NRIs are allowed to invest in companies listed on the Indian stock exchanges, subject to certain stipulations. The committee said all individual non-residents and non-resident corporates should be allowed to invest in the Indian stock market through Sebi-registered entities, including mutual funds and portfolio management schemes. These entities will be responsible for meeting KYC and FATF norms and the money should come through bank accounts in India. The committee has also recommended that the resident foreign currency (RFC) and RFC (deposit) accounts should be merged. The account holders should be allowed to move foreign currency balances to overseas banks. For those wishing to continue with the RFC accounts, foreign currency current/savings chequable accounts should be provided, in addition to the foreign currency term deposits. Capital account and, by extension, full convertibility of the rupee has emerged as an often debated issue in the context of the liberalization process in India. It is worth nothing, at the outset, that India is not alone in its endeavor to make its currency convertibility, nor is it the only country which is facing the daunting task of overcoming several hurdles on its way to full currency convertibility. Indeed, only the developed economics of North

America, Western Europe, Japan and Australia have joined the race towards full convertibility. A number of Latin American, Central European and Asian Countries, however, have joined the race towards full convertibility. Aside from India, the list of these countries include Argentina, China, Chile, Columbia, Indonesia, Malaysia, Philippines, Republic of Korea and Thailand. Importantly, these countries are not at the same stage of currency convertibility. The Korean currency, for example, is much convertible than the Chinese currency. Indeed, it is important to note at the outset that the issue is not a matter of choice between convertibility and nonconvertibility. There exists a wide spectrum between these two extremes, and India and the aforementioned countries lie at various points of this spectrum. The important issue, in other words, is to decide the extent to which a currency (say, the rupee) will be convertible at a point of time, and the pace at which it will attain higher levels of convertibility in the future. In order to appreciate the meaning and the implication of currency convertibility, however, one has to first take into consideration two different aspects. A currency, it has to be noted, can be convertible on the current account of balance of payments (BOP), and/or on the capital account of BOP. The currency is deemed fully convertible if it is convertible on both these accounts. A clear understanding of the notion of convertibility, therefore, entails an understanding of the current and capital accounts of BOP. As such, the current account of the BOP comprises trade in goods and services. In other words, the current account balance takes into account exports, imports, and net foreign income from unilateral transfers. The capital account of the BOP, on the other hand, takes into account crossborder flow of funds that are associated with financial or other assets in the trading countries. For example, the direct and portfolio investments made by foreign investors, in India, are captured by the capital account balance of the BOP. The capital account also encompasses foreign investments of Indian companies, foreign aid and bank deposits of Non-resident Indians (NRI). A currency is deemed convertible on the current account if it can be freely converted into other convertible currencies for purchase and sale of commodities and services. For example, if the rupee is convertible on the current account an Indian firm should be able to freely convert rupee into Yen (JPY) to purchase mods from a Japanese Company. Similarly, a German company should be able to freely convert the mark (DM) into rupee to pay an Indian software consultancy firm for its services. It is evident that the ideal of free trade lies at the heart of current account convertibility. Capital account convertibility, on the other hand, implies the right to transact in financial and other assets with foreign countries without restriction. For example, if a currency is convertible on the capital account, the residents of the domestic currency may freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility. Convertibility as an issue, and subsequently as a goal, was a priority in the agenda of the member countries of the International Monetary Fund (IMF) which was born out of the Bretton Woods Agreement. During the Bretton Woods period, "[t]he term convertibility [was] used in two

different contexts: convertibility into gold and convertibility into other currencies. Only the United States maintained gold convertibility during Bretton woods... Convertibility into other currencies for current account transaction purposes was a main goal of Bretton Woods and was reached, to a large extent, early on in the system; however, the agreements to the IMF allowed more flexibility with regard to the imposition of exchange controls on capital account transactions. The flexibility was partly a result of a prevailing feeling that short-run speculative capital flows could be potentially destabilising and governments should therefore have the freedom to resist them." Owing to other reasons, developing countries have historically not had convertible currencies. Typically, their currencies have been partially convertible on the current account and the capital of the BOP, the rationale for the choice being embedded in the macroeconomic realities and the policy perspectives of the countries concerned. In India, the rupee was made convertible on the current account in August 1994. However, the currency as yet has limited convertibility on the capital account, and that indeed is the centre of a countrywide debate. What might be the rationale behind the aforementioned choice: making rupee convertible on the current account while maintaining exchange control for capital account transactions? What, indeed, are the policy implications of free capital mobility that is associated with Capitalism is an economic system that is based on private ownership of the means of production and the creation of goods and services for profit. Other elements central to capitalism include capital accumulation and competitive markets.[1] In a capitalist system, wage rates, costs of goods and services, interest rates, the production and hierarchy of capital and consumer goods are coordinated by supply and demand in a free price system.[2][3] There are multiple variants of capitalism, including laissez-faire, welfare capitalism and state capitalism. Capitalism is considered to have been applied in a variety of historical cases, varying in time, geography, politics, and culture.[4] There is general agreement that capitalism became dominant in the Western world following the demise of feudalism.[5] Economists (including political economists) and historians have taken different perspectives on the analysis of capitalism. Economists usually emphasize the degree to which government does not have control over markets (laissez-faire), as well as the importance of property rights.[6][7] Most political economists emphasize private property as well, in addition to power relations, wage labor, class, and the uniqueness of capitalism as a historical formation.[8] The extent to which different markets are free, as well as the rules defining private property, is a matter of politics and policy. Many states have what are termed mixed economies, referring to the varying degree of planned and market-driven elements in an economic system.[8] In the 20th century, in reaction to the negative connotations sometimes associated with capitalism, defenders of the capitalist system often replaced the terms capitalist and capitalism by phrases such as free enterprise and private enterprise.[9] The term capitalism gradually spread throughout the Western world in the 19th and 20th centuries largely through the writings of Karl Marx
capital account and have full convertibility? Is India ready for full currency convertibility?

There are a number of different elements in the capitalist socio-economic system. Capitalism is defined as a social and economic system where capital assets are mainly owned and controlled by private persons, where labor is purchased for money wages, capital gains accrue to private owners, and the price mechanism is utilized to allocate capital goods between uses. The extent to which the price mechanism is used, the degree of competitiveness, and government intervention in markets distinguish exact forms of capitalism.[10] There are different variations of capitalism which have different relationships to markets and the state. In free-market and Laissez-faire forms of capitalism, markets are utilized most extensively with minimal or no regulation over the pricing mechanism. In interventionist and mixed economies, markets continue to play a dominant role but are regulated to some extent by government in order to correct market failures, promote social welfare, conserve natural resources, and fund defense and public safety. In state capitalist systems, markets are relied upon the least, with the state relying heavily on state-owned enterprises or indirect economic planning to accumulate capital. Capitalism and capitalist economics is generally considered to be the opposite of socialism, which contrasts with all forms of capitalism in the following ways: social ownership of the means of production, where returns on the means of production accrue to society at large, and goods and services are produced directly for their utility (as opposed to being produced by profitseeking businesses).

Factors of production
A product is any good produced for exchange on a market. A commodity refers to any good exchanged in a market, but more recently refers solely to standard products such as raw materials. There are two types of products:

capital goods (or the means of production including intermediate goods) consumer goods capital goods (i.e., raw materials, tools, industrial machines, vehicles, and factories) are used to produce consumer goods (e.g., televisions, cars, computers, houses) to be sold to others.

The three inputs required for production are:

labor (including human capital) land (i.e., natural resources, which exist prior to human beings) and capital goods

Capitalism entails the private ownership of the latter two natural resources and capital goods by a class of owners called capitalists, either individually, collectively or through a state apparatus that operates to maximize profits or that serves the interests of capital owners.

Money, capital, and accumulation

Money was primarily a standardized medium of exchange, and final means of payment, that serves to measure the value of all goods and commodities in a standard of value. It is an abstraction of economic value and medium of exchange that eliminates the cumbersome system of barter by separating the transactions involved in the exchange of products, thus greatly facilitating specialization and trade through encouraging the exchange of commodities. Capitalism involves the further abstraction of money into other exchangeable assets and the accumulation of money through ownership, exchange, interest and various other financial instruments. Capital in this sense refers to money used to buy something only in order to sell it again to realize a financial profit. The accumulation of capital refers to the process of "making money", or growing an initial sum of money through investment in production. Capitalism is based around the accumulation of capital, whereby financial capital is invested in order to realize a profit and then reinvested into further production in a continuous process of accumulation. In Marxian economic theory, this dynamic is called the law of value.

Capital and financial markets

The defining feature of capitalist markets, in contrast to markets and exchange in pre-capitalist societies like feudalism, is the existence of a market for capital goods (the means of production), meaning exchange-relations (business relationships) exist within the production process. Additionally, capitalism features a market for labor. This distinguishes the capitalist market from pre-capitalist societies which generally only contained market exchange for final goods and secondary goods. The "market" in capitalism refers to capital markets and financial markets. Capitalism is the system of raising, conserving and spending a set monetary value in a specified market. There are three main markets in a basic capitalistic economy: labor, goods and services, and financial. Labor markets (people) make products and get paid for work by the goods and services market (companies, firms, or corporations, etc.) which then sells the products back to the laborers. However, both of the first two markets pay into and receive benefits from the financial market, which handles and regulates the actual money in the economic system. This includes banks, credit-unions, stock exchanges, etc. From a monetary standpoint, governments control just how much money is in circulation worldwide, which plays an immense role on how money is spent in one's own country.

Wage labor and class structure

Wage labor refers to the class-structure of capitalism, whereby workers receive either a wage or a salary, and owners receive the profits generated by the factors of production employed in the production of economic value. Individuals who possess and supply financial capital to productive ventures become owners, either jointly (as shareholders) or individually. These owners of the means of production and suppliers of capital are generally called capitalists. The

description of the role of the capitalist has shifted, first referring to a useless intermediary between producers to an employer of producers, and eventually came to refer to owners of the means of production.[9] "Workers" includes those who expend both manual and mental (or creative) labor in production, where production does not simply mean physical production but refers to the production of both tangible and intangible economic value. "Capitalists" are individuals who derive income from investments. Labor includes all physical and mental human resources, including entrepreneurial capacity and management skills, which are needed to produce products and services. Production is the act of making products or services by applying labor power to the means of production.[11][12]

Macroeconomics
Macroeconomics keeps its eyes on things such as inflation: the rate at which money loses its value over time; growth: how much money a government has and how quickly it accrues money; unemployment, and rates of trade between other countries. Whereas microeconomics deals with individual firms, people, and other institutions that work within a set frame work of rules to balance prices and the workings of a singular government. Both micro and macroeconomics work together to form a single set of evolving rules and regulations. Governments (the macroeconomic side) set both national and international regulations that keep track of prices and corporations' (microeconomics) growth rates, set prices, and trade, while the corporations influence what federal laws are set.[13][14][15]

Types of capitalism
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There are many variants of capitalism in existence that differ according to country and region. They vary in their institutional makeup and by their economic policies. The common features among all the different forms of capitalism is that they are based on the production of goods and services for profit, predominately market-based allocation of resources, and they are structured upon the accumulation of capital. The major forms of capitalism are listed below:

Mercantilism
Main articles: Mercantilism and Protectionism

Mercantilism is a nationalist form of early capitalism that came into existence approximately in the late 16th century. It is characterized by the intertwining of national business interests to stateinterest and imperialism, and consequently, the state apparatus is utilized to advance national business interests abroad. An example of this is colonists living in America who were only allowed to trade with and purchase goods from their respective mother countries (Britain, France, etc.). Mercantilism holds that the wealth of a nation is increased through a positive balance of trade with other nations, and corresponds to the phase of capitalist development called the Primitive accumulation of capital.

Free-market capitalism
See also: Free market and Laissez-faire

Free-market capitalism refers to an economic system where prices for goods and services are set freely by the forces of supply and demand and are allowed to reach their point of equilibrium without intervention by government policy. It typically entails support for highly-competitive markets, private ownership of productive enterprises. Laissez-faire is a more extensive form of free-market capitalism where the role of the state is limited to protecting property rights.

Social-market economy
Main articles: Social market and Nordic model

A social-market economy is a nominally free-market system where government intervention in price formation is kept to a minimum but the state provides significant services in the area of social security, unemployment benefits and recognition of labor rights through national collective bargaining arrangements. This model is prominent in Western and Northern European countries, albeit in slightly different configurations. The vast majority of enterprises are privately-owned in this economic model.

State capitalism
Main article: State capitalism

State capitalism consists of state ownership of the means of production within a state. The debate between proponents of private versus state capitalism is centered around questions of managerial efficacy, productive efficiency, and fair distribution of wealth. According to Aldo Musacchio, a professor at Harvard Business School, it is a system in which governments, whether democratic or autocratic, exercise a widespread influence on the economy, through either direct ownership or various subsidies. Musacchio also emphasises the difference between today's state capitalism and its predecessors. Gone are the days when governments appointed bureaucrats to run companies. The world's largest state-owned enterprises are traded on the public markets and kept in good health by large institutional investors.[16]

Corporate capitalism
Main article: Corporate capitalism See also: State monopoly capitalism See also: Crony capitalism

Corporate capitalism is a free or mixed-market economy characterized by the dominance of hierarchical, bureaucratic corporations, which are legally required to pursue profit. Statemonopoly capitalism was originally a Marxist concept referring to a form of corporate capitalism in which state policy is utilized to benefit and promote the interests of dominant or established corporations by shielding them from competitive pressures or by providing them with subsidies.[citation needed]

Mixed economy
Main article: Mixed economy See also: Economic interventionism

A mixed economy is a largely market-based economy consisting of both private and public ownership of the means of production and economic interventionism through macroeconomic policies intended to correct market failures, reduce unemployment and keep inflation low. The degree of intervention in markets varies among different countries. Some mixed economies, such as France under dirigisme, also featured a degree of indirect economic planning over a largely capitalist-based economy. Most capitalist economies are defined as "mixed economies" to some degree.[citation needed]

Other
Other variants of capitalism include:

Anarcho-capitalism Crony capitalism Finance capitalism

Financial capitalism Late capitalism Neo-capitalism

Post-capitalism Technocapitalism Welfare capitalism

Etymology and early usage

The term capitalist as referring to an owner of capital (rather than its meaning of someone adherent to the economic system) shows earlier recorded use than the term capitalism, dating back to the mid-17th century. Capitalist is derived from capital, which evolved from capitale, a late Latin word based on protoIndo-European caput, meaning "head" also the origin of chattel and cattle in the sense of movable property (only much later to refer only to livestock). Capitale emerged in the 12th to 13th centuries in the sense of referring to funds, stock of merchandise, sum of money, or money carrying interest.[25][26][27] By 1283 it was used in the sense of the capital assets of a trading firm. It was frequently interchanged with a number of other words wealth, money, funds, goods, assets, property, and so on.[25] The Hollandische Mercurius uses capitalists in 1633 and 1654 to refer to owners of capital.[25] In French, tienne Clavier referred to capitalistes in 1788,[28] six years before its first recorded English usage by Arthur Young in his work Travels in France (1792).[27][29] David Ricardo, in his Principles of Political Other terms sometimes used for capitalism:

Capitalist mode of production Economic liberalism

[17]

Free-enterprise economy [5][18] Free market[18][19] Laissez-faire economy [20] Market economy [21] Market liberalism
[22][23]

Self-regulating market [18] Profits system[24]

Economy and Taxation (1817), referred to "the capitalist" many times.[30] Samuel Taylor Coleridge, an English poet, used capitalist in his work Table Talk (1823).[31] Pierre-Joseph Proudhon used the term capitalist in his first work, What is Property? (1840) to refer to the owners of capital. Benjamin Disraeli used the term capitalist in his 1845 work Sybil.[27] Karl Marx and Friedrich Engels used the term capitalist (Kapitalist) in The Communist Manifesto (1848) to refer to a private owner of capital. According to the Oxford English Dictionary (OED), the term capitalism was first used by novelist William Makepeace Thackeray in 1854 in The Newcomes, where he meant "having ownership of capital".[27] Also according to the OED, Carl Adolph Douai, a German-American socialist and abolitionist, used the term private capitalism in 1863. The initial usage of the term capitalism in its modern sense has been attributed to Louis Blanc in 1850 and Pierre-Joseph Proudhon in 1861.[32] Karl Marx and Friedrich Engels referred to the capitalistic system (kapitalistisches System)[33][34] and to the capitalist mode of production (kapitalistische Produktionsform) in Das Kapital (1867).[35] The use of the word "capitalism" in reference to an economic system appears twice in Volume I of Das Kapital, p. 124 (German edition), and in Theories of Surplus Value, tome II, p. 493 (German edition). Marx did not extensively use the form capitalism, but instead those of capitalist and capitalist mode of production, which appear more than 2600 times in the trilogy Das Kapital. Marx's notion of the capitalist mode of production is characterised as a system of primarily private ownership of the means of production in a mainly market economy, with a legal framework on commerce and a physical infrastructure provided by the state. He believed that no legal framework was available to protect the laborers, and so exploitation by the companies was rife.[36][page needed] Engels made more frequent use of the term capitalism; volumes II and III of Das Kapital, both edited by Engels after Marx's death, contain the word "capitalism" four and three times, respectively. The three combined volumes of Das Kapital (1867, 1885, 1894) contain the word capitalist more than 2,600 times. An 1877 work entitled Better Times by Hugh Gabutt and an 1884 article in the Pall Mall Gazette also used the term capitalism.[27] A later use of the term capitalism to describe the production system was by the German economist Werner Sombart, in his 1902 book The Jews and Modern Capitalism (Die Juden und das Wirtschaftsleben). Sombart's close friend and colleague, Max Weber, also used capitalism in his 1904 book The Protestant Ethic and the Spirit of Capitalism (Die protestantische Ethik und der Geist des Kapitalismus).

History
Main article: History of capitalism

Economic trade for profit has existed since the second millennium BC.[37] However, capitalism in its modern form is usually traced to the Mercantilism of the 16th18th Centuries.

Mercantilism

Main article: Mercantilism

A painting of a French seaport from 1638 at the height of mercantilism.

The period between the sixteenth and eighteenth centuries is commonly described as mercantilism.[38] This period, the Age of Discovery, was associated with geographic exploration being exploited by merchant overseas traders, especially from England and the Low Countries; the European colonization of the Americas; and the rapid growth in overseas trade. Mercantilism was a system of trade for profit, although commodities were still largely produced by noncapitalist production methods.[4] While some scholars see mercantilism as the earliest stage of capitalism, others argue that capitalism did not emerge until later. For example, Karl Polanyi, noted that "mercantilism, with all its tendency toward commercialization, never attacked the safeguards which protected [the] two basic elements of productionlabor and landfrom becoming the elements of commerce"; thus mercantilist attitudes towards economic regulation were closer to feudalist attitudes, "they disagreed only on the methods of regulation." Moreover Polanyi argued that the hallmark of capitalism is the establishment of generalized markets for what he referred to as the "fictitious commodities": land, labor, and money. Accordingly, "not until 1834 was a competitive labor market established in England, hence industrial capitalism as a social system cannot be said to have existed before that date."[39] Evidence of long-distance merchant-driven trade motivated by profit has been found as early as the second millennium BCE, with the Old Assyrian merchants.[37] The earliest forms of mercantilism date back to the Roman Empire and Ancient China. When the Roman Empire expanded, the mercantilist economy expanded throughout Europe. After the collapse of the Roman Empire, most of the European economy became controlled by local feudal powers, and mercantilism collapsed there, however, mercantilism persisted in Arabia, the silk road trade lines continued, and mercantilism cycled following dynasty rise and collapse in East Asia. Due to its proximity to neighboring countries, the Arabs established trade routes to Egypt, Persia, and Byzantium. As Islam spread in the 7th century, mercantilism spread rapidly to Spain, Portugal, Northern Africa, and Asia. Mercantilism finally revived in Europe in the 14th century, as mercantilism spread from Spain and Portugal.[40]

Among the major tenets of mercantilist theory was bullionism, a doctrine stressing the importance of accumulating precious metals. Mercantilists argued that a state should export more goods than it imported so that foreigners would have to pay the difference in precious metals. Mercantilists argued that only raw materials that could not be extracted at home should be imported; and promoted government subsidies, such as the granting of monopolies and protective tariffs, which mercantilists thought were necessary to encourage home production of manufactured goods.

Robert Clive after the Battle of Plassey. The battle began East India Company rule in India.

European merchants, backed by state controls, subsidies, and monopolies, made most of their profits from the buying and selling of goods. In the words of Francis Bacon, the purpose of mercantilism was "the opening and well-balancing of trade; the cherishing of manufacturers; the banishing of idleness; the repressing of waste and excess by sumptuary laws; the improvement and husbanding of the soil; the regulation of prices..."[41] Similar practices of economic regimentation had begun earlier in the medieval towns. However, under mercantilism, given the contemporaneous rise of absolutism, the state superseded the local guilds as the regulator of the economy. During that time the guilds essentially functioned like cartels that monopolized the quantity of craftsmen to earn above-market wages.[42] At the period from the 18th century, the commercial stage of capitalism originated from the start of the British East India Company and the Dutch East India Company.[43][44] These companies were characterized by their colonial and expansionary powers given to them by nation-states.[43] During this era, merchants, who had traded under the previous stage of mercantilism, invested capital in the East India Companies and other colonies, seeking a return on investment. In his "History of Economic Analysis," Joseph Schumpeter reduced mercantilist propositions to three main concerns: exchange controls, export monopolism and balance of trade.[45]

Industrialism
See also: Industrial Revolution

A Watt steam engine. The steam engine fuelled primarily by coal propelled the Industrial Revolution in Great Britain.[46]

A new group of economic theorists, led by David Hume[47] and Adam Smith, in the mid-18th century, challenged fundamental mercantilist doctrines as the belief that the amount of the worlds wealth remained constant and that a state could only increase its wealth at the expense of another state. During the Industrial Revolution, the industrialist replaced the merchant as a dominant actor in the capitalist system and affected the decline of the traditional handicraft skills of artisans, guilds, and journeymen. Also during this period, the surplus generated by the rise of commercial agriculture encouraged increased mechanization of agriculture. Industrial capitalism marked the development of the factory system of manufacturing, characterized by a complex division of labor between and within work process and the routine of work tasks; and finally established the global domination of the capitalist mode of production.[38] Britain also abandoned its protectionist policy, as embraced by mercantilism. In the 19th century, Richard Cobden and John Bright, who based their beliefs on the Manchester School, initiated a movement to lower tariffs.[48] In the 1840s, Britain adopted a less protectionist policy, with the repeal of the Corn Laws and the Navigation Acts.[38] Britain reduced tariffs and quotas, in line with Adam Smith and David Ricardo's advocacy for free trade. Karl Polanyi argued that capitalism did not emerge until the progressive commodification of land, money, and labor culminating in the establishment of a generalized labor market in Britain in the 1830s. For Polanyi, "the extension of the market to the elements of industry land, labor and money was the inevitable consequence of the introduction of the factory system in a commercial society."[49] Other sources argued that mercantilism fell after the repeal of the Navigation Acts in 1849.[48][50][51]

Keynesianism and neoliberalism

Main articles: Keynesianism and Neoliberalism

The New York stock exchange traders' floor (1963)

In the period following the global depression of the 1930s, the state played an increasingly prominent role in the capitalistic system throughout much of the world. After World War II, a broad array of new analytical tools in the social sciences were developed to explain the social and economic trends of the period, including the concepts of post-industrial society and the welfare state.[38] This era was greatly influenced by Keynesian economic stabilization policies. The postwar boom ended in the late 1960s and early 1970s, and the situation was worsened by the rise of stagflation.[52] Exceptionally high inflation combined with slow output growth, rising unemployment, and eventually recession to cause a loss of credibility in the Keynesian welfare-statist mode of regulation. Under the influence of Friedrich Hayek and Milton Friedman, Western states embraced policy prescriptions inspired by laissez-faire capitalism and classical liberalism. In particular, monetarism, a theoretical alternative to Keynesianism that is more compatible with laissez-faire, gained increasing prominence in the capitalist world, especially under the leadership of Ronald Reagan in the US and Margaret Thatcher in the UK in the 1980s. Public and political interest began shifting away from the so-called collectivist concerns of Keynes's managed capitalism to a focus on individual choice, called "remarketized capitalism." [53] In the eyes of many economic and political commentators, the collapse of the Soviet Union brought further evidence of the superiority of market capitalism over planned economy.

Globalization
Main article: Globalization

Although international trade has been associated with the development of capitalism for over five hundred years, some thinkers argue that a number of trends associated with globalization have acted to increase the mobility of people and capital since the last quarter of the 20th century, combining to circumscribe the room to maneuver of states in choosing non-capitalist models of development. Today, these trends have bolstered the argument that capitalism should now be viewed as a truly world system.[38] However, other thinkers argue that globalization, even in its quantitative degree, is no greater now than during earlier periods of capitalist trade.[54]

Perspectives
Classical political economy
Main articles: Classical economics and Classical liberalism

Adam Smith

The classical school of economic thought emerged in Britain in the late 18th century. The classical political economists Adam Smith, David Ricardo, Jean-Baptiste Say, and John Stuart Mill published analyses of the production, distribution and exchange of goods in a market that have since formed the basis of study for most contemporary economists. In France, 'Physiocrats' like Franois Quesnay promoted free trade based on a conception that wealth originated from land. Quesnay's Tableau conomique (1759), described the economy analytically and laid the foundation of the Physiocrats' economic theory, followed by Anne Robert Jacques Turgot who opposed tariffs and customs duties and advocated free trade. Richard Cantillon defined long-run equilibrium as the balance of flows of income, and argued that the supply and demand mechanism around land influenced short-term prices. Smith's attack on mercantilism and his reasoning for "the system of natural liberty" in The Wealth of Nations (1776) are usually taken as the beginning of classical political economy. Smith devised a set of concepts that remain strongly associated with capitalism today. His theories regarding the "invisible hand" are commonly misinterpreted to mean individual pursuit of self-interest unintentionally producing collective good for society.[55] It was necessary for Smith to be so forceful in his argument in favor of free markets because he had to overcome the popular mercantilist sentiment of the time period.[56]

He criticized monopolies, tariffs, duties, and other state enforced restrictions of his time and believed that the market is the most fair and efficient arbitrator of resources. This view was shared by David Ricardo, second most important of the classical political economists and one of the most influential economists of modern times.[57] In The Principles of Political Economy and Taxation (1817), he developed the law of comparative advantage, which explains why it is profitable for two parties to trade, even if one of the trading partners is more efficient in every type of economic production. This principle supports the economic case for free trade. Ricardo was a supporter of Say's Law and held the view that full employment is the normal equilibrium for a competitive economy.[58] He also argued that inflation is closely related to changes in quantity of money and credit and was a proponent of the law of diminishing returns, which states that each additional unit of input yields less and less additional output.[59] The values of classical political economy are strongly associated with the classical liberal doctrine of minimal government intervention in the economy, though it does not necessarily oppose the state's provision of a few basic public goods.[60] Classical liberal thought has generally assumed a clear division between the economy and other realms of social activity, such as the state.[61] While economic liberalism favors markets unfettered by the government, it maintains that the state has a legitimate role in providing public goods.[62] For instance, Adam Smith argued that the state has a role in providing roads, canals, schools and bridges that cannot be efficiently implemented by private entities. However, he preferred that these goods should be paid proportionally to their consumption (e.g. putting a toll). In addition, he advocated retaliatory tariffs to bring about free trade, and copyrights and patents to encourage innovation.[62]

Marxist political economy

Main article: Marxian economics

Karl Marx considered capitalism to be a historically specific mode of production (the way in which the productive property is owned and controlled, combined with the corresponding social relations between individuals based on their connection with the process of production) in which capitalism has become the dominant mode of production.[38] The capitalist stage of development or "bourgeois society," for Marx, represented the most advanced form of social organization to date, but he also thought that the working classes would come to power in a worldwide socialist or communist transformation of human society as the end of the series of first aristocratic, then capitalist, and finally working class rule was reached.[63][64]

Karl Marx

Following Adam Smith, Marx distinguished the use value of commodities from their exchange value in the market. Capital, according to Marx, is created with the purchase of commodities for the purpose of creating new commodities with an exchange value higher than the sum of the original purchases. For Marx, the use of labor power had itself become a commodity under capitalism; the exchange value of labor power, as reflected in the wage, is less than the value it produces for the capitalist. This difference in values, he argues, constitutes surplus value, which the capitalists extract and accumulate. In his book Capital, Marx argues that the capitalist mode of production is distinguished by how the owners of capital extract this surplus from workersall prior class societies had extracted surplus labor, but capitalism was new in doing so via the sale-value of produced commodities.[65] He argues that a core requirement of a capitalist society is that a large portion of the population must not possess sources of self-sustenance that would allow them to be independent, and must instead be compelled, to survive, to sell their labor for a living wage.[66][67][68] In conjunction with his criticism of capitalism was Marx's belief that exploited labor would be the driving force behind a revolution to a socialist-style economy.[69] For Marx, this cycle of the extraction of the surplus value by the owners of capital or the bourgeoisie becomes the basis of class struggle. This argument is intertwined with Marx's version of the labor theory of value arguing that labor is the source of all value, and thus of profit. Vladimir Lenin, in Imperialism, the Highest Stage of Capitalism (1916), modified classic Marxist theory and argued that capitalism necessarily induced monopoly capitalismwhich he also called "imperialism"to find new markets and resources, representing the last and highest stage of capitalism.[70] Some 20th-century Marxian economists consider capitalism to be a social formation where capitalist class processes dominate, but are not exclusive.[71] Capitalist class processes, to these thinkers, are simply those in which surplus labor takes the form of surplus value, usable as capital; other tendencies for utilization of labor nonetheless exist simultaneously in existing societies where capitalist processes are predominant. However, other

late Marxian thinkers argue that a social formation as a whole may be classed as capitalist if capitalism is the mode by which a surplus is extracted, even if this surplus is not produced by capitalist activity, as when an absolute majority of the population is engaged in non-capitalist economic activity.[72] In Limits to Capital (1982), David Harvey outlines an overdetermined, "spatially restless" capitalism coupled with the spatiality of crisis formation and resolution. Harvey used Marxs theory of crisis to aid his argument that capitalism must have its fixes but that we cannot predetermine what fixes will be implemented, nor in what form they will be. His work on contractions of capital accumulation and international movements of capitalist modes of production and money flows has been influential.[73] According to Harvey, capitalism creates the conditions for volatile and geographically uneven development [74]

Weberian political sociology

Max Weber in 1917

In social science, the understanding of the defining characteristics of capitalism has been strongly influenced by the German sociologist, Max Weber. Weber considered market exchange, a voluntary supply of labor and a planned division of labor within the entreprises as defining features of capitalism. Capitalist enterprises, in contrast to their counterparts in prior modes of economic activity, were directed toward the rationalization of production, maximizing efficiency and productivity - a tendency embedded in a sociological process of enveloping rationalization that formed modern legal bureaucracies in both public and private spheres.[75] According to Weber, workers in pre-capitalist economies understood work in terms of a personal relationship between master and journeyman in a guild, or between lord and peasant in a manor.[76] For these developments of capitalism to emerge, Weber argued, it was necessary the development of a "capitalist spirit"; that is, ideas and habits that favor a rational pursuit of economic gain. These ideas, in order to propagate a certain manner of life and come to dominate others, "had to originate somewhere... as a way of life common to whole groups of men".[77] In his book The Protestant Ethic and the Spirit of Capitalism (19041905), Weber sought to trace how a particular form of religious spirit, infused into traditional modes of economic activity, was a condition of possibility of modern western capitalism. For Weber, the 'spirit of capitalism' was, in general, that of ascetic Protestantism; this ideology was able to motivate extreme rationalization of daily life, a propensity to accumulate capital by a religious ethic to advance

economically through hard and diligent work, and thus also the propensity to reinvest capital. This was sufficient, then, to create "self-mediating capital" as conceived by Marx. This is pictured in the Protestant understanding of beruf [78] - whose meaning encompass at the same time profession, vocation, and calling - as exemplified in Proverbs 22:29, Seest thou a man diligent in his calling? He shall stand before kings. In the Protestant Ethic, Weber describes the developments of this idea of calling from its religious roots, through the understanding of someone`s economic success as a sign of his salvation, until the conception that moneymaking is, within the modern economic order, the result and the expression of diligence in ones calling. Finally, as the social mores critical for its development became no longer necessary for its maintenance, modern western capitalism came to represent the order "now bound to the technical and economic conditions of machine production which today determine the lives of all the individuals who are born into this mechanism, not only those directly concerned with economic acquisition, with irresistible force. Perhaps it will so determine them until the last ton of fossilized coal is burnt" (p. 123).[79] This is further seen in his criticism of "specialists without spirit, hedonists without a heart" that were developing, in his opinion, with the fading of the original Puritan "spirit" associated with capitalism.

Institutional economics
Main article: Institutional economics

Thorstein Veblen

Institutional economics, once the main school of economic thought in the United States, holds that capitalism cannot be separated from the political and social system within which it is

embedded. It emphasizes the legal foundations of capitalism (see John R. Commons) and the evolutionary, habituated, and volitional processes by which institutions are erected and then changed (see John Dewey, Thorstein Veblen, and Daniel Bromley.) One key figure in institutional economics was Thorstein Veblen who in his book, The Theory of the Leisure Class (1899), analyzed the motivations of wealthy people in capitalism who conspicuously consumed their riches as a way of demonstrating success. The concept of conspicuous consumption was in direct contradiction to the neoclassical view that capitalism was efficient. In The Theory of Business Enterprise (1904) Veblen distinguished the motivations of industrial production for people to use things from business motivations that used, or misused, industrial infrastructure for profit, arguing that the former often is hindered because businesses pursue the latter. Output and technological advance are restricted by business practices and the creation of monopolies. Businesses protect their existing capital investments and employ excessive credit, leading to depressions and increasing military expenditure and war through business control of political power.

German Historical School and Austrian School

Main articles: Historical school of economics and Austrian School

From the perspective of the German Historical School, capitalism is primarily identified in terms of the organization of production for markets. Although this perspective shares similar theoretical roots with that of Weber, its emphasis on markets and money lends it different focus.[38] For followers of the German Historical School, the key shift from traditional modes of economic activity to capitalism involved the shift from medieval restrictions on credit and money to the modern monetary economy combined with an emphasis on the profit motive.

Ludwig von Mises

In the late 19th century, the German Historical School of economics diverged, with the emerging Austrian School of economics, led at the time by Carl Menger. Later generations of followers of the Austrian School continued to be influential in Western economic thought in the early part of the 20th century. Austrian-born economist Joseph Schumpeter, sometimes associated with the School,[80] emphasized the "creative destruction" of capitalismthe fact that market economies undergo constant change. Schumpeter argued that at any moment in time there are rising industries and declining industries. Schumpeter, and many contemporary economists influenced by his work, argue that resources should flow from the declining to the expanding industries for an economy to grow, but they recognized that sometimes resources are slow to withdraw from the declining industries because of various forms of institutional resistance to change. The Austrian economists Ludwig von Mises and Friedrich Hayek were among the leading defenders of market economy against 20th century proponents of socialist planned economies. Mises and Hayek argued that only market capitalism could manage a complex, modern economy. Since a modern economy produces such a large array of distinct goods and services, and consists of such a large array of consumers and enterprises, argued Mises and Hayek, the information problems facing any other form of economic organization other than market capitalism would exceed its capacity to handle information. Thinkers within Supply-side economics built on the work of the Austrian School, and particularly emphasize Say's Law: "supply creates its own demand." Capitalism, to this school, is defined by lack of state restraint on the decisions of producers. Austrian economists such as Murray Rothbard argued that Marx failed to make the distinction between capitalism and mercantilism.[81][82] They argue that Marx conflated the imperialistic, colonialistic, protectionist and interventionist doctrines of mercantilism with capitalism. Austrian economics has been a major influence on some forms of libertarianism, in which laissez-faire capitalism is considered to be the ideal economic system.[83]

Keynesian economics
Main article: Keynesian economics

John Maynard Keynes

In his 1937 The General Theory of Employment, Interest, and Money, the British economist John Maynard Keynes argued that capitalism suffered a basic problem in its ability to recover from periods of slowdowns in investment. Keynes argued that a capitalist economy could remain in an indefinite equilibrium despite high unemployment. Essentially rejecting Say's law, he argued that some people may have a liquidity preference that would see them rather hold money than buy new goods or services, which therefore raised the prospect that the Great Depression would not end without what he termed in the General Theory "a somewhat comprehensive socialization of investment." Keynesian economics challenged the notion that laissez-faire capitalist economics could operate well on their own, without state intervention used to promote aggregate demand, fighting high unemployment and deflation of the sort seen during the 1930s. He and his followers recommended "pump-priming" the economy to avoid recession: cutting taxes, increasing government borrowing, and spending during an economic down-turn. This was to be accompanied by trying to control wages nationally partly through the use of inflation to cut real wages and to deter people from holding money.[84] John Maynard Keynes tried to provide solutions to many of Marxs problems without completely abandoning the classical understanding of capitalism. His work attempted to show that regulation can be effective, and that economic stabilizers can rein in the aggressive expansions and recessions that Marx disliked. These changes sought to create more stability in the business cycle, and reduce the abuses of laborers. Keynesian economists argue that Keynesian policies were one of the primary reasons capitalism was able to recover following the Great Depression.[85] The premises of Keyness work have, however, since been challenged by neoclassical and supply-side economics and the Austrian School.

Another challenge to Keynesian thinking came from his colleague Piero Sraffa, and subsequently from the Neo-Ricardian school that followed Sraffa. In Sraffa's highly technical analysis, capitalism is defined by an entire system of social relations among both producers and consumers, but with a primary emphasis on the demands of production. According to Sraffa, the tendency of capital to seek its highest rate of profit causes a dynamic instability in social and economic relations.

Neoclassical economics and the Chicago School

Main article: Neoclassical economics

Today, the majority of academic research on capitalism in the English-speaking world draws on neoclassical economic thought. It favors extensive market coordination and relatively neutral patterns of governmental market regulation aimed at maintaining property rights; deregulated labor markets; corporate governance dominated by financial owners of firms; and financial systems depending chiefly on capital market-based financing rather than state financing.

Milton Friedman

Milton Friedman took many of the basic principles set forth by Adam Smith and the classical economists and gave them a new twist. One example of this is his article in the September 1970 issue of The New York Times Magazine, where he argues that the social responsibility of business is to use its resources and engage in activities designed to increase its profits...(through) open and free competition without deception or fraud. This is similar to Smiths argument that self-interest in turn benefits the whole of society.[86] Work like this helped lay the foundations for the coming marketization (or privatization) of state enterprises and the supply-side economics of Ronald Reagan and Margaret Thatcher.

The Chicago School of economics is best known for its free market advocacy and monetarist ideas. According to Friedman and other monetarists, market economies are inherently stable if left to themselves and depressions result only from government intervention.[87] Friedman, for example, argued that the Great Depression was result of a contraction of the money supply, controlled by the Federal Reserve, and not by the lack of investment as John Maynard Keynes had argued. Ben Bernanke, current Chairman of the Federal Reserve, is among the economists today generally accepting Friedman's analysis of the causes of the Great Depression.[88] Neoclassical economists, today the majority of economists,[89] consider value to be subjective, varying from person to person and for the same person at different times, and thus reject the labor theory of value. Marginalism is the theory that economic value results from marginal utility and marginal cost (the marginal concepts). These economists see capitalists as earning profits by forgoing current consumption, by taking risks, and by organizing production.

Neoclassical economic theory

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Neoclassical economics explain capitalism as made up of individuals, enterprises, markets and government. According to their theories, individuals engage in a capitalist economy as consumers, laborers, and investors. As laborers, individuals may decide which jobs to prepare for, and in which markets to look for work. As investors they decide how much of their income to save and how to invest their savings. These savings, which become investments, provide much of the money that businesses need to grow. Business firms decide what to produce and where this production should occur. They also purchase inputs (materials, labor, and capital). Businesses try to influence consumer purchase decisions through marketing and advertisement, as well as the creation of new and improved products. Driving the capitalist economy is the search for profits (revenues minus expenses). This is known as the profit motive, and it helps ensure that companies produce the goods and services that consumers desire and are able to buy. To be profitable, firms must sell a quantity of their product at a certain price to yield a profit. A business may lose money if sales fall too low or if its costs become too high. The profit motive encourages firms to operate more efficiently. By using less materials, labor or capital, a firm can cut its production costs, which can lead to increased profits. An economy grows when the total value of goods and services produced rises. This growth requires investment in infrastructure, capital and other resources necessary in production. In a capitalist system, businesses decide when and how much they want to invest.

Income in a capitalist economy depends primarily on what skills are in demand and what skills are being supplied. Skills that are in scarce supply are worth more in the market and can attract higher incomes. Competition among workers for jobs and among employers for skilled workers help determine wage rates. Firms need to pay high enough wages to attract the appropriate workers; when jobs are scarce, workers may accept lower wages than they would when jobs are plentiful. Trade union and governments influence wages in capitalist systems. Unions act to represent their members in negotiations with employers over such things as wage rates and acceptable working conditions.

