Money

Figure 1Coins and banknotes – the two most common physical forms of money.

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

Money originated as commodity money, but nearly all contemporary money systems are based on
fiat money.[3] Fiat money is without intrinsic use value as a physical commodity, and derives its value by
being declared by a government to be legal tender; that is, it must be accepted as a form of payment within
the boundaries of the country, for "all debts, public and private".

The money supply of a country consists of currency (banknotes and coins) and demand deposits or
'bank money' (the balance held in checking accounts and savings accounts). These demand deposits usually
account for a much larger part of the money supply than currency. Bank money is intangible and exists only
in the form of various bank records. Despite being intangible, bank money still performs the basic functions
of money, being generally accepted as a form of payment.
History of Money

A 640 BC one-third stater electrum coin from Lydia.

The use of barter-like methods may date back to at least 100,000 years ago, though there is no
evidence of a society or economy that relied primarily on barter. [8] Instead, non-monetary societies operated
largely along the principles of gift economics. When barter did occur, it was usually between either
complete strangers or potential enemies.[9]

Many cultures around the world eventually developed the use of commodity money. The shekel was
originally a unit of weight, and referred to a specific weight of barley, which was used as currency.[10]. The
first usage of the term came from Mesopotamia circa 3000 BC. Societies in the Americas, Asia, Africa and
Australia used shell money – often, the shells of the money cowry (Cypraea moneta L. or C. annulus L.).
According to Herodotus, the Lydians were the first people to introduce the use of gold and silver coins.[11] It
is thought by modern scholars that these first stamped coins were minted around 650–600 BC.[12]

The system of commodity money eventually evolved into a system of representative money.[citation
needed]
This occurred because gold and silver merchants or banks would issue receipts to their depositors –
redeemable for the commodity money deposited. Eventually, these receipts became generally accepted as a
means of payment and were used as money. Paper money or banknotes were first used in China during the
Song Dynasty. These banknotes, known as "jiaozi" evolved from promissory notes that had been used since
the 7th century. However, they did not displace commodity money, and were used alongside coins.
Banknotes were first issued in Europe by Stockholms Banco in 1661, and were again also used alongside
coins. The gold standard, a monetary system where the medium of exchange are paper notes that are
convertible into pre-set, fixed quantities of gold, replaced the use of gold coins as currency in the 17th-19th
centuries in Europe. These gold standard notes were made legal tender, and redemption into gold coins was
discouraged. By the beginning of the 20th century almost all countries had adopted the gold standard,
backing their legal tender notes with fixed amounts of gold.

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

Etymology

The word "money" is believed to originate from a temple of Hera, located on Capitoline, one of
Rome's seven hills. In the ancient world Hera was often associated with money. The temple of Juno Moneta
at Rome was the place where the mint of Ancient Rome was located. [13] The name "Juno" may derive from
the Etruscan goddess Uni (which means "the one", "unique", "unit", "union", "united") and "Moneta" either
from the Latin word "monere" (remind, warn, or instruct) or the Greek word "moneres" (alone, unique).
 In the Western world, a prevalent term for coin-money has been specie, stemming from Latin in
specie, meaning 'in kind'.

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

Many items have been used as commodity money such as naturally scarce precious metals, cowry
shells, barley, beads etc., as well as many other things that are thought of as having value.

Modern money (and most ancient money) is essentially a token — in other words, an abstraction.
Paper currency is perhaps the most common type of physical money today. However, objects of gold or
silver present many of money's essential properties.

Non-monetary exchange: barter and gift

A 19th-century example of barter: A sample labor for labor note for the Cincinnati Time Store. Scanned from Equitable Commerce by Josiah Warren (1846)

Barter is a method of exchange by which goods or services are directly exchanged for other goods or
services without using a medium of exchange, such as money.[1] It is usually bilateral, but may be multilateral, and
usually exists parallel to monetary systems in most developed countries, though to a very limited extent. Barter
usually replaces money as the method of exchange in times of monetary crisis, when the currency is unstable and
devalued by hyperinflation.

History of Barter

Figure 2An 1874 newspaper illustration from Harper's Weekly, showing a man engaging in barter: offering chickens in exchange for his yearly newspaper
subscription.
 Contrary to popular conception, there is no evidence of a society or economy that relied primarily on
barter.[2] Instead, non-monetary societies operated largely along the principles of gift economics. When
barter did in fact occur, it was usually between either complete strangers or would-be enemies.[3]

While one-to-one bartering is practised between individuals and businesses on an informal basis,
organized barter exchanges have developed to conduct third party bartering. The barter exchange operates as
a broker and bank and each participating member has an account which is debited when purchases are made,
and credited when sales are made. With the removal of one-to-one bartering, concerns over unequal
exchanges are reduced.[citation needed]

Modern trade and barter has developed into a sophisticated tool to help businesses increase their
efficiencies by monetizing their unused capacities and excess inventories. The worldwide organized barter
exchange and trade industry has grown to an $8 billion a year industry and is used by thousands of
businesses and individuals. The advent of the Internet and sophisticated relational database software
programs has further advanced the barter industry's growth. Organized barter has grown throughout the
world to the point now where virtually every country has a formalized barter and trade network of some
kind. Complex business models based on the concept of barter are today possible since the advent of Web
2.0 technologies.[citation needed]

Bartering benefits companies and countries that see a mutual benefit in exchanging goods and
services rather than cash, and it also enables those who are lacking hard currency to obtain goods and
services. To make up for a lack of hard currency, Thailand's township, Amphoe Kut Chum, once issued its
own local scrip called Bia Kut Chum: Bia is Thai for cowry shell, was once 1⁄6400 Baht, and is still current
in metaphorical expressions. Running afoul of national currency laws, the community changed to barter
coupons called Boon Kut Chum that bear a fixed value in baht, which they swap for goods and services
within the community.[4]

Trade exchanges

A trade or barter exchange is a commercial organization that provides a trading platform and
bookkeeping system for its members or clients. The member companies buy and sell products and services
to each other using an internal currency known as barter or trade dollars. Modern barter and trade has
evolved considerably to become an effective method of increasing sales, conserving cash, moving inventory,
and making use of excess production capacity for businesses around the world. Businesses in a barter earn
trade credits (instead of cash) that are deposited into their account. They then have the ability to purchase
goods and services from other members utilizing their trade credits – they are not obligated to purchase from
who they sold to, and vice-versa. The exchange plays an important role because they provide the record-
keeping, brokering expertise and monthly statements to each member. Commercial exchanges make money
by charging a commission on each transaction either all on the buy side, all on the sell side, or a combination
of both. Transaction fees typically run between 8 and 15%.[citation needed]

It is estimated that over 350,000 businesses in the United States are involved in barter exchange
activities. There are approximately 400 commercial and corporate barter companies serving all parts of the
world. There are many opportunities for entrepreneurs to start a barter exchange. Several major cities in the
U.S. and Canada do not currently have a local barter exchange. There are two industry groups, the National
Association of Trade Exchanges (NATE) and the International Reciprocal Trade Association (IRTA). Both
offer training and promote high ethical standards among their members. Moreover, each has created its own
currency through which its member barter companies can trade. NATE's currency is the known as the
BANC and IRTA's currency is called Universal Currency (UC).
 The first exchange system was the Swiss WIR Bank. It was founded in 1934 as a result of currency
shortages after the stock market crash of 1929. "WIR" is both an abbreviation of Wirtschaftsring and the
word for "we" in German, reminding participants that the economic circle is also a community. Only small
and medium enterprises can join WIR. Its purpose is to encourage participating members to put their buying
power at each others disposal and keep it circulating within their ranks, thereby providing members with
additional sales volume

Corporate barter

Corporate barter focuses on larger transactions, which is different from a traditional, retail oriented
barter exchange. Corporate barter exchanges typically use media and advertising as leverage for their larger
transactions. It entails the use of a currency unit called a "trade-credit". The trade-credit must not only be
known and guaranteed, but also be valued in an amount the media and advertising could have been
purchased for had the "client" bought it themselves. (contract to eliminate ambiguity and risk).[

Internet bartering

Swapping is the increasingly prevalent informal bartering system in which participants in Internet
communities trade items of comparable value on a trust basis using the Internet. The most notable
disadvantage to electronic barter is inherent in Internet commerce, that of trust. How can consumers have
confidence that they will receive what they bargained, or paid, for? Although the Internet based consumer
market has by its continued existence and growth demonstrated that it works, there is never a guarantee of
satisfaction in consumer to consumer transactions. There is no absolute defense against fraud. However, it
can be argued that when a person barters there is less incentive to deliberately mislead. Neither party is paid;
each party receives something that would only then have to be converted to cash.[

Barter markets

In Spain (particularly the Catalonia region) there is a growing number of exchange markets. These
barter markets or swap meets work without money. Participants bring things they do not need and exchange
them for the unwanted goods of another participant. Swapping among three parties often helps satisfy tastes
when trying to get around the rule that money is not allowed.[5]

According to the International Reciprocal Trade Association, the industry trade body, more than
400,000 businesses transacted $10 billion globally in 2008 — and officials expect trade volume to grow by
15% in 2009.[

Environmental implications

Barter compliments the environmental movement that has gained traction in the late 20th and early
21st centuries. The expenditure of resources involved in the manufacture and distribution of new products is
concomitantly reduced by trading existing products. A global market for barter mitigates waste and acts as a
counterpoint to the disposable economy. Consumer and small business websites such as BarterQuest.com
and SwapTreasures promote bartering as a green alternative to buying and selling.[

Tax implications

In the United States, the sales a barter exchange makes are considered taxable revenue by the IRS and the
gross amount of a barter exchange member's sales are reported to the IRS by the barter exchange via a 1099-
B form. The requirement for barter exchanges to report members sales was enacted in the Tax Equity & Fair
Responsibility Act of 1982. According to the IRS, "The fair market value of goods and services exchanged
must be included in the income of both parties."[8] Other countries do not have the reporting requirement that
the U.S. does concerning proceeds from barter transactions, but taxation is handled the same way as a cash
transaction. If one barters for a profit, one pays the appropriate tax; if one generates a loss in the transaction,
they have a loss. Bartering for business is also taxed accordingly as business income or business expense.
Many barter exchanges require that one register as a business.