The market

The price (P) of a product is determined by a balance between production at each price (supply, S) and the desires of those with purchasing power at each price (demand, D). This results in a market equilibrium, with a given quantity (Q) sold of the product. A rise in demand would result in an increase in price and an increase in output.

Supply is the amount of a good or service produced by a firm and which is available for sale. Demand is the amount that people are willing to buy at a specific price. Prices tend to rise when demand exceeds supply, and fall when supply exceeds demand. In theory, the market is able to coordinate itself when a new equilibrium price and quantity is reached. Competition arises when more than one producer is trying to sell the same or similar products to the same buyers. In capitalist theory, competition leads to innovation and more affordable prices. Without competition, a monopoly or cartel may develop. A monopoly occurs when a firm supplies the total output in the market; the firm can therefore limit output and raise prices because it has no fear of competition. A cartel is a group of firms that act together in a monopolistic manner to control output and raise prices.

Role of government

Further information: Competition regulator, Consumer protection, and Competition law

In a capitalist system, the government does not prohibit private property or prevent individuals from working where they please. The government does not prevent firms from determining what wages they will pay and what prices they will charge for their products. Many countries, however, have minimum wage laws and minimum safety standards. Under some versions of capitalism, the government carries out a number of economic functions, such as issuing money, supervising public utilities and enforcing private contracts. Many countries have competition laws that prohibit monopolies and cartels from forming. Despite antimonopoly laws, large corporations can form near-monopolies in some industries. Such firms can temporarily drop prices and accept losses to prevent competition from entering the market, and then raise them again once the threat of entry is reduced. In many countries, public utilities (e.g. electricity, heating fuel, communications) are able to operate as a monopoly under government regulation, due to high economies of scale. Government agencies regulate the standards of service in many industries, such as airlines and broadcasting, as well as financing a wide range of programs. In addition, the government regulates the flow of capital and uses financial tools such as the interest rate to control factors such as inflation and unemployment.[90]

Democracy, the state, and legal frameworks

Main article: History of capitalist theory

Private property
The relationship between the state, its formal mechanisms, and capitalist societies has been debated in many fields of social and political theory, with active discussion since the 19th century. Hernando de Soto is a contemporary economist who has argued that an important characteristic of capitalism is the functioning state protection of property rights in a formal property system where ownership and transactions are clearly recorded.[91] According to de Soto, this is the process by which physical assets are transformed into capital, which in turn may be used in many more ways and much more efficiently in the market economy. A number of Marxian economists have argued that the Enclosure Acts in England, and similar legislation elsewhere, were an integral part of capitalist primitive accumulation and that specific legal frameworks of private land ownership have been integral to the development of capitalism.[92][93]

Institutions
New institutional economics, a field pioneered by Douglass North, stresses the need of a legal framework in order for capitalism to function optimally, and focuses on the relationship between the historical development of capitalism and the creation and maintenance of political and

economic institutions.[94] In new institutional economics and other fields focusing on public policy, economists seek to judge when and whether governmental intervention (such as taxes, welfare, and government regulation) can result in potential gains in efficiency. According to Gregory Mankiw, a New Keynesian economist, governmental intervention can improve on market outcomes under conditions of "market failure", or situations in which the market on its own does not allocate resources efficiently.[95] Market failure occurs when an externality is present and a market will either under-produce a product with a positive externalization or overproduce a product that generates a negative externalization. Air pollution, for instance, is a negative externalization that cannot be incorporated into markets as the worlds air is not owned and then sold for use to polluters. So, too much pollution could be emitted and people not involved in the production pay the cost of the pollution instead of the firm that initially emitted the air pollution. Critics of market failure theory, like Ronald Coase, Harold Demsetz, and James M. Buchanan argue that government programs and policies also fall short of absolute perfection. Market failures are often small, and government failures are sometimes large. It is therefore the case that imperfect markets are often better than imperfect governmental alternatives. While all nations currently have some kind of market regulations, the desirable degree of regulation is disputed.

Democracy
The relationship between democracy and capitalism is a contentious area in theory and popular political movements. The extension of universal adult male suffrage in 19th century Britain occurred along with the development of industrial capitalism, and democracy became widespread at the same time as capitalism, leading many theorists to posit a causal relationship between them, or that each affects the other. However, in the 20th century, according to some authors, capitalism also accompanied a variety of political formations quite distinct from liberal democracies, including fascist regimes, absolute monarchies, and single-party states.[38] While some thinkers argue that capitalist development more-or-less inevitably eventually leads to the emergence of democracy, others dispute this claim. Research on the democratic peace theory indicates that capitalist democracies rarely make war with one another[96] and have little internal violence. However, critics of the democratic peace theory note that democratic capitalist states may fight infrequently and or never with other democratic capitalist states because of political similarity or stability rather than because they are democratic or capitalist. Some commentators argue that though economic growth under capitalism has led to democratization in the past, it may not do so in the future, as authoritarian regimes have been able to manage economic growth without making concessions to greater political freedom.[97][98] States that have highly capitalistic economic systems have thrived under authoritarian or oppressive political systems. Singapore, which maintains a highly open market economy and attracts lots of foreign investment, does not protect civil liberties such as freedom of speech and expression. The private (capitalist) sector in the People's Republic of China has grown exponentially and thrived since its inception, despite having an authoritarian government. Augusto Pinochet's rule in Chile led to economic growth by using authoritarian means to create a safe environment for investment and capitalism.

In response to criticism of the system, some proponents of capitalism have argued that its advantages are supported by empirical research. Indices of Economic Freedom show a correlation between nations with more economic freedom (as defined by the indices) and higher scores on variables such as income and life expectancy, including the poor, in these nations.

Advocacy for capitalism

Economic growth

World's GDP per capita shows exponential growth since the beginning of the Industrial Revolution.[99]

Capitalism and the economy of the People's Republic of China

Many theorists and policymakers in predominantly capitalist nations have emphasized capitalism's ability to promote economic growth, as measured by Gross Domestic Product (GDP), capacity utilization or standard of living. This argument was central, for example, to Adam Smith's advocacy of letting a free market control production and price, and allocate resources. Many theorists have noted that this increase in global GDP over time coincides with the emergence of the modern world capitalist system.[100][101] In years 10001820 world economy grew sixfold, 50% per person. After capitalism had started to spread more widely, in years 18201998 world economy grew 50-fold, i.e., 9-fold per person.[102] In most capitalist economic regions such as Europe, the United States, Canada, Australia and New Zealand, the economy grew 19-fold per person even though these countries already had a higher starting level, and in Japan, which was poor in 1820, to 31-fold, whereas in the rest of the world the growth was only 5-fold per person.[102]

Proponents argue that increasing GDP (per capita) is empirically shown to bring about improved standards of living, such as better availability of food, housing, clothing, and health care.[103] The decrease in the number of hours worked per week and the decreased participation of children and the elderly in the workforce have been attributed to capitalism.[104][105] Proponents also believe that a capitalist economy offers far more opportunities for individuals to raise their income through new professions or business ventures than do other economic forms. To their thinking, this potential is much greater than in either traditional feudal or tribal societies or in socialist societies.

Political freedom
Milton Friedman stated that the economic freedom of capitalism is a requisite of political freedom which has been continuously echoed by others such as Andrew Brennan and Ronald Reagan. Friedman stated that centralized operations of economic activity is always accompanied by political repression. In his view, transactions in a market economy are voluntary, and the wide diversity that voluntary activity permits is a fundamental threat to repressive political leaders and greatly diminish power to coerce. Friedman's view was also shared by Friedrich Hayek and John Maynard Keynes, both of whom believed that capitalism is vital for freedom to survive and thrive.[106][107]

Self-organization
Austrian School economists have argued that capitalism can organize itself into a complex system without an external guidance or central planning mechanism. Friedrich Hayek considered the phenomenon of self-organization as underpinning capitalism. Prices serve as a signal as to the urgent and unfilled wants of people, and the promise of profits gives entrepreneurs incentive to use their knowledge and resources to satisfy those wants. Thus the activities of millions of people, each seeking his own interest, are coordinated.[108]

Criticisms
Main article: Criticism of capitalism

An Industrial Workers of the World poster (1911)

Critics of capitalism associate it with social inequality and unfair distribution of wealth and power; a tendency toward market monopoly or oligopoly (and government by oligarchy); imperialism, counter-revolutionary wars and various forms of economic and cultural exploitation; materialism; repression of workers and trade unionists; social alienation; economic inequality; unemployment; and economic instability. Individual property rights have also been associated with the tragedy of the anticommons. Notable critics of capitalism have included: socialists, anarchists, communists, national socialists, social democrats,[citation needed] technocrats, some types of conservatives, Luddites, Narodniks, Shakers and some types of nationalists. Marxists have advocated a revolutionary overthrow of capitalism that would lead to socialism, before eventually transforming into communism. Many socialists consider capitalism to be irrational, in that production and the direction of the economy are unplanned, creating many inconsistencies and internal contradictions.[109] Labor historians and scholars such as Immanuel Wallerstein have argued that unfree labor by slaves, indentured servants, prisoners, and other coerced persons is compatible with capitalist relations.[110] Many aspects of capitalism have come under attack from the anti-globalization movement, which is primarily opposed to corporate capitalism. Environmentalists have argued that capitalism requires continual economic growth, and that it will inevitably deplete the finite natural resources of the Earth.[111] Many religions have criticized or opposed specific elements of capitalism. Traditional Judaism, Christianity, and Islam forbid lending money at interest,[112][113] although alternative methods of banking have been developed. Some Christians have criticized capitalism for its materialist aspects[114] and its inability to account for the wellbeing of all people. Many of Jesus's parables

deal with clearly economic concerns: farming, shepherding, being in debt, doing hard labor, being excluded from banquets and the houses of the rich, and have implications for wealth and power distribution.[115][116]

Gustave Boulanger's painting The Slave Market

David Schweickart wrote that, in capitalist societies, "ordinary people are deemed competent enough to select their political leaders-but not their bosses. Contemporary capitalism celebrates democracy, yet denies us our democratic rights at precisely the point where they might be utilized most immediately and concretely: at the place where we spend most of the active and alert hours of our adult lives."[117]

Unpredictability
Economists such as John Stuart Mill point out that the behavior of men and women in the marketplace is not "calculable."[118] Stores go out of business for varied, often-overlapping reasons, which include: inadequate parking, shifting demand, excessive overhead, marketing problems, and competition.[119]

Response to Criticisms
A counter-argument to the criticisms of the depletion of finite natural resources consists of the economic Law of Diminishing Returns, opportunity cost, and scarcity in economics (all driving factors of pricing and demand). These principles denote that the more someone has of one product, the less that person is willing to pay for an additional unit of that same product; the finite ability of man to consume is limited to factors such as time - causing one to prioritize production and consumption; and, as scarcity of a commodity increases, higher prices result for that commodity. The self-regulating effect of the marketplace is what the renowned economist and philosopher Adam Smith describes with the metaphor of the Invisible Hand. What is the difference between the current account convertability and capital account convertibility?

Currency convertibility means the freedom to convert one currency into other internationally accepted currencies......wherein the exporters and importers where allowed a free conversion of rupee.But still noone was allowed to purchase any assets abroad.. Capital Account Convertibilty means that rupee can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency.. so if a foreginer buys a building in India..nd after 5 yrs its sellin price rises so sells it at five times d cost he collected...now he has rupees in hand..can he easily convert these rupees into say 'yen' easily? considering that exchange rate is better in terms of INR-JPY, the foreigner would want to convert the currency into yen..and this can be done if complete capital a/c convertibility takes place..

Remittance to foreign countries from india is restricted by RBI. for import of machines you are remitting abroad means it is capital account convertibility. if you remit money to your son or relative living abroad means current account convertibilty. Capital account convertibility It means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange.It refers to the removal of restraints on international flows on a country's capital account, enabling full currency convertibility and opening of the financial system. Capital account convertibility is considered to be one of the major features of a developed economy. It helps attract foreign investment.At the same time, capital account convertibility makes it easier for domestic companies to tap foreign markets. It is sometimes referred to as Capital Asset Liberation. Current account convertibility Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes such as investments and loans. In other words, it allows residents to make and receive trade-related payments -- receive dollars (or any other foreign currency) for export of goods and services and pay dollars for import of goods and services, make sundry remittances, access foreign currency for travel, studies abroad, medical treatment and gifts, etc.

What is rupee convertibility?

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Convertibility can be related as the extent to which a country's regulations allow free flow of money into and outside the country. For instance, in the case of India till 1990, one had to get permission from the Government or RBI as the case may be to procure foreign currency, say US Dollars, for any purpose. Be it import of raw material, travel abroad, procuring books or paying fees for a ward who pursues higher studies abroad. Similarly, any exporter who exports goods or services and brings foreign currency into the country has to surrender the foreign exchange to RBI and get it converted at a rate pre-determined by RBI. After liberalization began in 1991, the government eased the movement of foreign currency on trade account. I.e. exporters and importers were allowed to buy and sell foreign currency, as long as the items that they are exporting and importing were not in the banned list. They need not get permission on a CASE TO CASE basis as was prevalent in the earlier regime. This was the first concrete step the economy took towards making our currency convertible on trade account. In the next two to three years, government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purposes like travel abroad, studying abroad, engaging the services of foreign consultants etc. This set the first step towards getting our currency convertible on the current account. What it means is that people are allowed to have access to foreign currency for buying a whole range of consumable products and services. These relaxations coincided with the liberalization on the industry and commerce front - which is why we have Honda City cars, Mars chocolate bars and Bacardi in India. There was also simultaneous relaxation on the restriction on the funds that foreign investors can bring into India to invest in companies and the stock market in the country. This step led to partial convertibility on the Capital Account. "Capital Account convertibility in its entirety would mean that any individual, be it Indian or foreigner will be allowed to bring in any amount of foreign currency into the country and take any amount of foreign currency out of the country without any restriction." Indian companies were allowed to raise funds by way of equities (shares) or debts. The fancy terms like Global Depository Receipts (GDRs), Euro Convertible Bonds (ECBs), Foreign currency syndicated loans became household jargons of Indian investors. Listing in Nasdaq or NYSE became new found status symbols for Indian companies. However, Indian companies or individuals still had to get permission on a case to case basis for investing abroad. In 2000, the forex policy was further relaxed that allowed companies to acquire other companies abroad without having to go through the rigmarole of getting permission on a case to case basis. Further, Indian debt based mutual funds were also allowed to invest in AAA rated government /corporate bonds abroad. This got further relaxed with Indians being allowed to hold a portion of their foreign exchange earnings as foreign currency, subject to a limit in the recent monetary policy in October 2002.

In general, restrictions on foreign currency movements are placed by developing countries which have faced foreign exchange problems in the past is to avoid sudden erosion of their foreign exchange reserves which are essential to maintain stability of trade balance and stability in their economy. With India's forex reserves increasing steadily, it has slowly and steadily removed restrictions on movement of capital on many counts. The last few steps as and when they happen will allow an individual to invest in Microsoft or Intel shares that are traded on Nasdaq or buy a beach resort on Bahamas without any restrictions

The Indian rupee ( , Unicode ) is the official currency of the Republic of India. The issuance of the currency is controlled by the Reserve Bank of India.[1] The modern rupee is subdivided into 100 paise (singular paisa), although this division is now theoretical; as of 30 June 2011, coin denominations of less than 50 paise ceased to be legal tender.[2][3] Banknotes are available in nominal values of 5, 10, 20, 50, 100, 500 and 1000 rupees. Rupee coins are available in denominations of 1, 2, 5, 10, 100 and 1000; of these, the 100 and 1000 coins are for commemorative purposes only; the only other rupee coin has a nominal value of 50 paise, since lower denominations have been officially withdrawn. The Indian rupee symbol (officially adopted in 2010) is derived from the Devanagari consonant "" (Ra) with an added horizontal bar. The symbol can also be derived from the Latin consonant "R" by removing the vertical line, and adding two horizontal bars (like the symbols for the Japanese yen and the euro). The first series of coins with the rupee symbol was launched on 8 July 2011. The Reserve Bank manages currency in India.The Reserve Bank derives its role in currency management on the basis of the Reserve Bank of India Act, 1934. Recently RBI launched a website Paisa-Bolta-Hai to raise awareness of counterfeit currency among users of the INR.

Convertibility

Officially, the Indian rupee has a market-determined exchange rate. However, the RBI trades actively in the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a "managed float". Other rates (such as the EUR/INR and INR/JPY) have the volatility typical of floating exchange rates.[31] Unlike China, successive administrations (through RBI, the central bank) have not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI intervention in currency markets is

solely to ensure low volatility in exchange rates, and not to influence the rate (or direction) of the Indian rupee in relation to other currencies.[32] Also affecting convertibility is a series of customs regulations restricting the import and export of rupees. Legally, foreign nationals are forbidden from importing or exporting rupees; Indian nationals can import and export only up to 7,500 rupees at a time, and the possession of 500- and 1,000-rupee notes in Nepal is prohibited. RBI also exercises a system of capital controls in addition to intervention (through active trading) in currency markets. On the current account, there are no currency-conversion restrictions hindering buying or selling foreign exchange (although trade barriers exist). On the capital account, foreign institutional investors have convertibility to bring money into and out of the country and buy securities (subject to quantitative restrictions). Local firms are able to take capital out of the country in order to expand globally. However, local households are restricted in their ability to diversify globally. Because of the expansion of the current and capital accounts, India is increasingly moving towards full de facto convertibility. There is some confusion regarding the interchange of the currency with gold, but the system that India follows is that money cannot be exchanged for gold under any circumstances due to gold's lack of liquidity;[citation needed] therefore, money cannot be changed into gold by the RBI. India follows the same principle as Great Britain and the U.S.

Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation.[1] Paper currency and coins are common forms of legal tender in many countries. The origin of the term "legal tender" is from Middle English tendren, French tendre (verb form), meaning to offer. The Latin root is tendere (to stretch out), and the sense of tender as an offer is related to the etymology of the English word extend (to hold outward).[2] The noun form of a tender as an offering is a back-formation of the noun from the verb.[citation needed] Legal tender is variously defined in different jurisdictions. Formally, it is anything which when offered in payment extinguishes the debt. Thus, personal cheques, credit cards, debit cards, and similar non-cash methods of payment are not usually legal tender. The law does not relieve the debt obligation until payment is accepted. Coins and banknotes are usually defined as legal tender. Some jurisdictions may forbid or restrict payment made other than by legal tender. For example, such a law might outlaw the use of foreign coins and bank notes or require a license to perform financial transactions in a foreign currency. In some jurisdictions legal tender can be refused as payment if no debt exists prior to the time of payment (where the obligation to pay may arise at the same time as the offer of payment). For example vending machines and transport staff do not have to accept the largest denomination of banknote. Shopkeepers may reject large banknotes: this is covered by the legal concept known as invitation to treat. However, restaurants that do not collect payment until after a meal is served must accept that legal tender for the debt incurred in purchasing the meal.

The right, in many jurisdictions, of a trader to refuse to do business with any person means a purchaser may not insist on making a purchase and so declaring a legal tender in law, as anything other than an offered payment for debts already incurred would not be effective. Coins and banknotes may cease to be legal tender if new notes of the same currency substitute them or if a new currency is introduced replacing the former one.[3] Examples of this are:

The United Kingdom, adopting decimal currency in place of pounds, shillings, and pence in 1971. Banknotes remained unchanged (except for the replacement of the 10 shilling note by the 50 pence coin). In 1968 and 1969 decimal coins which had precise equivalent values in the old currency (5p, 10p, 50p) were introduced, while decimal coins with no precise equivalent (p, 1p, 2p) were introduced on 15 February 1971. The smallest and largest non-decimal circulating coins, the half penny and half crown, were withdrawn in 1969, and the other non-decimal coins with no precise equivalent in the new currency (1d, 3d) were withdrawn later in 1971. Nondecimal coins with precise decimal equivalents (6d ( = 2p), 1 and 2 shillings) remained legal tender either until the coins no longer circulated (1980 in the case of the 6d), or the equivalent decimal coins were reduced in size in the early 1990s. The 6d coin was permitted to remain in large circulation throughout the United Kingdom due to the London Underground committee's large investment in coin-operated ticketing machines that used it.[citation needed] Old coins returned to the Royal Mint through the UK banking system will be redeemed for legal tender without time limits, but coins issued before 1947 have a higher value for their silver content than for their monetary value.[citation needed] The successor states of the Soviet Union replacing the Soviet ruble in the 1990s.[citation needed] Currencies used in the Eurozone before being replaced by the euro are not legal tender, but all banknotes are redeemable for euros for a minimum of 10 years (for certain notes, there is no time limit).[citation needed]

Individual coins or banknotes can be demonetised and cease to be legal tender (for example, the pre-decimal United Kingdom farthing or the Bank of England 1 pound note), but the Bank of England does redeem all Bank of England banknotes for legal tender at its counters in London (or by post) regardless of how old they are. Banknotes issued by retail banks in the UK are not legal tender, but one of the criteria for legal protection under the Forgery and Counterfeiting Act is that banknotes must be payable on demand, therefore withdrawn notes remain a liability of the issuing bank without any time limits.[citation needed] In the case of the euro, coins and banknotes of former national currencies were considered as legal tender from 1 January 1999 until 28 February 2002 (in some cases). Legally, those coins and banknotes were considered non-decimal sub-divisions of the euro.[citation needed] When the Iraqi Swiss dinar ceased to be legal tender in Iraq, it still circulated in the northern Kurdish regions, and despite lacking government backing, it had a stable market value for more than a decade. This example is often cited to demonstrate that the value of a currency is not derived purely from its legal status[citation needed] (but this currency would not be legal tender). This is also true of the paper money issued by the Confederate States of America during the American Civil War. Although Confederate currency became worthless by its own terms after the war, since it could only be redeemed a stated number of years after a peace treaty was signed

between the Confederacy and the United States (which never happened as the Confederacy was defeated and dissolved), the value of Confederate currency today as a historical and collectible item is usually much greater than its face value.[citation needed] Demonetisation is currently prohibited in the United States and the Coinage Act of 1965 applies to all US coins and currency regardless of age. The closest historical equivalent in the US, other than Confederate money, was from 1933 to 1974, when the government banned most private ownership of gold bullion, including gold coins held for non-numismatic purposes. Now, however, even surviving pre-1933 gold coins are legal tender under the 1964 act.[citation needed]

Withdrawal from circulation

Banknotes and coins may be withdrawn from circulation, but remain legal tender. United States banknotes issued at any date remain legal tender even after they are withdrawn from circulation. Canadian 1- and 2-dollar bills remain legal tender even if they have been withdrawn and replaced by coins, but Canadian $1000 bills remain legal tender even if they are removed from circulation as they arrive at a bank. However, Bank of England notes that are withdrawn from circulation generally cease to be legal tender but remain redeemable for current currency at the Bank of England itself or by post. All paper and polymer issues of New Zealand banknotes issued from 1967 onwards (and 1- and 2-dollar notes until 1993) are still legal tender; however, 1- and 2-cent coins are no longer used in Australia and New Zealand.

Commemorative issues
Sometimes currency issues such as commemorative coins or transfer bills may be issued that are not intended for public circulation but are nonetheless legal tender. An example of such currency is Maundy money. Some currency issuers, particularly the Scottish banks, issue special commemorative banknotes which are intended for ordinary circulation. As well, some standard coins are minted on higher-quality dies as 'uncirculated' versions of the coin, for collectors to purchase at a premium; these coins are nevertheless legal tender. Some countries issue preciousmetal coins which have a currency value indicated on them which is far below the value of the metal the coin contains: these coins are known as "non-circulating legal tender" or "NCLT".

Legal tender status by country

Australia
In Australia, the creation of legal tender, in the form of notes and base metal coins, is the exclusive right of the Commonwealth Government. According to the Australian Constitution, s 115[4] which states: "A State shall not coin money, nor make anything but gold and silver coin a legal tender in payment of debts." Under this provision the Perth Mint, owned by the Western Australian Government, still produces gold and silver coins with legal tender status, the Australian Gold Nugget and Australian Silver Kookaburra. These, however, although having the status of legal tender, are almost never circulated or used in payment of debts, and are mostly considered bullion coins.

Australian notes are legal tender, as established by the Reserve Bank Act 1959[5] for all amounts. Australian coins for general circulation, now produced at the Royal Australian Mint in Canberra, are also legal tender, under the provisions of the Currency Act 1965,[6] but only for the following amounts:

not exceeding 20 if 1 and/or 2 coins are offered; not exceeding $5 if any of 5, 10, 20 and 50 coins are offered; not exceeding 10 times the face value if coins in the range 50 to $10 inclusive are offered; to any value if face value is greater than $10 are offered.

The one cent and two cent coins have been withdrawn from circulation since February 1992 but remain legal tender. According to the Reserve Bank of Australia,[7] the legal framework[8] for legal tender in Australia is somewhat unclear. The Reserve Bank Act 1959[5] and Currency Act 1965[6] establish that it is not legally required to accept legal tender, even for an existing debt, although failure to do so may be prejudicial in future legal proceedings. In Australia, except for when sending items via Registered Post, Australia Post prohibits the sending of coins or banknotes, for any country, in the post.
History

In 1901, notes in circulation in Australia consisted of bank notes payable in gold coin and issued by the trading banks, and Queensland Treasury notes. Bank notes circulated in all States except Queensland, but were not legal tender except for a brief period in 1893 in New South Wales. There were, however, some restrictions on their issue or other provisions for the protection of the public. Queensland Treasury notes were issued by the Queensland Government and were legal tender in that State. Notes of both categories continued in circulation until 1910, when the Australian Notes Act 1910 and Bank Notes Tax Act 1910 were passed by the Commonwealth Parliament. The Australian Notes Act 1910 prohibited the circulation of state notes as money, and the Bank Notes Tax Act 1910 imposed a tax of ten per cent per annum on 'all bank notes issued or re-issued by any bank in the Commonwealth after the commencement of this Act, and not redeemed'. These Acts effectively put an end to the issue of notes by the trading banks and the Queensland Treasury. The Reserve Bank Act 1959[5] expressly prohibits persons and states from issuing 'a bill or note for the payment of money payable to bearer on demand and intended for circulation'.

Canada
Canadian dollar banknotes issued by the Bank of Canada are legal tender in Canada. However, commercial transactions may legally be settled in any manner agreed by the parties involved with the transactions. For example, convenience stores may refuse $100 bank notes if they feel that would put them at risk of being counterfeit victims; however, official policy suggests that the retailers should evaluate the impact of that approach. In the case that no mutually acceptable form of payment can be found for the tender, the parties involved should seek legal advice.[9]

As outlined in the Currency Act, there is a limit the value of a transaction for which you can use only coins.[10] A payment in coins is legal tender for no more than the following amounts for the following denominations of coins:
1. 2. 3. 4. 5. forty dollars if the denomination is two dollars or greater but does not exceed ten dollars; twenty-five dollars if the denomination is one dollar; ten dollars if the denomination is ten cents or greater but less than one dollar; five dollars if the denomination is five cents; and twenty-five cents if the denomination is one cent.

Eurozone
Euro coins and banknotes became legal tender in most countries of the Eurozone on January 1, 2002. Although one side of the coins is used for different national marks for each country, all coins and all banknotes are legal tender throughout the eurozone. Therefore, it is possible to find Irish euro coins in Greece and Finnish euro coins in Portugal, for instance. Although some eurozone countries do not put 1 cent and 2 cent coins into general circulation (prices in those countries are by general understanding always rounded to whole multiples of 5 cent), 1 cent and 2 cent coins from other eurozone countries remain legal tender in those countries. European Regulation EC 974/98 limits the number of coins that can be offered for payment to fifty.[11] National laws may also impose restrictions as to maximal amounts that can be settled by coins or notes.

France
Legal tender was enacted the first time in 1870 for all notes and coins of the Banque de France. Anyone refusing such monies for their whole value would be prosecuted (French Penal Code art. R. 642-3).

Republic of Ireland
See also: Coinage of the Republic of Ireland

According to the Economic and Monetary Union Act, 1998 of the Republic of Ireland which replaced the legal tender provisions that had been re-enacted in Irish legislation from previous British enactments, No person, other than the Central Bank of Ireland and such persons as may be designated by the Minister by order, shall be obliged to accept more than 50 coins denominated in euro or in cent in any single transaction.
Irish history

The Decimal Currency Act, 1970 governed legal tender prior to the adoption of the euro and laid down the analogous provisions as in United Kingdom legislation (all inherited from previous British law), namely: coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, coins denominated not more than 10 pence became legal tender for

payment not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence.

India
The Indian rupee is the de facto legal tender currency in India. The Indian rupee is also legal tender in Nepal and Bhutan, but the Nepalese rupee and Bhutanese ngultrum are not legal tender in India. Both the Nepalese rupee and Bhutanese ngultrum are pegged with the Indian rupee.[12] The Indian rupee used to be an official currency of other countries, including the Straits Settlements (now Singapore and parts of Malaysia), Kuwait, Bahrain, Qatar, and the Trucial States (now the UAE). In 1837, the Indian rupee was made the sole official currency of the Straits Settlements, as it was administered as a part of India. In 1845, the British replaced the Indian rupee with the Straits dollar after administration of the Straits Settlements separated from India earlier in that same year. After partition of India and Pakistan in 1947, the Pakistani rupee came into existence, initially using Indian coins and Indian currency notes simply overstamped with the word "Pakistan". New coins and banknotes were issued in 1948. The Gulf rupee, also known as the Persian Gulf rupee (XPGR), was introduced by the Government of India as a replacement for the Indian rupee for circulation exclusively outside the country with the Reserve Bank of India Amendment Act of 1 May 1959. This creation of a separate currency was an attempt to reduce the strain put on India's foreign reserves by gold smuggling. Two states, Kuwait and Bahrain eventually replaced the Gulf rupee with their own currencies (the Kuwaiti dinar and the Bahraini dinar) after gaining independence from Britain in 1961 and 1965, respectively. On 6 June 1966, India devalued the rupee. To avoid following this devaluation, several of the states using the rupee adopted their own currencies. Qatar and most of the Trucial States adopted the Qatar and Dubai riyal, whilst Abu Dhabi adopted the Bahraini dinar. Only Oman continued to use the Gulf rupee until 1970, with the government backing the currency at its old peg to the pound. Oman later replaced the Gulf rupee with its own rial in 1970.

New Zealand
New Zealand has a complex history of legal tender. At the creation of the colony after the signing of the Treaty of Waitangi in 1840 there was no legal tender in New Zealand, because although the Treaty authorised the British Crown to govern, the laws of Great Britain had not been formally adopted by the new colony.

The British Laws Act 1858 retrospectively adopted the laws of Great Britain, and through the UK's Coinage Act 1816, British coins were confirmed as legal tender in New Zealand. Unusually, until 1989, the Reserve Bank did not have the right to issue coins as legal tender. Coins had to be issued by the Minister of Finance. The history of bank notes was considerably more complex. In 1840, the Union Bank started issuing bank notes under provisions of British law, but these were not automatically legal tender. In 1844, ordinances were passed making the Union Bank banknotes legal tender and authorising the government to issue debentures in small denominations, thus creating two sets of legal tender. These debentures were circulated but were traded at a discount to their face value because of distrust of the colonial government by the settler population. In 1845, the Ordinance was disallowed by the British Colonial office and they were recalled, not without first causing a panic among holders of the debentures. In 1847, the Colonial Bank of Issue became the only issuer of legal tender. In 1856, however the Colonial Bank of Issue was disbanded and through the Paper Currency Act 1856, the Union Bank was confirmed once again as an issuer of legal tender. The Act also authorised the Oriental Bank to issue legal tender but this bank ceased operations in 1861. Between 1861 and 1874, a number of other banks including the Bank of New Zealand, Bank of New South Wales, National Bank of New Zealand and Colonial Bank of New Zealand were created by Acts of Parliament and authorised to issue bank notes backed by gold, however these notes were not legal tender. The 1893 Bank Note Issue Act allowed the government to declare a bank's right to issue legal tender. This enabled the government to make such a declaration to assist the Bank of New Zealand when in 1895 the bank encountered financial difficulties that could have led to its failure. In 1914, the Banking Amendment Act gave legal tender status to bank notes from any issuer and removed the requirement that banks authorised to issue bank notes must redeem them on demand for gold (the gold standard). In 1933, the Coinage Act created a specific New Zealand coinage and removed legal tender status from British coins. In the same year the Reserve Bank of New Zealand was established. The bank was given a monopoly on the issue of legal tender. The Reserve Bank also provided a mechanism through which the other issuers of legal tender could phase out their bank notes. These banknotes were convertible into British legal tender on demand at the Reserve Bank and remained so until the 1938 Sterling Exchange Suspension Notice that suspended provisions of a 1936 amendment of the 1933 Reserve Bank of New Zealand Act. In 194?, the Reserve Bank of New Zealand Act restated that only notes issued by the Reserve Bank were legal tender. The Act also ended the right of individuals to redeem their bank notes for coin, effectively ending the distinction between coin and notes in New Zealand. The Act came into force in 1967 establishing as legal tender all New Zealand dollar five dollars

banknotes and greater, all decimal coins, the pre-decimal sixpence, the shilling, and the florin. Also passed in 1964 was the Decimal Currency Act, which created the basis for a decimal currency, introduced in 1967. As of 2005, banknotes were legal tender for all payments, and $1 and $2 coins were legal tender for payments up to $100, and 10c, 20c, and 50c silver coins were legal tender for payments up to $5. These older style silver coins were legal tender until October 2006, after which only the new 10c, 20c and 50c coins, introduced in August 2006, are legal.[13]

Norway
The Norwegian krone (NOK) is legal tender in Norway according to the Central Bank (Norwegian: Sentralbankloven) of 1985-05-24,[14] However, no-one is obliged to accept more than 25 coins of each denomination (of which currently 1, 5, 10 and 20 NOK denominations are in common circulation).

Singapore and Brunei

The Singapore dollar is legal tender in Brunei since a Currency Interchangeability Agreement was signed on 1967-06-12. Brunei dollar banknotes (but not coins) are widely accepted throughout Singapore and represent a "customary tender".[15]

Switzerland and Liechtenstein

Main article: Swiss franc

The Swiss franc is the only legal tender in Switzerland. Any payment consisting of up to 100 Swiss coins is legal tender; banknotes are legal tender for any amount.[16] The sixth series of Swiss bank notes from 1976, recalled by the National Bank in 2000, is no longer legal tender, but can be exchanged in banks for current notes until April 2020. The Swiss franc is also the legal tender of the Principality of Liechtenstein, which is joined to Switzerland in a customs union. The Swiss franc is also the currency used for administrative and accounting purposes by most of the numerous international organisations that are headquartered in Switzerland.

Taiwan
Main article: New Taiwan dollar

The New Taiwan dollar issued by the Central Bank of the Republic of China (Taiwan) is legal tender for all payments within the territory of the Republic of China, Taiwan.[17] However, candidates to become civil servants in elections in the Republic of China may not pay the deposits in coinage.[18]

United Kingdom
Legal tender is solely for the guaranteed settlement of debts and does not affect any party's right of refusal of service in any transaction.[19] In the 19th century, gold coins were legal tender to any amount, but silver coins were not legal tender for sums over 2 pounds as well as bronze for sums over 1 shilling. This provision was retained in revised form at the introduction of decimal currency, and the Coinage Act 1971 laid down that coins denominated above 10 pence became legal tender for payment not exceeding 10 pounds, non-bronze coins denominated not more than 10 pence became legal tender for payment not exceeding 5 pounds, and bronze coins became legal tender for payment not exceeding 20 pence. Throughout the United Kingdom, coins valued 1 pound, 2 pounds, and 5 pounds Sterling are legal tender in unlimited amounts. Twenty pence pieces and fifty pence pieces are legal tender in amounts up to 10 pounds; five pence pieces and ten pence pieces are legal tender in amounts up to 5 pounds; and pennies and two pence coins are legal tender in amounts up to 20 pence.[20] In accordance with the Coinage Act 1971,[21] gold sovereigns are also legal tender for any amount. Although it is not specifically mentioned on them, the face values of gold coins are 50p; 1; 2; and 5, a mere fraction of their worth as bullion. Maundy money is legal tender but may not be accepted by retailers and is worth much more than face value due to its rarity value and silver content. Bank of England notes are legal tender in England and Wales and are issued in the denominations of 5, 10, 20 and 50. English banknotes can always be redeemed at the Bank of England even if discontinued. Banknotes issued by Scottish and Northern Irish banks are not legal tender anywhere in England and Wales but can still be accepted with agreement between parties.[22] Whilst Banknotes issued by the Scottish banks are legal currency, that is approved by the UK Parliament, no banknotes issued by Scottish banks, Northern Ireland banks nor the Bank of England are legal tender in Scotland. Thus legal tender in Scotland is limited to coin as noted above.

United States
Before the Civil War (1861 to 1865), silver coins were legal tender only up to the sum of $5. Before 1853, when US silver coins were reduced in weight 7%, coins had exactly their value in metal (from 1830 to 1852). Two silver 50 cent coins had exactly $1 worth of silver. A gold US Dollar of 1849 had $1 worth of gold. With the flood of gold coming out of the California mines in the early 1850s, the price of silver rose (gold went down). Thus, 50 cent coins of 1840 to 1852 were worth 53 cents if melted down. The government could increase the value of the gold coins (expensive) or reduce the size of all US silver coins. With the reduction of 1853, a 50-cent coin now had only 48 cents of silver. This is the reason for the $5 limit of silver coins as legal tender; paying somebody $100 in the new silver coins would be giving them $96 worth of silver. Most people preferred bank check or gold coins for large purchases.

During the early American Civil War, the federal government first issued United States Notes (the first greenback notes) which were not redeemable in gold and silver coins but could be used to pay "all dues" to the Federal Government. Since land purchases and duties on imports were payable only in gold or the new Demand Notes, the Demand Notes were bought by importers and land speculators for about 97 cents on the gold dollar and never lost value. 1862 greenbacks (Legal Tender Notes) at first traded for 97 cents on the dollar but gained/lost value depending on fortunes of the Union army. The value of Legal Tender Greenbacks swung wildly but trading was from 85 to 33 cents on the gold dollar. This resulted in a situation in which the greenback "Legal Tender" notes of 1862 were fiat, and so gold and silver were held and paper circulated at a discount because of Gresham's Law. The 1861 Demand Notes were a huge success but robbed the customs house of much needed gold coin (interest on most bonds back then was paid in gold). A money-strapped Congress which had to pay for the war eventually adopted the Legal Tender Act of 1862, issuing United States Notes backed only by treasury securities, and compelled the people to accept the new notes at a discount; prices rose except for those who had gold and/or silver coins. Litigation resulted from debts incurred before the Civil War (when gold coins were common) and 5 years later, the debtor wanted to pay the debt in full with "Legal Tender" (worth only 55 cents on the gold dollar). Bank deposits were often in "current funds (paper money)" or gold coin. Checks were written to be cashed in "gold coin" or "current funds." The United States Supreme Court, with Salmon P. Chase (former Secretary of the Treasury) ruled the practice of legal tender unconstitutional in Hepburn v. Griswold in 1869, but later reversed its ruling within a month when confusion in the markets caused everybody not to accept "Legal Tender" notes at all. The Court held that paper money, even that not backed by specie such as the United States Notes can be legal tender, in the Legal Tender Cases, ranging from 1871 to 1884. On the other hand, coins made of gold or silver may not necessarily be legal tender, if they are not fiat money in the jurisdiction where they are preferred as payment. The Coinage Act of 1965 states (in part):
United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes and dues. Foreign gold or silver coins are not legal tender for debts. 31 U.S.C. 5103

There is, however, no federal statute that a private business, a person, or an organization must accept currency or coins as for payment for goods and/or services. Private businesses are free to develop their own policies on whether or not to accept cash unless there is a State law which says otherwise. For example, a bus line may prohibit payment of fares in pennies or dollar bills. In addition, movie theaters, convenience stores and gas stations may refuse to accept large denomination currency (usually notes above $20) as a matter of policy.[23]

On May 27, 2011, Jason West in Vernal, Utah dumped 2500 loose pennies onto the counter of Basin Clinic when disputing a bill.[24] The police there cited him with disorderly conduct for causing unnecessary alarm when the dumped pennies were strewn about the counter and the floor, but paying in pennies itself was not the reason to cite him.[25] The Trade-Weighted Effective Exchange Rate Index, a common form of the effective exchange rate index, is a multilateral exchange rate index. It is compiled as a weighted average of exchange rates of home versus foreign currencies, with the weight for each foreign country equal to its share in trade. Depending on the purpose for which it is used, it can be exportweighted, import-weighted, or total-external trade weighted. The trade-weighted effective exchange rate index is an economic indicator for comparing the exchange rate of a country against those of their major trading partners. By design, movements in the currencies of those trading partners with a greater share in an economy's exports and imports will have a greater effect on the effective exchange rate. In a multilateral, highly globalized, world, the effective exchange rate index is much more useful than a bilateral exchange rate, such as that between the Australian dollar and the United States dollar, for assessing changes in the competitiveness due to exchange rate movements. Generally, the weighting method is geometric weighting rather than arithmetic weighting. Refer to weighted geometric mean. The use of trade weights in a globalized economy is potentially misleading, because the amount of value added content in exports destined for a country may deviate significantly from the gross value of exports shipped to that country. See the entry under effective exchange rate index for an alternative approach to compiling an effective exchange rate index. The interpretation of the effective exchange rate is that if the index rises, other things being equal, the purchasing power of that currency also rises (the currency strengthened against those of the country's or area's trading partners). This will reduce the cost of imports but will undermine the competitiveness of exports. Here other things refer, in particular, to the relative inflation rates of the economy as compared to the inflation rates of its trading partners. To fully account for the effects of relative inflation rates, the real effective exchange rate index is compiled as the product of the effective exchange rate index and the relative price index between the home economy and the trading partners. Managed float regime is the current international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies. It is also known as a dirty float. In an increasingly integrated world economy, the currency rates impact any given country's economy through the trade balance. In this aspect, almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. The balance of trade, or net exports (sometimes symbolized as NX), is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the

relationship between a nation's imports and exports.[1][dead link] A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance. Early understanding of the functioning of balance of trade informed the economic policies of Early Modern Europe that are grouped under the heading mercantilism. An early statement appeared in Discourse of the Common Wealth of this Realm of England, 1549: "We must always take heed that we buy no more from strangers than we sell them, for so should we impoverish ourselves and enrich them."[2] Similarly a systematic and coherent explanation of balance of trade was made public through Thomas Mun's c1630 "England's treasure by forraign trade, or, The balance of our forraign trade is the rule of our treasure"[3]

Definition

The balance of trade encompasses the activity of exports and imports, like the work of this cargo ship going through the Panama Canal.