Limitations of a barter economy

 Need for presence of double coincidence of wants:

 For barter to occur between two people, both would have to have what the other wants and want what the
other has — an unlikely occurrence. [citation needed]
 Absence of common measure of value:
 In a monetary economy, money plays the role of a measure of value of all goods, so their values can be
measured against each other; this role may be absent in a barter economy.
 Indivisibility of certain goods:
 If a person wants to buy a certain amount of another's goods, but only has for payment one indivisible unit
of another good which is worth more than what the person wants to obtain, a barter transaction cannot
occur.
 Lack of standards for deferred payments:
 This is related to the absence of a common measure of value, although if the debt is denominated in units of
the good that will eventually be used in payment, it is not a problem.
 Difficulty in storing wealth:
 If a society relies exclusively on perishable goods, storing wealth for the future may be impractical. However,
some barter economies rely on durable goods like pigs or cattle for this purpose.

Contrary to popular conception, there is no evidence of a society or economy that relied primarily on barter.
[1]
Instead, non-monetary societies operated largely along the principles of gift economics. When barter did
in fact occur, it was usually between either complete strangers or would-be enemies.[2]

With barter, an individual possessing a material object of value, such as a measure of grain, could directly
exchange that object for another object perceived to have equivalent value, such as a small animal, a clay pot
or a tool. The capacity to carry out transactions is severely limited since it depends on a coincidence of
wants. The seller of food grain has to find a buyer who wants to buy grain and who also could offer in return
something the seller wants to buy. There is no common medium of exchange into which both seller and
buyer could convert their tradable commodities. There is no standard which could be applied to measure the
relative value of various goods and services.

In a gift economy, valuable goods and services are regularly given without any explicit agreement for
immediate or future rewards (i.e. there is no formal quid pro quo).[3] Ideally, simultaneous or recurring
giving serves to circulate and redistribute valuables within the community.

There are various social theories concerning gift economies. Some consider the gifts to be a form of
reciprocal altruism. Another interpretation is that social status is awarded in return for the 'gifts'. [4] Consider
for example, the sharing of food in some hunter-gatherer societies, where food-sharing is a safeguard against
the failure of any individual's daily foraging. This custom may reflect altruism, it may be a form of informal
insurance, or may bring with it social status or other benefits.
The emergence of money

The Sumer civilization developed a large scale economy based on commodity money. The Babylonians and
their neighboring city states later developed the earliest system of economics as we think of it today, in
terms of rules on debt, legal contracts and law codes relating to business practices and private property.[5][6]

The Code of Hammurabi (Codex Hammurabi), the best preserved ancient law code, was created ca. 1760
BC (middle chronology) in ancient Babylon. It was enacted by the sixth Babylonian king, Hammurabi.
Earlier collections of laws include the codex of Ur-Nammu, king of Ur (ca. 2050 BC), the Codex of
Eshnunna (ca. 1930 BC) and the codex of Lipit-Ishtar of Isin (ca. 1870 BC).[7] These law codes formalized
the role of money in civil society. They set amounts of interest on debt... fines for 'wrong doing'... and
compensation in money for various infractions of formalized law.

The Shekel referred to an ancient unit of weight and currency. The first usage of the term came from
Mesopotamia circa 3000 BC. and referred to a specific mass of barley which related other values in a metric
such as silver, bronze, copper etc. A barley/shekel was originally both a unit of currency and a unit of
weight, just as the British Pound was originally a unit denominating a one pound mass of silver.

In the absence of a medium of exchange, non-monetary societies operated largely along the principles of gift
economics.[1] When barter did in fact occur, it was usually between either complete strangers or would-be
enemies.[2]
Functions of Money

In the past, money was generally considered to have the following four main functions, which are summed
up in a rhyme found in older economics textbooks: "Money is a matter of functions four, a medium, a
measure, a standard, a store." That is, money functions as a medium of exchange, a unit of account, a
standard of deferred payment, and a store of value.[4] However, most modern textbooks now list only three
functions, that of medium of exchange, unit of account, and store of value, not considering a standard of
deferred payment as a distinguished function, but rather subsuming it in the others.[3][15][16]

There have been many historical disputes regarding the combination of money's functions, some arguing
that they need more separation and that a single unit is insufficient to deal with them all. One of these
arguments is that the role of money as a medium of exchange is in conflict with its role as a store of value:
its role as a store of value requires holding it without spending, whereas its role as a medium of exchange
requires it to circulate.[4] Others argue that storing of value is just deferral of the exchange, but does not
diminish the fact that money is a medium of exchange that can be transported both across space and time.
[17] The term 'financial capital' is a more general and inclusive term for all liquid instruments, whether or
not they are a uniformly recognized tender.

Medium of exchange

When money is used to intermediate the exchange of goods and services, it is performing a function as a
medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the 'double coincidence
of wants' problem.

Unit of account

A unit of account is a standard numerical unit of measurement of the market value of goods, services, and
other transactions. Also known as a "measure" or "standard" of relative worth and deferred payment, a unit
of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To
function as a 'unit of account', whatever is being used as money must be:

 Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down
into bars again.
 Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds,
works of art or real estate are not suitable as money.
 A specific weight, or measure, or size to be verifiably countable. For instance, coins are often milled with a
reeded edge, so that any removal of material from the coin (lowering its commodity value) will be easy to
detect.

Store of value

To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and be
predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain
stable over time. In that sense, inflation by reducing the value of money, diminishes the ability of the money
to function as a store of value.[3]

Standard of deferred payment

While standard of deferred payment is distinguished by some texts, particularly older ones, other texts
subsume this under other functions. A "standard of deferred payment" is an accepted way to settle a debt – a
unit in which debts are denominated, and the status of money as legal tender, in those jurisdictions which
have this concept, states that it may function for the discharge of debts. When debts are denominated in
money, the real value of debts may change due to inflation and deflation, and for sovereign and international
debts via debasement and devaluation.

Money supply

In economics, money is a broad term that refers to any financial instrument that can fulfill the functions of
money (detailed above). These financial instruments together are collectively referred to as the money
supply of an economy. Since the money supply consists of various financial instruments (usually currency,
demand deposits and various other types of deposits), the amount of money in an economy is measured by
adding together these financial instruments creating a monetary aggregate. Modern monetary theory
distinguishes among different types of monetary aggregates, using a categorization system that focuses on
the liquidity of the financial instrument used as money.

Market liquidity

Market liquidity describes how easily an item can be traded for another item, or into the common currency
within an economy. Money is the most liquid asset because it is universally recognised and accepted as the
common currency. In this way, money gives consumers the freedom to trade goods and services easily
without having to barter.

Liquid financial instruments are easily tradable and have low transaction costs. There should be no (or
minimal) spread between the prices to buy and sell the instrument being used as money.

Measures of money

The money supply is the amount of financial instruments within a specific economy available for purchasing
goods or services. The money supply is usually measured as three escalating categories M1, M2 and M3.
The categories grow in size with M1 being currency (coins and bills) and checking account deposits. M2 is
currency, checking account deposits and savings account deposits, and M3 is M2 plus time deposits. M1
includes only the most liquid financial instruments, and M3 relatively illiquid instruments.

Another measure of money, M0, is also used, although unlike the other measures, it does not represent
actual purchasing power by firms and households in the economy. M0 is base money, or the amount of
money actually issued by the central bank of a country. It is measured as currency plus deposits of banks and
other institutions at the central bank. M0 is also the only money that can satisfy the reserve requirements of
commercial banks.
Types of money

Currently, most modern monetary systems are based on fiat money. However, for most of history, almost all
money was commodity money, such as gold and silver coins. As economies developed, commodity money
was eventually replaced by representative money, such as the gold standard, as traders found the physical
transportation of gold and silver burdensome. Fiat currencies gradually took over in the last hundred years,
especially since the breakup of the Bretton Woods system in the early 1970s.

Commodity Money

1742 drawing of shells of the money cowry, Cypraea moneta

Bartering has several problems, most notably the coincidence of wants problem. For example, if a wheat
farmer needs what a fruit farmer produces, a direct swap is impossible as seasonal fruit would spoil before
the grain harvest. A solution is to trade fruit for wheat indirectly through a third, "intermediate", commodity:
the fruit is exchanged for the intermediate commodity when the fruit ripens. If this intermediate commodity
doesn't perish and is reliably in demand throughout the year (e.g. copper, gold, or wine) then it can be
exchanged for wheat after the harvest. The function of the intermediate commodity as a store-of-value can
be standardized into a widespread commodity money, reducing the coincidence of wants problem. By
overcoming the limitations of simple barter, a commodity money makes the market in all other commodities
more liquid.

Many cultures around the world eventually developed the use of commodity money. Ancient China and
Africa used cowrie shells. Trade in Japan's feudal system was based on the koku - a unit of rice per year.
The shekel was an ancient unit of weight and currency. The first usage of the term came from Mesopotamia
circa 3000 BC and referred to a specific weight of barley, which related other values in a metric such as
silver, bronze, copper etc. A barley/shekel was originally both a unit of currency and a unit of weight.[8]

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

Standardized coinage

Greek drachm of Aegina. Obverse: Land turtle / Reverse: ΑΙΓ(INA) and dolphin. The oldest turtle coin dates 700 BC
A 640 BC one-third stater coin from Lydia, shown larger.

From early times, metals, where available, have usually been favored for use as proto-money over such
commodities as cattle, cowry shells, or salt, because they are at once durable, portable, and easily
divisible[citation needed]. The use of gold as proto-money has been traced back to the fourth millennium B.C.
when the Egyptians used gold bars of a set weight as a medium of exchange [citation needed], as the Sumerians
earlier had done with silver bars[citation needed]. The first known ruler who officially set standards of weight and
money was Pheidon [9]. The first stamped money (having the mark of some authority in the form of a picture
or words) can be seen in the Bibliothèque Nationale of Paris. It is an electrum stater of a turtle coin, coined
at Aegina island. This remarkable coin [3] dates about 700 B.C.[10]. Electrum coins were also introduced
about 650 B.C. in Lydia.[11]

Coinage was widely adopted across Ionia and mainland Greece during the 6th century B.C., eventually
leading to the Athenian Empire's 5th century B.C., dominance of the region through their export of silver
coinage, mined in southern Attica at Laurium and Thorikos. A major silver vein discovery at Laurium in 483
BC led to the huge expansion of the Athenian military fleet. Competing coinage standards at the time were
maintained by Mytilene and Phokaia using coins of Electrum; Aegina used silver.

It was the discovery of the touchstone which led the way for metal-based commodity money and coinage.
Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of
a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a
result, monetary gold spread very quickly from Asia Minor, where it first gained wide usage, to the entire
world.

A Persian 309-379 AD silver drachm from the Sasanian Dynasty.

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

Although gold and silver were commonly used to mint coins, other metals could be used. For instance,
Ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade. In the early
seventeenth century Sweden lacked more precious metal and so produced "plate money", which were large
slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of
their value.

Metal based coins had the advantage of carrying their value within the coins themselves — on the other
hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal.
A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. English
and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect
that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and
1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into
the country at a rate no other European nation would share. The effect was worsened with Asian traders not
sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities
European observers like Isaac Newton, Master of the Royal Mint observed with unease.[12]

Stability came into the system with national Banks guaranteeing to change money into gold at a promised
rate; it did, however, not come easily. The Bank of England risked a national financial catastrophe in the
1730s when customers demanded their money be changed into gold in a moment of crisis. Eventually
London's merchants saved the bank and the nation with financial guarantees.

Another step in the evolution of money was the change from a coin being a unit of weight to being a unit of
value. a distinction could be made between its commodity value and its specie value. The difference is these
values is seigniorage.[13]

Trade Bills of Exchange

Bills of exchange became prevalent with the expansion of European trade toward the end of the Middle
Ages. A flourishing Italian wholesale trade in cloth, woolen clothing, wine, tin and other commodities was
heavily dependent on credit for its rapid expansion. Goods were supplied to a buyer against a bill of
exchange, which constituted the buyer's promise to make payment at some specified future date. Provided
that the buyer was reputable or the bill was endorsed by a credible guarantor, the seller could then present
the bill to a merchant banker and redeem it in money at a discounted value before it actually became due.

These bills could also be used as a form of payment by the seller to make additional purchases from his own
suppliers. Thus, the bills – an early form of credit – became both a medium of exchange and a medium for
storage of value. Like the loans made by the Egyptian grain banks, this trade credit became a significant
source for the creation of new money. In England, bills of exchange became an important form of credit and
money during last quarter of the 18th century and the first quarter of the 19th century before banknotes,
checks and cash credit lines were widely available.[14]

Tallies

The acceptance of symbolic forms of money opened up vast new realms for human creativity. A symbol
could be used to represent something of value that was available in physical storage somewhere else in
space, such as grain in the warehouse. It could also be used to represent something of value that would be
available later in time, such as a promissory note or bill of exchange, a document ordering someone to pay a
certain sum of money to another on a specific date or when certain conditions have been fulfilled.

In the 12th Century, the English monarchy introduced an early version of the bill of exchange in the form of
a notched piece of wood known as a tally stick. Tallies originally came into use at a time when paper was
rare and costly, but their use persisted until the early 19th Century, even after paper forms of money had
become prevalent. The notches were used to denote various amounts of taxes payable to the crown. Initially
tallies were simply used as a form of receipt to the tax payer at the time of rendering his dues. As the
revenue department became more efficient, they began issuing tallies to denote a promise of the tax assessee
to make future tax payments at specified times during the year. Each tally consisted of a matching pair – one
stick was given to the assessee at the time of assessment representing the amount of taxes to be paid later
and the other held by the Treasury representing the amount of taxes be collected at a future date.

The Treasury discovered that these tallies could also be used to create money. When the crown had
exhausted its current resources, it could use the tally receipts representing future tax payments due to the
crown as a form of payment to its own creditors, who in turn could either collect the tax revenue directly
from those assessed or use the same tally to pay their own taxes to the government. The tallies could also be
sold to other parties in exchange for gold or silver coin at a discount reflecting the length of time remaining
until the taxes was due for payment. Thus, the tallies became an accepted medium of exchange for some
types of transactions and an accepted medium for store of value. Like the girobanks before it, the Treasury
soon realized that it could also issue tallies that were not backed by any specific assessment of taxes. By
doing so, the Treasury created new money that was backed by public trust and confidence in the monarchy
rather than by specific revenue receipts.[15]

Goldsmith bankers

The highly successful ancient grain bank also served as a model for the emergence of the goldsmith bankers
in 17th Century England. These were the early days of the mercantile revolution before the rise of the
British Empire when merchant ships began plying the coastal seas laden with silks and spices from the
orient and shrewd traders amassed huge hoards of gold in the bargain. Since no banks existed in England at
the time, these entrepreneurs entrusted their wealth with the leading goldsmith of London, who already
possessed stores of gold and private vaults within which to store it safely, and paid a fee for that service. In
exchange for each deposit of precious metal, the goldsmiths issued paper receipts certifying the quantity and
purity of the metal they held on deposit. Like the grain receipts, tallies and bills of exchange, the goldsmith
receipts soon began to circulate as a safe and convenient form of money backed by gold and silver in the
goldsmiths’ vaults.

Knowing that goldsmiths were laden with gold, it was only natural that other traders in need of capital might
approach them for loans, which the goldsmiths made to trustworthy parties out of their gold hoards in
exchange for interest. Like the grain bankers, goldsmith began issuing loans by creating additional paper
gold receipts that were generally accepted in trade and were indistinguishable from the receipts issued to
parties that deposited gold. Both represented a promise to redeem the receipt in exchange for a certain
amount of metal. Since no one other than the goldsmith knew how much gold he held in store and how
much was the value of his receipts held by the public, he was able to issue receipts for greater value than the
gold he held. Gold deposits were relatively stable, often remaining with the goldsmith for years on end, so
there was little risk of default so long as public trust in the goldsmith's integrity and financial soundness was
maintained. Thus, the goldsmiths of London became the forerunners of British banking and prominent
creators of new money. They created money based on public trust.

Demand deposits

The primary business of the grain and goldsmith bankers was safe storage of savings. The primary business
of the early merchant banks was promotion of trade. The new class of commercial banks made accepting
deposits and issuing loans their principal activity. They lend the money they received on deposit. They
created additional money in the form of new bank notes. They also created additional money in the form of
demand deposits simply by making numerical entries in the ledgers of their account holders. The money
they created was partially backed by gold, silver or other assets and partially backed only by public trust in
the institutions that created it.
Banknotes

The history of money and banking are inseparably interlinked. The issuance of paper money was initiated by
commercial banks. Inspired by the success of the London goldsmiths, some of which became the
forerunners of great English banks, banks began issuing paper notes quite properly termed ‘banknotes’
which circulated in the same way that government issued currency circulates today. In England this practice
continued up to 1694. Scottish banks continued issuing notes until 1850. In USA, this practice continued
through the 19th Century, where at one time there were more than 5000 different types of bank notes issued
by various commercial banks in America. Only the notes issued by the largest, most creditworthy banks
were widely accepted. The script of smaller, lesser known institutions circulated locally. Farther from home
it was only accepted at a discounted rate, if it was accepted at all. The proliferation of types of money went
hand in hand with a multiplication in the number of financial institutions.

These banknotes were a form of representative money which could be converted into gold or silver by
application at the bank. Since banks issued notes far in excess of the gold and silver they kept on deposit,
sudden loss of public confidence in a bank could precipitate mass redemption of banknotes and result in
‘’bankruptcy’’.

The use of bank notes issued by private commercial banks as legal tender has gradually been replaced by the
issuance of bank notes authorized and controlled by national governments. The Bank of England was
granted sole rights to issue banknotes in England after 1694. In the USA, the Federal Reserve Bank was
granted similar rights after its establishment in 1913. Until recently, these government-authorized currencies
were forms of representative money, since they were partially backed by gold or silver and were
theoretically convertible into gold or silver.

Gold-backed banknotes

The term gold standard is often erroneously thought to refer to a currency where notes were fully backed by
and redeemable in an equivalent amount of gold. The British pound was the strongest, most stable currency
of the 19th Century and often considered the closest equivalent to pure gold, yet at the height of the gold
standard there was only sufficient gold in the British treasury to redeem a small fraction of the currency then
in circulation. In 1880, US government gold stock was equivalent in value to only 16% of currency and
demand deposits in commercial banks. By 1970, it was about 0.5%. The gold standard was only a system for
exchange of value between national currencies, never an agreement to redeem all paper notes for gold. The
classic gold standard prevailed during the period 1880 and 1913 when a core of leading trading nations
agreed to adhere to a fixed gold price and continuous convertibility for their currencies. Gold was used to
settle accounts between these nations. With the outbreak of World War I, Britain was forced to abandon the
gold standard even for their international transactions. Other nations quickly followed suit. After a brief
attempt to revive the gold standard during the 1920s, it was finally abandoned by Britain and other leading
nations during the Great Depression.

Prior to the abolition of the gold standard, the following words were printed on the face of every US dollar:
"I promise to pay the bearer on demand, the sum of one dollar" followed by the signature of the US
Secretary of the Treasury. Other denominations carried similar pledges proportionate to the face value of
each note. The currencies of other nations bore similar promises too. In earlier times this promise signified
that a bearer could redeem currency notes for their equivalent value in gold or silver. The US adopted a
silver standard in 1785, meaning that the value of the US dollar represented a certain equivalent weight in
silver and could be redeemed in silver coins. But even at its inception, the US Government was not required
to maintain silver reserves sufficient to redeem all the notes that it issued. Through much of the 20th
Century until 1971, the US dollar was ‘backed’ by gold, but from 1934 only foreign holders of the notes
could exchange them for metal.
Representative money

An example of representative money, this 1896 note could be exchanged for five US Dollars worth of silver.