The balance of trade forms part of the current account, which includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position. The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by almost 1%; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely. Factors that can affect the balance of trade include:

The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis-vis those in the importing economy; The cost and availability of raw materials, intermediate goods and other inputs; Exchange rate movements; Multilateral, bilateral and unilateral taxes or restrictions on trade; Non-tariff barriers such as environmental, health or safety standards; The availability of adequate foreign exchange with which to pay for imports; and Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle. Since the mid 1980s, the United States has had a growing deficit in tradeable goods, especially with Asian nations (China and Japan) which now hold large sums of U.S debt that has funded the consumption.[4][5] The U.S. has a trade surplus with nations such as Australia. The issue of trade deficits can be complex. Trade deficits generated in tradeable goods such as manufactured goods or software may impact domestic employment to different degrees than trade deficits in raw materials. Economies such as Canada, Japan, and Germany which have savings surpluses, typically run trade surpluses. China, a high growth economy, has tended to run trade surpluses. A higher savings rate generally corresponds to a trade surplus. Correspondingly, the U.S. with its lower savings rate has tended to run high trade deficits, especially with Asian nations.

Views on economic impact

Conditions where trade imbalances may be problematic
Those who ignore the effects of long run trade deficits may be confusing David Ricardo's principle of comparative advantage with Adam Smith's principle of absolute advantage, specifically ignoring the latter. The economist Paul Craig Roberts notes that the comparative advantage principles developed by David Ricardo do not hold where the factors of production are internationally mobile.[6][7] Global labor arbitrage, a phenomenon described by economist

Stephen S. Roach, where one country exploits the cheap labor of another, would be a case of absolute advantage that is not mutually beneficial.[8][9][10]
The case of the United States

Since the stagflation of the 1970s, the U.S. economy has been characterized by slower GDP growth. In 1985, the U.S. began its growing trade deficit with China. Over the long run, nations with trade surpluses tend also to have a savings surplus. The U.S. generally has lower savings rates than its trading partners, which tend to have trade surpluses. Germany, France, Japan, and Canada have maintained higher savings rates than the U.S. over the long run.[11] Some economists believe that GDP and employment can be dragged down by an over-large deficit over the long run.[12][13] Others believe that trade deficits are good for the economy.[14] The opportunity cost of a forgone tax base may outweigh perceived gains, especially where artificial currency pegs and manipulations are present to distort trade.[15] Wealth-producing primary sector jobs in the U.S. such as those in manufacturing and computer software have often been replaced by much lower paying wealth-consuming jobs such as those in retail and government in the service sector when the economy recovered from recessions.[7][16][17] Some economists contend that the U.S. is borrowing to fund consumption of imports while accumulating unsustainable amounts of debt.[4][18] In 2006, the primary economic concerns focused on: high national debt ($9 trillion), high nonbank corporate debt ($9 trillion), high mortgage debt ($9 trillion), high financial institution debt ($12 trillion), high unfunded Medicare liability ($30 trillion), high unfunded Social Security liability ($12 trillion), high external debt (amount owed to foreign lenders) and a serious deterioration in the United States net international investment position (NIIP) (-24% of GDP),[4] high trade deficits, and a rise in illegal immigration.[18][19] These issues have raised concerns among economists and unfunded liabilities were mentioned as a serious problem facing the United States in the President's 2006 State of the Union address.[19][20] On June 26, 2009, Jeff Immelt, the CEO of General Electric, called for the U.S. to increase its manufacturing base employment to 20% of the workforce, commenting that the U.S. has outsourced too much in some areas and can no longer rely on the financial sector and consumer spending to drive demand.[21]
See also: Friedrich List

Conditions where trade imbalances may not be problematic

Small trade deficits are generally not considered to be harmful to either the importing or exporting economy. However, when a national trade imbalance expands beyond prudence (generally thought to be several[clarification needed] percent of GDP, for several years), adjustments tend to occur. While unsustainable imbalances [22] may persist for long periods (cf, Singapore and New Zealands surpluses and deficits, respectively), the distortions likely to be caused by

large flows of wealth out of one economy and into another tend to become intolerable.[citation
needed]

In simple terms, trade deficits are paid for out of foreign exchange reserves, and may continue until such reserves are depleted. At such a point, the importer can no longer continue to purchase more than is sold abroad. This is likely to have exchange rate implications: a sharp loss of value in the deficit economys exchange rate with the surplus economys currency will change the relative price of tradable goods, and facilitate a return to balance or (more likely) an overshooting into surplus the other direction. More complexly, an economy may be unable to export enough goods to pay for its imports, but is able to find funds elsewhere. Service exports, for example, are more than sufficient to pay for Hong Kongs domestic goods export shortfall. In poorer countries, foreign aid may fill the gap while in rapidly developing economies a capital account surplus often off-sets a current-account deficit. There are some economies where transfers from nationals working abroad contribute significantly to paying for imports. The Philippines, Bangladesh and Mexico are examples of transfer-rich economies. Finally, a country may partially rebalance by use of quantitative easing at home. This involves a central bank buying back long term government bonds from other domestic financial institutions without reference to the interest rate (which is typically low when QE is called for), seriously increasing the money supply. This debases the local currency but also reduces the debt owed to foreign creditors - effectively "exporting inflation".

Adam Smith on trade deficits

"In the foregoing part of this chapter I have endeavoured to show, even upon the principles of the commercial system, how unnecessary it is to lay extraordinary restraints upon the importation of goods from those countries with which the balance of trade is supposed to be disadvantageous. Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon which, not only these restraints, but almost all the other regulations of commerce are founded. When two places trade with one another, this [absurd] doctrine supposes that, if the balance be even, neither of them either loses or gains; but if it leans in any degree to one side, that one of them loses and the other gains in proportion to its declension from the exact equilibrium." (Smith, 1776, book IV, ch. iii, part ii) [23]

Frdric Bastiat on the fallacy of trade deficits

The 19th century economist and philosopher Frdric Bastiat expressed the idea that trade deficits actually were a manifestation of profit, rather than a loss. He proposed as an example to suppose that he, a Frenchman, exported French wine and imported British coal, turning a profit. He supposed he was in France, and sent a cask of wine which was worth 50 francs to England. The customhouse would record an export of 50 francs. If, in England, the wine sold for 70 francs (or the pound equivalent), which he then used to buy coal, which he imported into France, and was found to be worth 90 francs in France, he would have made a profit of 40 francs. But the customhouse would say that the value of imports exceeded that of exports and was trade deficit against the ledger of France.[24]

By reductio ad absurdum, Bastiat argued that the national trade deficit was an indicator of a successful economy, rather than a failing one. Bastiat predicted that a successful, growing economy would result in greater trade deficits, and an unsuccessful, shrinking economy would result in lower trade deficits. This was later, in the 20th century, affirmed by economist Milton Friedman.

John Maynard Keynes on the balance of trade

In the last few years of his life, John Maynard Keynes was much preoccupied with the question of balance in international trade. He was the leader of the British delegation to the United Nations Monetary and Financial Conference in 1944 that established the Bretton Woods system of international currency management. He was the principal author of a proposal the so-called Keynes Plan for an International Clearing Union. The two governing principles of the plan were that the problem of settling outstanding balances should be solved by 'creating' additional 'international money', and that debtor and creditor should be treated almost alike as disturbers of equilibrium. In the event, though, the plans were rejected, in part because "American opinion was naturally reluctant to accept the principle of equality of treatment so novel in debtor-creditor relationships".[25] His view, supported by many economists and commentators at the time, was that creditor nations may be just as responsible as debtor nations for disequilibrium in exchanges and that both should be under an obligation to bring trade back into a state of balance. Failure for them to do so could have serious consequences. In the words of Geoffrey Crowther, then editor of The Economist, "If the economic relationships between nations are not, by one means or another, brought fairly close to balance, then there is no set of financial arrangements that can rescue the world from the impoverishing results of chaos."[26] These ideas were informed by events prior to the Great Depression when in the opinion of Keynes and others international lending, primarily by the U.S., exceeded the capacity of sound investment and so got diverted into non-productive and speculative uses, which in turn invited default and a sudden stop to the process of lending.[27] Influenced by Keynes, economics texts in the immediate post-war period put a significant emphasis on balance in trade. For example, the second edition of the popular introductory textbook, An Outline of Money,[28] devoted the last three of its ten chapters to questions of foreign exchange management and in particular the 'problem of balance'. However, in more recent years, since the end of the Bretton Woods system in 1971, with the increasing influence of Monetarist schools of thought in the 1980s, and particularly in the face of large sustained trade imbalances, these concerns and particularly concerns about the destabilising effects of large trade surpluses have largely disappeared from mainstream economics discourse[29] and Keynes' insights have slipped from view.[30] They are receiving some attention again in the wake of the Financial crisis of 20072010.[31]

Milton Friedman on trade deficits

In the 1980s, Milton Friedman, the Nobel Prize-winning economist and father of Monetarism, contended that some of the concerns of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting industries. Prof. Friedman argued that trade deficits are not necessarily as important as high exports raise the value of the currency, reducing aforementioned exports, and vice versa for imports, thus naturally removing trade deficits not due to investment. Since 1971, when the Nixon administration decided to abolish fixed exchange rates, America's Current Account accumulated trade deficits have totaled $7.75 Trillion as of 2010. This deficit exists as it is matched by investment coming in to the United States- purely by the definition of the balance of payments, any current account deficit that exists is matched by an inflow of foreign investment. In the late 1970s and early 1980s, the U.S. had experienced high inflation and Friedman's policy positions tended to defend the stronger dollar at that time. He stated his belief that these trade deficits were not necessarily harmful to the economy at the time since the currency comes back to the country (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). However, it may be in one form or another including the possible tradeoff of foreign control of assets. In his view, the "worst case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging them for pieces of cheaply made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation.[32] This position is a more refined version of the theorem first discovered by David Hume.[33] Hume argued that England could not permanently gain from exports, because hoarding gold (i.e., currency) would make gold more plentiful in England; therefore, the prices of English goods would rise, making them less attractive exports and making foreign goods more attractive imports. In this way, countries' trade balances would balance out.[34] Friedman believed that deficits would be corrected by free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength. In the real world, a potential difficulty is that currency markets are far from a free market, with government and central banks being major players, and this is unlikely to change within the foreseeable future. Nevertheless, recent developments have shown that the global economy is undergoing a fundamental shift. For many years, the U.S. has borrowed and bought while in general, the rest of the world has lent and sold. As of October 2007, the U.S. dollar weakened against the euro, British pound, and many other currencies. For instance, the euro hit $1.42 in October 2007,[35] the strongest it has been since its birth in 1999. Against this backdrop, American exporters are finding quite favorable overseas markets for their products and U.S. consumers are responding to their general housing slowdown by slowing their spending. Furthermore, China, the Middle East, central Europe and Africa are absorbing more of the world's imports which in the end may result in a world economy that is more evenly balanced. All of this could well add up to a major readjustment of the U.S. trade deficit, which as a percentage of GDP, began in 1991.[36]

Friedman contended that the structure of the balance of payments was misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He essentially claimed that the foreign assets were not carried on the books at their higher, truer value.[citation needed] Friedman presented his analysis of the balance of trade in Free to Choose, widely considered his most significant popular work.

Warren Buffett on trade deficits

The successful American businessman and investor Warren Buffett was quoted in the Associated Press (January 20, 2006) as saying "The U.S trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil... Right now, the rest of the world owns $3 trillion more of us than we own of them." In a more detailed 2003 Fortune article, Buffett proposed a tool called Import Certificates as a solution to the United States' problem and ensure balanced trade. "The rest of the world owns a staggering $2.5 trillion more of the U.S. than we own of other countries. Some of this $2.5 trillion is invested in claim checksU.S. bonds, both governmental and private and some in such assets as property and equity securities."[37]

Physical balance of trade

Monetary balance of trade is different from physical balance of trade[38] (which is expressed in amount of raw materials, known also as Total Material Consumption). Developed countries usually import a lot of primary raw materials from developing countries at low prices. Often, these materials are then converted into finished products, and a significant amount of value is added. Although for instance the EU (as well as many other developed countries) has a balanced monetary balance of trade, its physical trade balance (especially with developing countries) is negative, meaning that a lot less material is exported than imported. For this reason, activists talk about the issue of ecological debt which implies a sort of predatory economic system. The nature of the trade balance statistics is such that it conceals distorted material flow.

United States trade deficit

United States balance of trade (19802011), with negative numbers denoting a trade deficit

Deteriorating U.S. net international investment position

The U.S. has held a trade deficit starting late in the 1960s. Its trade deficit has been increasing at a large rate since 1997 [39] (See chart) and increased by 49.8 billion dollars between 2005 and 2006, setting a record high of 817.3 billion dollars, up from 767.5 billion dollars the previous year.[40] The graph indicates that, as Frdric Bastiat predicted, the deficit slackened during recessions and grew during periods of expansion. Also of note, many economists calculate trade deficits and/or current account deficits as a percentage of GDP. The US last had a trade surplus in

1975.[41] Every year there has been a major reduction in economic growth, it is followed by a reduction in the US trade deficit.[36] In economics, the current account is one of the two primary components of the balance of payments, the other being capital account. It is the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers. The current account balance is one of two major measures of the nature of a country's foreign trade (the other being the net capital outflow). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. It is called the current account because goods and services are generally consumed in the current period.[1] The balance of trade is the difference between a nation's exports of goods and services and its imports of goods and services, if all financial transfers, investments and other components are ignored. A Nation is said to have a trade deficit if it is importing more than it exports. Positive net sales abroad generally contributes to a current account surplus; negative net sales abroad generally contributes to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This however is not always the case with secluded economies such as that of Australia featuring an income deficit larger than its trade surplus.[2] The net factor income or income account, a sub-account of the current account, is usually presented under the headings income payments as outflows, and income receipts as inflows. Income refers not only to the money received from investments made abroad (note: investments are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc. The various subcategories in the income account are linked to specific respective subcategories in the capital account, as income is often composed of factor payments from the ownership of capital (assets) or the negative capital (debts) abroad. From the capital account, economists and central banks determine implied rates of return on the different types of capital. The United States, for example, gleans a substantially larger rate of return from foreign capital than foreigners do from owning United States capital. In the traditional accounting of balance of payments, the current account equals the change in net foreign assets. A current account deficit implies a paralleled reduction of the net foreign assets.
current account = changes in net foreign assets

If an economy is running current account deficit, it is absorbing (absorption = domestic consumption + investment + government spending) more than that it is producing. This can only happen if some other economies are lending their savings to it (in the form of debt to or direct/ portfolio investment in the economy) or the economy is running down its foreign assets such official foreign currency reserve. On the other hand, if an economy is running a current account surplus it is absorbing less than that it is producing. This means it is saving. As the economy is open, this saving is being invested abroad and thus foreign assets are being created.

How to calculate the current account

Normally,the current account is calculated by adding up the 4 components of current account: Goods, services, income and current transfers.[3]

Goods
Being movable and physical in nature, goods are often traded by countries all over the world. When a transaction of certain good's ownership from a local country to a foreign country takes place, this is called as an "export." The other way around, when a good's owner changes to a local inhabitant from a foreigner, is defined to be an "import." In calculating current account, exports are marked as credit (the inflow of money) and imports as debit. (the outflow of money.)

Services
When an intangible service (e.g. tourism) is used by a foreigner in a local land and the local resident receives the money from a foreigner, this is also counted as an export, thus a credit.

Income
A credit of income happens when an individual or a company of domestic nationality receives money from a company or individual with foreign identity. A foreign company's investment upon a domestic company or a local government is also considered as a credit.

Current Transfers
Current transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or official assistance.

A formula for calculating current accounts

Thus, one can see that a certain country's current account can be calculated by the following formula:

When CA is the current account, X and M the export and import of goods and services respectively, NY the net income from abroad, and NCT the net current transfers.

Reducing current account deficits

Action to reduce a substantial current account deficit usually involves increasing exports (goods going out of a country and entering abroad countries) or decreasing imports (goods coming from a foreign country into a country). Firstly, this is generally accomplished directly through import restrictions, quotas, or duties (though these may indirectly limit exports as well), or by promoting exports (through subsidies,custom duty exemptions etc.).Influencing the exchange rate to make exports cheaper for foreign buyers will indirectly increase the balance of payments. Also, Currency wars, a phenomenon evident in post recessionary markets is a protectionist policy, whereby countries devalue their currencies to ensure export competitiveness. Secondly, adjusting government spending to favor domestic suppliers is also effective. Less obvious methods to reduce a current account deficit include measures that increase domestic savings (or reduced domestic borrowing), including a reduction in borrowing by the national government.

The Pitchford thesis

The quarterly current account of Australia ($A million) since 1959

A current account deficit is not always a problem. The Pitchford thesis states that a current account deficit does not matter if it is driven by the private sector. It is also known as the "consenting adults" view of the current account, as it holds that deficits are not a problem if they result from private sector agents engaging in mutually beneficial trade. A Current Account Deficit creates an obligation of repayments of foreign capital, and that capital consists of many individual transactions. Pitchford asserts that since each of these transactions were individually considered financially sound when they were made, their aggregate effect (the Current Account Deficit) is also sound. Some feel that this theory has held true for the Australian economy, which has had a persistent current account deficit, yet has experienced economic growth for the past 18 years (19912009).

Interrelationships in the balance of payments

Main article: Balance of payments

Absent changes in official reserves, the current account is the mirror image of the sum of the capital and financial accounts. One might then ask: Is the current account driven by the capital and financial accounts or is it vice versa? The traditional response is that the current account is the main causal factor, with capital and financial accounts simply reflecting financing of a deficit or investment of funds arising as a result of a surplus. However, more recently some observers have suggested that the opposite causal relationship may be important in some cases. In particular, it has controversially been suggested that the United States current account deficit is driven by the desire of international investors to acquire U.S. assets (See Ben Bernanke,[4] William Poole links below). However, the main viewpoint undoubtedly remains that the causative factor is the current account and that the positive financial account reflects the need to finance the country's current account deficit.

U.S. account deficits

Since 1989, the current account deficit of the US has been increasingly large, reaching close to 7% of the GDP in 2006. In 2011, it was the highest deficit in the world.[5] New evidences, however, suggest that the U.S. current account deficits are being mitigated by positive valuation effects.[6] That is, the U.S. assets overseas are gaining in value relative to the domestic assets held by foreign investors. The U.S. net foreign assets therefore is not deteriorating one to one with the current account deficits. The most recent experience has reversed this positive valuation effect, however, with the US net foreign asset position deteriorating by more than two trillion dollars in 2008.[7] This was due primarily to the relative under-performance of domestic ownership of foreign assets (largely foreign equities) to foreign ownership of domestic assets (largely US treasuries and bonds). Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.[1] These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries. While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is

positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign exchange reserves do not change. Historically there have been different pedagolocigal approaches to the question of how or even whether to eliminate current account or trade imbalances. With record trade imbalances held up as one of the contributing factors to the financial crisis of 20072010, plans to address global imbalances have been high on the agenda of policy makers since 2009.

Composition of the balance of payments sheet

BOP The two principal parts of the BOP accounts are the current account and the capital account. The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers. It is called the current account as it covers transactions in the "here and now" - those that don't give rise to future claims.[2] The Capital Account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account.[3] Expressed with the broader meaning for the capital account, the BOP identity assumes that any current account surplus will be balanced by a capital account deficit of equal size - or alternatively a current account deficit will be balanced by a corresponding capital account surplus:

The balancing item, which may be positive or negative, is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero. By the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts automatically balance. A balance isn't always reflected in reported figures for the current and capital accounts, which might, for example, report a surplus for both accounts, but when this happens it always means something has been missedmost commonly, the operations of the country's central bankand what has been missed is recorded in the statistical discrepancy term (the balancing item).[3] An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:

Trade buying and selling of goods and services o Exports a credit entry o Imports a debit entry Trade balance the sum of Exports and Imports Factor income repayments and dividends from loans and investments o Factor earnings a credit entry o Factor payments a debit entry Factor income balance the sum of earnings and payments.

Especially in older balance sheets, a common division was between visible and invisible entries. Visible trade recorded imports and exports of physical goods (entries for trade in physical goods excluding services is now often called the merchandise balance). Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings.[1] The term "balance of payments surplus" (or deficit a deficit is simply a negative surplus) refers to the sum of the surpluses in the current account and the narrowly defined capital account (excluding changes in central bank reserves). Denoting the balance of payments surplus as BOP surplus, the relevant identity is

Variations in the use of term "balance of payments"

Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of misunderstanding due to divergent expectations about what the term denotes. Grabbe says the term is sometimes misused by people who aren't aware of the accepted meaning, not only in general conversation but in financial publications and the economic literature.[3] A common source of confusion arises from whether or not the reserve account entry, part of the capital account, is included in the BOP accounts. The reserve account records the activity of the nation's central bank. If it is excluded, the BOP can be in surplus (which implies the central bank is building up foreign exchange reserves) or in deficit (which implies the central bank is running down its reserves or borrowing from abroad).[1][3]

The term "balance of payments" is sometimes misused by non-economists to mean just relatively narrow parts of the BOP such as the trade deficit,[3] which means excluding parts of the current account and the entire capital account. Another cause of confusion is the different naming conventions in use.[4] Before 1973 there was no standard way to break down the BOP sheet, with the separation into invisible and visible payments sometimes being the principal divisions. The IMF have their own standards for BOP accounting which is equivalent to the standard definition but uses different nomenclature, in particular with respect to the meaning given to the term capital account.

The IMF definition

The International Monetary Fund (IMF) use a particular set of definitions for the BOP accounts, which is also used by the Organisation for Economic Co-operation and Development (OECD), and the United Nations System of National Accounts (SNA).[5] The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, form a small part of the overall capital account.[6] The IMF separates these transactions out to form an additional top level division of the BOP accounts. Expressed with the IMF definition, the BOP identity can be written:

The IMF uses the term current account with the same meaning as that used by other organizations, although it has its own names for its three leading sub-divisions, which are:

The goods and services account (the overall trade balance) The primary income account (factor income such as from loans and investments) The secondary income account (transfer payments)

Imbalances
While the BOP has to balance overall,[7] surpluses or deficits on its individual elements can lead to imbalances between countries. In general there is concern over deficits in the current account.[8] Countries with deficits in their current accounts will build up increasing debt and/or see increased foreign ownership of their assets. The types of deficits that typically raise concern are[1]

A visible trade deficit where a nation is importing more physical goods than it exports (even if this is balanced by the other components of the current account.) An overall current account deficit. A basic deficit which is the current account plus foreign direct investment (but excluding other elements of the capital account like short terms loans and the reserve account.)

As discussed in the history section below, the Washington Consensus period saw a swing of opinion towards the view that there is no need to worry about imbalances. Opinion swung back in the opposite direction in the wake of financial crisis of 20072009. Mainstream opinion expressed by the leading financial press and economists, international bodies like the IMFas well as leaders of surplus and deficit countrieshas returned to the view that large current account imbalances do matter.[9] Some economists do, however, remain relatively unconcerned about imbalances[10] and there have been assertions, such as by Michael P. Dooley, David Folkerts-Landau and Peter Garber, that nations need to avoid temptation to switch to protectionism as a means to correct imbalances.[11]

Causes of BOP imbalances

There are conflicting views as to the primary cause of BOP imbalances, with much attention on the US which currently has by far the biggest deficit. The conventional view is that current account factors are the primary cause[12] - these include the exchange rate, the government's fiscal deficit, business competitiveness, and private behaviour such as the willingness of consumers to go into debt to finance extra consumption.[13] An alternative view, argued at length in a 2005 paper by Ben Bernanke, is that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation.[14]

Reserve asset
Main article: Reserve currency

The US dollar has been the leading reserve asset since the end of the gold standard.

In the context of BOP and international monetary systems, the reserve asset is the currency or other store of value that is primarily used by nations for their foreign reserves.[15] BOP imbalances tend to manifest as hoards of the reserve asset being amassed by surplus countries, with deficit countries building debts denominated in the reserve asset or at least depleting their supply. Under a gold standard, the reserve asset for all members of the standard is gold. In the Bretton Woods system, either gold or the U.S. dollar could serve as the reserve asset, though its

smooth operation depended on countries apart from the US choosing to keep most of their holdings in dollars. Following the ending of Bretton Woods, there has been no de jure reserve asset, but the US dollar has remained by far the principal de facto reserve. Global reserves rose sharply in the first decade of the 21st century, partly as a result of the 1997 Asian Financial Crisis, where several nations ran out of foreign currency needed for essential imports and thus had to accept deals on unfavourable terms. The International Monetary Fund (IMF) estimates that between 2000 to mid-2009, official reserves rose from $1,900bn to $6,800bn.[16] Global reserves had peaked at about $7,500bn in mid 2008, then declined by about $430bn as countries without their own reserve currency used them to shield themselves from the worst effects of the financial crisis. From Feb 2009 global reserves began increasing again to reach close to $9,200bn by the end of 2010.[17] [18] As of 2009 approximately 65% of the world's $6,800bn total is held in U.S. dollars and approximately 25% in euros. The UK pound, Japanese yen, IMF special drawing rights (SDRs), and precious metals[19] also play a role. In 2009 Zhou Xiaochuan, governor of the People's Bank of China, proposed a gradual move towards increased use of SDRs, and also for the national currencies backing SDRs to be expanded to include the currencies of all major economies.[20] [21] Dr Zhou's proposal has been described as one of the most significant ideas expressed in 2009.[22] While the current central role of the dollar does give the US some advantages such as lower cost of borrowings, it also contributes to the pressure causing the U.S. to run a current account deficit, due to the Triffin dilemma. In a November 2009 article published in Foreign Affairs magazine, economist C. Fred Bergsten argued that Dr Zhou's suggestion or a similar change to the international monetary system would be in the United States' best interests as well as the rest of the world's.[23] Since 2009 there has been a notable increase in the number of new bilateral agreements which enable international trades to be transacted using a currency that isn't a traditional reserve asset, such as the renminbi, as the Settlement currency. [24]

Balance of payments crisis

Main article: Currency crisis

A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation's currency. Crises are generally preceded by large capital inflows, which are associated at first with rapid economic growth.[25] However a point is reached where overseas investors become concerned about the level of debt their inbound capital is generating, and decide to pull out their funds.[26] The resulting outbound capital flows are associated with a rapid drop in the value of the affected nation's currency. This causes issues for firms of the affected nation who have received the inbound investments and loans, as the revenue of those firms is typically mostly derived domestically but their debts are often denominated in a reserve currency. Once the nation's government has exhausted its foreign reserves trying to support the value of the domestic currency, its policy options are very limited. It can raise its interest rates to try to prevent further declines in the value of its currency, but while this can help those with

debts denominated in foreign currencies, it generally further depresses the local economy.[25] [27]
[28]

Balancing mechanisms
One of the three fundamental functions of an international monetary system is to provide mechanisms to correct imbalances.[29][30] Broadly speaking, there are three possible methods to correct BOP imbalances, though in practice a mixture including some degree of at least the first two methods tends to be used. These methods are adjustments of exchange rates; adjustment of a nations internal prices along with its levels of demand; and rules based adjustment.[31] Improving productivity and hence competitiveness can also help, as can increasing the desirability of exports through other means, though it is generally assumed a nation is always trying to develop and sell its products to the best of its abilities.

Rebalancing by changing the exchange rate

An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus. It also tends to make investment flows into the capital account less attractive so will help with a surplus there too. Conversely a downward shift in the value of a nation's currency makes it more expensive for its citizens to buy imports and increases the competitiveness of their exports, thus helping to correct a deficit (though the solution often doesn't have a positive impact immediately due to the MarshallLerner condition).[32] Exchange rates can be adjusted by government[33] in a rules based or managed currency regime, and when left to float freely in the market they also tend to change in the direction that will restore balance. When a country is selling more than it imports, the demand for its currency will tend to increase as other countries ultimately[34] need the selling country's currency to make payments for the exports. The extra demand tends to cause a rise of the currency's price relative to others. When a country is importing more than it exports, the supply of its own currency on the international market tends to increase as it tries to exchange it for foreign currency to pay for its imports, and this extra supply tends to cause the price to fall. BOP effects are not the only market influence on exchange rates however, they are also influenced by differences in national interest rates and by speculation.

Rebalancing by adjusting internal prices and demand

When exchange rates are fixed by a rigid gold standard,[35] or when imbalances exist between members of a currency union such as the Eurozone, the standard approach to correct imbalances is by making changes to the domestic economy. To a large degree, the change is optional for the surplus country, but compulsory for the deficit country. In the case of a gold standard, the mechanism is largely automatic. When a country has a favourable trade balance, as a consequence of selling more than it buys it will experience a net inflow of gold. The natural effect of this will be to increase the money supply, which leads to inflation and an increase in

prices, which then tends to make its goods less competitive and so will decrease its trade surplus. However the nation has the option of taking the gold out of economy (sterilising the inflationary effect) thus building up a hoard of gold and retaining its favourable balance of payments. On the other hand, if a country has an adverse BOP it will experience a net loss of gold, which will automatically have a deflationary effect, unless it chooses to leave the gold standard. Prices will be reduced, making its exports more competitive, and thus correcting the imbalance. While the gold standard is generally considered to have been successful[36] up until 1914, correction by deflation to the degree required by the large imbalances that arose after WWI proved painful, with deflationary policies contributing to prolonged unemployment but not re-establishing balance. Apart from the US most former members had left the gold standard by the mid 1930s. A possible method for surplus countries such as Germany to contribute to re-balancing efforts when exchange rate adjustment is not suitable, is to increase its level of internal demand (i.e. its spending on goods). While a current account surplus is commonly understood as the excess of earnings over spending, an alternative expression is that it is the excess of savings over investment.[37] That is:

where CA = current account, NS = national savings (private plus government sector), NI = national investment. If a nation is earning more than it spends the net effect will be to build up savings, except to the extent that those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any current account surplus will tend to be reduced. However in 2009 Germany amended its constitution to prohibit running a deficit greater than 0.35% of its GDP[38] and calls to reduce its surplus by increasing demand have not been welcome by officials,[39] adding to fears that the 2010s will not be an easy decade for the eurozone.[40] In their April 2010 world economic outlook report, the IMF presented a study showing how with the right choice of policy options governments can transition out of a sustained current account surplus with no negative effect on growth and with a positive impact on unemployment.[41]

Rules based rebalancing mechanisms

Nations can agree to fix their exchange rates against each other, and then correct any imbalances that arise by rules based and negotiated exchange rate changes and other methods. The Bretton Woods system of fixed but adjustable exchange rates was an example of a rules based system, though it still relied primarily on the two traditional mechanisms. John Maynard Keynes, one of the architects of the Bretton Woods system had wanted additional rules to encourage surplus countries to share the burden of rebalancing, as he argued that they were in a stronger position to do so and as he regarded their surpluses as negative externalities imposed on the global economy.[42] Keynes suggested that traditional balancing mechanisms should be supplemented by the threat of confiscation of a portion of excess revenue if the surplus country did not choose to spend it on additional imports. However his ideas were not accepted by the Americans at the

time. In 2008 and 2009, American economist Paul Davidson had been promoting his revamped form of Keynes's plan as a possible solution to global imbalances which in his opinion would expand growth all round without the downside risk of other rebalancing methods.[32][43][44]

History of balance of payments issues

Historically, accurate balance of payments figures were not generally available. However, this did not prevent a number of switches in opinion on questions relating to whether or not a nations government should use policy to encourage a favourable balance.

Pre-1820: mercantilism
Up until the early 19th century, international trade was generally very small in comparison with national output, and was often heavily regulated. In the Middle Ages, European trade was typically regulated at municipal level in the interests of security for local industry and for established merchants.[45] From about the 16th century, mercantilism became the dominant economic theory influencing European rulers, which saw local regulation replaced by national rules aiming to harness the countries' economic output.[46] Measures to promote a trade surplus such as tariffs were generally favoured. Power was associated with wealth, and with low levels of growth, nations were best able to accumulate funds either by running trade surpluses or by forcefully confiscating the wealth of others. Rulers sometimes strove to have their countries outsell competitors and so build up a "war chest" of gold.[47] This era saw low levels of economic growth; average global per capita income is not considered to have significantly risen in the whole 800 years leading up to 1820, and is estimated to have increased on average by less than 0.1% per year between 1700 and 1820.[25] With very low levels of financial integration between nations and with international trade generally making up a low proportion of individual nations' GDP, BOP crises were very rare.[25]

18201914: free trade

Gold was the primary reserve asset during the gold standard era.

From the late 18th century, mercantilism was challenged by the ideas of Adam Smith and other economic thinkers favouring free trade. After victory in the Napoleonic wars Great Britain began

promoting free trade, unilaterally reducing her trade tariffs. Hoarding of gold was no longer encouraged, and in fact Britain exported more capital as a percentage of her national income than any other creditor nation has since.[48] Great Britain's capital exports further helped to correct global imbalances as they tended to be counter cyclical, rising when Britain's economy went into recession, thus compensating other states for income lost from export of goods.[25] According to historian Carroll Quigley, Great Britain could afford to act benevolently[49] in the 19th century due to the advantages of her geographical location, its naval power and economic ascendancy as the first nation to enjoy an industrial revolution.[50] A view advanced by economists such as Barry Eichengreen is that the first age of Globalization began with the laying of transatlantic cables in the 1860s, which facilitated a rapid increase in the already growing trade between Britain and America.[28] Though Current Account controls were still widely used (in fact all industrial nations apart from Great Britain and the Netherlands actually increased their tariffs and quotas in the decades leading up to 1914, though this was motivated more by a desire to protect "infant industries" than to encourage a trade surplus[25]), capital controls were largely absent, and people were generally free to cross international borders without requiring passports. A gold standard enjoyed wide international participation especially from 1870, further contributing to close economic integration between nations. The period saw substantial global growth, in particular for the volume of international trade which grew tenfold between 1820 and 1870 and then by about 4% annually from 1870 to 1914. BOP crises began to occur, though less frequently than was to be the case for the remainder of the 20th century. From 1880 to 1914, there were approximately [51] 8 BOP crises and 8 twin crises - a twin crises being a BOP crises that coincides with a banking crises.[25]

19141945: deglobalisation
The favourable economic conditions that had prevailed up until 1914 were shattered by the first world war, and efforts to re-establish them in the 1920s were not successful. Several countries rejoined the gold standard around 1925. But surplus countries didn't "play by the rules",[25][52] sterilising gold inflows to a much greater degree than had been the case in the pre-war period. Deficit nations such as Great Britain found it harder to adjust by deflation as workers were more enfranchised and unions in particular were able to resist downwards pressure on wages. During the Great Depression most countries abandoned the gold standard, but imbalances remained an issue and international trade declined sharply. There was a return to mercantilist type "beggar thy neighbour" policies, with countries competitively devaluing their exchange rates, thus effectively competing to export unemployment. There were approximately 16 BOP crises and 15 twin crises (and a comparatively very high level of banking crises.)[25]

19451971: Bretton Woods

Main article: Bretton Woods system

Following World War II, the Bretton Woods institutions (the International Monetary Fund and World Bank) were set up to support an international monetary system designed to encourage free trade while also offering states options to correct imbalances without having to deflate their economies. Fixed but flexible exchange rates were established, with the system anchored by the dollar which alone remained convertible into gold. The Bretton Woods system ushered in a period of high global growth, known as the Golden Age of Capitalism, however it came under pressure due to the inability or unwillingness of governments to maintain effective capital controls [53] and due to instabilities related to the central role of the dollar. Imbalances caused gold to flow out of the US and a loss of confidence in the United States ability to supply gold for all future claims by dollar holders resulted in escalating demands to convert dollars, ultimately causing the US to end the convertibility of the dollar into gold, thus ending the Bretton Woods system.[25] The 1945 - 71 era saw approximately 24 BOP crises and no twin crises for advanced economies, with emerging economies seeing 16 BOP crises and just one twin crises.[25]

19712009: transition, Washington Consensus, Bretton Woods II

Main article: Washington Consensus

Manmohan Singh, currently PM of India, showed that the challenges caused by imbalances can be an opportunity when he led his country's successful economic reform programme after the 1991 crisis.