Representative money refers to money that consists of a token or certificate made of paper. The use of the
various types of money including representative money, tracks the course of money from the past to the
present.[16] Token money may be called "representative money" in the sense that, say, a piece of paper
might 'represent' or be a claim on a commodity also.[17] Gold certificates or Silver certificates are a type of
representative money[17] which were used in the United States as currency until 1933.

The term 'representative money' has been used in the past "to signify that a certain amount of bullion was
stored in a Treasury while the equivalent paper in circulation" represented the bullion.[18] Representative
money differs from commodity money which is actually made of some physical commodity. In his Treatise
on Money,(1930:7) Keynes distinguished between commodity money and representative money, dividing
the latter into "fiat money" and "managed money."[19]

Fiat money

Fiat money refers to money that is not backed by reserves of another commodity. The money itself is given
value by government fiat (Latin for "let it be done") or decree, enforcing legal tender laws, previously
known as "forced tender", whereby debtors are legally relieved of the debt if they pay it in the government's
money. By law, the refusal of a legal tender (offering) extinguishes the debt in the same way acceptance
does.[20] At times in history (e.g. Rome under Diocletian, and post-revolutionary France during the collapse
of the assignats) the refusal of legal tender money in favor of some other form of payment was punished
with the death penalty.

Governments through history have often switched to forms of fiat money in times of need such as war,
sometimes by suspending the service they provided of exchanging their money for gold, and other times by
simply printing the money that they needed. When governments produce money more rapidly than
economic growth, the money supply overtakes economic value. Therefore, the excess money eventually
dilutes the market value of all money issued. This is called inflation. See open market operations.

In 1971 the United States finally switched to fiat money indefinitely. At this point in time many of the
economically developed countries' currencies were fixed to the US dollar (see Bretton Woods Conference),
and so this single step meant that much of the western world's currencies became fiat money based.

Following the first Gulf War the president of Iraq, Saddam Hussein, repealed the existing Iraqi fiat currency
and replaced it with a new currency. Despite having no backing by a commodity and with no central
authority mandating its use or defending its value, the old currency continued to circulate within the
politically isolated Kurdish regions of Iraq. It became known as the "Swiss dinar". This currency remained
relatively strong and stable for over a decade. It was formally replaced following the second Gulf War.
Commercial bank money

Demand deposit in cheque form.

Commercial bank money or demand deposits are claims against financial institutions that can be used for the
purchase of goods and services. A demand deposit account is an account from which funds can be
withdrawn at any time by check or cash withdrawal without giving the bank or financial institution any prior
notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand
(or 'at call'). Demand deposit withdrawals can be performed in person, via checks or bank drafts, using
automatic teller machines (ATMs), or through online banking.[26]

Commercial bank money is created through fractional-reserve banking, the banking practice where banks
keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the
remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.[27]
[28] Commercial bank money differs from commodity and fiat money in two ways, firstly it is non-physical,
as its existence is only reflected in the account ledgers of banks and other financial institutions, and
secondly, there is some element of risk that the claim will not be fulfilled if the financial institution becomes
insolvent. The process of fractional-reserve banking has a cumulative effect of money creation by
commercial banks, as it expands money supply (cash and demand deposits) beyond what it would otherwise
be. Because of the prevalence of fractional reserve banking, the broad money supply of most countries is a
multiple larger than the amount of base money created by the country's central bank. That multiple (called
the money multiplier) is determined by the reserve requirement or other financial ratio requirements
imposed by financial regulators.

The money supply of a country is usually held to be the total amount of currency in circulation plus the total
amount of checking and savings deposits in the commercial banks in the country.

What is “the Demand for Money?”

How much money would you like to have? A billion or two? Of course, that is not
what we mean by your demand for money! What we do mean by your demand for money
is this: how much of your wealth do you wish to keep in the form of money, that is,
currency and bank deposits?
For example, suppose that the Joneses have $50,000 in financial assets which
they divide between investment in bonds and holding money. How are they going to
decide how much of their $50,000 to invest in bonds and how much to hold in the form
of money, including currency and the balance in their checking account? An investment
in bonds pays interest, but currency pays none and the Joneses receive no interest from
their bank on their checking account.
Clearly, the opportunity cost of holding money is the rate of interest. If the Joneses
keep $1,000, on average, in currency and in their checking account during the year and
bonds yield 10%, then it costs the Joneses $100 in foregone interest to hold that $1,000.
Why, then, should the Joneses hold any money at all instead of putting all of their
wealth into bonds and other assets that will earn a return? For that matter, why does
anyone hold any money?

Economists have identified three primary motives for holding money:

 To settle transactions, since money is the medium of exchange.
 As a precautionary store of liquidity, in the event of unexpected need.
 To reduce the riskiness of a portfolio of assets by including some money in the portfolio, since
the value of money is very stable compared with that of stocks, bonds, or real estate.

These three motives for holding money are often referred to as the transactions
motive, the precautionary motive, and the portfolio motive respectively. Together they
provide good reasons for the Joneses to hold some money in their portfolio in spite of the
opportunity cost of foregone interest.
Now suppose, hypothetically, that with the interest rate at 20% the Joneses
choose to hold $1,000 of their $50,000 in the form of money. What will they do if the
interest rate now drops to 5%? With the opportunity cost of holding money reduced, they
will very likely choose to increase their money holdings by reducing their bond holdings.
After all, it now costs the Jones only 5 cents per year to hold an extra dollar instead of
20 cents, while adding to their holdings of money will give them more of the services that
holding money provides. The more currency in your wallet the less frequently you need
to stand in line at a cash machine or teller's window. The larger your checking account
balance the more readily you can meet unexpected payments, such as buying that suit
that is on sale even though your credit card is up to its limit. The larger your cash
position, the less worrisome is a fall in the stock market.
As a result of the interest rate falling from 20% to 5% the Joneses might well
decide to increase their money holdings, say from $1,000 to $1,500. They would
accomplish that increase in their money holdings by selling bonds worth $500 and
keeping the money they would be paid.
The amount of money demanded by the Joneses would change if their income
increased. They would demand more money (at a given level of interest rates) primarily
because their transactions and precautionary demands would increase at their new
higher level of spending. An increase in their wealth would increase their portfolio
demand for money. Even a change of jobs could affect their demand for money. Someone
who travels a great deal in a sales position will have a greater precautionary demand for
money than someone who stays in town.
We see, then, that a households' demand for money depends on the interest rate,
their income, and wealth, among perhaps many other variables. Firms are also holders
of money, in their cash registers and bank accounts, for essentially the same basic
reasons as households. When we add up the demand for money by all households and
firms we have the total demand for money in the economy and that demand will be most
importantly a function of the interest rate, income, and wealth in the economy.
The demand for any good or service is usually pictured in economics as a function
of its price, holding income and other factors constant. In the case of holding money, the
"price" is the opportunity cost of holding one dollar for one year, the interest rate. When
we plot the quantity of money demanded on the horizontal axis and the interest rate on
the vertical axis, just as we would the quantity of oranges demanded and the price of
oranges, we will have a demand curve like the one pictured in Figure 7.1.
Note that the quantity of money demanded is higher when the interest rate is
lower, just as the quantity of oranges demanded is higher when the price of oranges is
lower. As this hypothetical demand for money has been drawn, the demand for money is
$600 billion when the interest rate is 5%, but only $150 billion when it is 20%. This
inverse relationship between the interest rate and the demand for money just reflects the
fact that when the opportunity cost of holding money is low, people will want to hold
more of it, and when it is high people will want to hold less of it.
Notice, too, that at very low levels of the interest rate in Figure 7.1, the quantity of
money demanded increases dramatically, meaning that people would then want to hold
a very great amount of their wealth in the form of money. And why not hold money
instead of bonds when the reward to holding bonds is very, very small? After all, money
is more liquid than bonds, and bonds are subject to the risk of price fluctuation.
In contrast, even when the interest rate is very, very high, people will still want to
hold some money. Even if it costs 30 cents per year to hold a dollar, we will still hold
some dollars because it is even more costly to revert to barter in making transactions.
How will the demand for money change when the income and wealth increases?
Imagine that over the next decade the economy grows in real terms by 3% per year while
inflation averages 4%, so nominal income roughly doubles (Remember how to compute
doubling time?). Clearly the quantity of money demanded will rise. Sales at the
supermarket will have doubled, reflecting both the greater quantity of goods and higher
prices, so the transactions demand for money must roughly double.
Further, it is likely that rising wealth will also contribute to higher demand for money
holdings through the portfolio motive. Indeed, it seems likely that wealth would also
roughly double in nominal terms over a decade in which nominal income had doubled.
Overall, the quantity of money demanded at any given interest rate will be much higher
a decade later under our assumptions, probably about twice its level a decade earlier.
We depict this change in the demand for money by shifting the demand curve to the
right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the demand for
money at any given interest rate. For example, at an interest rate of 5%, the quantity of
money demanded is $1,200 billion at the end of the decade, while it was only $600
billion at the beginning of the decade ago when nominal income and wealth were half as
great.