The Bretton Woods system came to an end between 1971 and 1973. There were attempts to repair the system of fixed exchanged rates over the next few years, but these were soon abandoned, as were determined efforts for the U.S. to avoid BOP imbalances. Part of the reason was displacement of the previous dominant economic paradigm Keynesianism by the Washington Consensus, with economists and economics writers such as Murray Rothbard and Milton Friedman[54] arguing that there was no great need to be concerned about BOP issues. According to Rothbard:

Fortunately, the absurdity of worrying about the balance of payments is made evident by focusing on inter-state trade. For nobody worries about the balance of payments between New York and New Jersey, or, for that matter, between Manhattan and Brooklyn, because there are no customs officials recording such trade and such balances.[55]

In the immediate aftermath of the Bretton Woods collapse, countries generally tried to retain some control over their exchange rate by independently managing it, or by intervening in the foreign exchange market as part of a regional bloc, such as the Snake which formed in 1971.[29] The Snake was a group of European countries who tried to retain stable rates at least with each other; the group eventually evolved into the European Exchange Rate Mechanism (ERM) by 1979. From the mid 1970s however, and especially in the 1980s and early 1990s, many other countries followed the US in liberalising controls on both their capital and current accounts, in adopting a somewhat relaxed attitude to their balance of payments and in allowing the value of their currency to float relatively freely with exchange rates determined mostly by the market.[25][29] Developing countries who chose to allow the market to determine their exchange rates would often develop sizeable current account deficits, financed by capital account inflows such as loans and investments,[56] though this often ended in crises when investors lost confidence.[25][57] [58] The frequency of crises was especially high for developing economies in this era - from 1973 to 1997 emerging economies suffered 57 BOP crises and 21 twin crises. Typically but not always the panic among foreign creditors and investors that preceded the crises in this period was usually triggered by concerns over excess borrowing by the private sector, rather than by a government deficit. For advanced economies, there were 30 BOP crises and 6 banking crises. A turning point was the 1997 Asian BOP Crisis, where unsympathetic responses by western powers caused policy makers in emerging economies to re-assess the wisdom of relying on the free market; by 1999 the developing world as a whole stopped running current account deficits [27] while the U.S. current account deficit began to rise sharply.[59] [60] This new form of imbalance began to develop in part due to the increasing practice of emerging economies, principally China, in pegging their currency against the dollar, rather than allowing the value to freely float. The resulting state of affairs has been referred to as Bretton Woods II.[11] According to Alaistair Chan, "At the heart of the imbalance is China's desire to keep the value of the yuan stable against the dollar. Usually, a rising trade surplus leads to a rising value of the currency. A rising currency would make exports more expensive, imports less so, and push the trade surplus towards balance. China circumvents the process by intervening in exchange markets and keeping the value of the yuan depressed."[61] According to economics writer Martin Wolf, in the eight years leading up to 2007, "three quarters of the foreign currency reserves accumulated since the beginning of time have been piled up".[62] In contrast to the changed approach within the emerging economies, US policy makers and economists remained relatively unconcerned about BOP imbalances. In the early to mid 1990s, many free market economists and policy makers such as U.S. Treasury secretary Paul O'Neill and Fed Chairman Alan Greenspan went on record suggesting the growing US deficit was not a major concern. While several emerging economies had intervening to boost their reserves and assist their exporters from the late 1980s, they only began running a net current account surplus after 1999. This was mirrored in the faster growth for the US current account deficit from the same year, with surpluses, deficits and the associated

build up of reserves by the surplus countries reaching record levels by the early 2000s and growing year by year. Some economists such as Kenneth Rogoff and Maurice Obstfeld began warning that the record imbalances would soon need to be addressed from as early as 2001, joined by Nouriel Roubini in 2004, but it wasn't until about 2007 that their concerns began to be accepted by the majority of economists.[27][63]

2009 and later: post Washington Consensus

Speaking after the 2009 G-20 London summit, Gordon Brown announced "the Washington Consensus is over".[64] There is now broad agreement that large imbalances between different countries do matter; for example mainstream U.S. economist C. Fred Bergsten has argued the U.S. deficit and the associated large inbound capital flows into the U.S. was one of the causes of the financial crisis of 20072010.[23] Since the crisis, government intervention in BOP areas such as the imposition of capital controls or foreign exchange market intervention has become more common and in general attracts less disapproval from economists, international institutions like the IMF and other governments.[65] [66] In 2007 when the crises began, the global total of yearly BOP imbalances was $1680 billion. On the credit side, the biggest current account surplus was China with approx. $362 billion, followed by Japan at $213bn and Germany at 185 billion, with oil producing countries such as Saudi Arabia also having large surpluses. On the debit side, the US had the biggest current account deficit at over $1100 billion, with the UK, Spain and Australia together accounting for close to a further $300 billion.[62] While there have been warnings of future cuts in public spending, deficit countries on the whole did not make these in 2009, in fact the opposite happened with increased public spending contributing to recovery as part of global efforts to increase demand.[67] The emphases has instead been on the surplus countries, with the IMF, EU and nations such as the U.S., Brazil and Russia asking them to assist with the adjustments to correct the imbalances. [68] [69] Economists such as Gregor Irwin and Philip R. Lane have suggested that increased use of pooled reserves could help emerging economies not to require such large reserves and thus have less need for current account surpluses. [70] Writing for the FT in Jan 2009, Gillian Tett says she expects to see policy makers becoming increasingly concerned about exchange rates over the coming year.[71] In June 2009, Olivier Blanchard the chief economist of the IMF wrote that rebalancing the world economy by reducing both sizeable surpluses and deficits will be a requirement for sustained recovery.[72] In 2008 and 2009, there was some reduction in imbalances, but early indications towards the end of 2009 were that major imbalances such as the U.S. current account deficit are set to begin increasing again.[10] [73] Japan had allowed her currency to appreciate through 2009, but has only limited scope to contribute to the rebalancing efforts thanks in part to her aging population. The euro used by Germany is allowed to float fairly freely in value, however further appreciation would be problematic for other members of the currency union such as Spain, Greece and Ireland who run

large deficits. Therefore Germany has instead been asked to contribute by further promoting internal demand, but this hasn't been welcomed by German officials.[68] China has been requested to allow the renminbi to appreciate but until 2010 had refused, the position expressed by her premier Wen Jiabao being that by keeping the value of the renmimbi stable against the dollar China has been helping the global recovery, and that calls to let her currency rise in value have been motivated by a desire to hold back China's development.[69] After China reported favourable results for her December 2009 exports however, the Financial Times reported that analysts are optimistic that China will allow some appreciation of her currency around mid 2010.[74] In April 2010 a Chinese official signalled the government is considering allowing the renminbi to appreciate, [75] but by May analysts were widely reporting the appreciation would likely be delayed due to the falling value of the Euro following the 2010 European sovereign debt crisis.[76] China announced the end of the renminbi's peg to the dollar in June 2010; the move was widely welcomed by markets and helped defuse tension over imbalances prior to the 2010 G-20 Toronto summit. However the renminbi remains managed and the new flexibility means it can move down as well as up in value; two months after the peg ended the renminbi had only appreciated against the dollar by about 0.8%.[77] By January 2011, the renminbi had appreciated against the dollar by 3.7%, which means it's on track to appreciate in nominal terms by 6% per year. As this reflects a real appreciation of 10% when China's higher inflation is accounted for, the U.S. Treasury once again declined to label China a currency manipulator in their February 2011 report to Congress. However Treasury officials did advise the rate of appreciation was still too slow for the best interests of the global economy.[78][79] In February 2011, Moody's analyst Alaistair Chan has predicted that despite a strong case for an upward revaluation, an increased rate of appreciation against the dollar is unlikely in the short term.[80] And as of February 2012, China's currency had been continuing to appreciate for a year and a half, while drawing remarkably little notice.[81] While some leading surplus countries including China have been taking steps to boost domestic demand, these have not yet been sufficient to rebalance out of their current account surpluses. By June 2010, the U.S. monthly current account deficit had risen back to $50 billion, a level not seen since mid 2008. With the US currently suffering from high unemployment and concerned about taking on additional debt, fears are rising that the US may resort to protectionist measures.[82]
Competitive devaluation after 2009 Main article: Currency war

By September 2010, international tensions relating to imbalances had further increased. Brazil's finance minister Guido Mantega declared that an "international currency war" has broken out, with countries competitively trying to devalue their currency so as to boost exports. Brazil has been one of the few major economies lacking a reserve currency to abstain from significant

currency intervention, with the real rising by 25% against the dollar since January 2009. Some economists such as Barry Eichengreen have argued that competitive devaluation may be a good thing as the net result will effectively be equivalent to expansionary global monetary policy. Others such as Martin Wolf saw risks of tensions further escalating and advocated that coordinated action for addressing imbalances should be agreed on at the November G20 summit.[17][83][84] Commentators largely agreed that little substantive progress was made on imbalances at the November 2010 G20. An IMF report released after the summit warned that without additional progress there is a risk of imbalances approximately doubling to reach pre-crises levels by 2014.[85] There are in total 6 types of financial crisis namely: 1) Balance-of-payment crisis, 2) Currency Crisis, 3) Banking Crisis, 4) Twin Crisis, 5) Sovereign Debt Crisis and 6) Sudden Stops. Currency Crisis is one of the 6 crises and is started by speculative attacks on the currency. This ultimately creates a loss in revenues and currency depreciation. It occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value. Currency crises usually affect fixed exchange rate regimes, rather than floating regimes. A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. Currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar, Euro or Pound sterling). Currency crises have large, measurable costs on an economy, but the ability to predict the timing and magnitude of crises is limited by theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations, and government policy.[1] Recessions attributed to currency crises include the 1994 economic crisis in Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002).

Theories
The currency crises and sovereign debt crises that have occurred with increasing frequency since the Latin American debt crisis of the 1980s have inspired a huge amount of research. There have been several 'generations' of models of currency crises.[2]

First generation
The 'first generation' of models of currency crises began with Paul Krugman's adaptation of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market.[3] In his article,[4] Krugman argues that a sudden speculative attack on a fixed exchange rate, even though it appears to be an irrational change in expectations, can result from rational behavior by investors. This happens if investors foresee that a government is running an excessive deficit, causing it to run short of liquid assets or "harder" foreign currency which it can sell to support its currency at the fixed rate. Investors are willing to continue holding the currency as long as they

expect the exchange rate to remain fixed, but they flee the currency en masse when they anticipate that the peg is about to end.

Second generation
The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986).[5] In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency.

Third generation
'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.[6] McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks). Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics. Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,[7] Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.[8][9] Krugman(1999)[10] suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, in his model, banking system plays no role. His model led to the policy prescription: impose a curfew on capital flight which was implemented by Malaysia during the Asian financial crisis. A Tobin tax, suggested by Nobel Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another. The tax is intended to put a penalty on short-term financial round-trip excursions into another currency. Tobin suggested his currency transaction tax in 1972 in his Janeway Lectures at Princeton, shortly after the Bretton Woods system of monetary management ended in 1971.[1] Prior to 1971, one of the chief features of the Bretton Woods system was an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value

plus or minus one percentin terms of gold. Then, on August 15, 1971, United States President Richard Nixon announced that the United States dollar would no longer be convertible to gold, effectively ending the system. This action created the situation whereby the U.S. dollar became the sole backing of currencies and a reserve currency for the member states of the Bretton Woods system, leading the system to collapse in the face of increasing financial strain in that same year. In that context, Tobin suggested a new system for international currency stability, and proposed that such a system include an international charge on foreign-exchange transactions. In 2001, in another context, just after "the nineties' crises in Mexico, Southeast Asia and Russia,"[2] which included the 1994 economic crisis in Mexico, the 1997 Asian Financial Crisis, and the 1998 Russian financial crisis, Tobin summarized his idea: The tax on foreign exchange transactions was devised to cushion exchange rate fluctuations. The idea is very simple: at each exchange of a currency into another a small tax would be levied let's say, 0.5% of the volume of the transaction. This dissuades speculators as many investors invest their money in foreign exchange on a very short-term basis. If this money is suddenly withdrawn, countries have to drastically increase interest rates for their currency to still be attractive. But high interest is often disastrous for a national economy, as the nineties' crises in Mexico, Southeast Asia and Russia have proven. My tax would return some margin of manoeuvre to issuing banks in small countries and would be a measure of opposition to the dictate of the financial markets.[3][4][5][6][7] Though James Tobin suggested the rate as "let's say 0.5%", in that interview setting, others have tried to be more precise in their search for the optimum rate

Tobin's concept
James Tobin's purpose in developing his idea of a currency transaction tax was to find a way to manage exchange-rate volatility. In his view, "currency exchanges transmit disturbances originating in international financial markets. National economies and national governments are not capable of adjusting to massive movements of funds across the foreign exchanges, without real hardship and without significant sacrifice of the objectives of national economic policy with respect to employment, output, and inflation.[1] Tobin saw two solutions to this issue. The first was to move toward a common currency, common monetary and fiscal policy, and economic integration.[1] The second was to move toward greater financial segmentation between nations or currency areas, permitting their central banks and governments greater autonomy in policies tailored to their specific economic institutions and objectives.[1] Tobins preferred solution was the former one but he did not see this as politically viable so he advocated for the latter approach: I therefore regretfully recommend the second, and my proposal is to throw some sand in the wheels of our excessively efficient international money markets.[1] Tobins method of throwing sand in the wheels was to suggest a tax on all spot conversions of one currency into another, proportional to the size of the transaction. He said:

It would be an internationally agreed uniform tax, administered by each government over its own jurisdiction. Britain, for example, would be responsible for taxing all inter-currency transactions in Eurocurrency banks and brokers located in London, even when sterling was not involved. The tax proceeds could appropriately be paid into the IMF or World Bank. The tax would apply to all purchases of financial instruments denominated in another currency---from currency and coin to equity securities. It would have to apply, I think, to all payments in one currency for goods, services, and real assets sold by a resident of another currency area. I don't intend to add even a small barrier to trade. But I see offhand no other way to prevent financial transactions disguised as trade.[1] In the development of his idea, Tobin was influenced by the earlier work of John Maynard Keynes on general financial transaction taxes: I am a disciple of Keynes, and he, in his famous chapter XII of the General Theory on Employment Interest and Money, had already prescribed a tax on transactions, with the aim of linking investors to their actions in a lasting fashion. In 1971 I transferred this idea to exchange markets.[3][4] Keynes' concept stems from 1936 when he proposed that a transaction tax should be levied on dealings on Wall Street, where he argued that excessive speculation by uninformed financial traders increased volatility. For Keynes (who was himself a speculator) the key issue was the proportion of 'speculators' in the market, and his concern that, if left unchecked, these types of players would become too dominant.[8] Keynes writes: Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. (,[8] p. 104) The introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States. (,[8] p. 105)

Variations on Tobin tax idea

The Spahn tax Main article: Spahn tax

According to Paul Bernd Spahn in 1995, "Analysis has shown that the Tobin tax as originally proposed is not viable and should be laid aside for good." Furthermore, he said:
"...it is virtually impossible to distinguish between normal liquidity trading and speculative "noise" trading. If the tax is generally applied at high rates, it will severely impair financial operations and create international liquidity problems, especially if derivatives are taxed as well. A lower tax rate would reduce the negative impact on financial markets, but not mitigate speculation where expectations of an exchange rate change exceed the tax margin."[9]

Spahn suggested an alternative involving

"...a two-tier rate structure consisting of a low-rate financial transactions tax, plus an exchange surcharge at prohibitive rates as a piggyback. The latter would be dormant in times of normal financial activities, and be activated only in the case of speculative attacks. The mechanism allowing the identification of abnormal trading in world financial markets would make reference to a "crawling peg" with an appropriate exchange rate band. The exchange rate would move freely within this band without transactions being taxed. Only transactions effected at exchange rates outside the permissible range would become subject to tax. This would automatically induce stabilizing behavior on the part of market participants."[9] Special Drawing Rights

On September 19, 2001, retired speculator George Soros put forward a proposal, special drawing rights (SDRs) that the rich countries would pledge for the purpose of providing international assistance, without necessarily dismissing the Tobin tax idea. He stated, "I think there is a case for a Tobin tax ... (but) it is not at all clear to me that a Tobin tax would reduce volatility in the currency markets. It is true that it may discourage currency speculation but it would also reduce the liquidity of the marketplace." [10]

Scope of the Tobin concept

The term "Tobin tax" has sometimes been used interchangeably with a specific currency transaction tax (CTT) in the manner of Tobin's original idea, and other times it has been used interchangeably with the various different ideas of a more general financial transaction tax (FTT). In both cases, the various ideas proposed have included both national and multinational concepts. A 2001 example of its association with the specific currency transaction tax is shown here: "The concept of a Tobin tax has experienced a resurgence in the discussion on reforming the international financial system. In addition to many legislative initiatives in favour of the Tobin tax in national parliaments, possible ways to introduce a Tobin-style currency transaction tax (CTT) are being scrutinised by the United Nations."[11] A 2009 example of its association with a general financial transaction tax is shown here: "European Union leaders urged the International Monetary Fund on Friday to consider a global tax on financial transactions in spite of opposition from the US and doubts at the IMF itself. In a communiqu issued after a two-day summit, the EUs 27 national leaders stopped short of making a formal appeal for the introduction of a so-called Tobin tax but made clear they regarded it as a potentially useful revenue-raising instrument."[12]

Evaluating the Tobin tax as a Currency Transaction Tax (CTT)

See also: Currency transaction tax

See also Evaluating the Tobin tax as a general Financial Transaction Tax

Are different players in the economy operating at cross purposes to each other?
In 1994, Canadian economist Rodney Schmidt noted that
in two-thirds of all the outright forward and [currency] swap transactions, the money moved into another currency for fewer than seven days. In only 1 per cent did the money stay for as long as one year. While the volatile exchange rates caused by all this rapid movement posed problems for national economies, it was the bread and butter of those playing the currency markets. Without constant fluctuations in the currency markets, Schmidt noted, there was little opportunity for profit.[13]

This certainly seemed to suggest the interests of currency traders and the interests of ordinary citizens [in national economies] were operating at cross-purposes.[13]
Schmidt also noted another interesting aspect of the foreign- exchange market: The dominant players were the private banks, which had huge pools of capital and access to information about currency values. Since much of the market involved moving large sums of money (typically in the tens of millions of dollars) for very short periods of time (often less than a day), banks were perfectly positioned to participate. Among swap transactions, which represented a major chunk of the foreign exchange market, 86 per cent of the transactions were actually between banks.[13]

Stability, volatility and speculation

The appeal of stability to many players in the world economy

In 1972, Tobin examined the global monetary system that remained after the Bretton Woods monetary system was abandoned. This examination was subsequently revisited by other analysts, such as Ellen Frank, who, in 2002 wrote: "If by globalization we mean the determined efforts of international businesses to build markets and production networks that are truly global in scope, then the current monetary system is in many ways an endless headache whose costs are rapidly outstripping its benefits."[14] She continues with a view on how that monetary system stability is appealing to many players in the world economy, but is being undermined by volatility and fluctuation in exchange rates: "Money scrambles around the globe in quest of the bankers holy grail sound money of stable value while undermining every attempt by cash-strapped governments to provide the very stability the wealthy crave."[14] Frank then corroborates Tobin's comments on the problems this instability can create (e.g. high interest rates) for developing countries such as Mexico (1994), countries in South East Asia

(1997), and Russia (1998).[2] She writes, "Governments of developing countries try to peg their currencies, only to have the peg undone by capital flight. They offer to dollarize or euroize, only to find themselves so short of dollars that they are forced to cut off growth. They raise interest rates to extraordinary levels to protect investors against currency losses, only to topple their economies and the source of investor profits. ... IMF bailouts provide a brief respite for international investors but they are, even from the perspective of the wealthy, a short-term solution at best ... they leave countries with more debt and fewer options."[14]
Effect on volatility

One of the main economic hypotheses raised in favor of financial transaction taxes is that such taxes reduce return volatility, leading to an increase of long-term investor utility or more predictable levels of exchange rates. The impact of such a tax on volatility is of particular concern because the main justification given for this tax by Tobin was to improve the autonomy of macroeconomic policy by curbing international currency speculation and its destabilizing effect on national exchange rates.[1] Economist Korkut Erturk states: if the Tobin Tax is not stabilizing, then much of the rest of the discussion on its feasibility and other related issues are probably moot.[15]
Theoretical models

Most studies of the likely impact of the Tobin tax on financial markets volatility have been theoreticalresearches conducted laboratory simulations or constructed economic models. Some of these theoretical studies have concluded that a transaction tax could reduce volatility by crowding out speculators[16] or eliminating individual 'noise traders'[17] but that it 'would not have any impact on volatility in case of sufficiently deep global markets such as those in major currency pairs,[15] unlike in case of less liquid markets, such as those in stocks and (especially) options, where volatility would probably increase with reduced volumes.[18][19] Behavioral finance theoretical models, such as those developed by Wei and Kim (1997)[20] or Westerhoff and Dieci (2006)[21] suggest that transaction taxes can reduce volatility, at least in the foreign exchange market. In contrast, some papers find a positive effect of a transaction tax on market volatility.[22][23] Lanne and Vesala (2006) argue that a transaction tax "is likely to amplify, not dampen, volatility in foreign exchange markets", because such tax penalises informed market participants disproportionately more than uninformed ones, leading to volatility increases.[24]
Empirical studies

In most of the available empirical studies however, no statistically significant causal link has been found between an increase in transaction costs (transaction taxes or government-controlled minimum brokerage commissions) and a reduction in volatilityin fact a frequent unintended consequence observed by 'early adopters' after the imposition of a financial transactions tax (see Werner, 2003)[25] has been an increase in the volatility of stock market returns, usually coinciding with significant declines in liquidity (market volume) and thus in taxable revenue (Umlauf, 1993).[26]

For a recent evidence to the contrary, see, e.g., Liu and Zhu (2009),[27] which may be affected by selection bias given that their Japanese sample is subsumed by a research conducted in 14 Asian countries by Hu (1998),[28] showing that "an increase in tax rate reduces the stock price but has no significant effect on market volatility". As Liu and Zhu (2009) point out, [...] the different experience in Japan highlights the comment made by Umlauf (1993) that it is hazardous to generalize limited evidence when debating important policy issues such as the STT [securities transaction tax] and brokerage commissions." See also "Tobin tax proponents response to empirical evidence on volatility"
Historical attempts to reduce speculation via fixed exchange rates

Matthew Sinclair, Research Director of TaxPayers' Alliance, notes that

one reason why few have supported a Tobin tax is that worries about foreign exchange speculation have slowly subsided as more countries have moved towards floating exchange rates, which do more to limit the potential for exchange rate speculation than a Tobin tax possibly could. Attempts to fix rates such as in the 1980s and 1990s the European Exchange Rate Mechanism (ERM) meant that we got large and sudden movements in exchange rates when speculators sensed that a peg could not be maintained, rather than the more fluid shifts of today.[29]

Is there an optimum Tobin tax rate?

When James Tobin was interviewed by Der Spiegel in 2001, the tax rate he suggested was 0.5%.[4][5][6] His use of the phrase "let's say" ("sagen wir") indicated that he was not, at that point, in an interview setting, trying to be precise. Others have tried to be more precise or practical in their search for the Tobin tax rate. Tax rates of the magnitude of 0.1%-1% have been proposed by normative economists, without addressing how practicable these would be to implement. In positive economics studies however, where due reference was made to the prevailing market conditions, the resulting tax rates have been significantly lower.[citation needed] According to Garber (1996), competitive pressure on transaction costs (spreads) in currency markets has reduced these costs to fractions of a basis point. For example the EUR.USD currency pair trades with spreads as tight as 1/10 of a basis point, i.e. with just a 0.00001 difference between the bid and offer price, so "a tax on transactions in foreign exchange markets imposed unilaterally, 6/1000 of a basis point (or 0.00006%) is a realistic maximum magnitude."[30] Similarly Shvedov (2004) concludes that "even making the unrealistic assumption that the rate of 0.00006% causes no reduction of trading volume, the tax on foreign currency exchange transactions would yield just $4.3 billion a year, despite an annual turnover in dozens of trillion dollars.[31] Accordingly, one of the modern Tobin tax versions, called the Sterling Stamp Duty, sponsored by certain UK charities, has a rate of 0.005% "in order to avoid market distortions", i.e., 1/100 of

what Tobin himself envisaged in 2001. Sterling Stamp Duty supporters argue that this tax rate would not adversely affect currency markets and could still raise large sums of money.[32] The same rate of 0.005% was proposed for a currency transactions tax (CTT) in a report prepared by Rodney Schmidt for The North-South Institute (a Canadian NGO whose "research supports global efforts to [..] improve international financial systems and institutions").[33] Schmidt (2007) used the observed negative relationship between bid-ask spreads and transactions volume in foreign exchange markets to estimate the maximum "non-disruptive rate" of a currency transaction tax. A CTT tax rate designed with a pragmatic goal of raising revenue for various development projects, rather than to fulfill Tobin's original goals (of "slowing the flow of capital across borders" and "preventing or managing exchange rate crises"), should avoid altering the existing "fundamental market behavior", and thus, according to Schmidt, must not exceed 0.00005, i.e., the observed levels of currency transactions costs (bid-ask spreads).[34] The mathematician Paul Wilmott has pointed out that while perhaps some trading ought to be discouraged, trading for the hedging of derivatives is generally considered a good thing in that it can reduce risk, and this should not be punished. He estimates that any financial tax should be at most one basis point so as to have negligible effect on hedging.[35] Assuming that all currency market participants incur the same maximum level of transaction costs (the full cost of the bid-ask spread), as opposed to earning them in their capacity of market makers, and assuming that no untaxed substitutes exist for spot currency markets transactions (such as currency futures and currency exchange-traded funds), Schmidt (2007) finds that a CTT rate of 0.00005 would be nearly volume-neutral, reducing foreign exchange transaction volumes by only 14%. Such volume-neutral CTT tax would raise relatively little revenue though, estimated at around $33 bn annually, i.e., an order of magnitude less than the "carbon tax [which] has by far the greatest revenue-raising potential, estimated at $130-750 bn annually." The author warns however that both these market-based revenue estimates "are necessarily speculative", and he has more confidence in the revenue-raising potential of "The International Finance Facility (IFF) and International Finance Facility for Immunisation (IFFIm)."[34] In 2000, a representative of another "pro-Tobin tax" non-governmental organization stated that Tobin's idea was
to throw some sand in the wheels of speculative flows. For a currency transaction to be profitable *to the speculator], the change in value of the currency must be greater than the proposed tax. Since speculative currency trades occur on much smaller margins, the Tobin Tax would reduce or eliminate the profits and, logically, the incentive to speculate. The tax is designed to help stabilize exchange rates by reducing the volume of speculation. And it is set deliberately low so as not to have an adverse effect on trade in goods and services or long-term investments.[36]

Is the tax easy to avoid?

Technical feasibility

Although Tobin had said his own tax idea was unfeasible in practice, Joseph Stiglitz, former Senior Vice President and Chief Economist of the World Bank, said, on October 5, 2009, that modern technology meant that was no longer the case. Stiglitz said, the tax is "much more feasible today" than a few decades ago, when Tobin recanted.[37] However, on November 7, 2009, at the G20 finance ministers summit in Scotland, Dominique Strauss-Khan, head of the International Monetary Fund, said "transactions are very difficult to measure and so it's very easy to avoid a transaction tax."[38] Nevertheless in early December 2009, economist Stephany Griffith-Jones agreed that the "greater centralisation and automisation of the exchanges and banks clearing and settlements systems ... makes avoidance of payment more difficult and less desirable."[39] In January, 2010, feasibility of the tax was supported and clarified by researchers Rodney Schmidt, Stephan Schulmeister and Bruno Jetin who noted it is technically easy to collect a financial tax from exchanges ... transactions taxes can be collected by the central counterparty at the point of the trade, or automatically in the clearing or settlement process."[40][41] (All largevalue financial transactions go through three steps. First dealers agree to a trade; then the dealers banks match the two sides of the trade through an electronic central clearing system; and finally, the two individual financial instruments are transferred simultaneously to a central settlement system. Thus a tax can be collected at the few places where all trades are ultimately cleared or settled.)[41][42] When presented with the problem of speculators shifting operations to offshore tax havens, a representative of a pro Tobin tax NGO argued as follows:
Agreement between nations could help avoid the relocation threat, particularly if the tax were charged at the site where dealers or banks are physically located or at the sites where payments are settled or netted. The relocation of Chase Manhattan Bank to an offshore site would be expensive, risky and highly unlikely particularly to avoid a small tax. Globally, the move towards a centralized trading system means transactions are being tracked by fewer and fewer institutions. Hiding trades is becoming increasingly difficult. Transfers to tax havens like the Cayman Islands could be penalized at double the agreed rate or more. Citizens of participating countries would also be taxed regardless of where the transaction was carried out.[36]

Based on digital technology, a new form of taxation, levied on bank transactions, was successfully used in Brazil from 1993 to 2007 and proved to be evasion-proof, more efficient and less costly than orthodox tax models. In his book, Bank transactions: pathway to the single tax ideal, Marcos Cintra carries out a qualitative and quantitative in-depth comparison of the efficiency, equity and compliance costs of a bank transactions tax relative to orthodox tax systems, and opens new perspectives for the use of modern banking technology in tax reform across the world.[43]

See also: Currency transaction report, Money Laundering Control Act, Bank Secrecy Act, Suspicious activity report, Money laundering, Structuring, and Electronic trading How many nations are needed to make it feasible?

There has been debate as to whether one single nation could unilaterally implement a "Tobin tax." Speaking to this question, Schmidt states, "It is possible for a single country to apply a securities transaction tax unilaterally without significant capital flight to exchanges in other jurisdictions. There are many examples of such taxes already in existence. Britain levies a "Stamp Duty", a 0.5% tax on purchases of shares of UK companies whether the transaction occurs in the UK or overseas. Such specific financial transaction taxes exist in Austria, Greece, Luxembourg, Poland, Portugal, Spain, Switzerland, Hong Kong, China and Singapore. The state of New York levies a stamp duty on trades taking place on both the New York Stock Exchange and on NASDAQ."[42] In the year 2000, "eighty per cent of foreign-exchange trading [took] place in just seven cities. Agreement [to implement the tax] by [just three cities,] London, New York and Tokyo alone, would capture 58 per cent of speculative trading."[36]

Evaluating the Tobin tax as a general Financial Transaction Tax (FTT)

See also: Financial transaction tax and Let Wall Street Pay for the Restoration of Main Street Bill

Sweden's experience in implementing Tobin taxes in the form of general financial transaction taxes
In July, 2006, analyst Marion G. Wrobel examined the actual international experiences of various countries in implementing financial transaction taxes.[44] Wrobel's paper highlighted the Swedish experience with financial transaction taxes. In January 1984, Sweden introduced a 0.5% tax on the purchase or sale of an equity security. Thus a round trip (purchase and sale) transaction resulted in a 1% tax. In July 1986 the rate was doubled. In January 1989, a considerably lower tax of 0.002% on fixed-income securities was introduced for a security with a maturity of 90 days or less. On a bond with a maturity of five years or more, the tax was 0.003%. The revenues from taxes were disappointing; for example, revenues from the tax on fixedincome securities were initially expected to amount to 1,500 million Swedish kronor per year. They did not amount to more than 80 million Swedish kronor in any year and the average was closer to 50 million.[45] In addition, as taxable trading volumes fell, so did revenues from capital gains taxes, entirely offsetting revenues from the equity transactions tax that had grown to 4,000 million Swedish kronor by 1988.[46] On the day that the tax was announced, share prices fell by 2.2%. But there was leakage of information prior to the announcement, which might explain the 5.35% price decline in the 30

days prior to the announcement. When the tax was doubled, prices again fell by another 1%. These declines were in line with the capitalized value of future tax payments resulting from expected trades. It was further felt that the taxes on fixed-income securities only served to increase the cost of government borrowing, providing another argument against the tax. Even though the tax on fixed-income securities was much lower than that on equities, the impact on market trading was much more dramatic. During the first week of the tax, the volume of bond trading fell by 85%, even though the tax rate on five-year bonds was only 0.003%. The volume of futures trading fell by 98% and the options trading market disappeared. On 15 April 1990, the tax on fixed-income securities was abolished. In January 1991 the rates on the remaining taxes were cut in half and by the end of the year they were abolished completely. Once the taxes were eliminated, trading volumes returned and grew substantially in the 1990s.
Tobin tax proponents reaction to the Swedish experience

The Swedish experience of a transaction tax was with purchase or sale of equity securities, fixed income securities and derivatives. In global international currency trading, however, the situation could, some argue, look quite different. In 2000, Round argued as follows:
[The Tobin tax] could boost world trade by helping to stabilize exchange rates. Wildly fluctuating rates play havoc with businesses dependent on foreign exchange as prices and profits move up and down, depending on the relative value of the currencies being used. When importers and exporters cant be certain from one day to the next what their money is worth, economic planning including job creation goes out the window. Reduced exchange-rate volatility means that businesses would need to spend less money hedging (buying currencies in anticipation of future price changes), thus freeing up capital for investment in new production.[36]

Wrobel's studies do not address the global economy as a whole, as James Tobin did when he spoke of "the nineties' crises in Mexico, South East Asia and Russia,"[7][47] which included the 1994 economic crisis in Mexico, the 1997 Asian Financial Crisis, and the 1998 Russian financial crisis.

Who would gain and who would lose if the Tobin tax (FTT) were implemented?
See also: Financial transaction tax and Let Wall Street Pay for the Restoration of Main Street Bill Views of ABAC (APEC Business Advisory Council) expressed in open letter to IMF

The APEC Business Advisory Council, the business representatives' body in APEC, which is the forum for facilitating economic growth, cooperation, trade and investment in the Asia-Pacific region, expressed its views in a letter to the IMF on 15 February 2010. The APEC Business Advisory Council stated:
We believe that imposition of a global tax is an inappropriate response and a further burden to industries, especially small and medium enterprises, and consumers in the wake of the global financial

crisis. We also believe that the proposals under consideration would be harmful for a range of additional reasons, including the practical challenges of implementing any such tax.[48]

In addition, ABAC expressed further concerns in the letter:

Key to the APEC agenda is reduction of transaction costs. The proposal is directly counterproductive to this goal. It would have a very significant negative impact on real economic recovery, as these additional costs are likely to further reduce financing of business activities at a time when markets remain fragile and prospects for the global economy are still uncertain. Industries and consumers as a whole would be unfairly penalized. It would further weaken financial markets and reduce the liquidity, particularly in the case of illiquid assets. Effective implementation would be virtually impossible, especially as opportunities for crossborder arbitrage arise from decisions of certain jurisdictions not to adopt the tax or to exempt particular activities. There is no global consensus why a tax is needed and what the revenue would be used for, and therefore no understanding how much is needed. Any consequential tax would need to be supported by clear consensus for its application.

Note - APEC's 21 Member Economies are Australia, Brunei Darussalam, Canada, Chile, People's Republic of China, Hong Kong, China, Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, The Republic of the Philippines, The Russian Federation, Singapore, Chinese Taipei, Thailand, United States of America, Viet Nam.
Views of the ITUC/APLN (Asia-Pacific Labour Network) expressed in their statement to the 2010 APEC Economic Leaders Meeting

The International Trade Union Confederation/Asia-Pacific Labour Network (ITUC/APLN), the informal trade union body of the Asia-Pacific, supported the Tobin Tax in their Statement to the 2010 APEC Economic Leaders Meeting. The representatives of APEC's national trade unions centers also met with the Japanese Prime Minister, Naoto Kan, the host Leader of APEC for 2010, and called for the Prime Minister's support on the Tobin Tax.[49] The ITUC/APLN stated:
APEC Leaders should support measures that will downsize the financial sector and return it to its legitimate function of serving the real economy. Instead of fiscal austerity policies and increased expenditure cuts APEC economies should exploit new sources of finance, such as the Financial Transactions Tax (FTT), and raise more revenue with progressive tax systems.[49]

The ITUC shares its support for Tobin Tax with the Trade Union Advisory Council (TUAC), the official OECD trade union body, in a research[50] on the feasibility, strengths and weaknesses of a potential Tobin Tax. ITUC, APLN and TUAC refer to Tobin Tax as the Financial Transactions Tax.

Would 'regular investors like you and me' lose?

An economist speaking out against the common belief that investment banks would bear the burden of a Tobin tax is Simon Johnson, Professor of Economics at the MIT and a former Chief Economist at the IMF, who in a BBC Radio 4 interview discussing banking system reforms presented his views on the Tobin tax Evan Davis, BBC Radio 4:
There are various ideas around, aren't there, one of them is a Tobin tax, it's been associated with the [British] Prime Ministera tax on global financial transactions. Is that a response, do you think, to the problems created by large banks and big bail-outs?

Prof. Simon Johnson:

I think it's hmm... partially a response, or an attempt to respond, that's not my preferred [...] approach to the problem, I think that would lead to a lot of distortions, a lot of moving of activities offshore. If you did it at the full level of the G20, you might be able to get some traction. Evasion at that level would be hard. But still I think it doesn't address the core problem which is really about financial institutions that are 'Too Big to Fail'. Financial transaction tax is more of a tax on regular people like you and me.[51][52] Let Wall Street Pay for the Restoration of Main Street Bill Main article: Let Wall Street Pay for the Restoration of Main Street Bill

In 2009, U.S. Representative Peter DeFazio of Oregon proposed a financial transaction tax in his "Let Wall Street Pay for the Restoration of Main Street Bill". (This was proposed domestically for the United States only.)[53]
Would there be net job losses if a FTT tax was introduced?

Schwabish (2005) examined the potential effects of introducing a stock transaction (or "transfer") tax in a single city (New York) on employment not only in the securities industry, but also in the supporting industries. A financial transactions tax would lead to job losses also in non-financial sectors of the economy through the so-called multiplier effect forwarding in a magnified form any taxes imposed on Wall Street employees through their reduced demand to their suppliers and supporting industries. The author estimated the ratios of financial- to nonfinancial job losses of between 10:1 to 10:4, that is "a 10 percent decrease in securities industry employment would depress employment in the retail, services, and restaurant sectors by more than 1 percent; in the business services sector by about 4 percent; and in total private jobs by about 1 percent."[54] It is also possible to estimate the impact of a reduction in stock market volume caused by taxing stock transactions on the rise in the overall unemployment rate. For every 10 percent decline in stock market volume, elasticities estimated by Schwabish[54] implied that a stock transaction ("transfer") tax could cost New York City between 30,000 and 42,000 private-sector jobs, and if

the stock market volume reductions reached levels observed by Umlauf (1993) in Sweden after a stock FTT was introduced there ("By 1990, more than 50% of all Swedish trading had moved to London")[26] then according to Schwabish (2005), following an introduction of a FTT tax, there would be 150,000-210,000 private-sector jobs losses in the New York alone. In 2000, Round argued as follows:
When importers and exporters cant be certain from one day to the next what their money is worth, economic planningincluding job creationgoes out the window. Reduced exchange-rate volatility means that businesses would need to spend less money hedging (buying currencies in anticipation of future price changes), thus freeing up capital for investment in new production [and the accompanying new jobs].[36]

The cost of currency hedgesand thus "certainty what importers and exporters' money is worth"has nothing to do with volatility whatsoever, as this cost is exclusively determined by the interest rate differental between two currencies. Nevertheless, as Tobin said, "If ... [currency] is suddenly withdrawn, countries have to drastically increase interest rates for their currency to still be attractive."[3][4]

Is there an optimum tax rate?

Financial transaction tax rates of the magnitude of 0.1%-1% have been proposed by normative economists, without addressing the practicability of implementing a tax at these levels. In positive economics studies however, where due reference was paid to the prevailing market conditions, the resulting tax rates have been significantly lower. For instance, Edwards (1993) concluded that if the transaction tax revenue from taxing the futures markets were to be maximized (see Laffer curve), with the tax rate not leading to a prohibitively large increase in the marginal cost of market participants, the rate would have to be set so low that "a tax on futures markets will not achieve any important social objective and will not generate much revenue."[55]

Political opinion
Opinions are divided between those who applaud that the Tobin tax could protect countries from spillovers of financial crises, and those who claim that the tax would also constrain the effectiveness of the global economic system, increase price volatility, widen bid-ask spreads for end users such as investors, savers and hedgers, and destroy liquidity.
Tobin tax proponents response to empirical evidence on volatility

Lack of direct supporting evidence for stabilizing (volatility-reducing) properties of Tobin-style transaction taxes in econometric research is acknowledged by some of the Tobin tax supporters:

Ten studies report a positive relationship between transaction taxes and short-term price volatility, five studies did not find any significant relationship. (Schulmeister et al, 2008, p. 18).[56]

These Tobin tax proponents have to therefore rely on indirect evidence in their favor, reinterpreting studies which do not deal directly with volatility, but instead with trading volume (with volume being generally reduced by transaction taxes, though it constitutes their tax base, see: negative feedback loop). This allows these Tobin tax proponents to state that "some studies show (implicitly) that higher transaction costs might dampen price volatility. This is so because these studies report that a reduction of trading activities is associated with lower price volatility." So if a study finds that reducing trading volume or trading frequency reduces volatility, these Tobin tax supporters combine it with the observation that Tobin-style taxes are volume-reducing, and thus should also indirectly reduce volatility ("this finding implies a negative relationship between [..] transaction tax [..] and volatility, because higher transaction costs will 'ceteris paribus' always dampen trading activities)." (Schulmeister et al., 2008, p. 18).[56] There is yet another reason why some proponents of the Tobin tax maintain that it can reduce volatility, despite prevailing empirical evidence to the contrary. This is possible, because some Tobin tax supporters created a concept of a separate, custom-defined volatility. Rather than adopting one of the standard statistical definitions (e.g., conditional variance of returns, see Engle, 1982 [57]) leading economists favoring the Tobin tax prefer to define volatility as a "longterm overshooting of speculative prices" (see Tobin, 1978 [58] and Eichengreen, Tobin and Wyplosz, 1995 [59]). Evidence about this special type of volatility is missing and this is why some of the proponents, instead of conducting their own tests, prefer to blame financial econometric researchers for not addressing their special needs:
Unfortunately, all empirical studies on the relationship between transaction costs, trading volume and price volatility in general, and on the possible effects of an FTT on volatility in particular, deal with shortterm statistical volatility only. Therefore, the results of these studies cannot help to answer the question whether or not an FTT will mitigate misalignments of asset prices over the medium and long run. Schulmeister et al, 2008, p. 11[56]

Thus the beneficial impact of transaction taxes on the "Tobin volatility" can co-exist as a valid economic theory even without direct supporting evidence from the statistical volatility research, simply because of the special volatility definition, which allows all economists defending the Tobin tax to escape Popperian falsifiability.[citation needed] Another shortcoming of all of the empirical volatility studies pointed out by some of the Tobin tax proponents is the lack of distinction between "basic" and "excessive" volatility, which "might have contributed to the contradictory and, hence, inconclusive results of these studies" (Schulmeister et al., 2008, p. 11-12).[56] Unfortunately, no tests have been conducted so far, which would be able to operationalize "excessive" volatility assumed to exist by the Tobin tax theory (see Schulmeister et al., 2008, p. 11),[56] therefore the acceptance of the Tobin-style transactions tax as a fiscal or monetary policy instrument requires clear understanding that basic theoretical phenomena underlying this tax, such as "excessive" volatility, still remain untested.

Should speculators be encouraged, penalized or dissuaded?

The Tobin tax rests on the premise that speculators ought to be, as Tobin puts it, "dissuaded."[4][5][6][7] This premise itself is a matter of debate: See Speculation. Matthew Sinclair, Research Director of TaxPayers' Alliance, argues that "The whole idea of a Tobin tax is based on the flawed view that trading or speculation is a bad thing. The truth is that it isnt: it helps the process of price discovery, makes markets work better, enhances liquidity, ensures that resources are priced correctly and generally helps oil the cogs of the global economy."[29] On the other side of the debate were the leaders of Germany who, in May 2008, planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds. At that time India, with similar concerns, had already suspended futures trading of five commodities.[60] On December 3, 2009, US Congressman Peter DeFazio stated, "The American taxpayers bailed out Wall Street during a crisis brought on by reckless speculation in the financial markets, ... This [ proposed financial transaction tax ] legislation will force Wall Street to do their part and put people displaced by that crisis back to work."[53] On January 21, 2010, President Barack Obama endorsed the Volcker Rule which deals with proprietary trading of investment banks[61] and restricts banks from making certain speculative kinds of investments if they are not on behalf of their customers.[61] Former U.S. Federal Reserve Chairman Paul Volcker, President Obama's advisor, has argued that such speculative activity played a key role in the financial crisis of 20072010. Volcker endorsed only the UK's tax on bank bonuses, calling it "interesting", but was wary about imposing levies on financial market transactions, because he is "instinctively opposed" to any tax on financial transactions.[62]

Questions of volatility
In February 2010, Tim Harford, writing in the Undercover Economist column of the Financial Times, commented directly on the claims of Keynes and Tobin that 'taxes on financial transactions would reduce financial volatility'.[63] Harford wrote:This is possible but far from obvious, when you realise that the tax might encourage bigger, more irregular financial transactions. An analogy: if I have to pay a charge whenever I use a cash machine, I make fewer, larger withdrawals and the amount of money in my wallet fluctuates more widely. Bear in mind, too, that the most bubble-prone asset market is for housing, which is bought in very lumpy, longterm chunks. There isnt much evidence as to whether transaction charges reduce volatility. What there is is mixed but perhaps leaning against the Robin Hood tax. On the French stock market, coarser 'tick sizes' raise spreads and act like a tax: they increase volatility. Transaction taxes on Swedish stocks in the 1980s reduced prices and turnover but left volatility unchanged.

Comparing Currency Transaction Taxes (CTT) and Financial Transaction Taxes (FTT)
See also: Currency transaction tax and Financial transaction tax

Research evidence
In 2003, researchers like Aliber et al. proposed that empirical evidence on the observed effects of the already introduced and abolished stock transaction taxes[where?] and a hypothetical CTT (Tobin) can probably be treated interchangeably.[64] They did not find any evidence on the differential effects of introducing or removing, stock transactions taxes or a hypothetical currency (Tobin) tax on any subset of markets or all markets. Researchers have used models belonging to the GARCH family[65][66][67] to describe both the volatility behavior of stock market returns and the volatility behavior of foreign exchange rates. This is used as evidence that the similarity between currencies and stocks in the context of a tax designed to curb volatility such as a CTT (or FTT in general) can be inferred from the almost identical (statistically indistinguishable) behavior of the volatilities of equity and exchange rate returns.

Practical considerations
Hanke et al. state, "The economic consequences of introducing a [currency-only] Tobin Tax are [...] completely unknown, as such a tax has not been introduced on any real foreign exchange market so far".[68] At the same time, even in the case of stock transaction taxes, where some empirical evidence is available, researchers warn that "it is hazardous to generalize limited evidence when debating important policy issues such as the transaction taxes".[26][27] According to Stephan Schulmeister, Margit Schratzenstaller, and Oliver Picek (2008), from the practical viewpoint it is no longer possible to introduce a non-currency transactions tax (even if foreign exchange transactions were formally exempt) since the advent of currency derivatives and currency exchange-traded funds. All of these would have to be taxed together under a "noncurrency" financial transactions tax (such as under certain proposals] in the U.S. in 2009 which, although not intending to tax currencies directly, would still do so due to taxation of currency futures and currency exchange traded funds). Because these three groups of instruments are nearly perfect substitutes, if at least one of these groups were to be exempt, it would likely attract most market volume from the taxed alternatives.[69] According to Stephan Schulmeister, Margit Schratzenstaller, and Oliver Picek (2008), restricting the financial transactions tax to foreign exchange only (as envisaged originally by Tobin) would not be desirable.[69] Any "general FTT seems...more attractive than a specific transaction tax" (such as a currency-only Tobin tax), because it could reduce tax avoidance (i.e., substitution of similar untaxed instruments), could significantly increase the tax base and could be implemented more easily on organized exchanges than in a dealership market like the global foreign exchange market.[69] (See also the discussion of tax avoidance as it relates to a currency transaction tax.)

On October 5, 2009, Joseph Stiglitz said that any new tax should be levied on all asset classes not merely foreign exchange, and would be based on the gross value of the assets, thereby helping to discourage the creation of asset bubbles.[37]

Original idea and alter-globalization movement

Tobin's more specific concept of a "currency transaction tax" from 1972 lay dormant for more than 20 years but was revived by the advent of the 1997 Asian Financial Crisis. In December, 1997 Ignacio Ramonet, editor of Le Monde Diplomatique, renewed the debate around the Tobin tax with an editorial titled "Disarming the markets". Ramonet proposed to create an association for the introduction of this tax, which was named ATTAC (Association for the Taxation of financial Transactions for the Aid of Citizens). The tax then became an issue of the global justice movement or alter-globalization movement and a matter of discussion not only in academic institutions but even in streets and in parliaments in the UK, France, and around the world. In an interview[70] given to the Italian independent radio network Radio Popolare in July 2001 James Tobin distanced himself from the global justice movement. There are agencies and groups in Europe that have used the Tobin Tax as an issue of broader campaigns, for reasons that go far beyond my proposal. My proposal was made into a sort of milestone for an antiglobalization program. James Tobin's interview with Radio Popolare was quoted by the Italian foreign minister at the time, former director-general of the World Trade Organisation Renato Ruggiero, during a Parliamentary debate on the eve of the G8 2001 summit in Genoa. Afterwards James Tobin distanced himself from the global justice movement [71][72] also in an interview given to Der Spiegel in 2001, and continued to state the validity of his proposal,
I have absolutely nothing in common with those anti-globalisation rebels. Of course I am pleased; but the loudest applause is coming from the wrong side. Look, I am an economist and, like most economists, I support free trade. Furthermore, I am in favour of the International Monetary Fund, the World Bank, the World Trade Organisation. They've hijacked my name. ... The tax on foreign exchange transactions was devised to cushion exchange rate fluctuations.[4][5][6][7] (See last part of quote in the above lead section).

Tobin observed that, while his original proposal had only the goal of "putting a brake on the foreign exchange trafficking", the antiglobalization movement had stressed "the income from the taxes with which they want to finance their projects to improve the world". He declared himself not contrary to this use of the tax's income, but stressed that it was not the important aspect of the tax. ATTAC and other organizations have recognized that while they still consider Tobin's original aim as paramount, they think the tax could produce funds for development needs in the South (such as the Millennium Development Goals),[32] and allow governments, and therefore citizens, to reclaim part of the democratic space conceded to the financial markets. In March, 2002, London School of Economics Professor Willem Buiter, who studied under James Tobin, wrote a glowing[peacock term] obituary for the man,[73] but also remarked that, "This

[Tobin Tax] ... was in recent years adopted by some of the most determined enemies of trade liberalisation, globalisation and the open society." Buiter added, "The proposal to use the Tobin tax as a means of raising revenues for development assistance was rejected by Tobin, and he forcefully repudiated the anti-globalisation mantra of the Seattle crowd." In September 2009, Buiter also wrote in the Financial Times, "Tobin was a genius ... but the Tobin tax was probably his one daft idea".[74] In those same "years" that Buiter spoke of, the Tobin tax was also "adopted" or supported in varying degrees by the people who were not, as he put it, "enemies of trade liberalisation." Among them were several supporters from 1990 to 1999, including Larry Summers and several from 2000 to 2004, including lukewarm support from George Soros.

Tobin tax proposals and implementations around the world

It was originally assumed that the Tobin tax would require multilateral implementation, since one country acting alone would find it very difficult to implement this tax. Many people have therefore argued that it would be best implemented by an international institution. It has been proposed that having the United Nations manage a Tobin tax would solve this problem and would give the UN a large source of funding independent from donations by participating states. However, there have also been initiatives of national dimension about the tax. (This is in addition to the many countries that have foreign exchange controls.) Whilst finding some support in countries with strong left-wing political movements such as France and Latin America, the Tobin tax proposal came under much criticism from economists and governments, especially those with liberal markets and a large international banking sector, who said it would be impossible to implement and would destabilise foreign exchange markets. Most of the actual implementation of Tobin taxes, whether in the form of a specific currency transaction tax, or a more general financial transaction tax, has occurred at a national level. In July, 2006, analyst Marion G. Wrobel examined the international experiences of various countries with financial transaction taxes.[44]

Sweden's experience with financial transaction taxes

See also: Financial transaction tax

Wrobel's paper highlighted the Swedish experience with financial transaction taxes.[44] In January 1984, Sweden introduced a 0.5% tax on the purchase or sale of an equity security. Thus a round trip (purchase and sale) transaction resulted in a 1% tax. In July 1986 the rate was doubled. In January 1989, a considerably lower tax of 0.002% on fixed-income securities was introduced for a security with a maturity of 90 days or less. On a bond with a maturity of five years or more, the tax was 0.003%. The revenues from taxes were disappointing; for example, revenues from the tax on fixedincome securities were initially expected to amount to 1,500 million Swedish kronor per year. They did not amount to more than 80 million Swedish kronor in any year and the average was

closer to 50 million.[45] In addition, as taxable trading volumes fell, so did revenues from capital gains taxes, entirely offsetting revenues from the equity transactions tax that had grown to 4,000 million Swedish kronor by 1988.[46] On the day that the tax was announced, share prices fell by 2.2%. But there was leakage of information prior to the announcement, which might explain the 5.35% price decline in the 30 days prior to the announcement. When the tax was doubled, prices again fell by another 1%. These declines were in line with the capitalized value of future tax payments resulting from expected trades. It was further felt that the taxes on fixed-income securities only served to increase the cost of government borrowing, providing another argument against the tax. Even though the tax on fixed-income securities was much lower than that on equities, the impact on market trading was much more dramatic. During the first week of the tax, the volume of bond trading fell by 85%, even though the tax rate on five-year bonds was only 0.003%. The volume of futures trading fell by 98% and the options trading market disappeared. On 15 April 1990, the tax on fixed-income securities was abolished. In January 1991 the rates on the remaining taxes were cut in half and by the end of the year they were abolished completely. Once the taxes were eliminated, trading volumes returned and grew substantially in the 1990s.[citation needed]
Tobin tax proponents reaction to the Swedish experience

The Swedish experience of a transaction tax was with purchase or sale of equity securities, fixed income securities and derivatives. In global international currency trading, however, the situation could, some argue, look quite different. In 2000, Round argued as follows:
[The Tobin tax] could boost world trade by helping to stabilize exchange rates. Wildly fluctuating rates play havoc with businesses dependent on foreign exchange as prices and profits move up and down, depending on the relative value of the currencies being used. When importers and exporters cant be certain from one day to the next what their money is worth, economic planning including job creation goes out the window. Reduced exchange-rate volatility means that businesses would need to spend less money hedging (buying currencies in anticipation of future price changes), thus freeing up capital for investment in new production.[36]

Wrobel's studies do not address the global economy as a whole, as James Tobin did when he spoke of "the nineties' crises in Mexico, South East Asia and Russia,"[7][47] which included the 1994 economic crisis in Mexico, the 1997 Asian Financial Crisis, and the 1998 Russian financial crisis.

United Kingdom experience with stock transaction tax (Stamp Duty)

See also: Stamp Duty Reserve Tax

An existing example of a Financial Transaction Tax (FTT) is Stamp Duty Reserve Tax (SDRT) and stamp duty.[75] Stamp duty was introduced as an ad valorem tax on share purchases in 1808,[76] preceding by over 150 years the Tobin tax on currency transactions. Changes were

made in 1963.[77] In 1963 the rate of the UK Stamp Duty was 2%, subsequently fluctuating between 1% and 2%, until a process of its gradual reduction started in 1984, when the rate was halved, first from 2% to 1%, and then once again in 1986 from 1% to the current level of 0.5%.[77] The changes in Stamp Duty rates in 1974, 1984, and 1986 provided researchers with "natural experiments", allowing them to measure the impact of transaction taxes on market volume, volatility, returns, and valuations of UK companies listed on the London Stock Exchange. Jackson and O'Donnel (1985), using UK quarterly data, found that the 1% cut in the Stamp Duty in April 1984 from 2% to 1% lead to a "dramatic 70% increase in equity turnover" .[78] Analyzing all three Stamp Duty rate changes, Saporta and Kan (1997) found that the announcements of tax rate increases (decreases) were followed by negative (positive) returns, but even though these results were statistically significant, they were likely to be influenced by other factors, because the announcements were made on Budget Days.[79] Bond et al. (2005) confirmed the findings of previous studies, noting also that the impact of the announced tax rate cuts was more beneficial (increasing market value more significantly) in case of larger firms, which had higher turnover, and were therefore more affected by the transaction tax than stocks of smaller companies, less frequently traded.[80] Because the UK tax code provides exemptions from the Stamp Duty Reserve Tax for all financial intermediaries, including market makers, investment banks and other members of the LSE,[81] and due to the strong growth of the contracts for difference (CFD) industry, which provides UK investors with untaxed substitutes for LSE stocks, according to the Oxera (2007) report,[77] more than 70% percent of the total UK stock market volume, including the entire institutional volume remained (in 2005) exempt from the Stamp Duty, in contrast to the common perception of this tax as a "tax on bank transactions" or a "tax on speculation". On the other hand, as much as 40% of the Stamp Duty revenues come from taxing foreign residents,[82] because the tax is "chargeable whether the transaction takes place in the UK or overseas, and whether either party is resident in the UK or not."[80]

Sterling Stamp Duty - a currency transactions tax proposed for pound sterling
In 2005 the Tobin tax was developed into a modern proposal by the United Kingdom NGO Stamp Out Poverty. It simplified the two-tier tax in favour of a mechanism designed solely as a means for raising development revenue. The currency market by this time had grown to $2,000 billion a day. To investigate the feasibility of such a tax they hired the City of London firm Intelligence Capital, who found that a tax on Pound sterling wherever it was traded in the world, as opposed to a tax on all currencies traded in the UK, was indeed feasible and could be unilaterally implemented by the UK government.[32] The Sterling Stamp Duty, as it became known, was to be set at a rate 200 times lower than Tobin had envisaged in 2001, which pro Tobin tax supporters claim wouldn't have affected currency markets and could still raise large sums of money. The global currency market grew to $3,200 billion a day in 2007, or 400,000 billion per annum with the trade in sterling, the fourth most traded currency in the world, worth 34,000 billion a year.[83] A sterling stamp duty set at 0.005% as some claim would have raised in the region of 2 billion a year in 2007.[84] The All

Party Parliamentary Group for Debt, Aid and Trade published a report in November 2007 into financing for development in which it recommended that the UK government undertake rigorous research into the implementation of a 0.005% stamp duty on all sterling foreign exchange transactions, to provide additional revenue to help bridge the funding gap required to pay for the Millennium Development Goals.[85]

Multinational proposals
In 1996 the United Nations Development Programme sponsored a comprehensive feasibility and cost-benefit study of the Tobin tax: Haq, Mahbub ul; Kaul, Inge; Grunberg, Isabelle (August 1996). The Tobin Tax: Coping with Financial Volatility. Oxford University Press. ISBN 978-019-511180-4.
European idea for a 'first Euro tax'

In late 2001, a Tobin tax amendment was adopted by the French National Assembly. However, it was overturned by March 2002 by the French Senate.[86][87][88] On June 15, 2004, the Commission of Finance and Budget in the Belgian Federal Parliament approved a bill implementing a Spahn tax.[89] According to the legislation, Belgium will introduce the Tobin tax once all countries of the eurozone introduce a similar law.[90] In July 2005 former Austrian chancellor Wolfgang Schssel called for a European Union Tobin tax to base the communities' financial structure on more stable and independent grounds. However, the proposal was rejected by the European Commission. On November 23, 2009, the President of the European Council, Herman Van Rompuy, after attending a meeting of the Bilderberg Group argued for a European version of the Tobin tax.[91][92] This tax would go beyond just financial transactions: "all shopping and petrol would be taxed.".[91] Countering him was his sister, Christine Van Rompuy, who said, "any new taxes would directly affect the poor".[93] On June 29, 2011, the European Commission called for Tobin-style taxes on the EU's financial sector to generate direct revenue starting from 2014. At the same time it suggested to reduce existing levies coming from the 27 member states.[94]
Support in some G20 nations

The first nation in the G20 group to formally accept the Tobin tax was Canada.[95] On March 23, 1999, the Canadian House of Commons passed a resolution directing the government to "enact a tax on financial transactions in concert with the international community."[36] However, ten years later, in November 2009, at the G20 finance ministers summit in Scotland, the representatives of the minority government of Canada spoke publicly on the world stage in opposition to that Canadian House of Commons resolution.[38] In September 2009, French president Nicolas Sarkozy brought up the issue of a Tobin tax once again, suggesting it be adopted by the G20.[96]

On November 7, 2009, prime minister Gordon Brown said that G-20 should consider a tax on speculation, although did not specify that it should be on currency trading alone. The BBC reported that there was a negative response to the plan among the G20.[38] By December 11, 2009, European Union leaders expressed broad support for a Tobin tax in a communiqu sent to the International Monetary Fund.[12] On that day, the Financial Times reported the following:
Since the Nov 7 [2009] summit of the G20 Finance Ministers , the head of the International Monetary Fund, Mr Strauss-Kahn seems to have softened his doubts, telling the CBI employers' conference: "We have been asked by the G20 to look into financial sector taxes. ... This is an interesting issue. ... We will look at it from various angles and consider all proposals." [97]

For supporters of a Tobin tax, there is a wide range of opinion on who should administer a global Tobin tax and what the revenue should be used for. There are some who think that it should take the form of an insurance: In early November 2009, at the G20 finance ministers summit in Scotland, the British Prime Minister "Mr. Brown and Nicolas Sarkozy, Frances president, suggested that revenues from the Tobin tax could be devoted to the worlds fight against climate change, especially in developing countries. They suggested that funding could come from a global financial transactions tax." However British officials later argued the main point of a financial transactions tax would be provide insurance for the global taxpayer against a future banking crisis."[12][38]
The feasibility of gradual implementation of the FTT, beginning with a few EU nations

John Dillon contends that it is not necessary to have unanimous agreement on the feasibility of an international FTT before moving forward. He proposes that it could be introduced gradually, beginning probably in Europe where support is strongest. The first stage might involve a levy on financial instruments within a few countries. Stephan Schulmeister of the Austrian Institute for Economic Re-search has suggested that initially Britain and Germany could implement a tax on a range of financial instruments since about 97% of all transactions on European Union exchanges occur in these two countries [42] This scenario is possible, given the events in May and June, 2010:

On June 27, 2010 at the 2010 G-20 Toronto summit, the G20 leaders declared that a "global tax" was no longer "on the table," but that individual countries will be able to decide whether to implement a levy against financial institutions to recoup billions of dollars in taxpayer-funded bailouts.[98] Nevertheless Britain, France and Germany had already agreed before the summit to impose a "bank tax." [98] On May 20, 2010, German officials were understood to favour a financial transaction tax over a financial activities tax.[99]

Two simultaneous taxes considered in the European Union

On June 28, 2010, the European Union's executive said it will study whether the European Union should go alone in imposing a tax on financial transactions after G20 leaders failed to agree on the issue. The financial transactions tax would be separate from a bank levy, or a resolution levy, which some governments are also proposing to impose on banks to insure them against the costs of any future bailouts. EU leaders instructed their finance ministers, in May, 2010, to work out by the end of October 2010, details for the banking levy, but any financial transaction tax remains much more controversial.[100]
Latin America - Bank of the South

In early November 2007, a regional Tobin tax was adopted by the Bank of the South, after an initiative of Presidents Hugo Chavez from Venezuela and Nstor Kirchner from Argentina.[101]
UN Global Tax

According to Stephen Spratt, "the revenues raised could be used for ... international development objectives ... such as meeting the Millennium Development Goals."(,[32] p. 19) These are eight international development goals that 192 United Nations member states and at least 23 international organizations have agreed (in 2000) to achieve by the year 2015. They include reducing extreme poverty, reducing child mortality rates, fighting disease epidemics such as AIDS, and developing a global partnership for development.[102] In 2000, a representative of a pro Tobin tax NGO proposed the following:
In the face of increasing income disparity and social inequity, the Tobin Tax represents a rare opportunity to capture the enormous wealth of an untaxed sector and redirect it towards the public good. Conservative estimates show the tax could yield from $150-300 billion annually. The UN estimates that the cost of wiping out the worst forms of poverty and environmental destruction globally would be around $225 billion per year.[36]

At the UN September 2001 World Conference against Racism, when the issue of compensation for colonialism and slavery arose in the agenda, Fidel Castro, the President of Cuba, advocated the Tobin Tax to address that issue. (According to Cliff Kincaid, Castro advocated it "specifically in order to generate U.S. financial reparations to the rest of the world," however a closer reading of Castro's speech shows that he never did mention "the rest of the world" as being recipients of revenue.) Castro cited Holocaust reparations as a previously established precedent for the concept of reparations.[103][104] Castro also suggested that the United Nations be the administrator of this tax, stating the following:

May the tax suggested by Nobel Prize Laureate James Tobin be imposed in a reasonable and effective way on the current speculative operations accounting for trillions of US dollars every 24 hours, then the United Nations, which cannot go on depending on meager, inadequate, and belated donations and charities, will have one trillion US dollars annually to save and develop the world. Given the seriousness and urgency of the existing problems, which have become a real hazard for the very survival of our species on the planet, that is what would actually be needed before it is too late.[103]

On March 6, 2006, US Congressman Ron Paul stated the following:

The United Nations remains determined to rob from wealthy countries and, after taking a big cut for itself, send whats left to the poor countries. Of course, most of this money will go to the very dictators whose reckless policies have impoverished their citizens. The UN global tax plan ... resurrects the longheld dream of the 'Tobin Tax'. A dangerous precedent would be set, however: the idea that the UN possesses legitimate taxing authority to fund its operations.[10

The Robin Hood tax commonly refers to a package of financial transaction taxes (FTT), proposed by a campaigning group of civil society NGOs. Campaigners have suggested the tax could be implemented globally, regionally or unilaterally by individual nations. Conceptually similar to the Tobin tax, it would affect a wider range of asset classes including the purchase and sale of stocks, bonds, commodities, unit trusts, mutual funds, and derivatives such as futures and options. The Tobin tax was proposed for foreign currency exchange only. A UK based global campaign for the Robin Hood tax was launched on 10 February 2010 [1] and is being run by a coalition of over 50 charities and organizations, including Christian Aid, Comic Relief and UNICEF.[2] The UK government published a response[3] favouring instead bank levies and a financial activities tax, citing the International Monetary Fund's report to the June 2010 G20 meeting, "A Fair and Substantial Contribution by the Financial Sector".[4] The Robin Hood tax campaign also supports both a Bank levy and a Financial Activity Tax, saying they are agnostic about the chosen mechanism providing it involves a sizable transfer of wealth from the financial sector to the needy. However most of their campaigning efforts have focussed on the FTT variant. By autumn 2011 the Robin Hood campaign had gained considerable extra momentum and support from prominent opinion formers, with a proposal from the European Commission to implement an FTT tax at EU level set to enter the legislative pipeline. The campaign has also attracted extensive criticism, with a global implementation of the FTT tax being opposed by several G20 members at the November Summit, with several EU members also opposing a regional FTT for Europe.

Early history of the terminology

In 2001 the charity War on Want released The Robin Hood Tax,[5] an earlier proposal presenting their case for a currency transaction tax. In 2008, Italian treasury minister Giulio Tremonti introduced a windfall tax on the profits of energy companies.[6] Mr Tremonti called the tax a "Robin Hood Tax" as it was aimed at the wealthy with revenue to be used for the benefit of

poorer citizens, though unlike the tax campaigned for in 2010 it was not a transaction tax nor global nor aimed at banks.

The 2010 UK campaign

The campaign (U.S.: lobbying effort) has proposed to set taxes on a range of financial transactions - the rate would vary but would average at about 0.05%.[1] The tax would be applied to those trading in financial products such as stocks, bonds, currencies, commodities, futures, and options. It would affect individual investors, banks, hedge funds and other financial institutions. The campaign is sponsored by various prominent charities, aiming to raise money for International development, to tackle climate change and to protect public services. The amount of money raised would depend on a number of different factors, including how many countries agree to the tax and the rate. In March 2010 the campaign's web site stated that: "$400 billion is our best estimate of what the tax will eventually raise from a range of rates on different transactions."[7] It has been proposed by the campaigning (lobbying) group that the money raised from this tax be split between domestic use and international aid.[8] In an article co-authored by one of the campaign's most prominent advocates, Comic Relief founder Richard Curtis, it was suggested that approximately 50% of funds raised would be assigned to domestic use to protect public services and for governments to tackle poverty at home. Under the proposal, international efforts to reduce global poverty would receive another 25%, and the remaining 25% would go towards helping low income countries mitigate the effects of climate change and to reduce their own emissions.[9] The British campaign's launch was accompanied by an online poll on the charity's web site for the public to have a say on whether they support the tax. Initially, there was an apparent backlash with what appeared to be thousands of members of the public visiting the Robin Hood Tax to vote against the idea. However on investigation it was claimed by the lobbying group that some five thousand of the "no" votes came from only two servers, one of them belonging to the investment bank Goldman Sachs.[10] The Robin Hood tax has been supported by some 350 economists in a letter written to the G20, including Joseph Stiglitz and Jeffery Sachs.[11] Politicians supporting the tax include Angela Merkel, Nicolas Sarkozy and Katsuya Okada, Japan's foreign minister.[12] [13] According to a press release by the lobbying organization, support has been forthcoming from the financial sector by prominent figures including George Soros, Warren Buffett and Lord Turner, chairman of the UKs Financial Services Authority.[13] At the February 5, 2010 G7 meeting in Canada consensus was formed for some form of tax charged against large banks to cover the cost to government of insuring banks against future crisis. G7 officials planned to seek approval from other G20 nations at the June 2010 summit before progressing towards implementation.[14]

While the movement supporting this or similar transaction taxes is international,[15] the use of the "Robin Hood" theme has been especially prominent in Great Britain. An early thrust of the 2010 campaign involved grass roots supporters being encouraged to lobby MPs and the British Treasury for an implementation of the Robin Hood tax to be announced unilaterally as part of the UK's 24 March 2010 Budget. The British Chancellor refused to implement a Robin Hood tax, saying it would need to be co-ordinated internationally or else it would result in thousands of jobs being lost in the UK. [16] Another theatre for the campaign is the European Parliament, where in March 2010 a resolution was passed calling for progress to be made in identifying ways to set up a "Robin Hood" type tax.[17]

Ongoing efforts: 2011 and later

Campaigning for the tax continued in 2011, with over 1000 economists signing a letter addressed to G20 finance ministers prior to their April 2011 meeting in Washington. Prominent signatories include Jeffery Sachs ; Nobel prize winners Joseph Stiglitz and Paul Krugman ; Harvard's Dani Rodrik and Cambridge's Ha-Joon Chang. A copy of the letter was also sent to Bill Gates, who has been commissioned by G20 chair and French president Nicolas Sarkozy to investigate new ways of funding the development of low income countries. The Guardian reported that staff from the Gates Foundation are also involved in international lobbying at G20 capitals.[18][19] The Robin Hood campaign has been attempting to build international public enthusiasm for the tax prior to the November G20 summit; in June the organisation reported the staging of campaigning events in 43 different countries.[20] In late June the European Commission reversed its earlier opposition to the tax, proposing EU financial transaction tax be adopted within the 27 member states of the European Union. Moves to pass the proposal through the legislative process are scheduled to commence in autumn 2011. [21] A European version of the tax is projected to raise up to 30bn a year. ECB president Jean-Claude Trichet warned that implementing the tax could hurt Europe unless it could be rolled out globally.[22] In August 2011 Sarkozy and German Chancellor Angela Merkel affirmed their support for the proposed European implementation. Great Britain's prime minister David Cameron remains opposed to the tax unless it can be implemented globally, meaning that a European implementation would likely have to be confined to the Eurozone not the whole EU.[23][24] As part of his September State of the Union speech, President of the European Commission Jos Manuel Barroso officially proposed an upgraded package of transaction taxes for adoption by the EU, now projected to raise up to 55bn ($75bn) per year. Also in September, Bill Gates presented his preliminary findings to the 2011 IMF & World Bank meeting in support of the Robin Hood tax. Gates's proposal is for a set of taxes which could raise between $48250bn per year. Unlike Barrosol's proposal, Gates is advocating the tax be adopted on a G20 wide bases rather than for just the EU, and Gate's plan is geared more towards raising funds for aid and development rather than for regular public spending and repairing government finances. Various British business, banks and economists such as Howard Davies have attacked the EU proposal saying it would be bad for growth and would harm the economy. Mark Lawson for the Robin Hood campaign responded to developments by saying "Game on!".[25] [26] [27]

In October, Adbusters, the organization responsible for sparking the Occupy movement, called for a global march in support of the Robin Hood tax, to take place on October 29 just before the 2011 G20 leaders summit.[28] [29] [30] Marches did not occur in all "occupied" cities, but events involving several hundred protesters did take place at locations including Washington DC, Vancouver and Edinburgh.[31] Also in October the Robin Hood tax was endorsed by Pope Benedict XVI .[32] In November, Rowan Williams the Archbishop of Canterbury, re-affirmed his support the Robin Hood campaign with an article in the Financial Times, saying the Vatican's strong backing for a FTT was "probably the most far-reaching" of their recent statements on reforming the International monetary system.[33][34] In November, Bill Gates presented his report to the 2011 G-20 Cannes summit, saying that a FTT tax could be an effective way to raise funds to tackle poverty in the developing world. However Gates also told the Financial Times that an FTT was only one option among many, admitting that in his opinion it was less important than tobacco and fuel taxes. At the G20 Summit there was strong support for the Robin Hood tax from Germany and France but opposition from other members including the US, Canada and Australia.[35] A few days after the G20 Summit, European finance leaders debated the possible introduction of a regional FTT tax. Again there was strong support from Germany and France[36] but also from Austria, Belgium, Greece, Finland, Luxembourg, Spain, Portugal,[37] while strong opposition comes from Britain, Sweden, Denmark, the Czech Republic, Romania and Bulgaria, with some members being skeptical especially about the value of implementing an FTT without including at least all 27 EU states.[36] As European Union members remain divided over the issue, advocates of the FTT have said it could be implemented only within the eurozone, excluding countries like Sweden and the United Kingdom.[38] France's president Hollande had committed to a Robin Hood tax in his 2012 election campaign. In a meeting just prior to the 2012 G8 summit he advised that he intends to uphold his commitment, though David Cameron repeated that Britain would veto the tax if attempts were made to impose it across the EU. Plans are underway in France to implement the tax unilaterally.[39][40]

Celebrity involvement
The campaign involves a fictional film made by Richard Curtis and starring Bill Nighy, in which Bill Nighy plays a banker who is being questioned about the Robin Hood tax.[41] He eventually admits that the tax would be a good idea and would not be too damaging to the financial sector.

Comparison with the Tobin Tax

Main article: Tobin tax

As of November 2011, the term "Tobin tax" is often used as a synonym for the Robin Hood tax. The Robin Hood FTT variant is similar to the original Tobin tax proposal but would apply to a broader set of financial sector transactions. Tobin suggested a form of currency transaction tax.

This is a type of financial transaction tax, which taxes specific types of currency transaction. This term has been most commonly associated with the financial sector, as opposed to consumption taxes paid by consumers. Another difference between the Robin Hood FTT and the Tobin tax is that the Tobin tax was intended primarily to stabilize the economic market rather than generate revenue.[42][43] Economists and analysts are now divided as to whether a small transaction tax would have a significant braking effect on the velocity of trades. According to the campaigning organization, the Robin Hood Tax campaign presents the raising of revenue for domestic use and to fund international aid as a leading aim.[44]

Evaluation and reception of the Robin Hood tax

Despite the early support for the FTT variant by leading statesmen such as Gordon Brown, by March 2010 The Financial Times had reported the international consensus now favoured a straightforward levy against various bank assets rather than a financial transaction tax.[45] After the June 2010 G20 meeting of finance ministers in Busan, the G20 were no longer agreed even for the less radical global bank levy, with opposition led by Canada and Australia.[46] Officials from EU, USA and UK said they were still planning to implement levies on their own banks, although the tax would likely be at a lower rate now to limit the risk of banks moving to jurisdictions that aren't planning on implementing the levy. Following on from the Pusan meeting but prior to the main 2010 G-20 Toronto summit, the European Union president Herman Van Rompuy announced that the EU had a common position in favour of both a Robin Hood style transaction tax and a bank levy which they would push for at the G20 gathering. However, according to the Canadian Embassy Newspaper there were divisions within the EU with some member countries such as the Czech Republic against any form of bank tax. [47] [48] No consensus for the tax emerged from the 2010 G20 summit. Prior to the 2011 G20 Summit in November, the Robin Hood campaign had became even more prominent, though it also provoked dozens of critical articles. Again it failed to achieve consensus at the 2011 summit.

General Criticism
The proposed FTT could reduce the total volume traded in financial products, with negative consequences for employment. While this may reduce employment in brokerages and other areas of the securities industry, a further consequence could be unemployment outside of the financial sector. Schwabish (2005) examined the potential effects of introducing a stock transaction (or "transfer") tax in a single city (New York) on employment not only in the securities industry, but also in the supporting industries. A financial transactions tax could lead to job losses also in nonfinancial sectors of the economy through the so-called multiplier effect forwarding in a magnified form any taxes imposed on Wall Street employees through their reduced demand to their suppliers and supporting industries. The author estimated the ratios of financial- to nonfinancial job losses of between 10:1 to 10:4, that is "a 10 percent decrease in securities industry employment would depress employment in the retail, services, and restaurant sectors by more than 1 percent; in the business services sector by about 4 percent; and in total private jobs by about 1 percent." [49]

Other unintended consequences of an FTT could include a reduction in professional market participants such as market makers who stand ready to buy or sell at prevailing prices. This could impact the orderly and efficient operation of markets, including the price discovery process. It has been suggested that such reforms could lead to reduced liquidity, wider bid / offer spreads, and greater volatility.[50] According to the United States Chamber of Commerce, the tax could double the cost of certain financial transactions and could cause the Dow Jones Industrial Average to fall by 12.5%.[51] Mike Devereux, director of the Centre for Business Taxation at Oxford University, has argued the tax would effectively be a stealth tax as the banks would pass all costs on to their customers, with no guaranteed transparency about who exactly would bear the costs.[52] Economics writer Tim Worstall has made similar arguments, stating the tax would ultimately be paid not by the banks but by ordinary consumers and workers. Worstall also argues that overall an FTT tax would reduce tax revenue, so would fail to help provide extra money for helping the poor.[53] In 2011 Oxfam banned a pensioner from one of its stores as he was incensed by the organization's support for the tax, feeling that it could reduce the income of small time pensioners and shareholders like himself.[54]

Criticism against implementation at national or regional level only

If implemented just at EU level rather than globally, critics has stated the negative consequences would be felt disproportionately in Britain, with economists such as Tim Congdon estimating an FTT could result in over 100,000 job losses from London's financial sector.[55] [56] Andrew Tyrie, Chairman of the UK Treasury Select Committee, has listed 17 problems with the FTT tax, including a loss of overall tax revenue for Britain.[56] Critics have conceded that the FTT would reduce the overall volume of transactions, especially those originating from Highfrequency trading, but deny that it would reduce the risk of further crises in the financial sector.[56] When a 0.5% financial transaction tax was implemented in Sweden, over 50% of trades in Swedish equities moved to London.[55] On 15 April 1990, the tax on fixed-income securities was abolished. It is notable that the tax imposed an increased cost on government borrowing, and this may have influenced the decision to repeal the tax.[57]

Public opinion
A recent Eurobarometer poll of more than 27,000 people published in January 2011 found that Europeans are strongly in favour of a financial transaction tax by a margin of 61 to 26 per cent. Of those, more than 80 per cent agree that if global agreement cannot be reached - an FTT should, initially, be implemented in just the EU. Support for an FTT, in the UK, is 65 per cent. Another survey published earlier by YouGov suggests that more than four out of five people in the UK, France, Germany, Spain and Italy think the financial sector has a responsibility to help repair the damage caused by the economic crisis. The poll also indicated strong support for an

FTT among supporters of all the three main UK political parties.[37][58] Despite the arguments that an EU only FTT tax would hurt Great Britain, other 2011 polls have suggested about two thirds of the British public support the Robin Hood tax campaign.[56] A bank tax ("bank levy") is a tax on banks. One of the earliest modern uses of the term "bank tax" occurred in the context of the Financial crisis of 20072010. On 16 April 2010, the International Monetary Fund (IMF) proposed the idea of a "financial stability contribution" (FSC), which many media have referred to as a "bank tax." It was proposed as one of three possible options to deal with the crisis. These options were presented in response to an earlier request of the G-20 leaders, at the September 2009 Pittsburgh summit, for an investigative report on all possible options to deal with the crisis.[1] Both before and after that IMF report, there was considerable debate amongst national leaders as to whether such a "bank tax" should be global or semi-global, or whether it should be applied only in certain nations

History
In the context of the Financial crisis of 20072010, in August 2009, British Financial Services Authority chairman Lord Adair Turner said in Prospect magazine that he would be happy to consider a "tax on banks" to prevent excessive bonus payments.[2]

G20 request to IMF

At the September 2009 G-20 Pittsburgh summit, the G20 nation leaders asked the IMF "to prepare a report for our next meeting with regard to the range of options countries have adopted or are considering as to how the financial sector could make a fair and substantial contribution toward paying for any burdens associated with government interventions to repair the banking system."[3]

IMF responds to G20 request

When the IMF presented its interim report[4][5] for the G20 on April 16, 2010, it laid out the following three options. Notice that they are all distinct from each other:
1. Financial stability contribution (FSC), or "Bank tax"

Financial stability contribution (FSC), or "Bank tax," or "Bank Levy," a tax on financial institutions balance sheets (most probably on their liabilities or possibly on their assets) whose proceeds would most likely be used to create an insurance fund to bail them out in any future crisis rather than making taxpayers pay for bailouts.

Much of the IMFs report is devoted to the first option of a levy on all major financial institutions balance sheets. Initially it could be imposed at a flat rate and later it could be refined so that the institutions with the most risky portfolios would pay more than those who took on

fewer risks. Such a levy could be modeled on President Obamas proposed Financial Crisis Responsibility Fee that would raise US$90 billion over 10 years from US banks with assets of more than US$50 billion. If Obamas proposal is approved by the US Congress, the proceeds would go into general government revenues. They would be used to pay the costs of the current crisis rather than go into an insurance fund in anticipation of the next one.[3][6]
2. Financial Activities Tax (FAT)

A Financial Activities Tax or FAT raised on the sum of bank profits and bankers remuneration packages with the proceeds going into general government revenues.[7][8]

3. Financial Transaction Tax Main article: Financial transaction tax

A Financial Transactions Tax (FTT) on a broad range of financial instruments including stocks, bonds, currencies and derivatives.