Overall, the quantity of money demanded at any given interest rate will be much
higher a decade later under our assumptions, probably about twice its level a decade
earlier. We depict this change in the demand for money by shifting the demand curve to
the right. In Figure 7.2, the doubling of nominal incomes and wealth doubles the
demand for money at any given interest rate. For example, at an interest rate of 5%, the
quantity of money demanded is $1,200 billion at the end of the decade, while it was only
$600 billion at the beginning of the decade ago when nominal income and wealth were
half as great.
How the Supply of Money and the Demand for Money Determine the Interest
Rate
Just as the price we pay at the store for oranges is the price at which the demand for
oranges equals the supply of oranges, the "price" of money is the interest rate at which
the demand for money equals the supply of money. Now the supply of money is the
quantity of currency and bank deposits which is set by the Fed. Since the supply of
money does not vary with the rate of interest, we can depict the supply curve of money
simply as a vertical line at the actual quantity of money.
In Figure 7.3 the supply of money is a vertical line at the quantity $300 billion,
indicating that in this hypothetical economy the Fed has set the supply of money at
$300 billion. The supply of money is fixed at that quantity, and it will remain there until
the Fed decides to change it. The quantity of money demanded is equal to the quantity
supplied, $300 billion, at an interest rate of 10%. At that interest rate, people are
content to hold the quantity of money that is supplied by the Fed. What are the forces
that will move the interest rate to 10% in Figure 7.3, and what forces keep it there until
the supply or demand curve shifts?
Consider what would happen if, somehow, the interest rate were 9% instead of
10%. At an opportunity cost of only 9% people would want to hold more money than
when the opportunity cost is 10%. As we see in Figure 7.3, they would want to hold
more money than the Fed has actually supplied. In an attempt to increase their holdings
of money to the level they desire, people like the Joneses would sell some of their bonds
in order to increase their holdings of money.
However, while any one economic agent can increase or decrease the quantity of
money that they hold, all economic agents taken together cannot change the quantity of money that
they hold because the quantity of money is fixed. Currency and bank account balances can move
from one agent to another, but only the Fed can change the total amount of money that
everybody holds in aggregate. What can change is the interest rate. As everybody tried to
sell bonds to increase their holding of money, the price of bonds would fall, causing
bond yields to rise. Recalling that the interest rate is just the yield on bonds, we see that
the interest rate would rise and it would continue to rise until it was back up to 10%. At
that point the interest rate would stop rising because then the Joneses and everyone
else would be content to hold the quantity of money that exists.
 Suppose, on the other hand, the interest rate rose temporarily to 11%. Then the
Joneses and others would find the cost of holding money had risen, and they would
want to reduce their money balances in order to hold more of their assets in the form of
bonds. As the Joneses and others try to purchase bonds, they bid bond prices up and
bond yields down.
Again, keep in mind that the total quantity of money in the economy is not altered
by the attempts of individuals to change their own holdings of money. The currency or
checking account balance that one person uses to buy a bond only passes into someone
else's hands. Therefore, the adjustment process can only be complete when the interest
rate has fallen enough so that the Joneses and others are content to hold the existing
quantity of money, and that occurs only when the interest rate is 10%. This is why
economists refer to the intersection of the demand curve and the supply line as the
equilibrium in the money market. In our hypothetical example pictured in Figure 7.3,
the equilibrium occurs at an interest rate of 10%.

Two Sides of the Same Coin

Students are sometimes puzzled that we think of the interest rate being
determined by the supply and demand for money rather than by the supply and demand
for bonds, since, after all, the price of a bond is just a transformation of the interest rate.
Indeed, it would be paradoxical if the price of bonds were not in fact determined by the
supply and demand for bonds. There is no paradox here because the two markets, for
money and for bonds, can be thought of as two sides of the same coin (no pun intended).
Agents make a portfolio decision to divide their financial wealth between money,
which offers no reward other than its services, and securities such as bonds and stocks
that pay interest and may rise or fall in price. Our analysis is simplified by using bonds
to represent all financial assets, and the yield on bonds as the reward for holding
financial assets. Agents then decide to divide their wealth between money and bonds in
light of the interest rate offered on bonds, and other factors. The interest rate, then, can
be thought of as being determined in either the bond market or the money market
interchangeably.
A Shift in the Supply of Money
What happens to the interest rate when the Fed increases the supply of money? For
example, imagine that the Fed boosts the money supply suddenly from $300 billion to
$600 billion. In Figure 7.4 this is indicated by the shift in the vertical supply line to the
right. At the old interest rate of 10%, agents wish to hold only $300 billion, not $600
billion. What could induce them to hold the additional money? Certainly an increase in
their income or wealth would induce them to hold larger money balances, but it seems
evident that these variables do not change very rapidly. What can change rapidly enough
to clear the money market is the rate of interest. In fact, interest rates do change daily
and even hourly in response to Fed actions. How will the interest rate change as a result
of our hypothetical doubling of the money supply?
Clearly, the interest rate must fall so that the opportunity cost of holding money is
reduced to the point that people want to hold twice as much money. From Figure 7.4 we
see that at an interest rate of 5% the quantity of money demanded is equal to the
supply, $600 billion. Money is now much cheaper to hold because there is much more of
it available.
The mechanism that pushes the interest rate down from 10% to 5% in our
example is, again, the efforts of households and firms to adjust their money balances to
their desired levels. At the old interest rate of 10%, economic agents find that their
money holdings, now $600 billion, are too large. Their ensuing efforts to switch from
money into bonds will bid bond prices up and bond yields down until the new
equilibrium is reached at the new, lower interest rate. Finally, at an interest rate of 5%
the agents in this economy are content to hold the $600 billion supply of money and the
money market is again in equilibrium.
 This application of the principle supply and demand shows how the Fed uses its control of the money
supply to move interest rates up or down.

A Shift in the Demand for Money

The interest rate will also change when there is a shift in the demand for money. By a
shift in the demand for money we mean a change in the quantity demanded at any given
interest rate. We have already surmised that the demand for money depends on nominal
income and wealth. It will also be affected by fluctuations in the volume of transactions
of assets. Heavy trading on the stock exchanges or rapid turnover in the real estate
market, for example, will both increase the quantity of money demanded simply because
these transactions are settled in the medium of exchange, money. A great deal of money
is used in retail trade, so during the holiday season in December there is always a large
increase in the demand for money.
Pursuing this strategy, it seems reasonable, as a working assumption, that the quantity
of money demanded at a given interest rate will be roughly proportional to nominal
income. This is easiest to see as a consequence of the transactions motive for money
holding. If your nominal income doubles you probably will want to keep about twice as
much cash on hand since your transactions will be about twice as great in dollars as
before. This relation should hold regardless of whether income doubles because of a
doubling of the price level, or because of a doubling of real income, or because of
increases in both.
For example, if we learn that over time the Jones' income has increased from
$25,000 per year to $50,000 per year, we would not be surprised to find that they now
have $2,000 in the bank instead of $1,000 (assuming the interest rate is still 10%). In
addition, we can think of changes in nominal income as also serving as a "proxy" for
other variables, such as wealth and the volume of trading in stocks and real estate, that
tend over time to increase in proportion to income. our measure of nominal income for
the economy is, of course, nominal GDP.
Money supply

In economics, the money supply or money stock, is the total amount

of money available in an economy at a particular point in time.[1] There are several ways
to define "money," but standard measures usually include currency in circulation
and demand deposits (depositors' easily-accessed assets on the books of financial
institutions).
Money supply data are recorded and published, usually by the government or the
central bank of the country. Public and private sector analysts have long monitored
changes in money supply because of its possible effects on the price level, inflation and
the business cycle.[4]
That relation between money and prices is historically associated with
the quantity theory of money. There is strong empirical evidence of a direct relation
between long-term price inflation and money-supply growth, at least for rapid increases
in the amount of money in the economy. That is, a country such as Zimbabwe which
saw rapid increases in its money supply also saw rapid increases in prices
(hyperinflation). This is one reason for the reliance on monetary policy as a means of
controlling inflation in the U.S.[5][6] This causal chain is contentious, however:
some heterodox economistsargue that the money supply is endogenous (determined by
the workings of the economy, not by the central bank) and that the sources of inflation
must be found in the distributional structure of the economy.[7] In addition to some
economists' seeing the central bank's control over the money supply as feeble, many
would also say that there are two weak links between the growth of the money supply
and the inflation rate: first, an increase in the money supply, unless trapped in the
financial system as excess reserves, can cause a sustained increase in real production
instead of inflation in the aftermath of a recession, when many resources are
underutilized. Second, if the velocity of money, i.e., the ratio between nominal GDP and
money supply changes, an increase in the money supply could have either no effect, an
exaggerated effect, or an unpredictable effect on the growth of nominal GDP.
Empirical measures

Money is used as a medium of exchange, in final settlement of a debt, and as a

ready store of value. Its different functions are associated with
different empirical measures of the money supply. There is no single "correct" measure
of the money supply: instead, there are several measures, classified along a spectrum or
continuum between narrow and broad monetary aggregates. Narrow measures include
only the most liquid assets, the ones most easily used to spend (currency, checkable
deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.)
This continuum corresponds to the way that different types of money are more or
less controlled by monetary policy. Narrow measures include those more directly affected
and controlled by monetary policy, whereas broader measures are less closely related to
monetary-policy actions.[6] It is a matter of perennial debate as to whether narrower or
broader versions of the money supply have a more predictable link to nominal GDP.
The different types of money are typically classified as "M"s. The "M"s usually
range from M0 (narrowest) to M3 (broadest) but which "M"s are actually used depends
on the country's central bank. The typical layout for each of the "M"s is as follows:
 M0: In some countries, such as the United Kingdom, M0 includes bank reserves, so M0 is referred to
as the monetary base, or narrow money.[11]

 MB: is referred to as the monetary base or total currency.[8] This is the base from which other forms
of money (like checking deposits, listed below) are created and is traditionally the most liquid measure
of the money supply.[12]

 M1: Bank reserves are not included in M1.

 M2: represents money and "close substitutes" for money.[13] M2 is a broader classification of money
than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to
explain different economic monetary conditions. M2 is a key economic indicator used to forecast
inflation.[14]

 M3: Since 2006, M3 is no longer published or revealed to the public by the US central bank.
[15]
 However, there are still estimates produced by various private institutions.

 MZM: Money with zero maturity. It measures the supply of financial assets redeemable at par on
demand.
The ratio of a pair of these measures, most often M2/M0, is called an (actual, empirical) money multiplier.