In November 2009, (two months after the 2009 G-20 Pittsburgh summit of heads of state), the G20 nation Finance Ministers met in Scotland to address the Financial crisis of 20072010. However, they were unwilling to endorse the German proposal for a Financial Transactions Tax: "European Union leaders urged the International Monetary Fund on Friday to consider a global tax on financial transactions in spite of opposition from the US and doubts at the IMF itself. In a communiqu issued after a two-day summit, the EUs 27 national leaders stopped short of making a formal appeal for the introduction of a so-called "Tobin tax" but made clear they regarded it as a potentially useful revenue-raising instrument."[9] While the IMF does not endorse an FTT, it concedes that "The FTT should not be dismissed on grounds of administrative practicality."[3][4]
The difference between a Bank Tax and a Financial Transaction Tax

A "bank tax" ("bank levy) is distinct from a financial transaction tax in the following way: A financial transaction tax is a tax placed on a specific type (or types) of financial transaction for a specific purpose (or purposes). This term has been most commonly associated with the financial sector, as opposed to consumption taxes paid by consumers. However, it is not a taxing of the financial institutions themselves. Instead, it is charged only on the specific transactions that are designated as taxable. If an institution never carries out the taxable transaction, then it will never be taxed on that transaction.[10] Furthermore, if it carries out only one such transaction, then it will only be taxed for that one transaction. As such, this tax is neither a financial activities tax, nor a "bank tax,"[11] for example. This clarification is important in discussions about using a financial transaction tax as a tool to selectively discourage excessive speculation without discouraging any other activity (as Keynes originally envisioned it in the 1936.[12] )

Aftermath to IMF report

On June 27, 2010 at the 2010 G-20 Toronto summit, the G20 leaders declared that a "global tax" was no longer "on the table," but that individual countries will be able to decide whether to implement a levy against financial institutions to recoup billions of dollars in taxpayer-funded bailouts.[13] Nevertheless Britain, France and Germany had already agreed before the summit to impose a "bank tax." [13] On May 20, 2010, German officials were understood to favour a financial transaction tax over a financial activities tax.[14]

Two simultaneous taxes considered in the European Union

On June 28, 2010, the European Union's executive said it will study whether the European Union should go alone in imposing a tax on financial transactions after G20 leaders failed to agree on the issue. The financial transactions tax would be separate from a bank levy, or a resolution levy, which some governments are also proposing to impose on banks to insure them against the costs of any future bailouts. EU leaders instructed their finance ministers in May 2010 to work out by the end of October 2010, details for the banking levy, but any financial transaction tax remains much more controversial.[1][15]

Controversies
Should the bank tax be global?
On August 30, 2009, British Financial Services Authority chairman Lord Adair Turner had said it was "ridiculous" to think he would propose a new tax on London and not the rest of the world.[16] However, in May, and June 2010, the government of Canada expressed opposition to the bank tax becoming "global" in nature.[11]

Controversy over the IMF's refusal to promote a financial-transactions tax

In a detailed analysis of the IMFs proposals, Stephan Schulmeister of the Austrian Institute of Economic Research finds that, "the assertion of the IMF paper, that [a financial-transactions tax] is not focused on the core sources of financial instability, does not seem to have a solid foundation in the empirical evidence."[17] Yet at least one independent commentator has endorsed the IMF's view.[1] In an alternative critique of the IMF's stance, Aldo Caliari of U.S. NGO the Center of Concern said, "the naivet with which the IMF approaches its preferred mechanisma bank tax tied to systemic risksis astonishing for such a knowledgeable institution, unless it is in fact designed to let the financial sector off the hook."[17] He argues that the FAT and FSC do not reduce the overall risk in the system, and may increase it if banks are encouraged to feel that the taxes provide a government guarantee of future bailouts. Nonetheless, a 2010 Tulane Law Review article lent lukewarm support to President Obama's Financial Crisis Responsibility Fee, which is

a "bank tax" similar to the FSC.[1] The Tulane article concluded that taxing financial transactions would be "foolish", and that a bank tax "could constitute shrewd regulatory reform if done properly. The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. EBS and Reuters' dealing 3000 are two main interbank FX trading platforms. The foreign exchange market determines the relative values of different currencies.[1] The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Eurozone members and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.[2] In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements,[3] as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.[4] The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps

$43 billion currency swaps $207 billion in options and other products

History
Ancient
Forex first existed in ancient times. [5] Money-changing people, people helping others to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times). These people (sometimes called "kollybists") used city-stalls, at feast times the temples Court of the Gentiles instead. [6] The money-changer was also in more recent ancient times silver-smiths and, or, gold-smiths. [7] During the fourth century the Byzantium government kept a monopoly on forexes. [8]

Medieval and later

During the fifteenth century the Medici family were required to open banks at foreign locations in order to exchange currencies to act for textile merchants. [9][10] To facilitate trade the bank created the nostro (from Italian translated - "ours") account book which contained two columned entries showing amounts of foreign and local currencies, information pertaining to the keeping of an account with a foreign bank. [11][12] [13][14] During the 17th (or 18th ) century Amsterdam maintained an active forex market. [15] During 1704 foreign exchange took place between agents acting in the interests of the nations of England and Holland. [16]

Early modern
The firm Alexander Brown & Sons traded foreign currencies exchange sometime about 1850 and were a leading participant in this within the U.S. of A. [17] During 1880 J.M. do Esprito Santo de Silva (Banco Esprito e Comercial de Lisboa) applied for and was given permission to began to engage in a foreign exchange trading business. [18][19] 1880 is considered by one source to be the beginning of modern foreign exchange, significant for the fact of the beginning of the gold standard during the year.[20]

Modern to post-modern
Before WWII

From 1899 to 1913 holdings of countries foreign exchange increased by 10.8%, while holdings of gold increased by 6.3%. [21] At the time of the closing of the year 1913, nearly half of the world's forexes were being performed using sterling. [22] The number of foreign banks operating within the boundaries of London increased in the years from 1860 to 1913 from 3 to 71. In 1902 there were altogether two London foreign exchange brokers. [23] In the earliest years of the twentieth century trade was most active in Paris, New York and Berlin, while Britain remained

largely uninvolved in trade until 1914. Between 1919 and 1922 the employment of a foreign exchange brokers within London increased to 17, in 1924 there were 40 firms operating for the purposes of exchange. [24] During the 1920s the occurrence of trade in London resembled more the modern manifestation, by 1928 forex trade was integral to the financial functioning of the city. Continental exchange controls, plus other factors, in Europe and Latin America, hampered any attempt at wholesale prosperity from trade for those of 1930's London. [25] During the 1920s foreign exchange the Kleinwort family were known to be the leaders of the market, Japhets, S,Montagu & Co. and Seligmans as significant participants still warrant recognition. [26] In the year 1945 the nation of Ethiopias' government possessed a foreign exchange surplus. [27]
After WWII

After WWII the Bretton Woods Accord was signed allowing currencies to fluctuate within a range of 1% to the currencies par. [28] In Japan the law was changed during 1954 by the Foreign Exchange Bank Law, so, the Bank of Tokyo was to become because of this the centre of foreign exchange by September of that year. Between 1954 and 1959 Japanese law was made to allow the inclusion of many more Occidental currencies in Japanese forex. [29] President Nixon is credited with ending the Bretton Woods Accord, and fixed rates of exchange, bringing about eventually a free-floating currency system. After the ceasing of the enactment of the Bretton Woods Accord (during 1971 [30]) the Smithsonian agreement allowed trading to range to 2%. During 1961-62 the amount of foreign operations by the U.S. of America's Federal Reserve was relatively low.[31][32] Those involved in controlling exchange rates found the boundaries of the Agreement were not realistic and so ceased this in March of 1973, when sometime afterward none of the major currencies were maintained with a capacity for conversion to gold, organisations relied instead on reserves of currency. [33][34] During 1970 to 1973 the amount of trades occurring in the market increased three-fold. [35][36][37] At some time (according to Gandolfo during February-March 1973) some of the markets' were "split", so a two tier currency market was subsequently introduced, with dual currency rates. This was abolished during March of 1974. [38][39][40] Reuters introduced during June of 1973 computer monitors, replacing the telephones and telex used previously for trading quotes.[41]
-markets close

Due to the ultimate ineffectiveness of the Bretton Woods Accord and the European Joint Float the forex markets were forced to close sometime during 1972 and March 1973. [42][43] The very largest of all purchases of dollars in the history of 1976 was when the West German government achieved an almost 3 billion dollar acquisition (a figure given as 2.75 billion in total by The Statesman: Volume 18 1974 [6]), this event indicated the impossibility of the balancing of exchange stabilities by the measures of control used at the time and the monetary system and the foreign exchange markets in "West" Germany and other countries within Europe closed for two weeks (during February and, or, March of 1973. Giersch, Paqu, & Schmieding state closed after

purchase of "7.5 million Dmarks" Brawley states "... Exchange markets had to be closed. When they re-opened ... March 1 " that is a large purchase occurred after the close). [44][45][46][47]
after 1973

In fact 1973 marks the point to which nation-state, banking trade and controlled foreign exchange ended and complete floating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source), [48] although another states the first time a currency pair were given as an option for U.S.A. traders to purchase was during 1982, with additional currencies available by the next year. [49][50] On 1 January 1981 (as part of changes beginning during 1978 [51]) the Bank of China allowed certain domestic "enterprises" to participate in foreign exchange trading. [52] Sometime during the months of 1981 the South Korean government ended forex controls and allowed free trade to occur for the first time. During 1988 the countries government accepted the IMF quota for international trade. [53] Intervention by European banks especially the Bundesbank influenced the forex market, on February the 27th 1985 particularly. [54] The greatest proportion of all trades world-wide during 1987 were within the United Kingdom, slightly over one quarter, with the U.S. of America the nation with the second most places involved in trading. [55] During 1991 the republic of Iran changed international agreements with some countries from oilbarter to foreign exchange. [56]

Market size and liquidity

Main foreign exchange market turnover, 19882007, measured in billions of USD.

The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the

global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[3] Of this $3.98 trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards, swaps and other derivatives. Trading in the United Kingdom accounted for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the United States accounted for 17.9%, and Japan accounted for 6.2%.[57] Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Most developed countries permit the trading of derivative products (like futures and options on futures) on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging economies do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies.[58] Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls.
Top 10 currency traders [59]
% of overall volume, May 2012

Rank 1 2 3 4 5 6 7 8

Name Deutsche Bank Citi Barclays Investment Bank UBS AG HSBC JPMorgan Royal Bank of Scotland Credit Suisse

Market share 14.57% 12.26% 10.95% 10.48% 6.72% 6.6% 5.86% 4.68%

Morgan Stanley

3.52% Foreign exchange trading increased by 20%

between April 2007 and April 2010 and has more [60] The increase in 10 Goldman Sachs 3.12% than doubled since 2004. turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is estimated to account for up to 10% of spot turnover, or $150 billion per day (see retail foreign exchange platform). Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day.

Market participants
Financial markets

Public market

Exchange Securities

Bond market

Bond valuation Corporate bond Fixed income Government bond High-yield debt Municipal bond

Stock market

Common stock Preferred stock Registered share

Stock

Stock certificate Stock exchange Voting share

Derivatives market

Credit derivative Futures exchange Hybrid security Securitization

Over-the-counter

Forwards Options Spot market Swaps

Foreign exchange

Currency Exchange rate

Other markets

Commodity market Money market Reinsurance market Real estate market

Practical trading

Clearing house Financial regulation

Financial market participants

Finance series

Banks and banking Corporate finance Personal finance Public finance

v t e

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens (for example from 0-1 pip to 1-2 pips for a currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 39% of all transactions [57]. From there, smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail market makers. According to Galati and Melvin, Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general,

and in FX markets in particular, since the early 2000s. (2004) In addition, he notes, Hedge funds have grown markedly over the 20012004 period in terms of both number and overall size.[61] Central banks also participate in the foreign exchange market to align currencies to their economic needs.

Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

Foreign exchange fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in the market. Banks, dealers and traders use fixing rates as a trend indicator. The mere expectation or rumor of a central bank foreign exchange intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank.[62] Several scenarios of this nature were seen in the 199293 European Exchange Rate Mechanism collapse, and in more recent times in Asia.

Hedge funds as speculators

About 70% to 90%[citation needed] of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus

may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. While the number of this type of specialist firms is quite small, many have a large value of assets under management) and, hence, can generate large trades.

Retail foreign exchange traders

Individual Retail speculative traders constitute a growing segment of this market with the advent of retail foreign exchange platforms, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading Commission and National Futures Association have in the past been subjected to periodic Foreign exchange fraud.[63][64] To deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA instead of a CTA). Those NFA members that would traditionally be subject to minimum net capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if they deal in Forex. A number of the foreign exchange brokers operate from the UK under Financial Services Authority regulations where foreign exchange trading using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for differences and financial spread betting. There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments[65] are made via Foreign Exchange Companies.[66] These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.

Money transfer/remittance companies and bureaux de change

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange[citation needed] Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers. These are typically located at airports and stations or at tourist locations and allow physical notes to be exchanged from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange companies.

Trading characteristics
Most traded currencies by value
Currency distribution of global foreign exchange market turnover
[3]

Rank 1 2 3 4 5 6 7 8 9 10

Currency

ISO 4217 code % daily share (Symbol) (April 2010) 84.9% 39.1% 19.0% 12.9% 7.6% 6.4% 5.3% 2.4% 2.2% 1.6%

United States dollar USD ($) Euro Japanese yen Pound sterling Australian dollar Swiss franc Canadian dollar Hong Kong dollar Swedish krona EUR () JPY () GBP () AUD ($) CHF (Fr) CAD ($) HKD ($) SEK (kr)

New Zealand dollar NZD ($)

11 12 13 14 15

South Korean won Singapore dollar Norwegian krone Mexican peso Indian rupee

KRW () SGD ($) NOK (kr) MXN ($) INR () Other Total[67]

1.5% 1.4% 1.3% 1.3% 0.9% 12.2% 200%

There is no unified or centrally cleared market for the majority of trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currencies instruments are traded. This implies that there is not a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker is trading, and where it is. In practice the rates are quite close due to arbitrage. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. Major trading exchanges include EBS and Reuters, while major banks also offer trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing mechanism.[citation needed] The main trading centers are New York and London, though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the North American session and then back to the Asian session, excluding weekends. Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large crossborder M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow. Currencies are traded against one another in pairs. Each currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX) is the base currency that is quoted relative to the second currency (YYY), called the counter currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the price of the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as the

base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD). The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive currency correlation between XXXYYY and XXXZZZ. On the spot market, according to the 2010 Triennial Survey, the most heavily traded bilateral currency pairs were:

EURUSD: 28% USDJPY: 14% GBPUSD (also called cable): 9%

and the US currency was involved in 84.9% of transactions, followed by the euro (39.1%), the yen (19.0%), and sterling (12.9%) (see table). Volume percentages for all individual currencies should add up to 200%, as each transaction involves two currencies. Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as oil), as well as a larger component of foreign reserves by banks, has increased dramatically[citation needed]. Transactions in the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased[citation needed]

Determinants of exchange rates

See also: exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):
1. International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world. 2. Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit. 3. Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness

to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and everchanging mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.[68]

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors
These include: (a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates). Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation. Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector [7].

Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight to quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.[69] Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.[70] "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[71] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices. Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight. Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[72]

Financial instruments
Spot

Main article: Foreign exchange spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction.

Forward
See also: Forward contract

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Swap
Main article: Foreign exchange swap

The most common type of forward transaction is the swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed.

Future
Main article: Currency future

Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Option
Main article: Foreign exchange option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The options market is the deepest, largest and most liquid market for options of any kind in the world.

Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists including Milton Friedman have argued that speculators ultimately are a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[73] Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.[74] Large hedge funds and other well capitalized "position traders" are the main professional speculators. According to some economists, individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.[75] Currency speculation is considered a highly suspect activity in many countries.[where?] While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[76] Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators. Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.[77] In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.

Risk aversion
See also: Safe-haven currency

Fig.1 Chart showing MSCI World Index of Equities fell while the US Dollar Index rose.

Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behavior is caused when risk averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.[78] In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US Dollar.[79] Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the Financial Crisis of 2008. The value of equities across the world fell while the US Dollar strengthened (see Fig.1). This happened despite the strong focus of the crisis in the USA.[80]

Carry Trade
Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate. A large difference in rates can be highly profitable for the trader, especially if high leverage is used. However, with all levered investments this is a double edged sword, and large exchange rate fluctuations can suddenly swing trades into huge losses.

Forex Signals
Forex trade alerts, often referred to as Forex Signals are trade strategies provided by either experienced traders or market analysts. These signals which are often charged a premium fee for can then be copied or replicated by a trader to his own live account. Forex Signal products are packaged as either alerts delivered to a users inbox or sms, or can be installed to a trader's trading platform. In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency.[1] For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such

as traveller's cheques) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash.

Retail exchange market

People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveller can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveller's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveller has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com.[3] This studied consumer banks in the U.S., and Travelex, showed that the credit card networks save travellers about 8% relative to banks and roughly 15% relative to airport companies.[3]

Quotations

Exchange rates display in Thailand Main article: Currency pair

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars. There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR GBP AUD NZD USD others. Accordingly, a conversion from EUR to AUD, EUR is the base currency, AUD is the term currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.

Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective)[4] and are used by most countries. Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone. Using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - : 1.4436 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places. In 2005 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places on their electronic dealing platform.[5] The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this system.

Exchange rate regime

Main article: Exchange rate regime

Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid. If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. [1] But

that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes. Still, some governments keep their currency within a narrow range. As a result currencies become over-valued or under-valued, causing trade deficits or surpluses.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued[by whom?] that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)[citation needed]

Purchasing power of currency

The "real exchange rate" (RER) is the purchasing power of a currency relative to another. It is based on the GDP deflator measurement of the price level in the domestic and foreign countries ( ), which is arbitrarily set equal to 1 in a given base year. Therefore, the level of the RER is arbitrarily set depending on which year is chosen as the base year for the GDP deflator of two countries. The changes of the RER are instead informative on the evolution over time of the relative price of a unit of GDP in the foreign country in terms of GDP units of the domestic country. If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the GDP deflators of the two countries, and the RER would be constant and equal to one.

Bilateral vs. effective exchange rate

Example of GNP-weighted nominal exchange rate history of a basket of 6 important currencies (US Dollar, Euro, Japanese Yen, Chinese Renmenbi, Swiss Franks, Pound Sterling

Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

Uncovered interest rate parity

See also: Interest rate parity#Uncovered interest rate parity

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates increase while Japanese interest rates remain unchanged then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage (in reality the opposite, appreciation, quite frequently happens in the short-term, as explained below). The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium. UIRP showed no proof of working after the 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher-yielding currency.

Balance of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market

place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium. Like PPP, the balance of payments model focuses largely on trade-able goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Asset market model

See also: Capital asset pricing model and Net Capital Outflow

The expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as economic growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.[6] The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with other markets, particularly equities. Like the stock exchange, money can be made (or lost) on the foreign exchange market by investors and speculators buying and selling at the right (or wrong) times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates

Manipulation of exchange rates

Countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low, typically by the national central bank engaging in open market operations. It is argued that the People's Republic of China has succeeded in doing this over a long period of time. In 2010, other nations, including Japan and Brazil, attempted to devalue their currency in the hopes of subsidizing cheap exports and bolstering their ailing economies. A low exchange rate lowers the price of a country's goods for consumers in other countries but raises the price of goods, especially imported goods, for consumers in the manipulating country.[7] In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing

to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.[2] Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded over the counter (OTC), forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain The value of a forward position at maturity depends on the relationship between the delivery price ( ) and the underlying price ( ) at that time.

For a long position this payoff is: For a short position, it is:

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current ratethese two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

Example of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him the opportunity cost will be covered.

Spotforward parity

Main article: Forward price See also: Cost of carry and convenience yield

For liquid assets ("tradeables"), spotforward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:

pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as o an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities); o or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.)

Investment assets
For an asset that provides no income, the relationship between the current forward ( ( ) prices is ) and spot

where is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. For an asset that pays known income, the relationship becomes:

Discrete: Continuous:

where the present value of the discrete income at time , and is the continuously compounded dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income ( or ) must be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and example of an asset which pays a continuous yield might be a foreign currency or a stock index. For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:

Discrete: Continuous:

where the present value of the discrete storage cost at time , and is the continuously compounded storage cost where it is proportional to the price of the commodity, and is hence a 'negative yield'. The intuition here is that because storage costs make the final price higher, we have to add them to the spot price.

Consumption assets
Consumption assets are typically raw material commodities which are used as a source of energy or in a production process, for example crude oil or iron ore. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include the ability to profit from temporary shortages and the ability to keep a production process running,[1] and are referred to as the convenience yield. Thus, for consumption assets, the spot-forward relationship is:

Discrete storage costs: Continuous storage costs:

where is the convenience yield over the life of the contract. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward, it can be modelled as a type of 'dividend yield'. However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity. If users have low inventories of the commodity, this implies a greater chance of shortage, which means a higher convenience yield. The opposite is true when high inventories exist.[1]

Cost of carry
The relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Thus, all of the costs and benefits above can be summarised as the cost of carry, . Hence,

Discrete: Continuous:

Relationship between the forward price and the expected future spot price
Main articles: Normal backwardation and Contango

The market's opinion about what the spot price of an asset will be in the future is the expected future spot price.[1] Hence, a key question is whether or not the current forward price actually predicts the respective spot price in the future. There are a number of different hypotheses which try to explain the relationship between the current forward price, and the expected future spot price, .

The economists John Maynard Keynes and John Hicks argued that in general, the natural hedgers of a commodity are those who wish to sell the commodity at a future point in time.[3][4] Thus, hedgers will collectively hold a net short position in the forward market. The other side of these contracts are held by speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will hence only enter the contracts if they expect to make money. Thus, if speculators are holding a net long position, it must be the case that the expected future spot price is greater than the forward price. In other words, the expected payoff to the speculator at maturity is:
, where is the delivery price at maturity

Thus, if the speculators expect to profit,

, as

when they enter the contract

This market situation, where , is referred to as normal backwardation. Since forward/futures prices converge with the spot price at maturity (see basis), normal backwardation implies that futures prices for a certain maturity are increasing over time. The opposite situation, where , is referred to as contango. Likewise, contango implies that futures prices for a certain maturity are falling over time.[5]

Rational pricing
If is the spot price of an asset at time , and must satisfy is the continuously compounded rate, then the . forward price at a future time

To prove this, suppose not. Then we have two possible cases. Case 1: Suppose that time : . Then an investor can execute the following trades at

1. go to the bank and get a loan with amount at the continuously compounded rate r; 2. with this money from the bank, buy one unit of stock for ; 3. enter into one short forward contract costing 0. A short forward contract means that the investor owes the counterparty the stock at time .

The initial cost of the trades at the initial time sum to zero. At time the investor can reverse the trades that were executed at time . Specifically, and mirroring the trades 1., 2. and 3. the investor
1. ' repays the loan to the bank. The inflow to the investor is 2. ' settles the short forward contract by selling the stock for is now because the buyer receives from the investor. ; . The cash inflow to the investor

The sum of the inflows in 1.' and 2.' equals , which by hypothesis, is positive. This is an arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is called a cash and carry arbitrage because you "carry" the stock until maturity. Case 2: Suppose that . Then an investor can do the reverse of what he has done above in case 1. But if you look at the convenience yield page, you will see that if there are

finite stocks/inventory, the reverse cash and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and such like.

Extensions to the forward pricing formula

Suppose that is the time value of cash flows X at the contract expiration time forward price is then given by the formula: . The

The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset. If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices. As a result, the forward price for nonperishable commodities, securities or currency is no more a predictor of future price than the spot price is - the relationship between forward and spot prices is driven by interest rates. For perishable commodities, arbitrage does not have this The above forward pricing formula can also be written as:

Where

is the time t value of all cash flows over the life of the contract.

For more details about pricing, see forward price.

Theories of why a forward contract exists

Allaz and Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment) for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to firms having Stackelberg incentives to anticipate their production through forward contracts.

In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).[1] see Foreign exchange derivative. Structure
A foreign exchange swap consists of two legs:

a spot foreign exchange transaction, and a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other. It is also common to trade forward-forward, where both transactions are for (different) forward dates.

Uses
By far and away the most common use of foreign exchange swaps is for institutions to fund their foreign exchange balances. Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency, and a negative (or short) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back settling the day after. The interest collected or paid every night is referred to as the cost of carry. As currency traders know roughly how much holding a currency position will make or cost on a daily basis, specific trades are put on based on this; these are referred to as carry trades.

Pricing
Main article: Interest rate parity

The relationship between spot and forward is known as the interest rate parity, which states that

where

F = forward rate S = spot rate rd = simple interest rate of the term currency rf = simple interest rate of the base currency T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

if is small. Thus, the value of the swap points is roughly proportional to the interest rate differential.

Related instruments
A foreign exchange swap should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.

A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate. As of 2010, the average daily turnover of global FX spot transactions reached nearly 1.5 trillion USD, counting 37.4% of all foreign exchange transactions.[1] Settlement date
The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two business days from the trade date. A notable exception is the USD/CAD currency pair, which settles at T + 1.

Execution methods
Common methods of executing a spot foreign exchange transaction include the following:[1]

Direct. Executed between two parties directly and not intermediated by a third party. For example, a transaction executed via direct telephone communication or direct electronic dealing systems such as Reuters Conversational Dealing. Electronic broking systems. Executed via automated order matching system for foreign exchange dealers. Examples of such systems are EBS and Reuters Matching 2000/2. Electronic trading systems. Executed via a single-bank proprietary platform or a multibank dealing system. These systems are generally geared towards customers. Examples of multibank systems include FXall, Currenex, FXConnect, Globalink and eSpeed. Voice broker. Executed via telephone communication with a foreign exchange voice broker

A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage.[1] A currency swap should be distinguished from a central bank liquidity swap.

In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the right", which is only slightly different from the meaning of option. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable, and can be sold independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends. Warrants are actively traded in some financial markets such as Deutsche Brse and Hong Kong.[1] In Hong Kong Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable bull/bear contract.[2

Structure and features

Warrants have similar characteristics to that of other equity derivatives, such as options, for instance:

Exercising: A warrant is exercised when the holder informs the issuer their intention to purchase the shares underlying the warrant.

The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond. With warrants, it is important to consider the following main characteristics:

Premium: A warrant's "premium" represents how much extra you have to pay for your shares when buying them through the warrant as compared to buying them in the regular way. Gearing (leverage): A warrant's "gearing" is the way to ascertain how much more exposure you have to the underlying shares using the warrant as compared to the exposure you would have if you buy shares through the market. Expiration Date: This is the date the warrant expires. If you plan on exercising the warrant you must do so before the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant

(unless it depreciates). Therefore, the expiry date is the date on which the right to exercise ceases to exist. Restrictions on exercise: Like options, there are different exercise types associated with warrants such as American style (holder can exercise anytime before expiration) or European style (holder can only exercise on expiration date).[3]

Warrants are longer-dated options and are generally traded over-the-counter.

Secondary market
Sometimes the issuer will try to establish a market for the warrant and to register it with a listed exchange. In this case, the price can be obtained from a stockbroker. But often, warrants are privately held or not registered, which makes their prices less obvious. On the NYSE warrants can be easily tracked by adding a "w" after the companys ticker symbol to check the warrant's price. Unregistered warrant transactions can still be facilitated between accredited parties, and in fact several secondary markets have been formed to provide liquidity for these investments.

Comparison with call options

Warrants are very similar to call options. For instance, many warrants confer the same rights as equity options, and warrants often can be traded in secondary markets like options. However, there also are several key differences between warrants and equity options:

Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public options exchange. Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases. When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case of employee stock options, where new shares are created and issued by the company upon exercise). Unlike common stock shares outstanding, warrants do not have voting rights. Warrants are considered over the counter instruments, and thus are usually only traded by financial institutions with the capacity to settle and clear these types of transactions. A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months. Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two or three years. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price. Warrants are not standardized like exchange-listed options. While investors can write stock options on the ASX (or CBOE), they are not permitted to do so with ASX-listed warrants, since only companies can issue warrants, and while each option contract is over 1000 underlying ordinary shares (100 on CBOE), the number of warrants that must be exercised by the holder to buy the underlying asset depends on the conversion ratio set out in the offer documentation for the warrant issue.

Traded warrants

This section may require cleanup to meet Wikipedia's quality standards. No cleanup reason has been specified. Please help improve this section if you can. (June 2009)

"Traditional" warrant Naked warrant Exotic warrant o Barrier warrant Covered warrant Hit-warrant Turbo warrant Snail warrant Third party warrants

Pricing
There are various methods (models) of evaluation available to value warrants theoretically, including the Black-Scholes evaluation model. However, it is important to have some understanding of the various influences on warrant prices. The market value of a warrant can be divided into two components:

Intrinsic value: This is simply the difference between the exercise (strike) price and the underlying stock price. Warrants are also referred to as in-the-money or out-of-the-money, depending on where the current asset price is in relation to the warrant's exercise price. Thus, for instance, for call warrants, if the stock price is below the strike price, the warrant has no intrinsic value (only time valueto be explained shortly). If the stock price is above the strike, the warrant has intrinsic value and is said to be in-the-money. Time value: Time value can be considered as the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiry of the warrant gets closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards expiry. A warrant's time value is affected by the following factors: o Time to expiry: The longer the time to expiry, the greater the time value of the warrant. This is because the price of the underlying asset has a greater probability of moving inthe-money which makes the warrant more valuable. o Volatility: The more volatile the underlying instrument, the higher the price of the warrant will be (as the warrant is more likely to end up in-the-money). o Dividends: To include the factor of receiving dividends depends on if the holder of the warrant is permitted to receive dividends from the underlying asset. o Interest rates: An increase in interest rates will lead to more expensive call warrants and cheaper put warrants. The level of interest rates reflects the opportunity cost of capital.

Uses

Portfolio protection: Put warrants allow the owner to protect the value of the owner's portfolio against falls in the market or in particular shares.

Low cost Leverage

Risks
There are certain risks involved in trading warrantsincluding time decay. Time decay: "Time value" diminishes as time goes bythe rate of decay increases the closer to the date of expiration.

Types of warrants
A wide range of warrants and warrant types are available. The reasons you might invest in one type of warrant may be different from the reasons you might invest in another type of warrant.

Equity warrants: Equity warrants can be call and put warrants. o Callable warrants: Callable warrants give the Company the right to force the warrant holder to exercise the warrants into their predetermined number of shares at a predetermined price (or using a predetermined price formula) after certain contractual conditions are met o Putable warrants: Putable warrants give the warrant holder the right to force the Company to issue the underlying securities at a predetermined price after certain contractual conditions are met Covered warrants: A covered warrants is a warrant that has some underlying backing, for example the issuer will purchase the stock beforehand or will use other instruments to cover the option. Basket warrants: As with a regular equity index, warrants can be classified at, for example, an industry level. Thus, it mirrors the performance of the industry. Index warrants: Index warrants use an index as the underlying asset. Your risk is dispersed using index call and index put warrantsjust like with regular equity indexes. It should be noted that they are priced using index points. That is, you deal with cash, not directly with shares. Wedding warrants: are attached to the host debentures and can be exercised only if the host debentures are surrendered Detachable warrants: the warrant portion of the security can be detached from the debenture and traded separately. Naked warrants: are issued without an accompanying bond, and like traditional warrants, are traded on the stock exchange.

Traditional
Traditional warrants are issued in conjunction with a Bond (known as a warrant-linked bond), and represent the right to acquire shares in the entity issuing the bond. In other words, the writer of a traditional warrant is also the issuer of the underlying instrument. Warrants are issued in this way as a "sweetener" to make the bond issue more attractive, and to reduce the interest rate that must be offered in order to sell the bond issue.

Example

Price paid for bond with warrants Coupon payments C Maturity T Required rate of return r Face value of bond F

Value of warrants =

Naked
Naked warrants are issued without an accompanying bond, and like traditional warrants, are traded on the stock exchange. They are typically issued by banks and securities firms. These are also called covered warrants, and are settled for cash, e.g. do not involve the company who issues the shares that underlie the warrant. In most markets around the world, covered warrants are more popular than the traditional warrants described above. Financially they are also similar to call options, but are typically bought by retail investors, rather than investment funds or banks, who prefer the more keenly priced options which tend to trade on a different market. Covered warrants normally trade alongside equities, which makes them easier for retail investors to buy and sell them.

Third-party warrants
Third-party warrant is a derivative issued by the holders of the underlying instrument. Suppose a company issues warrants which give the holder the right to convert each warrant into one share at $500. This warrant is company-issued. Suppose, a mutual fund that holds shares of the company sells warrants against those shares, also exercisable at $500 per share. These are called third-party warrants. The primary advantage is that the instrument helps in the price discovery process. In the above case, the mutual fund selling a one-year warrant exercisable at $500 sends a signal to other investors that the stock may trade at $500-levels in one year. If volumes in such warrants are high, the price discovery process will be that much better; for it would mean that many investors believe that the stock will trade at that level in one year. Third-party warrants are essentially long-term call options. The seller of the warrants does a covered call-write. That is, the seller will hold the stock and sell warrants against them. If the stock does not cross $500, the buyer will not exercise the warrant. The seller will, therefore, keep the warrant premium.

Uses of the term warrant other than as an option on equities

Warrant as a check or IOU issued by a government agency

The term warrant is sometimes used in the US to mean a warrant of payment which is a check or an IOU issued by a governmental agency. California differentiates between regular warrants, which can be exchanged immediately for cash and registered warrants which are IOUs.[4] In the late 1990s, when the State of California had a budget crisis due to a disagreement between the governor and the legislature, the state treasurer was forced to issue warrants paying 18% interest in lieu of being able to pay the state's bills with real money. The state had not issued warrants since before the Depression of the 1930s. Many institutions accepted them at face value because of the interest provision. Interestingly, the controller of Los Angeles County was buying the warrants because the county had surplus funds to take advantage of the higher interest rates on the warrants. In some states, a warrant is a demand draft drawn on a government's treasury to pay its bills. Checks or electronic payments have replaced these warrants, but in Arkansas, some counties and school districts uses warrants for non-electronic payments

Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.[1] There are three different ways in which currency swaps can exchange loans:
1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FXswap.[2] 2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.[2] 3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap.[3]

Uses
Currency swaps have two main uses:

To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).[2] To hedge against (reduce exposure to) exchange rate fluctuations.[2]

Hedging example
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following:

If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

Abuses
In May 2011, Charles Munger of Berkshire Hathaway Inc. accused international investment banks of facilitating market abuse by national governments. For example, "Goldman Sachs helped Greece raise $1 billion of off- balance-sheet funding in 2002 through a currency swap, allowing the government to hide debt."[4] Greece had previously succeeded in getting clearance to join the euro on 1 January 2001, in time for the physical launch in 2002, by faking its deficit figures.[5]

History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to borrow Sterling.[6] While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage. Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years.[7] During the global financial crisis of 2008, the currency swap transaction structure was used by the United States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central bank of a developed[8] or stable emerging[9] economy agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas markets."[10] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions

driven by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be beneficial for the Dollar or the US in the long-term.[11] The People's Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, Belarus, Brazil, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, South Korea and Uzbekistan that perform a similar function to central bank liquidity swaps.[12] [13][14]
[15]

Currency Swap Example

A European Company A is doing business in the USA, and it has issued a $20 million dollardenominated bond to investors in the US. An American Company B is doing business in Europe, and it has issued a bond of 15 Million Euros. The two companies can enter into an agreement to exchange the principal and interest of the bonds. The 15 million Euro-denominated bond will be the obligation of company A, and company B will be obligated to the $20 million bond. [16] The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum reserves that each commercial bank must hold (rather than lend out) of customer deposits and notes. These required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with.[1] Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they generally prefer to use open market operations (buying and selling government-issued bonds) to implement their monetary policy. The People's Bank of China uses changes in reserve requirements as an inflation-fighting tool,[2] and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits and zero on time deposits and all other deposits. An institution that holds reserves in excess of the required amount is said to hold excess reserves.

Exceeding $79.5 million must have a liquidity ratio of 10%.[4]

The numerical amounts stated above are recalculated annually according to a statutory formula. Effective December 27, 1990, a liquidity ratio of zero has applied to CDs, savings deposits, and time deposits, owned by entities other than households, and the Eurocurrency liabilities of depository institutions. Deposits owned by foreign corporations or governments are currently not subject to reserve requirements.[5] When an institution fails to satisfy its reserve requirements, it can make up its deficiency with reserves borrowed either from a Federal Reserve Bank, or from an institution holding reserves in excess of reserve requirements. Such loans are typically due in 24 hours or less.

An institution's overnight reserves, averaged over some maintenance period, must equal or exceed its average required reserves, calculated over the same maintenance period. If this calculation is satisfied, there is no requirement that reserves be held at any point in time. Hence reserve requirements play only a limited role in money creation in the USA.

United Kingdom
The Bank of England holds to a voluntary reserve ratio system, with no minimum reserve requirement set. In theory this means that banks could retain zero reserves, effectively allowing an infinite amount of credit money creation. However, the average cash reserve ratio across the entire United Kingdom banking system is higher, with a 3.1% average as of 1998.

Other countries
Other countries have required reserve ratios (or RRRs) that are statutorily enforced (sourced from Lecture 8, Slide 4: Central Banking and the Money Supply, by Dr. Pinar Yesin, University of Zurich, based on 2003 survey of CBC participants at the Study Center Gerzensee[6]): Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital,[1] which consists primarily of common stock and disclosed reserves (or retained earnings),[2] but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both Tier 1 and Tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt. Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems. The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses, which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than 150% of the minimum requirement.

Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank). Most

central banks follow the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for Market Risk (typically based on value at risk (VAR) ) and Operational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the Financial Crisis.[3] As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%. There are two different conventions for calculating and quoting the Tier 1 capital ratio:

Tier 1 common capital ratio and Tier 1 total capital ratio

Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio.[4] As a result, the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same.
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base.[1] These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. In the calculation of regulatory capital, Tier 2 is limited to 100% of Tier 1 capital.

Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank. They must be accepted by the bank's supervisory authorities. Many countries do not accept this as an accounting concept or a legitimate form of capital.

Revaluation Reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. The reserve may arise out of a formal revaluation carried through to the bank's balance sheet, or a notional addition due to holding securities in the balance sheet valued at historic cost. Basel II also requires that the difference between the historic cost and the actual value be discounted by 55% when using these reserves to calculate Tier 2 capital.

General Provisions
A general provision is created against losses which have not yet been identified. They qualify for inclusion in Tier 2 capital as long as they are not created against a known deterioration in value. They are limited to

1.25% of RWA (Risk-weighted assets) for banks using the standardized approach 0.6% of credit risk-weighted assets for banks using the IRB approach

Hybrid Instruments
Hybrids are instruments that have some characteristics of both debt and equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Perpetual preferred stocks carrying a cumulative fixed charge are hybrid instruments. Cumulative perpetual preferred stocks are excluded from Tier 1.

Subordinated Term Debt

Subordinated debt is debt that ranks lower than ordinary depositors of the bank. Only those with a minimum original term to maturity of five years can be included in the calculation of this form of capital; they must be subject to proper amortization arrangements.
The Basel Accords (see alternative spellings below) refer to the banking supervision Accords (recommendations on banking regulations)Basel I, Basel II and Basel IIIissued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there.

Formerly, the Basel Committee consisted of representatives from central banks and regulatory authorities of the Group of Ten countries plus Luxembourg and Spain. Since 2009, all of the other G-20 major economies are represented, as well as some other major banking locales such as Hong Kong and Singapore. (See the Committee article for a full list of members.) The committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee's policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level.

Spelling
The Basel Committee is named after the city of Basel, Switzerland. In early publications, the Committee sometimes used the British spelling "Basle" or the French spelling "Ble," names that

are sometimes still used in the media. More recently, the Committee has deferred to the predominantly German-speaking population of the region and used the spelling "Basel", which is also a common spelling in English (if not the most common).

Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992 . Basel I is now widely viewed as outmoded. Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed. Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries. New updates, Basel III, were developed in response to the financial crisis. Background
The Committee was formed in response to the messy liquidation of a Cologne-based bank (Herstatt Bank) in 1974. On 26 June 1974, a number of banks had released Deutsche Mark (German Mark) to the Herstatt Bank in exchange for dollar payments deliverable in New York. On account of differences in the time zones, there was a lag in the dollar payment to the counterparty banks, and during this gap, and before the dollar payments could be effected in New York, the Herstatt Bank was liquidated by German regulators. This incident prompted the G-10 nations to form towards the end of 1974, the Basel Committee on Banking Supervision, under the auspices of the Bank of International Settlements (BIS) located in Basel, Switzerland.

Main framework
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8% of the risk-weighted assets. The creation of the credit default swap after the Exxon Valdez incident helped large banks hedge lending risk and allowed banks to lower their own risk to lessen the burden of these onerous restrictions.

Since 1988, this framework has been progressively introduced in member countries of G-10, currently comprising 13 countries, namely, Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America. Most other countries, currently numbering over 100, have also adopted, at least in name, the principles prescribed under Basel I. The efficacy with which the principles are enforced varies, even within nations of the Group. Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II, initially published in June 2004, was intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face. One focus was to maintain sufficient consistency of regulations so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believed that such an international standard could help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. Politically, it was difficult to implement Basel II in the regulatory environment prior to 2008, and progress was generally slow until that year's major banking crisis caused mostly by credit default swaps, mortgage-backed security markets and similar derivatives. As Basel III was negotiated, this was top of mind, and accordingly much more stringent standards were contemplated, and quickly adopted in some key countries including the USA.

Objective
The final version aims at:
1. Ensuring that capital allocation is more risk sensitive; 2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; 3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques; 4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic capital.

The accord in operation

Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches basic indicator approach or BIA, standardized approach or STA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). As the Basel II recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic and regulatory capital.

The second pillar

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system. It is the Internal Capital Adequacy Assessment Process (ICAAP) that is the result of Pillar II of Basel II accords.

The third pillar

This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others, including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the institution. It must be consistent with how the senior management, including the board, assess and manage the risks of the institution. When market participants have a sufficient understanding of a bank's activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not. These disclosures are required to be made at least twice a year, except qualitative disclosures providing a summary of the general risk management objectives and policies which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.