Fractional-reserve banking
The different forms of money in government money supply statistics arise from the
practice of fractional-reserve banking. Whenever a bank gives out a loan in a fractional-
reserve banking system, a new sum of money is created. This new type of money is what
makes up the non-M0 components in the M1-M3 statistics. In short, there are two types
of money in a fractional-reserve banking system[16][17]:

1. central bank money (physical currency, government money)

2. commercial bank money (money created through loans) - sometimes referred to as private
money, or checkbook money[18]
In the money supply statistics, central bank money is MB while the commercial
bank money is divided up into the M1-M3 components. Generally, the types of
commercial bank money that tend to be valued at lower amounts are classified in the
narrow category of M1 while the types of commercial bank money that tend to exist in
larger amounts are categorized in M2 and M3, with M3 having the largest.
 Reserves are deposits that banks have received but have not loaned out. In the
USA, the Federal Reserve regulates the percentage that banks must keep in their
reserves before they can make new loans. This percentage is called the minimum reserve
requirement. This means that if a person makes a deposit for $1000.00 and the bank
reserve mandated by the FED is 10% then the bank must increase its reserves by
$100.00 and is able to loan the remaining $900.00. The maximum amount of money the
banking system can legally generate with each dollar of reserves is called the
(theoretical) money multiplier, and, following the formula for the sum of an infinite
convergent geometric series, can be calculated as the reciprocal of the minimum reserve.
For example, with a reserve of 20%, the money multiplier would be 5, as 20% divided
into 100% makes 5.

Example

Note: The examples apply when read in sequential order.

M0

 Laura has ten US $100 bills, representing $1000 in the M0 supply for the United States. (MB = $1000, M0 =
$1000, M1 = $1000, M2 = $1000)
 Laura burns one of her $100 bills. The US M0, and her personal net worth, just decreased by $100. (MB =
$900, M0 = $900, M1 = $900, M2 = $900)

M1

 Laura takes the remaining nine bills and deposits them in her checking account at her bank. (MB = $900, M0
= 0, M1 = $900, M2 = $900)
 The bank then calculates its reserve using the minimum reserve percentage given by the Fed and loans the
extra money. If the minimum reserve is 10%, this means $90 will remain in the bank's reserve. The remaining
$810 can only be used by the bank as credit, by lending money, but until that happens it will be part of the
banks excess reserves.
 The M1 money supply increased by $810 when the loan is made. M1 the money has been created. ( MB =
$900 M0 = 0, M1 = $1710, M2 = $1710)
 Laura writes a check for $400, check number 7771. The total M1 money supply didn't change, it includes the
$400 check and the $500 left in her account. (MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
 Laura's check number 7771 is accidentally destroyed in the laundry. M1 and her checking account do not
change, because the check is never cashed. (MB = $900, M0 = 0, M1 = $1710, M2 = $1710)
 Laura writes check number 7772 for $100 to her friend Alice, and Alice deposits it into her checking account.
MB does not change, it still has $900 in it, Alice's $100 and Laura's $800. (MB = $900, M0 = 0, M1 = $1710, M2 =
$1710)
 The bank lends Mandy the $810 credit that it has created. Mandy deposits the money in a checking account at
another bank. The other bank must keep $81 as a reserve and has $729 available for loans. This creates a
promise-to-pay money from a previous promise-to-pay, thus the M1 money supply is now inflated by $729. (MB =
$900, M0 = 0, M1 = $2439, M2 = $2439)
 Mandy's bank now lends the money to someone else who deposits it on a checking account on yet another
bank, who again stores 10% as reserve and has 90% available for loans. This process repeats itself at the next
bank and at the next bank and so on, until the money in the reserves backs up an M1 money supply of $9000,
which is 10 times the M0 money. (MB = $900, M0 = 0, M1 = $9000, M2 = $9000)

M2

 Laura writes check number 7774 for $1000 and brings it to the bank to start a Money Market account (these
do not have a credit-creating charter), M1 goes down by $1000, but M2 stays the same. This is because M2
includes the Money Market account in addition to all money counted in M1.

Foreign Exchange

 Laura writes check number 7776 for $200 and brings it downtown to a foreign exchange bank teller at Credit
Suisse to convert it to British Pounds. On this particular day, the exchange rate is exactly USD $2.00 = GBP
£1.00. The bank Credit Suisse takes her $200 check, and gives her two £50 notes (and charges her a dollar for
the service fee). Meanwhile, at the Credit Suisse branch office in Hong Kong, a customer named Huang has £100
and wants $200, and the bank does that trade (charging him an extra £.50 for the service fee). US M0 still has the
$900, although Huang now has $200 of it. The £50 notes Laura walks off with are part of Britain's M0 money
supply that came from Huang.

 The next day, Credit Suisse finds they have an excess of GB Pounds and a shortage of US Dollars,
determined by adding up all the branch offices' supplies. They sell some of their GBP on the open  FX market with
Deutsche Bank, which has the opposite problem. The exchange rate stays the same.

 The day after, both Credit Suisse and Deutsche Bank find they have too many GBP and not enough USD,
along with other traders. Then, To move their inventories, they have to sell GBP at USD $1.999, that is, 1/10 cent
less than $2 per pound, and the exchange rate shifts. None of these banks has the power to increase or decrease
the British M0 or the American M0; they are independent systems.
 Money supplies around the world
United States

Components of
US money supply (currency, M1, M2, and M3) since 1959

The Federal Reserve previously published data on three

monetary aggregates, but on 10 November 2005
announced that as of 23 March 2006, it would cease
publication of M3.[15] Since the Spring of 2006, the
Federal Reserve only publishes data on two of these
aggregates. The first, M1, is made up of types of money
commonly used for payment, basically currency (M0)
and checking account balances. The second, M2,
Figure 3Year-on-year change in the components of the US money supply 1960-
2007 includes M1 plus balances that generally are similar to
transaction accounts and that, for the most part, can be
converted fairly readily to M1 with little or no loss of principal. The M2 measure is thought to be held primarily by
households. As mentioned, the third aggregate, M3 is no longer published. Prior to this discontinuation, M3 had
included M2 plus certain accounts that are held by entities other than individuals and are issued by banks and thrift
institutions to augment M2-type balances in meeting credit demands; it had also included balances in money market
mutual funds held by institutional investors. The aggregates have had different roles in monetary policy as their
reliability as guides has changed. The following details their principal components [19]:

 M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical
currency.
 M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or
"current" accounts).
 M2: M1 + most savings accounts, money market accounts, retail money market mutual funds,and small
denomination time deposits (certificates of deposit of under $100,000).
 M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits
of eurodollars and repurchase agreements.
When the Federal Reserve announced in 2005 that they would cease publishing M3 statistics in March 2006, they
explained that M3 did not convey any additional information about economic activity compared to M2, and thus, "has
not played a role in the monetary policy process for many years." Therefore, the costs to collect M3 data outweighed
the benefits the data provided.[15] Some politicians have spoken out against the Federal Reserve's decision to cease
publishing M3 statistics and have urged the U.S. Congress to take steps requiring the Federal Reserve to do so.
Libertarian congressman Ron Paul (R-TX) claimed that "M3 is the best description of how quickly the Fed is creating
new money and credit. Common sense tells us that a government central bank creating new money out of thin air
depreciates the value of each dollar in circulation."[20] Some of the data used to calculate M3 are still collected and
published on a regular basis.[15] Current alternate sources of M3 data are available from the private sector [21]. However,
some would argue[citation needed] that since theFederal Reserve has even less control over the fluctuations of M3 than over
those of M2, it is unclear why this number is relevant to monetary policy.

As of 4 November 2009 the Federal Reserve reported that the U.S. dollar monetary base is $1,999,897,000,000. This
is an increase of 142% in 2 years. [22] The monetary base is only one component of money supply, however. M2, the
broadest measure of money supply, has increased from approximately $7.41 trillion to $8.36 trillion from November
2007 to October 2009, the latest month-data available. This is a 2-year increase in U.S. M2 of approximately 12.9%. [23]
[edit]United Kingdom

M4 money supply of the United Kingdom 1984–2007 (NOTE: y axis needs units!)

There are just two official UK measures. M0 is referred to as the "wide monetary base" or "narrow money" and M4 is
referred to as "broad money" or simply "the money supply".

 M0: Cash outside Bank of England + Banks' operational deposits with Bank of England.
 M4: Cash outside banks (i.e. in circulation with the public and non-bank firms) + private-sector retail bank and
building society deposits + Private-sector wholesale bank and building society deposits and Certificate of Deposit.
[24]

There are several different definitions of money supply to reflect the differing stores of money. Due to the nature of
bank deposits, especially time-restricted savings account deposits, the M4 represents the most illiquid measure of
money. M0, by contrast, is the most liquid measure of the money supply.
European Union

The Euro money supply from 1998-2007.

The European Central Bank's definition of euro area monetary aggregates[25]:

 M1: Currency in circulation + overnight deposits

 M2: M1 + Deposits with an agreed maturity up to 2 years + Deposits redeemable at a period of notice up to 3
months
 M3: M2 + Repurchase agreements + Money market fund (MMF) shares/units + Debt securities up to 2 years

Australia

The money supply of Australia 1984-2007

The Reserve Bank of Australia defines the monetary aggregates as[26]:

 M1: currency bank + current deposits of the private non-bank sector

 M3: M1 + all other bank deposits of the private non-bank sector
 Broad Money: M3 + borrowings from the private sector by NBFIs, less the latter's holdings of currency and
bank deposits
 Money Base: holdings of notes and coins by the private sector plus deposits of banks with the Reserve Bank
of Australia (RBA) and other RBA liabilities to the private non-bank sector

New Zealand

New Zealand money supply 1988-2008

The Reserve Bank of New Zealand defines the monetary aggregates as[27]:

 M1: notes and coins held by the public plus chequeable deposits, minus inter-institutional chequeable
deposits, and minus central government deposits
 M2: M1 + all non-M1 call funding (call funding includes overnight money and funding on terms that can of right
be broken without break penalties) minus inter-institutional non-M1 call funding
 M3: the broadest monetary aggregate. It represents all New Zealand dollar funding of M3 institutions and any
Reserve Bank repos with non-M3 institutions. M3 consists of notes & coin held by the public plus NZ dollar
funding minus inter-M3 institutional claims and minus central government deposits
India

Components of the money supply of India 1970-2007

The Reserve Bank of India defines the monetary aggregates as[28]:

 Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI
= Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net
foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities.
 M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system +
‘Other’ deposits with the RBI).
 M2: M1 + Savings deposits with Post office savings banks.
 M3: M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the
commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the
public – Net non-monetary liabilities of the banking sector (Other than Time Deposits).
 M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

Japan
The Bank of Japan defines the monetary aggregates as[29]:

 M1: cash currency in circulation + deposit money

 M2 + CDs: M1 + quasi-money + CDs
 M3 + CDs: (M2 + CDs) + deposits of post offices + other savings and deposits with financial institutions +
money trusts
 Broadly-defined liquidity: (M3 + CDs) + money market + pecuniary trusts other than money trusts +
investment trusts + bank debentures + commercial paper issued by financial institutions + repurchase agreements
and securities lending with cash collateral + government bonds + foreign bonds

Link with inflation

Monetary exchange equation

Money supply is important because it is linked to inflation by the equation of exchange[citation needed]:

MV = PQ

 M is the total dollars in the nation’s money supply

 V is the number of times per year each dollar is spent
 P is the average price of all the goods and services sold during the year
 Q is the quantity of assets, goods and services sold during the year

In mathematical terms, this equation is really an identity which is true by definition rather than describing economic
behavior. That is, each term is defined by the values of the other three. Unlike the other terms, the velocity of money
has no independent measure and can only be estimated by dividing PQ by M. Adherents of the quantity theory of
money assume that the velocity of money is stable and predictable, being determined mostly by financial institutions. If
that assumption is valid, then changes in M can be used to predict changes in PQ. If not, then the equation of
exchange is useless to macroeconomics. Most macroeconomists replace the equation of exchange with equations for
the demand for money which describe more regular and predictable economic behavior. However, predictability (or
the lack thereof) of the velocity of money is equivalent to predictability (or the lack thereof) of the demand for money
(since in equilibrium real money demand is simply Q/V). Either way, this unpredictability made policy-makers at
the Federal Reserve rely less on the money supply in steering the U.S.economy. Instead, the policy focus has shifted
to interest rates such as the fed funds rate.

In practice, macroeconomists almost always use real GDP to measure Q, omitting the role of all transactions except
for those involving newly-produced goods and services (i.e., consumption goods, investment goods, government-
purchased goods, and exports). That is, the only assets counted as part of Q are newly-produced investment goods.
But the original quantity theory of money did not follow this practice: PQ was the monetary value of all new
transactions, whether of real goods and services or of paper assets.
U.S. M3 money supply as a proportion of gross domestic product.

The monetary value of assets, goods, and service sold during the year could be grossly estimated using
nominal GDP back in the 1960s. This is not the case anymore because of the dramatic rise of the number of financial
transactions relative to that of real transactions up until 2008. That is, the total value of transactions (including
purchases of paper assets) rose relative to nominal GDP (which excludes those purchases).

Ignoring the effects of monetary growth on real purchases and velocity, this suggests that the growth of the
money supply may cause different kinds of inflation at different times. For example, rises in the U.S. money supplies
between the 1970s and the present encouraged first a rise in the inflation rate for newly-produced goods and services
("inflation" as usually defined) in the seventies and then asset-price inflation in later decades: it may have encouraged
a stock market boom in the '80s and '90s and then, after 2001, a rise in home prices, i.e., the famous  housing bubble.
This story, of course, assumes that the amounts of money were the causes of these different types of inflation rather
than being endogenous results of the economy's dynamics.

When home prices went down, the Federal Reserve kept its loose monetary policy and lowered interest rates;
the attempt to slow price declines in one asset class, e.g. real estate, may well have caused prices in other asset
classes to rise, e.g. commodities[citation needed].
Rates of growth

In terms of percentage changes (to a close approximation under small growth rates, [30] the percentage change in a
product, say XY, is equal to the sum of the percentage changes %ΔX + %ΔY). So:

%ΔP + %ΔQ = %ΔM + %ΔV

That equation rearranged gives the "basic inflation identity":

%ΔP = %ΔM + %ΔV - %ΔQ

Inflation (%ΔP) is equal to the rate of money growth (%ΔM), plus the change in velocity (%ΔV), minus the
rate of output growth (%ΔQ). [31] As before, this equation is only useful if %ΔV follows regular behavior. It
also loses usefulness if the central bank lacks control over %ΔM.
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate ofinterest. Monetary policy is

usually used to attain a set of objectives oriented towards the growth and stability of the economy.[1] These goals usually include stable prices and

low unemployment. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of

money in the economy rapidly, and a contractionary policy decreases the total money supply or increases it only slowly. Expansionary policy is traditionally

used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.

Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. [2]

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 banksand 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, and deprecate interest rate targets as they are non-important and irrelevant in regarding to

monetary policies. 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. 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, wage-setting 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 would markets 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 [3] 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 necessary 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. [4]

History of monetary policy

Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about

coinage; (ii) Decisions to printpaper 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.

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. [5] 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 gold-backed 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 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[6] 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 macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low

inflation and stable output growth.[7] 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. [8] 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.[9][10]

[11]
 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[who?] 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[who?] 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 2008-2009.

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.[12] 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[who?] began to believe that making a nation's central bank independent of the rest of executive government is the best way to

ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools

of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee

which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more

transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will

typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation

target of 2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank

can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as

many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of

economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments[13], 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, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base

currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.

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.

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 the exact same variables (such as a harmonized consumer price index).

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.[14]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used

in Australia, Brazil, Canada, Chile, Colombia, the Eurozone, New Zealand, Norway, Iceland, 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 is offset in subsequent years such that over time the price level on

aggregate does not move.

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.

Gold standard

The gold standard is a system in which the price of the national currency is measured in units of gold bars and is kept constant by the daily buying and selling

of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and

stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of

"Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world between the mid-

1800s through 1971.[15] Its major advantages were simplicity and transparency. (See also: Bretton Woods system)

The major disadvantage of a gold standard is that it induces deflation, which occurs whenever economies grow faster than the gold supply. 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.

Deflation can cause economic problems, for instance, it tends to increase the ratio of debts to assets over time. As an example, the monthly cost of a fixed-

rate home mortgage stays the same, but the dollar value of the house goes down, and the value of the dollars required to pay the mortgage goes up. 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

 Australia - Inflation targeting

 Brazil - Inflation targeting

 Canada - Inflation targeting

 Chile - Inflation targeting

 China - Monetary targeting and targets a currency basket

 Eurozone - 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

 Switzerland - Inflation targeting [16]

 Turkey - Inflation targeting

 United Kingdom[17] - Inflation targeting, alongside secondary targets on 'output and employment'.

 United States[18] - Mixed policy (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)

Monetary policy tools
Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy.

A central bank can useopen market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When

the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.

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

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending

new loans, the monetary authority can directly change the size of the money supply.

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

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 three-fold:

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).
Role of RBI
 Firstly, the central bank could do this by setting a required reserve ratio, which would restrict the ability of the
commercial banks to increase the money supply by loaning out money. If this requirement were above the
ratio the commercial banks would have wished to have, then the banks will have to create fewer deposits and
make fewer loans then they could otherwise have profitably done. If the central bank imposed this
requirement in order to reduce the money supply, the commercial banks will probably be unable to borrow
from the central bank in order to increase their cash reserves if they wished to make further loans. They might
try to attract further deposits from customers by increasing their interest rates, but the central bank may
retaliate by increasing the required reserve ratio.
 • The central bank can affect the supply of money through special deposits. These are deposits at the central
bank, which the banking sector is required to lodge. These are then frozen, thus preventing the sector from
accessing them, although interest is paid at the average treasury bill rate. Making these special deposits
reduces the level of the commercial banks’ operational deposits, which forces them to cut back on lending.
 • The supply of money can also be controlled by the central bank by adjusting its interest rate, which it
charges when the commercial banks wish to borrow money (the discount rate). Banks usually have a ratio of
cash to deposits, which they consider to be the minimum safe level. If demand for cash is such that their
reserves fall below this level, they will able to borrow money from the central bank at its discount rate. If
market rates were 8%, and the discount rate were also 8%, then the banks could reduce their cash reserves
to their minimum ratio, knowing that if demand exceeds supply they will be able to borrow at 8%. The central
bank, though, may raise its discount rate to a value above the market level, in order to encourage banks not to
reduce their cash reserves to the minimum through excess loans. By raising the discount value to such a
level, the commercial banks are given an incentive to hold more reserves, thus reducing the money multiplier
and the money supply.
 • Another way the money supply can be affected by the central bank is through its manipulation of the interest
rate. This is akin to the discount rate mentioned above. By raising or lowering interest rates, the demand for
money is respectively reduced or increased. If it sets them at a certain level, it can clear the market at level by
supplying enough money to match the demand. Alternatively, it could fix the money supply at a certain rate
and let the market clear the interest rates at the equilibrium. Trying to fix the money supply is not easy, so
central banks usually set the interest rate and provide the amount of money the market demands.
 • The central bank may also affect the money supply through operating on the open market. This allows it to
manipulate the money supply through the monetary base. It may choose to either buy or sell securities in the
marketplace, which will either inject or remove money respectively. Thus, the monetary base will be affected,
causing the money supply to alter. To illustrate this, suppose the central bank sold gilts(Risk-free bonds) worth
$10 million. $10 million would flow from the deposits of the purchasers to the central bank, taking the $10
million out of the monetary base. To inject money into the economy, the central bank would have to buy the
gilts.
Investment in Indian market
India, among the European investors, is believed to be a good investment despite political uncertainty,
bureaucratic hassles, shortages of power and infrastructural deficiencies. India presents a vast
potential for overseas investment and is actively encouraging the entrance of foreign players into the
market. No company, of any size, aspiring to be a global player can, for long ignore this country which
is expected to become one of the top three emerging economies.