Recent chronological updates

September 2005 update
On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months.[1]

November 2005 update

On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005.[2]

July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement

and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version.[3]

November 2007 update

On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks.[4]

July 16, 2008 update

On July 16, 2008 the federal banking and thrift agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008.[5]

January 16, 2009 update

For public consultation, a series of proposals to enhance the Basel II framework was announced by the Basel Committee. It releases a consultative package that includes: the revisions to the Basel II market risk framework; the guidelines for computing capital for incremental risk in the trading book; and the proposed enhancements to the Basel II framework.[6]

July 89, 2009 update

A final package of measures to enhance the three pillars of the Basel II framework and to strengthen the 1996 rules governing trading book capital was issued by the newly expanded Basel Committee. These measures include the enhancements to the Basel II framework, the revisions to the Basel II market-risk framework and the guidelines for computing capital for incremental risk in the trading book.[7]

Basel II and the regulators

One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, complexities of public policy, and existing regulation. Banks' senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators.[citation needed]

To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP. For example, U.S. Federal Deposit Insurance Corporation Chair Sheila Bair explained in June 2007 the purpose of capital adequacy requirements for banks, such as the accord:
There are strong reasons for believing that banks left to their own devices would maintain less capitalnot morethan would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.[8]

Implementation progress
Regulators in most jurisdictions around the world plan to implement the new accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States' various regulators have agreed on a final approach.[9] They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will be available for smaller banks.[10] In India, Reserve Bank of India has implemented the Basel II standardized norms on 31 March 2009 and is moving to internal ratings in credit and AMA(Advanced Measurement Approach) norms for operational risks in banks. Existing RBI norms for banks in India (as of September 2010): Common equity (incl of buffer): 3.6%(Buffer Basel 2 requirement requirements are zero.); Tier 1 requirement: 6%. Total Capital : 9% of risk weighted assets. According to the draft guidelines published by RBI the capital ratios are set to become: Common Equity as 5% + 2.5% (Capital Conservation Buffer) + 02.5% (Counter Cyclical Buffer), 7% of Tier 1 capital and minimum capital adequacy ratio (excluding Capital Conservation Buffer) of 9% of Risk Weighted Assets. Thus the actual capital requirement is between 11 and 13.5% (including Capital Conservation Buffer and Counter Cyclical Buffer).[11] In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.[12]

The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions adopted it by 2008. Australia, through its Australian Prudential Regulation Authority, implemented the Basel II Framework on 1 January 2008.[13]

Basel II and the global financial crisis

The role of Basel II, both before and after the global financial crisis, has been discussed widely. While some argue that the crisis demonstrated weaknesses in the framework,[14] others have criticized it for actually increasing the effect of the crisis.[15] In response to the financial crisis, the Basel Committee on Banking Supervision published revised global standards, popularly known as Basel III.[16] The Committee claimed that the new standards would lead to a better quality of capital, increased coverage of risk for capital market activities and better liquidity standards among other benefits. Nout Wellink, former Chairman of the BCBS, wrote an article in September 2009 outlining some of the strategic responses which the Committee should take as response to the crisis.[17] He proposed a stronger regulatory framework which comprises five key components: (a) better quality of regulatory capital, (b) better liquidity management and supervision, (c) better risk management and supervision including enhanced Pillar 2 guidelines, (d) enhanced Pillar 3 disclosures related to securitization, off-balance sheet exposures and trading activities which would promote transparency, and (e) cross-border supervisory cooperation. Given one of the major factors which drove the crisis was the evaporation of liquidity in the financial markets,[18] the BCBS also published principles for better liquidity management and supervision in September 2008.[19] A recent OECD study [20] suggest that bank regulation based on the Basel accords encourage unconventional business practices and contributed to or even reinforced adverse systemic shocks that materialised during the financial crisis. According to the study, capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions. Tighter capital requirements based on risk-weighted assets, introduced in the Basel III, may further contribute to these skewed incentives. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation. Think-tanks such as the World Pensions Council (WPC) have also argued that European legislators have pushed dogmatically and naively for the adoption of the Basel II recommendations, adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they forced private banks, central banks, and bank regulators to rely more on assessments of credit risk by private rating agencies. Thus, part of the regulatory authority was abdicated in favor of private rating agencies.[
Basel III (or the Third Basel Accord) is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking

Supervision in 201011, and scheduled to be introduced from 2013 until 2018.[1][2] The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.050.15%.[3][4] Critics suggest that greater regulation is responsible for the slow recovery from the late-2000s financial crisis,[5][6] and that the Basel III requirements will increase the incentives of banks to game the regulatory framework and further negatively affect the stability of the financial system

Financial repression is any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt. The term financial repression was first introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon.[1][2] It was used to describe emerging market financial systems in the 1960s-80s. However, the same techniques were also used extensively in developed economies, particularly after World War II and up through the 1980s, when such direct government intervention in markets fell out of favour.

Techniques
In a 2011 NBER working paper, Carmen Reinhart and Belen Sbrancia speculate on a possible return by governments to this form of debt reduction in order to deal with their high levels of debt following the 2008 economic crisis.[3] Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:
1. Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q). 2. Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market. 3. Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer. 4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

These measures allow governments to issue debt at lower interest rates than would otherwise be possible. A low nominal interest rate can help governments reduce debt servicing costs, while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.[3] Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation,[4] or alternatively a form of debasement.[5]
"Unlike income, consumption, or sales taxes, the "repression" tax rate (or rates) are determined by financial regulations and inflation performance that are opaque to the highly politicized realm of fiscal measures. Given that deficit reduction usually involves highly unpopular

expenditure reductions and (or) tax increases...the relatively 'stealthier' financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts."[3]

Giovannini and de Melo (1993) calculated the size of the financial repression tax for a 24 emerging market country sample from 1974-1987. Their results showed that financial repression exceeded 2% of GDP for seven countries, and greater than 3% for five countries. For five countries (India, Mexico, Pakistan, Sri Lanka, and Zimbabwe) it represented approximately 20% of tax revenue. In the case of Mexico financial repression was 6% of GDP, or 40% of tax revenue.[6] As noted by Reinhart and others in a June 2011 IMF publication, "financial repression issues come under the broad umbrella of 'macroprudential regulation' (or macroprudential policy), which refers to government efforts to ensure the health of an entire financial system".[7]

Capital requirement (also known as Regulatory capital or Capital adequacy) is the amount of capital a bank or other financial institution has to hold by its financial regulator. This is in the context of fractional reserve banking and is usually expressed as a capital adequacy ratio of liquid assets that must be held compared to the amount of money that is lent out. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals.[ Regulations
A key part of bank regulation is to make sure that firms operating in the industry are prudently managed. The aim is to protect the firms themselves, their customers and the economy, by establishing rules to make sure that these institutions hold enough capital to ensure continuation of a safe and efficient market and able to withstand any foreseeable problems. The main international effort to establish rules around capital requirements has been the Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements. This sets a framework on how banks and depository institutions must calculate their capital. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as Basel I. This framework has been replaced by a significantly more complex capital adequacy framework commonly known as Basel II. After 2012 it will be replaced by Basel III.[2] Another term commonly used in the context of the frameworks is Economic Capital, which can be thought of as the capital level bank shareholders would choose

in absence of capital regulation. For a detailed study on the differences between these two definitions of capital, refer to.[3] The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Basel II requires that the total capital ratio must be no lower than 8%. Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate. The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital- have been replaced by one single criterion. While the international standards of bank capital were laid down in the 1988 Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement. Examples of national regulators implementing Basel II include the FSA in the UK, BaFin in Germany, OSFI in Canada, Banca d'Italia in Italy. In the European Union member states have enacted capital requirements based on the Capital Adequacy Directive CAD1 issued in 1993 and CAD2 issued in 1998. In the United States, depository institutions are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve System (FRB).[4] These guidelines are used to evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments, letters of credit, and derivatives and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio requirement. To be adequately capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. To be well-capitalized under federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. These capital ratios are reported quarterly on the Call Report or Thrift Financial Report. Although Tier 1 capital has traditionally been emphasized, in the Late-2000s recession regulators and investors began to focus on tangible common equity, which is different from Tier 1 capital in that it excludes preferred equity.[5]

Regulatory capital
In the Basel II accord bank capital has been divided into two "tiers" [6] , each with some subdivisions.

Tier 1 capital
Main article: Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $200. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities. In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a Systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non - Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but Net Owned Funds. Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any.

Tier 2 (supplementary) capital

Main article: Tier 2 capital

Tier 2 capital, or supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.
Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results.

Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.
General provisions

A general provision is created when a company is aware that a loss may have occurred but is not certain of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.
Hybrid debt capital instruments

They consist of instruments which combine certain characteristics of equity as well as debt. They can be included in supplementary capital if they are able to support losses on an on-going basis without triggering liquidation. Sometimes, it includes instruments which are initially issued with interest obligation (e.g. Debentures) but the same can later be converted into capital.
Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10 years and ranks senior to Tier 1 debt, but subordinate to senior debt. To ensure that the amount of capital outstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not be replaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (i.e. reduces) on a straight line basis from maturity minus 5 years (e.g. a 1bn issue would only count as worth 800m in capital 4years before maturity). The remainder qualifies as senior issuance. For this reason many Lower Tier 2 instruments were issued as 10yr non-call 5 year issues (i.e. final maturity after 10yrs but callable after 5yrs). If not called, issue has a large step similar to Tier 1 - thereby making the call more likely.

Different International Implementations

Regulators in each country have some discretion on how they implement capital requirements in their jurisdiction. For example, it has been reported[7] that Australia's Commonwealth Bank is measured as having 7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but this would be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial Services Authority. This demonstrates that international differences in implementation of the rule can vary considerably in their level of strictness.

Common capital ratios

Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6% Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) / Risk-adjusted assets >=10% Leverage ratio = Tier 1 capital / Average total consolidated assets >=5% Common stockholders equity ratio = Common stockholders equity / Balance sheet assets

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.[1] 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.[2][3] Most central banks and other monetary authorities regulate bank credit creation, imposing reserve requirements and other capital adequacy ratios. This limits the amount of money creation that occurs in the commercial banking system,[3] and ensures that banks have enough funds to meet the demand for withdrawals. To mitigate the risks of bank runs (when a large proportion of depositors seek withdrawal of their demand deposits at the same time) or, when problems are extreme and widespread, systemic crises, the governments of most countries regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.[2][3] Fractional-reserve banking is the current form of banking in all countries worldwide

History
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.[5] Savers looking to keep their valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became as an early form of circulating paper money.[6] 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.[6] 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.[7] 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-of-last-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.[3][8] 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.

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. 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.[3][9] 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.[10] Additionally, according to macroeconomic theory, a well-regulated fractional-reserve 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.[11] 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.[12][13]

Money creation process

Main article: Money creation

There are two types of money in a fractional-reserve banking system operating with a central bank:[14][15][16]
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.[3] This process is called "deposit multiplication".

Example of deposit multiplication

The table below displays the relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create $500 of commercial bank money (it is important to note that the 20% reserve rate used here is for ease of illustration, actual reserve requirements are usually a lot lower, for example around 3% in the USA and UK). Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands. The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money it is impossible to tell the two forms of money apart unless a bank run occurs.[3] At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.
Table Sources: Individual Bank A B C D Amount Deposited 100 80 64 51.20 Lent Out 80 64 51.20 40.96 Reserves 20 16 12.80 10.24

E F G H I J K

40.96 32.77 26.21 20.97 16.78 13.42 10.74

32.77 26.21 20.97 16.78 13.42 10.74

8.19 6.55 5.24 4.19 3.36 2.68

Total Reserves: 89.26 Total Amount of Deposits: 457.05 Total Amount Lent Out: 357.05 Total Reserves + Last Amount Deposited: 100

The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate. $400 of commercial bank money is created virtually through loans.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step

decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400. For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet. Fractional-reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank.

Money multiplier
Main article: 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 ratio.
Formula

The money multiplier, m, is the inverse of the reserve requirement, R:[17]

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 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.[18] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.[19]

Money supplies around the world

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased reporting it.

Components of the euro money supply 19982007 See also: 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). This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.[14] The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.[14][15] 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.[20] 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.[21]

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.[8][22]

Central banks
Main article: Central bank

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. 2. 3. 4. 5. 6. Minimum required reserve ratios (RRRs) Minimum capital ratios Government bond deposit requirements for note issue 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK) Sanction on bank defaults and protection from creditors for many months or even years, and 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. The UK for example, which does not have required reserves, does have requirements that the banks keep a certain amount of cash, and in Australia while there are no reserve requirements, there are a variety of

requirements to ensure the banks have a stabilising ratio of liquid assets, such as deposits held with local banks. Individual countries adhere to varying required reserve ratios which have changed over time. 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

Main articles: 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 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. 2. 3. 4. 5. Selling or redeeming other assets, or securitization of illiquid assets, Restricting investment in new loans, Borrowing funds (whether repayable on demand or at a fixed maturity), Issuing additional capital instruments, or Reducing dividends.[citation needed]

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[citation needed]

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.[citation needed] 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 bankspecific crisis.[citation needed]

Hypothetical example of a bank balance sheet and financial ratios

An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:
Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007[citation needed] ASSETS Cash Balance with Central Bank Other Liquid Assets NZ$m LIABILITIES 201 2809 1797 Demand Deposits NZ$m 25482

Term Deposits and other borrowings 35231 Due to Other Financial Institutions Derivative financial instruments Payables and other liabilities Provisions Bonds and Notes 3170 4924 1351 165 14607 2775 2062 99084 5943 83 2667 8703

Due from other Financial Institutions 3563 Trading Securities Derivative financial instruments Available for sale assets Net loans and advances Shares in controlled entities Current Tax Assets Other assets Deferred Tax Assets Premises and Equipment Goodwill and other intangibles 1887 4771 48

87878 Related Party Funding 206 112 1045 11 232 3297 [subordinated] Loan Capital Total Liabilities Share Capital [revaluation] Reserves Retained profits Total Equity

Total Assets

107787 Total Liabilities plus Net Worth

107787

In this example the cash reserves held by the bank is NZ$3010m (NZ$201m Cash + NZ$2809m Balance at Central Bank) and the Demand Deposits (liabilities) of the bank are NZ$25482m, for a cash reserve ratio of 11.81%.

Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc. For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:
1. 2. 3. 4. 5. The cash reserve ratio is $3010m/$25482m, i.e. 11.81%. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%. The equity capital ratio is $8703m/107787m, i.e. 8.07%. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02% The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.

It is very important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

How the example bank manages its liquidity

See also: Duration gap

The ANZ National Bank Limited explains its methods as:[citation needed]
Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements. The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown

such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour. Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007[citation needed] Total carrying Less than 3 value months Assets Liquid Assets 4807 4807 2650 440 187 286 312 months 15 years Beyond 5 years No Specified Maturity

Due from other financial 3563 institutions Derivative Financial Instruments 4711

4711 33 9276 970 18394 1 9906 179 10922 25013 45343 13 24142 44905 3754 8115 1

Assets available for sale 48 Net loans and advances 87878 Other Assets Total Assets Liabilities Due to other financial institutions Deposits and other borrowings Derivative financial instruments Other liabilities Bonds and notes Related party funding 3170 4903 107787

2356

405

32

377

70030

53059

14726

2245

4932 1516 14607 2275 1315 672 2275 96 4341 32 9594 60

4932 13

Loan capital Total liabilities Net liquidity gap Net liquidity gap cumulative

2062 99084 8703 8703 60177 (41783) (41783)

100 19668 (8746) (50529)

1653 13556 11457

309 746 44597 4937 3178 8703

(39072) 5525

Criticisms
The neutrality of this article is disputed. Relevant discussion may be found on the talk page. Please do not remove this message until the dispute is resolved. (December 2012)

Critics of fractional-reserve banking and proposals for monetary reform have included economists such as Irving Fisher[23] and Frank Knight.[24] U.S. Congressman Ron Paul and Austrian School economist Murray Rothbard have identified fractional-reserve banking, central banking, and fiat currency as interdependent and destructive features of modern monetary systems.[25][26] In Rothbard's analysis, the practice of fractional-reserve banking amounts to a form of fraud, embezzlement or legalized counterfeiting

History of Islamic banking

Introduction
An early market economy and an early form of mercantilism, called "Islamic capitalism", were developed between the eighth and twelfth centuries.[3] The monetary economy of the period was based on the widely circulated currency the gold dinar, and it tied together regions that were previously economically independent. A number of economic concepts and techniques were applied in early Islamic banking, including bills of exchange, partnership (mufawada, including limited partnerships, or mudaraba), and forms of capital (al-mal), capital accumulation (nama al-mal),[4] cheques, promissory notes,[5] trusts (see Waqf),[6] transactional accounts, loaning, ledgers and assignments.[7] Organizational enterprises independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced during that time.[8][9] Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.[4]

Riba

The word "Ribi" means interest, usury, excess, increase or addition, which according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). The definition of riba in classical Islamic jurisprudence was "surplus value without counterpart", or "to ensure equivalency in real value", and that "numerical value was immaterial." Applying interest was acceptable under some circumstances. Currencies that were based on guarantees by a government to honor the stated value (i.e. fiat currency) or based on other materials such as paper or base metals were allowed to have interest applied to them.[10] When base metal currencies were first introduced in the Islamic world, the question of "paying a debt in a higher number of units of this fiat money being riba" was not relevant as the jurists only needed to be concerned with the real value of money (determined by weight only) rather than the numerical value. For example, it was acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars of equal aggregate weight (i.e., the value in terms of weight had to be same because all makes of coins did not carry exactly similar weight).

Modern Islamic banking

Mirza Basheer-ud-Din Mahmood Ahmad was perhaps the first person to discuss Islamic Economics in detail in his books Nizame Nau (1942) and Islam ka Iqtisadi Nizaam (1945). Later work included that of Naeem Siddiqi and Maulana Maududi.[citation needed] The writings of Muhammad Hamidullah (1944, 1955, 1957 and 1962) should be included in this category. Also the Iqtisaduna (Arabic: "Our Economics") is a major work on Islamic economics by a prominent Shia cleric Muhammad Baqir al-Sadr. Written between 1960 and 1961, it is al-Sadr's main work[citation needed] on economics, and still forms much of the basis for modern Islamic banking. They have all recognised the need for commercial banks and their perceived "necessary evil," have proposed a banking system based on the concept of Mudarabha - profit and loss sharing.[citation needed] In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955).[citation needed] Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), alNajjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.[citation needed] The early 1970s saw greater institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the instrumental as the involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an intergovernmental bank established in 1975, was born of this process.[11] Dr. Sami Hassan Homoud a

Jordanian(1976) He made his PHD in Islamic Banking, where he was the first one writes about Morabha, and he Established Jordan Islamic Bank in 1978 The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic imagefor fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime.[citation needed] The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in country.[12]
This section requires expansion. (June 2008)

In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, currently, is still in business in Egypt. In 1975, the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries.[13] The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services. Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth.[14] Islamic banks have more than 300 institutions spread over 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed according to The Economist.[15] This represents approximately 0.5% of total world estimated assets as of 2005.[16] According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010.[17] Addressing the Oman Investment Forum in October 2011, all conventional banks in Oman can offer Sharia-based financial services upon approval from the Central Bank of Oman (CBO).[18] The Vatican has put forward the idea that "the principles of Islamic finance may represent a possible cure for ailing markets."[19]
Largest Islamic banks See also: Islamic Development Bank

Shariah-compliant assets reached about $400 billion throughout the world in 2009, according to Standard & Poors Ratings Services, and the potential market is $4 trillion.[20][21] Iran, Saudi Arabia and Malaysia have the biggest sharia-compliant assets.[22] In 2009 Iranian banks accounted for about 40 percent of total assets of the world's top 100 Islamic banks. Bank Melli Iran, with assets of $45.5 billion came first, followed by Saudi Arabia's Al Rajhi Bank, Bank Mellat with $39.7 billion and Bank Saderat Iran with $39.3 billion.[23][24] Iran holds the world's largest level of Islamic finance assets valued at $235.3bn

which is more than double the next country in the ranking with $92bn. Six out of ten top Islamic banks in the world are Iranian.[25][26][27] In November 2010, The Banker published its latest authoritative list of the Top 500 Islamic Finance Institutions with Iran topping the list. Seven out of ten top Islamic banks in the world are Iranian according to the list.[28]
Expansion into Islamic banking services

In May 2012, Trend News Agency reported that the Chairman of the International Bank of Azerbaijan, Jahangir Hajiyev, announced that his bank would expand into Islamic banking services. The expansion will take place in countries around Azerbaijan, such as Russia and Kazakhstan. Dr. Hajiyev told Trend News Agency, "For the first time in Azerbaijan's history, we are planning to establish a new office in the field (Islamic banking), enabling the country to become a regional center for Islamic financing."[29]

Principles
Islamic banking has the same purpose as conventional banking: to make money for the banking institute by lending out capital. But that is not the sole purpose either. Adherence to Islamic law and ensuring fair play is also at the core of Islamic banking. Because Islam forbids simply lending out money at interest (see riba), Islamic rules on transactions (known as Fiqh alMuamalat) have been created to prevent this perceived evil. The basic principle of Islamic banking is based on risk-sharing which is a component of trade rather than risk-transfer which we see in the conventional banking. Islamic banking introduces concepts such as profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar). In an Islamic mortgage transaction, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabahah. Another approach is EIjara wa EIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid). An innovative approach applied by some banks for home loans, called Musharaka alMutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows

for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system like in Malaysia. There are several other approaches used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profitsharing arrangement is concluded. This practice is called Musharaka. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy. Islamic banking is restricted to Islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc. The aim of this is to engage in only ethical investing, and moral purchasing. The Islamic Banking and Finance Database provides more information on the subject.[30] In theory, Islamic banking is an example of full-reserve banking, with banks achieving a 100% reserve ratio.[31] However, in practice, this is not the case, and no examples of 100 per cent reserve banking are observed.[32] Islamic banks have grown recently in the Muslim world but are a very small share of the global banking system. Micro-lending institutions founded by Muslims, notably Grameen Bank, use conventional lending practices and are popular in some Muslim nations, especially Bangladesh, but some do not consider them true Islamic banking. However, Muhammad Yunus, the founder of Grameen Bank and microfinance banking, and other supporters of microfinance, argue that the lack of collateral and lack of excessive interest in micro-lending is consistent with the Islamic prohibition of usury (riba).[33][34]

Shariah Advisory Council/Consultant

Islamic banks and banking institutions that offer Islamic banking products and services (IBS banks) are required to establish a Shariah Supervisory Board (SSB) to advise them and to ensure that the operations and activities of the banking institutions comply with Shariah principles. On the other hand, there are also those who believe that no form of banking that involves interest payments can ever comply with the Shariah.[35] In Malaysia, the National Shariah Advisory Council, which has been set up at Bank Negara Malaysia (BNM), advises BNM on the Shariah aspects of the operations of these institutions and on their products and services. (see Islamic banking in Malaysia). In Indonesia, the Ulama Council serves a similar purpose. A number of Shariah advisory firms have now emerged to offer Shariah advisory services to the institutions offering Islamic financial services. Issue of independence, impartiality and conflicts

of interest have also been recently voiced. The World Database for Islamic Banking and Finance (WDIBF) has been developed to provide information about all the websites related to this type of banking.[30]

Islamic Financial Accounting Standards

The Institute of Chartered Accountants of Pakistan issues Islamic Financial Accounting Standards (IFAS) for Islamic Mode of financing. IFAS 1 (issued in 2005) concerns Musharakah and Mudarabah. While, IFAS 2 (issued in 2007) relates to Ijarah.

Fundamentals of Islamic finance

The term Islamic banking refers to a system of banking or banking activity that is consistent with Islamic law (Shariah) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called riba in Islamic discourse. In addition, Islamic law prohibits investing in businesses that are considered unlawful, or haraam (such as businesses that sell alcohol or pork, or businesses that produce media such as gossip columns or pornography, which are contrary to Islamic values). Furthermore the Shariah prohibits what is called "Maysir" and "Gharar". Maysir is involved in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future whereas Gharar describes speculative transactions. Both concepts involve excessive risk and are supposed to foster uncertainty and fraudlent behaviour. Therefore the use of all conventional derivate instruments is impossible in Islamic banking.[36] In the late 20th century, a number of Islamic banks were created to cater to this particular banking market.

Usury in Islam
The criticism of usury in Islam was well established during the lifetime of the Islamic prophet Muhammad and reinforced by several verses in the Qur'an dating back to around 600 AD. The original word used for usury in this text was Riba, which literally means excess or addition. This was accepted to refer directly to interest on loans so that, according to Islamic economists Choudhury and Malik (1992), by the time of Caliph Umar, the prohibition of interest was a wellestablished working principle integrated into the Islamic economic system. This interpretation of usury has not been universally accepted or applied in the Islamic world. A school of Islamic thought which emerged in the 19th Century, led by Sir Sayyed, argues for an interpretative differentiation between usury, or consumptional lending, and interest, or lending for commercial investment (Ahmed, 1958). Nevertheless, Choudhury and Malik provide evidence for a gradual evolution of the institutions of interest-free financial enterprises across the world (1992: 104). They cite, for instance, the current existence of financial institutions in Iran, Pakistan and Saudi Arabia, the Dar-al-Mal-al-Islami in Geneva and Islamic trust companies in North America.

Islamic financial transaction terminology

This section may require cleanup to meet Wikipedia's quality standards. No cleanup reason has been specified. Please help improve this section if you can. (February 2010)

Bai' al 'inah (sale and buy-back agreement)

Bai' al inah is a financing facility with the underlying buy and sell transactions between the financier and the customer. The financier buys an asset from the customer on spot basis. The price paid by the financier constitutes the disbursement under the facility. Subsequently the asset is sold to the customer on a deferred-payment basis and the price is payable in installments. The second sale serves to create the obligation on the part of the customer under the facility. There are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah, however this is practised in Malaysia (a set of strict conditions must be complied)[citation needed] and the like jurisdictions.[37][38]

Bai' bithaman ajil (deferred payment sale)

This concept refers to the sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties. Like Bai' al 'inah, this concept is also used under an Islamic financing facility. Interest payment can be avoided as the customer is paying the sale price which is not the same as interest charged on a loan. The problem here is that this includes linking two transactions in one which is forbidden in Islam. The common perception is that this is simply straightforward charging of interest disguised as a sale.

Bai' muajjal (credit sale)

Literally bai' muajjal means a credit sale. Technically, it is a financing technique adopted by Islamic banks that takes the form of murabahah muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in installments. It has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Bai' muajjal is also called a deferred-payment sale. However, one of the essential descriptions of riba is an unjustified delay in payment or either increasing or decreasing the price if the payment is immediate or delayed.

Mudarabah
"Mudarabah" is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The capital investment comes from the first partner, who is called the "rabb-ul-mal", while the management and work is the exclusive responsibility of the other party, who is called the "mudarib". The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed

ratio. If there is a loss, the first partner "rabb-ul-mal" will lose his capital, and the other party "mudarib" will lose the time and effort invested in the project.

Murabahah
Main article: Murabahah

This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores.

Musawamah
Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Bai Salam
Bai salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.
Basic features and conditions of Salam 1. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. This is necessary so that the buyer can show that they are not entering into debt with a second party in order to eliminate the debt with the first party, an act prohibited under Sharia. The idea of Salam is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.

2. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain. 3. It is necessary that the quality of the commodity (intended to be purchased through salam) is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. 4. It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known. What is normally weighed cannot be quantified in measures and vice versa. 5. The exact date and place of delivery must be specified in the contract. 6. Salam cannot be effected in respect of things which must be delivered at spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shari'ah, that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale. Therefore the contract of salam in this case is not allowed. 7. This is the most preferred financing structure and carries higher order Shariah compliance.

Hibah (gift)
This is a token given voluntarily by a debtor to a debitor in return for a loan. Hibah usually arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a portion of the profit made by using those savings account balances in other activities. It is important to note that while it appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made (or not made) at the bank's discretion, and cannot be 'guaranteed.'(akin to Dividends earned by Shares, however it is not time bound but is at the bank's discretion) However, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.[39]

Istisna
Istisna (Manufacturing Finance) is a process where payments are made in stages to facilitate step wise progress in the Manufacturing / processing / construction works. Istisna enables any construction company get finance to construct slaps / sections of a building by availing finances in installments for each slap. Istisna also helps manufacturers to avail finance for manufacturing / processing cost for any large order for goods supposed to supply in stages. Istisna helps use of limited funds to develop higher value goods/assets in different stages / contracts.

Ijarah

Ijarah means lease, rent or wage. Generally, the Ijarah concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipment such as plant, office automation, motor vehicle for a fixed period and price.
Ijarah thumma al bai' (hire purchase)

Parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner (bank) at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed to price. The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent interrelated contracts is also prohibited under Shariah Law.
Ijarah-wal-iqtina

A contract under which an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the ome an integral part of the lease contract to make it conditional. The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

Musharakah (joint venture)

Musharakah is a relationship between two parties or more that contribute capital to a business and divide the net profit and loss pro rata. This is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assess an imputed rent and will share it as agreed in advance.[40] All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixedincome investing (i.e. issuance of loans).[citation needed]

Qard hassan/ Qardul hassan (good loan/benevolent loan)

sihT is a loan extended on a goodwill basis, and the debtor is only required to repay the amount borrowed. However, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan (without promising it) as a token of appreciation to the creditor. In the case that the debtor does not pay an extra amount to the creditor, this transaction is a true interest-free loan. Some Muslims consider this to be the only type of loan that does not violate the prohibition on 'riba, for it alone is a loan that truly does not compensate the creditor for the time value of money.[41]

Sukuk (Islamic bonds)

Main article: Sukuk

Sukuk, plural of Sakk, is the Arabic name for financial certificates that are the Islamic equivalent of bonds. However, fixed-income, interest-bearing bonds are not permissible in Islam. Hence, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets.

Takaful (Islamic insurance)

Main article: Takaful

Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes. Takaful is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the law of large numbers. See Takaful for details.

Wadiah (safekeeping)
In Wadiah, a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank's discretion, may be rewarded with Hibah (see above) as a form of appreciation for the use of funds by the bank.

Wakalah (power of attorney)

This occurs when a person appoints a representative to undertake transactions on his/her behalf, similar to a power of attorney.

Islamic equity funds

Main article: Sharia investments

Islamic investment equity funds market is one of the fastest-growing sectors within the Islamic financial system. Currently, there are approximately 100 Islamic equity funds worldwide. The total assets managed through these funds currently exceed US$5 billion and is growing by 12 15% per annum. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some Western majors have just joined the fray or are thinking of launching similar Islamic equity products. Despite these successes, this market has seen a record of poor marketing as emphasis is on products and not on addressing the needs of investors. Over the last few years, quite a number of funds have closed down. Most of the funds tend to target high net worth individuals and corporate institutions, with minimum investments ranging from US$50,000 to as high as US$1 million. Target markets for Islamic funds vary, some cater for their local markets, e.g., Malaysia and Gulf-based investment funds. Others clearly target the Middle East and Gulf regions, neglecting local markets and have been accused of failing to serve Muslim communities. Since the launch of Islamic equity funds in the early 1990s, there has been the establishment of credible equity benchmarks by Dow Jones Islamic market index (Dow Jones Indexes pioneered Islamic investment indexing in 1999) and the FTSE Global Islamic Index Series. The Web site failaka.com monitors the performance of Islamic equity funds and provide a comprehensive list of the Islamic funds worldwide.

Islamic derivatives
See also: Financial derivatives

With help of Bahrain-based International Islamic Financial Market and New York-based International Swaps and Derivatives Association, global standards for Islamic derivatives were set in 2010. The Hedging Master Agreement provides a structure under which institutions can trade derivatives such as profit-rate and currency swaps.[17]

Islamic laws on trading

The Qur'an prohibits gambling (games of chance involving money). The hadith, in addition to prohibiting gambling (games of chance), also prohibits bayu al-gharar (trading in risk, where the Arabic word gharar is taken to mean "risk" or excessive uncertainty). The Hanafi madhab (legal school) in Islam defines gharar as "that whose consequences are hidden." The Shafi legal school defined gharar as "that whose nature and consequences are hidden" or "that which admits two possibilities, with the less desirable one being more likely." The Hanbali school defined it as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." Ibn Hazm of the Zahiri school wrote "Gharar is where the buyer does not know what he bought, or the seller does not know what he sold." The modern scholar of Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of probable items

whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling." Other modern scholars, such as Dr. Sami al-Suwailem, have used Game Theory to try and reach a more measured definition of Gharar, defining it as "a zero-sum game with unequal payoffs".[42] There are a number of hadith that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g., selling the birds in the sky or the fish in the water, the catch of the diver, an unborn calf in its mother's womb etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal (permissible) while trading in non-minor risk (bayu alghasar) is deemed to be haram.[43] What gharar is, exactly, was never fully decided upon by the Muslim jurists. This was mainly due to the complication of having to decide what is and is not a minor risk. Derivatives instruments (such as stock options) have only become common relatively recently. Some Islamic banks do provide brokerage services for stock trading.

Microfinance
Microfinance is a key concern for Muslims states and recently Islamic banks also. Microfinance is ideologically compatible with Islamic finance, capable of Shariah-compliancy, and possesses a sizeable potential market. Islamic microfinance tools can enhance security of tenure and contribute to transformation of lives of the poor.[44] The use of interest found in conventional microfinance products and services can easily be avoided by creating microfinance hybrids delivered on the basis of the Islamic contracts of mudaraba, musharaka, and murabahah. Already, several microfinance institutions (MFIs) such as FINCA Afghanistan have introduced Islamic-compliant financial instruments that accommodate sharia criteria.

Controversy
In Islamabad, Pakistan, on June 16, 2004: Members of leading Islamist political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party, staged a protest walkout from the National Assembly of Pakistan against what they termed derogatory remarks by a minority member on interest banking: Taking part in the budget debate, M.P. Bhindara, a minority MNA [Member of the National Assembly]...referred to a decree by an Al-Azhar University's scholar that bank interest was not un-Islamic. He said without interest the country could not get foreign loans and could not achieve the desired progress. A pandemonium broke out in the house over his remarks as a number of MMA members...rose from their seats in protest and tried to respond to Mr Bhindara's observations. However, they were not allowed to speak on a point of order that led to their walkout.... Later, the opposition members were persuaded by a team of ministers...to return to the house...the government team accepted the right of the MMA to respond to the minority member's remarks.... Sahibzada Fazal Karim said the Council of Islamic ideology had decreed that interest

in all its forms was haram in an Islamic society. Hence, he said, no member had the right to negate this settled issue.[45] Some Islamic banks charge for the time value of money, the common economic definition of interest (riba). These institutions are criticized in some quarters of the Muslim community for their lack of strict adherence to Sharia. The concept of Ijarah is used by some Islamic Banks (the Islami Bank in Bangladesh, for example) to apply to the use of money instead of the more accepted application of supplying goods or services using money as a vehicle. A fixed fee is added to the amount of the loan that must be paid to the bank regardless if the loan generates a return on investment or not. The reasoning is that if the amount owed does not change over time, it is profit and not interest and therefore acceptable under Sharia. Islamic banks are also criticized by some for not applying the principle of Mudarabah in an acceptable manner. Where Mudarabah stresses the sharing of risk, critics point out that these banks are eager to take part in profit-sharing but they have little tolerance for risk. To some in the Muslim community, these banks may be conforming to the strict legal interpretations of Sharia but avoid recognizing the intent that made the law necessary in the first place.[citation needed] The majority of Islamic banking clients are found in the Gulf states and in developed countries. With 60% of Muslims living in poverty[citation needed], Islamic banking is of little benefit to the general population. The majority of financial institutions that offer Islamic banking services are majority owned by Non-Muslims. With Muslims working within these organizations being employed in the marketing of these services and having little input into the actual day to day management, the veracity of these institutions and their services are viewed with suspicion. One Malaysian Bank offering Islamic based investment funds was found to have the majority of these funds invested in the gaming industry; the managers administering these funds were non Muslim.[45] These types of stories contribute to the general impression within the Muslim populace that Islamic banking is simply another means for banks to increase profits through growth of deposits and that only the rich derive benefits from implementation of Islamic Banking principles. Hence, the controversy that surrounds the so-called, Islamic Banking, continues. The question of whether or not available Islamic banking really is Islamic is still a matter of debate among the Muslim academia. The green economy is one that results in improved human well-being and social equity, while significantly reducing environmental risks and ecological scarcities. Green economy is an economy or economic development model based on sustainable development and a knowledge of ecological economics.[1] A feature distinguishing it from prior economic regimes is the direct valuation of natural capital and ecological services as having economic value (see The Economics of Ecosystems and Biodiversity and Bank of Natural Capital) and a full cost accounting regime in which costs

externalized onto society via ecosystems are reliably traced back to, and accounted for as liabilities of, the entity that does the harm or neglects an asset.[citation needed] For an overview of the developments in international environment policy that led up to the UNEP Green Economy Report, see Runnals (2011).[2] Green Sticker and ecolabel practices have emerged as consumer facing measurements of sustainability. Many industries are starting to adopting these standards as a viable way to promote their greening practices in a globalizing economy.

"Green" economists and economics

"Green economics" is loosely defined as any theory of economics by which an economy is considered to be component of the ecosystem in which it resides (after Lynn Margulis). A holistic approach to the subject is typical, such that economic ideas are commingled with any number of other subjects, depending on the particular theorist. Proponents of feminism, postmodernism, the ecology movement, peace movement, Green politics, green anarchism and anti-globalization movement have used the term to describe very different ideas, all external to some equally ill-defined "mainstream" economics.[citation needed] The use of the term is further ambiguated by the political distinction of Green parties which are formally organized and claim the capital-G "Green" term as a unique and distinguishing mark. It is thus preferable to refer to a loose school of "'green economists"' who generally advocate shifts towards a green economy, biomimicry and a fuller accounting for biodiversity. (see The Economics of Ecosystems and Biodiversity especially for current authoritative international work towards these goals and Bank of Natural Capital for a layperson's presentation of these.)[citation needed] Some economists view green economics as a branch or subfield of more established schools. For instance, as classical economics where the traditional land is generalized to natural capital and has some attributes in common with labor and physical capital (since natural capital assets like rivers directly substitute for man-made ones such as canals). Or, as Marxist economics with nature represented as a form of lumpen proletariat, an exploited base of non-human workers providing surplus value to the human economy. Or as a branch of neoclassical economics in which the price of life for developing vs. developed nations is held steady at a ratio reflecting a balance of power and that of non-human life is very low.[citation needed] An increasing consensus around the ideas of natural capital and full cost accounting could blur distinctions between the schools and redefine them all as variations of "green economics". As of 2010 the Bretton Woods institutions (notably the World Bank[3] and International Monetary Fund (via its "Green Fund" initiative) responsible for global monetary policy have stated a clear intention to move towards biodiversity valuation and a more official and universal biodiversity finance.[citation needed] Taking these into account targeting not less but radically zero emission and waste is what is promoted by the Zero Emissions Research and Initiatives.[citation needed]

Definition of a Green economy

Karl Burkart defines a green economy as based on six main sectors:[4]

Renewable energy (solar, wind, geothermal, marine including wave, biogas, and fuel cell) Green buildings (green retrofits for energy and water efficiency, residential and commercial assessment; green products and materials, and LEED construction) Clean transportation (alternative fuels, public transit, hybrid and electric vehicles, carsharing and carpooling programs) Water management (Water reclamation, greywater and rainwater systems, low-water landscaping, water purification, stormwater management) Waste management (recycling, municipal solid waste salvage, brownfield land remediation, Superfund cleanup, sustainable packaging) Land management (organic agriculture, habitat conservation and restoration; urban forestry and parks, reforestation and afforestation and soil stabilization)

The three pillars of sustainability.

The Global Citizens Center, led by Kevin Danaher, defines green economy differently from the use of pricing mechanisms for protecting nature, by using the terms of a "triple bottom line," an economy concerned with being:[5]
1. Environmentally sustainable, based on the belief that our biosphere is a closed system with finite resources and a limited capacity for self-regulation and self-renewal. We depend on the earths natural resources, and therefore we must create an economic system that respects the integrity of ecosystems and ensures the resilience of life supporting systems. 2. Socially just, based on the belief that culture and human dignity are precious resources that, like our natural resources, require responsible stewardship to avoid their depletion. We must create a vibrant economic system that ensures all people have access to a decent standard of living and full opportunities for personal and social development. 3. Locally rooted, based on the belief that an authentic connection to place is the essential precondition to sustainability and justice. The Green Economy is a global aggregate of individual communities meeting the needs of its citizens through the responsible, local production and exchange of goods and services.

The Global Green Economy Index,[6] published annually by consultancy Dual Citizen Inc., measures and ranks the perception and performance of 27 national green economies. This index looks at 4 primary dimensions defining a national green economy as follows:
1. Leadership and the extent to which national leaders are champions for green issues on the local and international stage 2. Domestic policies and the success of policy frameworks to successfully promote renewable energy and green growth in home market 3. Cleantech Investment and the perceived opportunities and cleantech investment climate in each country 4. Green tourism and the level of commitment to promoting sustainable tourism through government[citation needed]

You can take part in a student project to define the Green Economy in the run-up to the Rio+20 [1] conference on the Green Economist website [2].