Success in India
Success in India will depend on the correct estimation of the country's potential, underestimation of its
complexity or overestimation of its possibilities can lead to failure. While calculating, due consideration
should be given to the factor of the inherent difficulties and uncertainties of functioning in the Indian
system.Entering India's marketplace requires a well-designed plan backed by serious thought and
careful research. For those who take the time and look to India as an opportunity for long-term
growth, not short-term profit- the trip will be well worth the effort.

Market potential
India is the fifth largest economy in the world (ranking above France, Italy, the United Kingdom, and
Russia) and has the third largest GDP in the entire continent of Asia. It is also the second largest
among emerging nations. (These indicators are based on purchasing power parity.) India is also one of
the few markets in the world which offers high prospects for growth and earning potential in practically
all areas of business.Yet, despite the practically unlimited possibilities in India for overseas businesses,
the world's most populous democracy has, until fairly recently, failed to get the kind of enthusiastic
attention generated by other emerging economies such as China.

Lack of enthusiasm among investors

The reason being, after independence from Britain 50 years ago, India developed a highly protected,
semi-socialist autarkic economy. Structural and bureaucratic impediments were vigorously fostered,
along with a distrust of foreign business. Even as today the climate in India has seen a seachange,
smashing barriers and actively seeking foreign investment, many companies still see it as a difficult
market. India is rightfully quoted to be an incomparable country and is both frustrating and challenging
at the same time. Foreign investors should be prepared to take India as it is with all of its difficulties,
contradictions and challenges.

Developing a basic understanding or potential of the Indian market, envisaging and

developing a Market Entry Strategy and implementing these strategies when actually
entering the market are three basic steps to make a successful entry into India.
Developing a basic understanding or potential of the Indian market
The Indian middle class is large and growing; wages are low; many workers are well educated and
speak English; investors are optimistic and local stocks are up; despite political turmoil, the country
presses on with economic reforms.But there is still cause for worries-

Infrastructural hassles. 
The rapid economic growth of the last few years has put heavy stress on India's infrastructural
facilities. The projections of further expansion in key areas could snap the already strained lines of
transportation unless massive programs of expansion and modernization are put in place. Problems
include power demand shortfall, port traffic capacity mismatch, poor road conditions (only half of the
country's roads are surfaced), low telephone penetration (1.4% of population).

Indian Bureaucracy.
Although the Indian government is well aware of the need for reform and is pushing ahead in this area,
business still has to deal with an inefficient and sometimes still slow-moving bureaucracy.
Diverse Market .
The Indian market is widely diverse. The country has 17 official languages, 6 major religions, and
ethnic diversity as wide as all of Europe. Thus, tastes and preferences differ greatly among sections of
consumers.

Therefore, it is advisable to develop a good understanding of the Indian market and overall economy
before taking the plunge. Research firms in India can provide the information to determine how, when
and where to enter the market. There are also companies which can guide the foreign firm through the
entry process from beginning to end --performing the requisite research, assisting with configuration of
the project, helping develop Indian partners and financing, finding the land or ready premises, and
pushing through the paperwork required.

Developing up-front takes: 

Market Study
Is there a need for the products/services/technology? What is the probable market for the
product/service? Where is the market located? Which mix of products and services will find the most
acceptability and be the most likely to generate sales? What distribution and sales channels are
available? What costs will be involved? Who is the competi

Check on Economic Policies

The general economic direction in India is toward liberalization and globalization. But the process is
slow. Before jumping into the market, it is necessary to discover whether government policies exist
relating to the particular area of business and if there are political concerns which should be taken into
account.

FDI Report

Investment in India - Foreign Direct Investment - Introduction

Foreign Direct Investment (FDI) is permited as under the following forms of investments.

 Through financial collaborations.

 Through joint ventures and technical collaborations.
 Through capital markets via Euro issues.
 Through private placements or preferential allotments.

Forbidden Territories: 
FDI is not permitted in the following industrial sectors:

 Arms and ammunition.

 Atomic Energy.
 Railway Transport.
 Coal and lignite.
 Mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper, zinc.

Foreign Investment through GDRs (Euro Issues) 

Foreign Investment through GDRs is treated as Foreign Direct Investment 
Indian companies are allowed to raise equity capital in the international market through the issue of
Global Depository Receipt (GDRs). GDRs are designated in dollars and are not subject to any ceilings
on investment. An applicant company seeking Government's approval in this regard should have
consistent track record for good performance (financial or otherwise) for a minimum period of 3 years.
This condition would be relaxed for infrastructure projects such as power generation,
telecommunication, petroleum exploration and refining, ports, airports and roads.

Clearance from FIPB
There is no restriction on the number of Euro-issue to be floated by a company or a group of
companies in the financial year . A company engaged in the manufacture of items covered under
Annex-III of the New Industrial Policy whose direct foreign investment after a proposed Euro issue is
likely to exceed 51% or which is implementing a project not contained in Annex-III, would need to
obtain prior FIPB clearance before seeking final approval from Ministry of Finance.

Use of GDRs
The proceeds of the GDRs can be used for financing capital goods imports, capital expenditure
including domestic purchase/installation of plant, equipment and building and investment in software
development, prepayment or scheduled repayment of earlier external borrowings, and equity
investment in JV/WOSs in India.

Restrictions
However, investment in stock markets and real estate will not be permitted. Companies may retain the
proceeds abroad or may remit funds into India in anticiption of the use of funds for approved end uses.
Any investment from a foreign firm into India requires the prior approval of the Government of India.

Investment in India - Foreign Direct Investment - Approval

Foreign direct investments in India are approved through two routes: 
Automatic approval by RBI: 
The Reserve Bank of India accords automatic approval within a period of two weeks (provided certain
parameters are met) to all proposals involving:

 foreign equity up to 50% in 3 categories relating to mining activities (List 2).

 foreign equity up to 51% in 48 specified industries (List 3).
 foreign equity up to 74% in 9 categories (List 4).
 where List 4 includes items also listed in List 3, 74% participation shall apply.

The lists are comprehensive and cover most industries of interest to foreign companies. Investments in
high-priority industries or for trading companies primarily engaged in exporting are given almost
automatic approval by the RBI.

Opening an office in India

Opening an office in India for the aforesaid incorporates assessing the commercial opportunity for self,
planning business, obtaining legal, financial, official, environmental, and tax advice as needed,
choosing legal and capital structure, selecting a location, obtaining personnel, developing a product
marketing strategy and more.

The FIPB Route:

Processing of non-automatic approval cases
FIPB stands for Foreign Investment Promotion Board which approves all other cases where the
parameters of automatic approval are not met. Normal processing time is 4 to 6 weeks. Its approach is
liberal for all sectors and all types of proposals, and rejections are few. It is not necessary for foreign
investors to have a local partner, even when the foreign investor wishes to hold less than the entire
equity of the company. The portion of the equity not proposed to be held by the foreign investor can
be offered to the public.

Total foreign investment and FDI

Total foreign investment in IFY 1997-98 was estimated at dols 4.8 billion in 1997-98, compared to dols
6 billion in 1996-97. Foreign Direct Investment (FDI) in 1997-98 was an estimated dols 3.1 billion, up
from dols 2.7 billion in1996-97. The government is likely to double FDI inflows within two years.
Foreign portfolio investment by foreign institutional investors was significantly lower at dols 752 million
for fiscal 1997-98, down compared to dols 1.9 billion in1996-97, partly reflecting the effect of the
recent crisis in Asia.

Foreign institutional investors

Foreign institutional investors (FIIs) were net sellers from November 1997 through January 1998. The
outflow, prompted by the economic and currency crisis in Asia and some volatility in the Indian rupee,
was modest compared to the roughly dols 9 billion which has been invested in India by FIIs since
1992.

FII investments
FII net investment declined to dols 1.5 billion for IFY 1997-98, compared to dols 2.2 billion in 1996-97.
The trend reversed itself in February and March 1998, reflecting the renewed stability of the rupee and
relatively attractive valuations on Indian stock markets.

Large outflows of capital

Large outflows began again in May 1998, following India's nuclear tests and volatility in the
rupee/dollar exchange rate. In an effort to avoid further heavy outflows, the RBI announced in June
that FIIs would be allowed to hedge their incremental investments in Indian markets after June11,
1998.
 How Is Money Printed by the RBI & Circulated?

The Reserve Bank of India manages the printing, minting and distribution of rupees

The RBI (Reserve Bank of India) owns a printing press (for paper rupees) and a mint (for coins). The RBI decides how much money to print and
mint based on inflation and demand for cash (how much paper money and coins people use in India as opposed to debit cards or other electronic
transfers of money).

Reserve Bank of India

The Reserve Bank of India is responsible for printing, minting and distributing rupees. The RBI is also responsible for monetary policy (such as
setting the basic interest rate) and keeps statistics on financial information such as exchange rates with foreign currency, investment and savings.

Circulation
After rupees are printed and minted, the RBI sends them to the 18 regional offices. These offices distribute them to commercial banks, and from
there they reach the public through bank and ATM withdrawals.

Currency Chests
Currency chests are stocks in commercial banks around India where the RBI puts rupees for local distribution, so that circulation is not limited to the
18 cities where the RBI has regional offices. As of mid-2006, the RBI had 4,428 authorized currency chests around India.

Demand
Demand for currency depends on how many people are using cash rupees as opposed to checks and debit or credit cards. The RBI estimates this
using economic growth rates, the replacement rate (how many worn and dirty notes and coins are being destroyed) and stock requirements (how
many physical rupees the government and commercial banks must have on hand).

Old Rupees
The RBI routinely takes worn and dirty notes out of circulation. When rupees reach the RBI, employees evaluate them using quality standards.
Some are put back in circulation, while worn and dirty notes are incinerated and replaced with new notes, and coins are melted down at the mint
and replaced with new rupee coins.