Other issues
Green economy includes green energy generation based on renewable energy to substitute for fossil fuels and energy conservation for efficient energy use.[citation needed] Because the market failure related to environmental and climate protection as a result of external costs, high future commercial rates and associated high initial costs for research, development, and marketing of green energy sources and green products prevents firms from being voluntarily interested in reducing environment-unfriendly activities (Reinhardt, 1999; King and Lenox, 2002; Wagner, 203; Wagner, et al., 2005), the green economy may need government subsidies as market incentives to motivate firms to invest and produce green products and services. The German Renewable Energy Act, legislations of many other member states of the European Union and the American Recovery and Reinvestment Act of 2009, all provide such market incentives.[citation needed]

Criticisms
A number of organisations and individuals have criticised aspects of the 'Green Economy', particularly the mainstream conceptions of it based on using price mechanisms to protect nature, arguing that this will extend corporate control into new areas from forestry to water. The research organisation ETC Group argues that the corporate emphasis on bio-economy "will spur even greater convergence of corporate power and unleash the most massive resource grab in more than 500 years."[7] Venezuelan professor Edgardo Lander says that the UNEP's report, Towards a Green Economy,[8] while well-intentioned "ignores the fact that the capacity of existing political systems to establish regulations and restrictions to the free operation of the markets even when a large majority of the population call for them is seriously limited by the political and financial power of the corporations." [9] Ulrich Hoffmann, in a paper for UNCTAD also says that the focus on Green Economy and "green growth" in particular, "based on an evolutionary (and often reductionist) approach will not be sufficient to cope with the complexities of climate change" and "may rather give much false hope and excuses to do nothing

really fundamental that can bring about a U-turn of global greenhouse gas emissions.[10] Clive Spash, an ecological economist, has criticised the use of economic growth to address environmental losses,[11] and argued that the Green Economy, as advocated by the UN, is not a new approach at all and is actually a diversion from the real drivers of environmental crisis.[12] He has also criticised the UN's project on the economics of ecosystems and biodiversity (TEEB),[13] and the basis for valuing ecosystems services in monetary terms

The circular economy is a generic term for an industrial economy that is, by design or intention, restorative and in which materials flows are of two types, biological nutrients, designed to reenter the biosphere safely, and technical nutrients, which are designed to circulate at high quality without entering the biosphere. Scope
The term encompasses more than the production and consumption of goods and services, including a shift from fossil fuels to the use of renewable energy, and the role of diversity as a characteristic of resilient and productive systems. It includes discussion of the role of money and finance as part of the wider debate, and some of its pioneers have called for a revamp of economic performance measurement tools.[1]

Origins
The circular economy is grounded in the study of feedback rich (non-linear) systems, particularly living systems. A major outcome of this is the notion of optimising systems rather than components, or the notion of design for fit. As a generic notion it draws from a number of more specific approaches including cradle to cradle, biomimicry, industrial ecology, and the blue economy. Most frequently described as a framework for thinking, its supporters claim it is a coherent model that has value as part of a response to the end of the era of cheap oil and materials.

Moving away from the linear model

Linear Take, Make, Dispose industrial processes and the lifestyles that feed on them deplete finite reserves to create products whose fate is, in the vast majority of cases, to end up in landfill or in incinerators. This realisation triggered the thought process of a few scientists and thinkers, among whom was Walter R. Stahel, an architect, economist and one of the founding fathers of industrial sustainability. Credited with having coined the expression Cradle to Cradle (in contrast with Cradle to Grave, illustrating our Resource to Waste way of functioning) in the late 1970s, Stahel worked on developing a closed loop approach to production processes and created the Product Life Institute in Geneva more than 25 years ago.

Creating the circular framework

In their 1976 research report to the European Commission in Brussels The Potential for Substituting Manpower for Energy, Walter Stahel and Genevieve Reday sketched the vision of an economy in loops (or circular economy) and its impact on job creation, economic competitiveness, resource savings and waste prevention. The report was published in 1982 as a book Jobs for Tomorrow, the Potential for Substituting Manpower for Energy.[2] Considered as one of the first pragmatic and credible sustainability think tanks, the main goals of Stahel's institute are product-life extension, long-life goods, reconditioning activities and waste prevention. It also insists on the importance of selling services rather than products, an idea referred to as the Functional Service Economy and sometimes put under the wider notion of Performance Economy which also advocates more localisation of economic activity.[3] In broader terms, the circular approach is a framework that takes insights from living systems. It considers that our systems should work like organisms, processing nutrients that can be fed back into the cycle whether biological or technical - hence the closed loop or regenerative terms usually associated with it.

Emergence of the idea

The generic Circular Economy label can be applied to, and claimed by, several different schools of thought, that all gravitate around the same basic principles which they have refined in different ways. The idea itself, which is centred on taking insights from living systems, is hardly a new one and hence cannot be traced back to one precise date or author, yet its practical applications to modern economic systems and industrial processes have gained momentum since the late 1970s, giving birth to four prominent movements, detailed below.

Founding principles
Waste is Food
Waste does not exist the biological and technical components (nutrients) of a product are designed by intention to fit within a materials cycle, designed for disassembly and re-purposing. The biological nutrients are non-toxic and can be simply composted. Technical nutrients polymers, alloys and other man-made materials are designed to be used again with minimal energy.

Diversity is strength
Modularity, versatility and adaptiveness are to be prioritised in an uncertain and fast evolving world. Diverse systems, with many connections and scales are more resilient in the face of external shocks, than systems built simply for efficiency.

Energy must come from renewable sources

As in life, any system should ultimately aim to run on current sunshine and generate energy through renewable sources.

Systems thinking
The ability to understand how things influence one another within a whole. Elements are considered as fitting in their infrastructure, environment and social context. Whilst a machine is also a system, systems thinking usually refers to non linear systems: systems where through feedback and imprecise starting conditions the outcome is not necessarily proportional to the input and where evolution of the system is possible : the system can display emergent properties. Examples of these systems are all living systems and any open system such as meteorological systems or ocean currents, even the orbits of the planets have non linear characteristics.

The circular economy framework

The circular economy is a framework that draws upon and encompasses principles from:

Biomimicry
Main article: Biomimicry

Janine Benyus, author of Biomimicry: Innovation Inspired by Nature, defines her approach as a new discipline that studies nature's best ideas and then imitates these designs and processes to solve human problems. Studying a leaf to invent a better solar cell is an example. I think of it as "innovation inspired by nature.[4] Biomimicry relies on three key principles:

Nature as model: Biomimicry studies natures models and emulates these forms, processes, systems, and strategies to solve human problems. Nature as measure: Biomimicry uses an ecological standard to judge the sustainability of our innovations. Nature as mentor: Biomimicry is a way of viewing and valuing nature. It introduces an era based not on what we can extract from the natural world, but what we can learn from it.

Industrial Ecology
Main article: Industrial Ecology

Industrial Ecology is the study of material and energy flows through industrial systems. Focusing on connections between operators within the industrial ecosystem, this approach aims at creating closed loop processes in which waste is seen as input, thus eliminating the notion of undesirable by-product. Industrial ecology adopts a systemic - or holistic - point of view, designing production processes according to local ecological constraints whilst looking at their global impact from the outset, and attempting to shape them so they perform as close to living

systems as possible. This framework is sometimes referred to as the science of sustainability, given its interdisciplinary nature, and its principles can also be applied in the services sector. With an emphasis on natural capital restoration, Industrial Ecology also focuses on social wellbeing.[5]

Cradle to Cradle
Main article: Cradle to Cradle Design

Created by German chemist Michael Braungart and American architect Bill McDonough, the Cradle to Cradle Design model considers that all material involved in industrial and commercial processes can be seen as nutrients, of which there are two main categories: technical and biological.[6] Technical nutrients should include only materials that do not have a negative impact on the environment (so non-harmful synthetic ones are accepted), while Biological nutrients are organic and can be returned to the soil without specific treatment to decompose and eventually become food for the ecosystem. What we need are completely healthful products that are either returned to the soil or flow back to industry forever, say McDonough and Braungart.
Principles

Waste = food Use current sunshine income Celebrate diversity

Blue Economy
Main article: The Blue Economy

Initiated by former Ecover CEO and Belgian businessman Gunter Pauli, the Blue Economy is an open-source movement bringing together concrete case studies, initially compiled in an eponymous report handed over to the Club of Rome. As the official manifesto states, using the resources available in cascading systems, (...) the waste of one product becomes the input to create a new cash flow.[7] Based on 21 founding principles, the Blue Economy insists on solutions being determined by their local environment and physical / ecological characteristics, putting the emphasis on gravity as the primary source of energy - a point that differentiates this school of thought from the others within the Circular Economy.[8] The report - which doubles as the movements manifesto - describes 100 innovations which can create 100 million jobs within the next 10 years, and provides many example of winning South-South collaborative projects, another original feature of this approach intent on promoting its hands-on focus.

Towards the Circular Economy

In January 2012, a report was released entitled Towards the Circular Economy: Economic and business rationale for an accelerated transition. The report, commissioned by the Ellen MacArthur Foundation and developed by McKinsey & Company, was the first of its kind to

consider the economic and business opportunity for the transition to a restorative, circular model. Using product case studies and economy-wide analysis, the report details the potential for significant benefits across the EU. It argues that a subset of the EU manufacturing sector could realise net materials cost savings worth up to $ 630 billion p.a. towards 2025--stimulating economic activity in the areas of product development, remanufacturing and refurbishment. Ecological economics is referred to as both a transdisciplinary and interdisciplinary field of academic research that aims to address the interdependence and coevolution of human economies and natural ecosystems over time and space.[1] It is distinguished from environmental economics, which is the mainstream economic analysis of the environment, by its treatment of the economy as a subsystem of the ecosystem and its emphasis upon preserving natural capital.[2] One survey of German economists found that ecological and environmental economics are different schools of economic thought, with ecological economists emphasizing "strong" sustainability and rejecting the proposition that natural capital can be substituted by human-made capital.[3] Ecological economics was founded as a modern movement in the works of and interactions between various European and American academics (see the section on history and development below). The related field of green economics is, in general, a more politically applied form of the subject.[4][5] According to ecological economist Malte Faber, ecological economics is defined by its focus on nature, justice, and time. Issues of intergenerational equity, irreversibility of environmental change, uncertainty of long-term outcomes, and sustainable development guide ecological economic analysis and valuation.[6] Ecological economists have questioned fundamental mainstream economic approaches such as cost-benefit analysis, and the separability of economic values from scientific research, contending that economics is unavoidably normative rather than positive (empirical).[7] Positional analysis, which attempts to incorporate time and justice issues, is proposed as an alternative

History and development

Early interest in ecology and economics dates back to the 1960s and the work by Kenneth Boulding and Herman Daly, but the first meetings occurred in the 1980s. It began with a 1982 symposium in Sweden which was attended by people who would later be instrumental in the field, including Robert Costanza, Herman Daly, Charles Hall, Ann-Mari Jansson, Bruce Hannon, H.T. Odum, and David Pimentel. Most were ecosystem ecologists or mainstream environmental economists, with the exception of Daly. In 1987, Daly and Costanza edited an issue of Ecological Modeling to test the waters. A book entitled Ecological Economics, by Juan Martinez-Alier, was published later that year.[10] 1989 saw the foundation of the International Society for Ecological Economics and publication of its journal, Ecological Economics, by Elsevier. Robert Costanza was the first president of the society and first editor of the journal, currently edited by Richard Howarth. European conceptual founders include Nicholas Georgescu-Roegen (1971), K. William Kapp (1950)[11] and Karl Polanyi (1944).[12] Some key concepts of what is now ecological economics

are evident in the writings of E.F. Schumacher, whose book Small Is Beautiful A Study of Economics as if People Mattered (1973) was published just a few years before the first edition of Herman Daly's comprehensive and persuasive Steady-State Economics (1977).[13][14] Other figures include ecologists C.S. Holling, H.T. Odum and Robert Costanza, biologist Gretchen Daily and physicist Robert Ayres. CUNY geography professor David Harvey explicitly added ecological concerns to political economic literature. This parallel development in political economy has been continued by analysts such as sociologist John Bellamy Foster. The antecedents can be traced back to the Romantics of the 19th century as well as some Enlightenment political economists of that era. Concerns over population were expressed by Thomas Malthus, while John Stuart Mill hypothesized that the "stationary state" of an economy was desirable, anticipating later insights of modern ecological economists, without having had their experience of the social and ecological costs of the dramatic post-World War II industrial expansion. As Martinez-Alier explores in his book the debate on energy in economic systems can also be traced into the 19th century e.g. Nobel prize-winning chemist, Frederick Soddy (18771956). Soddy criticized the prevailing belief of the economy as a perpetual motion machine, capable of generating infinite wealth a criticism echoed by his intellectual heirs in the now emergent field of ecological economics.[15] The Romanian economist Nicholas Georgescu-Roegen (19061994), who was among Daly's teachers at Vanderbilt University, provided ecological economics with a modern conceptual framework based on the material and energy flows of economic production and consumption. His magnum opus, The Entropy Law and the Economic Process (1971), has been highly influential.[16] Articles by Inge Ropke (2004, 2005)[17] and Clive Spash (1999)[18] cover the development and modern history of ecological economics and explain its differentiation from resource and environmental economics, as well as some of the controversy between American and European schools of thought. An article by Robert Costanza, David Stern, Lining He, and Chunbo Ma[19] responded to a call by Mick Common to determine the foundational literature of ecological economics by using citation analysis to examine which books and articles have had the most influence on the development of the field.

Nature and ecology

Environmental Scientist sampling water. Main articles: Nature and Ecology

A simple circular flow of income diagram is replaced in ecological economics by a more complex flow diagram reflecting the input of solar energy, which sustains natural inputs and environmental services which are then used as units of production. Once consumed, natural inputs pass out of the economy as pollution and waste. The potential of an environment to provide services and materials is referred to as an "environment's source function", and this function is depleted as resources are consumed or pollution contaminates the resources. The "sink function" describes an environment's ability to absorb and render harmless waste and pollution: when waste output exceeds the limit of the sink function, long-term damage occurs.[20]:8 Some persistent pollutants, such as some organic pollutants and nuclear waste are absorbed very slowly or not at all; ecological economists emphasize minimizing "cumulative pollutants".[20]:28 Pollutants affect human health and the health of the climate. The economic value of natural capital and ecosystem services is accepted by mainstream environmental economics, but is emphasized as especially important in ecological economics. Ecological economists may begin by estimating how to maintain a stable environment before assessing the cost in dollar terms.[20]:9 Ecological economist Robert Costanza led an attempted valuation of the global ecosystem in 1997. Initially published in Nature, the article concluded on $33 trillion with a range from $16 trillion to $54 trillion (in 1997, total global GDP was $27 trillion).[21] Half of the value went to nutrient cycling. The open oceans, continental shelves, and estuaries had the highest total value, and the highest per-hectare values went to estuaries, swamps/floodplains, and seagrass/algae beds. The work was criticized by articles in Ecological Economics Volume 25, Issue 1, but the critics acknowledged the positive potential for economic valuation of the global ecosystem.[20]:129 The Earth's carrying capacity is a central issue in ecological economics. Early economists such as Thomas Malthus pointed out the finite carrying capacity of the earth, which was also central to the MIT study Limits to Growth. Diminishing returns suggest that productivity increases will slow if major technological progress is not made. Food production may become a problem, as erosion, an impending water crisis, and soil salinity (from irrigation) reduce the productivity of agriculture. Ecological economists argue that industrial agriculture, which exacerbates these problems, is not sustainable agriculture, and are generally inclined favorably to organic farming, which also reduces the output of carbon.[20]:26 Global wild fisheries are believed to have peaked and begun a decline, with valuable habitat such as estuaries in critical condition.[20]:28 The aquaculture or farming of piscivorous fish, like salmon, does not help solve the problem because they need to be fed products from other fish. Studies have shown that salmon farming has major negative impacts on wild salmon, as well as the forage fish that need to be caught to feed them.[22][23] Since animals are higher on the trophic level, they are less efficient sources of food energy. Reduced consumption of meat would reduce the demand for food, but as nations develop, they

tend to adopt high-meat diets similar to that of the United States. Genetically modified food (GMF) a conventional solution to the problem, presents numerous problems Bt corn produces its own Bacillus thuringiensis, but the pest resistance is believed to be only a matter of time.[20]:31 The overall effect of GMF on yields is contentious, with the USDA and FAO acknowledging that GMFs do not necessarily have higher yields and may even have reduced yields.[24] Global warming is now widely acknowledged as a major issue, with all national scientific academies expressing agreement on the importance of the issue. As the population growth intensifies and energy demand increases, the world faces an energy crisis. Some economists and scientists forecast a global ecological crisis if energy use is not contained the Stern report is an example. The disagreement has sparked a vigorous debate on issue of discounting and intergenerational equity.

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Mainstream economics has attempted to become a value-free 'hard science', but ecological economists argue that value-free economics is generally not realistic. Ecological economics is more willing to entertain alternative conceptions of utility, efficiency, and cost-benefits such as positional analysis or multi-criteria analysis. Ecological economics is typically viewed as economics for sustainable development,[25] and may have goals similar to green politics.

Schools of thought
Various competing schools of thought exist in the field. Some are close to resource and environmental economics while others are far more heterodox in outlook. An example of the latter is the European Society for Ecological Economics. An example of the former is the Swedish Beijer International Institute of Ecological Economics.

Differentiation from mainstream schools

In ecological economics, natural capital is added to the typical capital asset analysis of land, labor, and financial capital. Ecological economics uses tools from mathematical economics, but may apply them more closely to the natural world. Whereas mainstream economists tend to be technological optimists, ecological economists are inclined to be technological pessimists. They reason that the natural world has a limited carrying capacity and that its resources may run out. Since destruction of important environmental resources could be practically irreversible and catastrophic, ecological economists are inclined to justify cautionary measures based on the precautionary principle.[26] The most cogent example of how the different theories treat similar assets is tropical rainforest ecosystems, most obviously the Yasuni region of Ecuador. While this area has substantial deposits of bitumen it is also one of the most diverse ecosystems on Earth and some estimates establish it has over 200 undiscovered medical substances in its genomes - most of which would be destroyed by logging the forest or mining the bitumen. Effectively, the instructional capital of the genomes is undervalued by analyses which view the rainforest primarily as a source of wood, oil/tar and perhaps food. Increasingly the carbon credit for leaving the extremely carbonintensive ("dirty") bitumen in the ground is also valued - the government of Ecuador set a price

of US$350M for an oil lease with the intent of selling it to someone committed to never exercising it at all and instead preserving the rainforest.

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A primary objective of ecological economics (EE) is to ground economic thinking and practice in physical reality, especially in the laws of physics (particularly the laws of thermodynamics) and in knowledge of biological systems. It accepts as a goal the improvement of human wellbeing through development, and seeks to ensure achievement of this through planning for the sustainable development of ecosystems and societies. Of course the terms development and sustainable development are far from lacking controversy. Richard Norgaard argues traditional economics has hi-jacked the development terminology in his book Development Betrayed.[27] Well-being in ecological economics is also differentiated from welfare as found in mainstream economics and the 'new welfare economics' from the 1930s which informs resource and environmental economics. This entails a limited preference utilitarian conception of value i.e., Nature is valuable to our economies, that is because people will pay for its services such as clean air, clean water, encounters with wilderness, etc. Ecological economics is distinguishable from neoclassical economics primarily by its assertion that the economy is embedded within an environmental system. Ecology deals with the energy and matter transactions of life and the Earth, and the human economy is by definition contained within this system. Ecological economists argue that neoclassical economics has ignored the environment, at best considering it to be a subset of the human economy. The neoclassical view ignores much of what the natural sciences have taught us about the contributions of nature to the creation of wealth e.g., the planetary endowment of scarce matter and energy, along with the complex and biologically diverse ecosystems that provide goods and ecosystem services directly to human communities: micro- and macro-climate regulation, water recycling, water purification, storm water regulation, waste absorption, food and medicine production, pollination, protection from solar and cosmic radiation, the view of a starry night sky, etc. There has then been a move to regard such things as natural capital and ecosystems functions as goods and services.[28][29] However, this is far from uncontroversial within ecology or ecological economics due to the potential for narrowing down values to those found in mainstream economics and the danger of merely regarding Nature as a commodity. This has been referred to as ecologists 'selling out on Nature'.[30] There is then a concern that ecological economics has failed to learn from the extensive literature in environmental ethics about how to structure a plural value system.

Allocation of resources
Resource and neoclassical economics focus primarily on the efficient allocation of resources, and less on two other fundamental economic problems which are central to ecological economics: distribution (equity) and the scale of the economy relative to the ecosystems upon which it is reliant.[31] Ecological Economics also makes a clear distinction between growth (quantitative increase in economic output) and development (qualitative improvement of the quality of life) while arguing that neoclassical economics confuses the two. Ecological economists point out that, beyond modest levels, increased per-capita consumption (the typical economic measure of

"standard of living") does not necessarily lead to improvement in human well-being, while this same consumption can have harmful effects on the environment and broader societal well-being.

Strong versus weak sustainability

Ecological economics challenges the conventional approach towards natural resources, claiming that it undervalues natural capital by considering it as interchangeable with human-made capitallabor and technology. The impending depletion of natural resources and increase of climate-changing greenhouse gasses should motivate us to examine how political, economic and social policies can benefit from alternative energy. Interestingly enough, shifting our dependence on fossil fuels with specific interest within just one of the above mentioned factors easily benefits at least one other. For instance, photo voltaic (or solar) panels have a 15% efficiency when absorbing the sun's energy, but it's construction demand has increased 120% within both commercial and residential properties. Additionally, this construction has led to a roughly 30% increase in work demands (Chen). The potential for the substitution of man-made capital for natural capital is an important debate in ecological economics and the economics of sustainability. There is a continuum of views among economists between the strongly neoclassical positions of Robert Solow and Martin Weitzman, at one extreme and the entropy pessimists, notably Nicholas Georgescu-Roegen and Herman Daly, at the other.[32] Neoclassical economists tend to maintain that man-made capital can, in principle, replace all types of natural capital. This is known as the weak sustainability view, essentially that every technology can be improved upon or replaced by innovation, and that there is a substitute for any and all scarce materials. At the other extreme, the strong sustainability view argues that the stock of natural resources and ecological functions are irreplaceable. From the premises of strong sustainability, it follows that economic policy has a fiduciary responsibility to the greater ecological world, and that sustainable development must therefore take a different approach to valuing natural resources and ecological functions.

Energy economics
Main article: Energy economics

A key concept of energy economics is net energy gain, which recognizes that all energy requires energy to produce. To be useful the energy return on energy invested (EROEI) has to be greater than one. The net energy gain from production coal, oil and gas has declined over time as the easiest to produce sources have been most heavily depleted.[33] Ecological economics generally rejects the view of energy economics that growth in the energy supply is related directly to well being, focusing instead on biodiversity and creativity - or

natural capital and individual capital, in the terminology sometimes adopted to describe these economically. In practice, ecological economics focuses primarily on the key issues of uneconomic growth and quality of life. Ecological economists are inclined to acknowledge that much of what is important in human well-being is not analyzable from a strictly economic standpoint and suggests an interdisciplinary approach combining social and natural sciences as a means to address this. Thermoeconomics is based on the proposition that the role of energy in biological evolution should be defined and understood through the second law of thermodynamics, but also in terms of such economic criteria as productivity, efficiency, and especially the costs and benefits (or profitability) of the various mechanisms for capturing and utilizing available energy to build biomass and do work.[34][35] As a result, thermoeconomics are often discussed in the field of ecological economics, which itself is related to the fields of sustainability and sustainable development. Exergy analysis is performed in the field of industrial ecology to use energy more efficiently.[36] The term exergy, was coined by Zoran Rant in 1956, but the concept was developed by J. Willard Gibbs. In recent decades, utilization of exergy has spread outside of physics and engineering to the fields of industrial ecology, ecological economics, systems ecology, and energetics.

Energy accounting and balance

Also see:Net energy gain

An energy balance can be used to track energy through a system, and is a very useful tool for determining resource use and environmental impacts, using the First and Second laws of thermodynamics, to determine how much energy is needed at each point in a system, and in what form that energy is a cost in various environmental issues.[citation needed] The energy accounting system keeps track of energy in, energy out, and non-useful energy versus work done, and transformations within the system.[37] Scientists have written and speculated on different aspects of energy accounting.[38]

Environmental services
A study was carried out by Costanza and colleagues[39] to determine the 'price' of the services provided by the environment. This was determined by averaging values obtained from a range of studies conducted in very specific context and then transferring these without regard to that context. Dollar figures were averaged to a per hectare number for different types of ecosystem e.g. wetlands, oceans. A total was then produced which came out at 33 trillion US dollars (1997 values), more than twice the total GDP of the world at the time of the study. This study was criticized by pre-ecological and even some environmental economists - for being inconsistent with assumptions of financial capital valuation - and ecological economists - for being inconsistent with an ecological economics focus on biological and physical indicators.[40] See also ecosystem valuation and price of life.

The whole idea of treating ecosystems as goods and services to be valued in monetary terms remains controversial to some. A common objection is that life is precious or priceless, but this demonstrably degrades to it being worthless under the assumptions of any branch of economics. Reducing human bodies to financial values is a necessary part of every branch of economics and not always in the direct terms of insurance or wages. Economics, in principle, assumes that conflict is reduced by agreeing on voluntary contractual relations and prices instead of simply fighting or coercing or tricking others into providing goods or services. In doing so, a provider agrees to surrender time and take bodily risks and other (reputation, financial) risks. Ecosystems are no different than other bodies economically except insofar as they are far less replaceable than typical labour or commodities. Despite these issues, many ecologists and conservation biologists are pursuing ecosystem valuation. Biodiversity measures in particular appear to be the most promising way to reconcile financial and ecological values, and there are many active efforts in this regard. The growing field of biodiversity finance[41] began to emerge in 2008 in response to many specific proposals such as the Ecuadoran Yasuni proposal[42][43] or similar ones in the Congo. US news outlets treated the stories as a "threat"[44] to "drill a park"[45] reflecting a previously dominant view that NGOs and governments had the primary responsibility to protect ecosystems. However Peter Barnes and other commentators have recently argued that a guardianship/trustee/commons model is far more effective and takes the decisions out of the political realm. Commodification of other ecological relations as in carbon credit and direct payments to farmers to preserve ecosystem services are likewise examples that enable private parties to play more direct roles protecting biodiversity. The United Nations Food and Agriculture Organization achieved near-universal agreement in 2008[46] that such payments directly valuing ecosystem preservation and encouraging permaculture were the only practical way out of a food crisis. The holdouts were all English-speaking countries that export GMOs and promote "free trade" agreements that facilitate their own control of the world transport network: The US, UK, Canada and Australia.[47]

Externalities
Ecological economics is founded upon the view that the neoclassical economics (NCE) assumption that environmental and community costs and benefits are mutually canceling "externalities" is not warranted. Juan Martinez Alier,[48] for instance shows that the bulk of consumers are automatically excluded from having an impact upon the prices of commodities, as these consumers are future generations who have not been born yet. The assumptions behind future discounting, which assume that future goods will be cheaper than present goods, has been criticized by Fred Pearce[49] and by the recent Stern Report (although the Stern report itself does employ discounting and has been criticized for this and other reasons by ecological economists such as Clive Spash).[50] Concerning these externalities, Paul Hawken argues that the only reason why goods produced unsustainably are usually cheaper than goods produced sustainably is due to a hidden subsidy, paid by the non-monetized human environment, community or future generations.[51] These

arguments are developed further by Hawken, Amory and Hunter Lovins in "Natural Capitalism: Creating the Next Industrial Revolution".[52]

Ecological-economic modeling
Mathematical modeling is a powerful tool that is used in ecological economic analysis. Various approaches and techniques include[53][54]: evolutionary, input-output, neo-Austrian modeling, entropy and thermodynamic models, multi-criteria, and agent-based modeling, the environmental Kuznets curve. Systems Dynamics and GIS are techniques applied, among other, to spatial dynamic landscape simulation modeling. Energy economics is a broad scientific subject area which includes topics related to supply and use of energy in societies.[1] Due to diversity of issues and methods applied and shared with a number of academic disciplines, energy economics does not present itself as a self-contained academic discipline, but it is an applied subdiscipline of economics. From the list of main topics of economics, some relate strongly to energy economics:

Econometrics Environmental economics Finance Industrial organization Microeconomics Macroeconomics Resource economics

Energy economics also draws heavily on results of energy engineering, geology, political sciences, ecology etc. Recent focus of energy economics includes the following issues:

Climate change and climate policy Risk analysis and security of supply Sustainability Energy markets and electricity markets - liberalisation, (de- or re-) regulation Demand response Energy and economic growth Economics of energy infrastructure Environmental policy Energy policy Energy derivatives Forecasting energy demand Elasticity of supply and demand in energy market Energy elasticity

Some institutions of higher education (universities) recognise energy economics as a viable career opportunity, offering this as a curriculum. The University of Cambridge, Massachusetts Institute of Technology and the Vrije Universiteit Amsterdam are the top three research universities, and Resources for the Future the top research institute.[2] There are numerous other

research departments, companies and professionals offering energy economics studies and consultations. Environmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program:

[...] Environmental Economics [...] undertakes theoretical or empirical studies of the economic effects of national or local environmental policies around the world [...]. Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming.[1]

Environmental economics is distinguished from Ecological economics that emphasizes the economy as a subsystem of the ecosystem with its focus upon preserving natural capital.[2] One survey of German economists found that ecological and environmental economics are different schools of economic thought, with ecological economists emphasizing "strong" sustainability and rejecting the proposition that natural capital can be substituted by human-made capital.[3] For an overview of international policy relating to environmental economics, see Runnals

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Central to environmental economics is the concept of market failure. Market failure means that markets fail to allocate resources efficiently. As stated by Hanley, Shogren, and White (2007) in their textbook Environmental Economics:[5] "A market failure occurs when the market does not allocate scarce resources to generate the greatest social welfare. A wedge exists between what a private person does given market prices and what society might want him or her to do to protect

the environment. Such a wedge implies wastefulness or economic inefficiency; resources can be reallocated to make at least one person better off without making anyone else worse off." Common forms of market failure include externalities, non-excludability and non-rivalry. Externality: the basic idea is that an externality exists when a person makes a choice that affects other people that are not accounted for in the market price. For instance, a firm emitting pollution will typically not take into account the costs that its pollution imposes on others. As a result, pollution in excess of the 'socially efficient' level may occur. A classic definition influenced by Kenneth Arrow and James Meade is provided by Heller and Starrett (1976), who define an externality as a situation in which the private economy lacks sufficient incentives to create a potential market in some good and the nonexistence of this market results in losses of Pareto efficiency.[6] In economic terminology, externalities are examples of market failures, in which the unfettered market does not lead to an efficient outcome. Common property and non-exclusion: When it is too costly to exclude people from access to an environmental resource for which there is rivalry, market allocation is likely to be inefficient. The challenges related with common property and non-exclusion have long been recognized. Hardin's (1968) concept of the tragedy of the commons popularized the challenges involved in non-exclusion and common property. "Commons" refers to the environmental asset itself, "common property resource" or "common pool resource" refers to a property right regime that allows for some collective body to devise schemes to exclude others, thereby allowing the capture of future benefit streams; and "open-access" implies no ownership in the sense that property everyone owns nobody owns.[7] The basic problem is that if people ignore the scarcity value of the commons, they can end up expending too much effort, over harvesting a resource (e.g., a fishery). Hardin theorizes that in the absence of restrictions, users of an open-access resource will use it more than if they had to pay for it and had exclusive rights, leading to environmental degradation. See, however, Ostrom's (1990) work on how people using real common property resources have worked to establish self-governing rules to reduce the risk of the tragedy of the commons.[7] Public goods and non-rivalry: Public goods are another type of market failure, in which the market price does not capture the social benefits of its provision. For example, efforts to mitigate climate change would be a public good since the risks of climate change are both non-rival and non-excludable. Such efforts are non-rival since climate mitigation provided to one does not reduce the level of mitigation that anyone else enjoys. They are non-excludable actions by one will have global consequences from which no one can be excluded. A country's incentive to invest in carbon abatement is reduced because it can "free ride" off the efforts of other countries. Over a century ago, Swedish economist Knut Wicksell (1896) first discussed how public goods can be under-provided by the market because people might conceal their preferences for the good, but still enjoy the benefits without paying for them.

GLOBAL BIOGEOCHEMICAL CYCLES CRITICAL FOR LIFE

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Valuation
Assessing the economic value of the environment is a major topic within the field. Use and indirect use are tangible benefits accruing from natural resources or ecosystem services (see the nature section of ecological economics). Non-use values include existence, option, and bequest values. For example, some people may value the existence of a diverse set of species, regardless of the effect of the loss of a species on ecosystem services. The existence of these species may have an option value, as there may be possibility of using it for some human purpose (certain plants may be researched for drugs). Individuals may value the ability to leave a pristine environment to their children. Use and indirect use values can often be inferred from revealed behavior, such as the cost of taking recreational trips or using hedonic methods in which values are estimated based on observed prices. Non-use values are usually estimated using stated preference methods such as contingent valuation or choice modelling. Contingent valuation typically takes the form of surveys in which people are asked how much they would pay to observe and recreate in the environment (willingness to pay) or their willingness to accept (WTA) compensation for the

destruction of the environmental good. Hedonic pricing examines the effect the environment has on economic decisions through housing prices, traveling expenses, and payments to visit parks.[8]

Solutions
Solutions advocated to correct such externalities include:

Environmental regulations. Under this plan, the economic impact has to be estimated by the regulator. Usually this is done using cost-benefit analysis. There is a growing realization that regulations (also known as "command and control" instruments) are not so distinct from economic instruments as is commonly asserted by proponents of environmental economics. E.g.1 regulations are enforced by fines, which operate as a form of tax if pollution rises above the threshold prescribed. E.g.2 pollution must be monitored and laws enforced, whether under a pollution tax regime or a regulatory regime. The main difference an environmental economist would argue exists between the two methods, however, is the total cost of the regulation. "Command and control" regulation often applies uniform emissions limits on polluters, even though each firm has different costs for emissions reductions. Some firms, in this system, can abate inexpensively, while others can only abate at high cost. Because of this, the total abatement has some expensive and some inexpensive efforts to abate. Environmental economic regulations find the cheapest emission abatement efforts first, then the more expensive methods second. E.g. as said earlier, trading, in the quota system, means a firm only abates if doing so would cost less than paying someone else to make the same reduction. This leads to a lower cost for the total abatement effort as a whole.[citation needed] Quotas on pollution. Often it is advocated that pollution reductions should be achieved by way of tradeable emissions permits, which if freely traded may ensure that reductions in pollution are achieved at least cost. In theory, if such tradeable quotas are allowed, then a firm would reduce its own pollution load only if doing so would cost less than paying someone else to make the same reduction. In practice, tradeable permits approaches have had some success, such as the U.S.'s sulphur dioxide trading program or the EU Emissions Trading Scheme, and interest in its application is spreading to other environmental problems. Taxes and tariffs on pollution/Removal of "dirty subsidies." Increasing the costs of polluting will discourage polluting, and will provide a "dynamic incentive," that is, the disincentive continues to operate even as pollution levels fall. A pollution tax that reduces pollution to the socially "optimal" level would be set at such a level that pollution occurs only if the benefits to society (for example, in form of greater production) exceeds the costs. Some advocate a major shift from taxation from income and sales taxes to tax on pollution - the so-called "green tax shift." Better defined property rights. The Coase Theorem states that assigning property rights will lead to an optimal solution, regardless of who receives them, if transaction costs are trivial and the number of parties negotiating is limited. For example, if people living near a factory had a right to clean air and water, or the factory had the right to pollute, then either the factory could pay those affected by the pollution or the people could pay the factory not to pollute. Or, citizens could take action themselves as they would if other property rights were violated. The US River Keepers Law of the 1880s was an early example, giving citizens downstream the right to end pollution upstream themselves if government itself did not act (an early example of bioregional

democracy). Many markets for "pollution rights" have been created in the late twentieth centurysee emissions trading.

Relationship to other fields

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Environmental economics is related to ecological economics but there are differences. Most environmental economists have been trained as economists. They apply the tools of economics to address environmental problems, many of which are related to so-called market failures circumstances wherein the "invisible hand" of economics is unreliable. Most ecological economists have been trained as ecologists, but have expanded the scope of their work to consider the impacts of humans and their economic activity on ecological systems and services, and vice-versa. This field takes as its premise that economics is a strict subfield of ecology. Ecological economics is sometimes described as taking a more pluralistic approach to environmental problems and focuses more explicitly on long-term environmental sustainability and issues of scale. Environmental economics is viewed as more pragmatic in a price system; ecological economics as more idealistic in its attempts not to use money as a primary arbiter of decisions. These two groups of specialists sometimes have conflicting views which may be traced to the different philosophical underpinnings. Another context in which externalities apply is when globalization permits one player in a market who is unconcerned with biodiversity to undercut prices of another who is - creating a race to the bottom in regulations and conservation. This in turn may cause loss of natural capital with consequent erosion, water purity problems, diseases, desertification, and other outcomes which are not efficient in an economic sense. This concern is related to the subfield of sustainable development and its political relation, the anti-globalization movement.

The three pillars of sustainability. Clickable.

Environmental economics was once distinct from resource economics. Natural resource economics as a subfield began when the main concern of researchers was the optimal commercial exploitation of natural resource stocks. But resource managers and policy-makers eventually began to pay attention to the broader importance of natural resources (e.g. values of fish and trees beyond just their commercial exploitation;, externalities associated with mining). It is now difficult to distinguish "environmental" and "natural resource" economics as separate fields as the two became associated with sustainability. Many of the more radical green economists split off to work on an alternate political economy. Environmental economics was a major influence for the theories of natural capitalism and environmental finance, which could be said to be two sub-branches of environmental economics concerned with resource conservation in production, and the value of biodiversity to humans, respectively. The theory of natural capitalism (Hawken, Lovins, Lovins) goes further than traditional environmental economics by envisioning a world where natural services are considered on par with physical capital. The more radical Green economists reject neoclassical economics in favour of a new political economy beyond capitalism or communism that gives a greater emphasis to the interaction of the human economy and the natural environment, acknowledging that "economy is three-fifths of ecology" - Mike Nickerson. These more radical approaches would imply changes to money supply and likely also a bioregional democracy so that political, economic, and ecological "environmental limits" were all aligned, and not subject to the arbitrage normally possible under capitalism. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1][2] The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowin Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks

which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. 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 instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market 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 or else relative to gold. 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; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (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).

Theory
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or

rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices.[citation needed] Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wagesetting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail. Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important

element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued[4] that to prevent some pathologies related to the time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessarily tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.[5]

History of monetary policy

Monetary policy is associated with interest rates and availabilility of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base.[6] For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation.

With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[7] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other goldbacked currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 18701920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[8] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output.[9] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[10] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[11] Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.[12][13][14] Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rates; credit quality; bonds and equities (corporate ownership and debt); government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people, primarily libertarians and Constitutionalists,[15] advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others[who?] see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a

debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt. In fact, many economists [16] disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 20082009.[17]

Trends in central banking

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[18] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate. In the 1980s, many economists {[19] which argues that central bank monetary policy aggravates the business cycle, creating malinvestment and maladjustments in the economy which then cause

downcycle corrections, but most economists fall into either the Keynesian or neoclassical camps on this issue.

Developing countries
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation. Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate. The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Inflation Targeting

Target Market Variable:

Long Term Objective:

Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency Gold Standard Mixed Policy The spot price of gold Usually interest rates Low inflation as measured by the gold price Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

Inflation targeting
Main article: Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[20] The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level

is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years. Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and workers, and undermines any information that can be gained from relative prices, as it is more difficult for firms to determine if a change in the price of a good or service is because of inflation or other factors, such as an increase in the efficiency of factors of production, if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money and increases transaction costs and shoe leather costs.

Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation. Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.) Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and

eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency. Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy). These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
See also: List of fixed currencies

Gold standard
Main article: Gold standard

The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971.[21] Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries sought to reinvigorate their economies by increasing their money supply.[22] The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath of World War II. However, this system too broke down during the Nixon shock of 1971. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays

the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recessions and financial crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

Policy of various nations

Bangladesh - Inflation targeting Australia Inflation targeting Brazil Inflation targeting Canada Inflation targeting Chile Inflation targeting China Monetary targeting and targets a currency basket Czech Republic Inflation targeting Colombia Inflation targeting Hong Kong Currency board (fixed to US dollar) India Multiple indicator approach New Zealand Inflation targeting Norway Inflation targeting Singapore Exchange rate targeting South Africa Inflation targeting Sri Lanka Monetary targeting Switzerland Inflation targeting [23] Turkey Inflation targeting United Kingdom[24] Inflation targeting, alongside secondary targets on 'output and employment'. United States[25] Mixed policy dedicated to maximum employment and stable prices (and since the 1980s it is well described by the "Taylor rule," which maintains that the Fed funds rate responds to shocks in inflation and output) Further information: Monetary policy of the USA

Monetary policy tools

Monetary base
Monetary policy can be implemented by changing the size of the monetary base. Central banks use open market operations to change the monetary base. The central bank buys or sells reserve assets (usually financial instruments such as bonds) in exchange for money on deposit at the central bank. Those deposits are convertible to currency. Together such currency and deposits constitute the monetary base which is the general liabilities of the central bank in its own

monetary unit. Usually other banks can use base money as a fractional reserve and expand the circulating money supply by a larger amount.

Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

Discount window lending

Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), thereby affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Interest rates
Main article: Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board
Main article: currency board

A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are threefold:
1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency. The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners. Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro). Currency boards have advantages for small, open economies that would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

Unconventional monetary policy at the zero bound

This section requires expansion. (February 2010)

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, and signaling. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an extended period, and the Bank of Canada made a conditional commitment to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.