Money, Banking & the Economy
Banks and the monies they administer play an invaluable role in a local, regional, national and even international economic system. Indeed, money is the driving force behind an economy. How it is managed and distributed within a given system is often the most pivotal issue facing developing as well as developed economies. In light of this fact, it is important to understand what money is and the role it plays. This paper will cast a more comprehensive light on the fundamental purposes of these two concepts and how money and banks positively and adversely impact an economy.
Keywords: Capital; Central Bank; Commodities; Fiat Money; Futures Trading; Greenbacks; Money Market
At the end of the American Revolution, the fledgling United States immediately found itself in deep debt. There was no common currency, as the states printed their own money after the failure of the first American national money, the "continental". Without such resources, it was feared that the United States would fail to develop a stable economy after the departure of the British.
The new Secretary of the Treasury, Alexander Hamilton, looked to create what so many other countries had installed within their own governments — a central bank. The bank would be responsible for issuing currency and fund the states' debt. However, Hamilton did not limit his vision to these parameters. He saw the key to economic development in the new country to be the establishment of new businesses. His brainchild, the First Bank of the United States, would not only be the earliest incarnation of what would eventually become the Federal Reserve — it would be a major commercial bank in a country largely bereft of them ("A history of," 2009).
As the example of the first federal financial institution in the US demonstrates, banks and the monies they administer play an invaluable role in a local, regional, national and even international economic system. This paper will cast a more comprehensive light on the fundamental purposes of these two concepts and how money and banks positively and adversely impact an economy.
Abraham Lincoln once commented on the need for the government to create, issue and circulate money that will satisfy its own spending needs as well as maximize the buying power of the consumers. By bringing such principles to bear, he is reported to have said, "Money will cease to be master and become the servant of humanity."
Indeed, money is the driving force behind an economy. How it is managed and distributed within a system is often the most pivotal issue facing developing as well as developed economies. In light of this fact, it is important to understand what money is and the role it plays.
In general terms, money is manifest in two forms. The first is a commodity, which is a physical currency that can be exchanged for goods and services. Commodities may be coins and paper monies, as long as they are interchangeable with other products of equal value. However, commodities may also be food products, grains and precious metals. Commodities may be exchanged in the open marketplace, or within a commodities exchange (InvestorWords.com, 2009). The second is fiat money. Although fiat money may appear in the form of currency as well, it has no value other than that which is assigned to it by those who printed or produced it (Hummel, 2008).
Commodities and fiat money have long played important roles in economies around the globe. In light of this fact, it is important to expound on the principles, benefits and shortcomings of each of these forms of money.
Put simply, commodities are physical items that are exchanged on the open market. Gold and silver are among the most well-known commodities, but equally important as commodities are such items as wheat, soy, crude oil, steel and other items. Throughout history, commodities have been exchanged for money in the marketplace. Chicago, for example, became a central market for the exchange of wheat between farmers and purchasers.
By the mid-19th century, commodities markets had become more complex; in addition to the open exchange, the practice of speculation became more widespread. This practice involves an investor predicting the price of the exchange of commodities based on futures contracts (an arrangement between buyers and sellers for the future delivery of commodities) and trading on the market based on his or her assessment of the profitability of such contracts ("A brief history," 2009).
Today, futures trading has become a vast and highly profitable form of commodities exchange. The world's largest market for futures exchanges is the New York Mercantile Exchange (also known as NYMEX), which has been in operation since 1874 and represents trading of a myriad of commodities, from precious metals to foodstuffs to uranium. As an example of the breadth of NYMEX's own operations, the exchange has a port through which hundreds of thousands of transactions take place each day in 400 commodities markets (NYMEX.com, 2009). Although none are as large as NYMEX, there are countless, similarly constructed exchanges in operation around the world.
Futures trading offers the potential for enormous profitability, which accounts for the tremendous volume of trading being conducted. However, there are risks involved with such activity. Commodities such as wheat, oil and other resources are subject to changes in conditions that may affect their price, often in dramatic fashion. A cold weather spell might cause an immediate drop in prices for Florida-grown oranges. Similarly, a terrorist attack on a pipeline might immediately send oil prices skyward. The futures trader banks on such fluctuations, looking to reap the benefits of a sizable differential in the agreed-upon price of a given futures contract. However, when the negative event takes place, the same trader stands to lose significantly. While he or she may take steps to mitigate a loss, there is no guarantee that he or she will lose not only the initial margin but the entire amount in the account (National Futures Association, 2009).
Commodities remain a robust monetary form in terms of exchange. However, it is not the only form of money that is employed in great volume around the globe.
Of course, most nations in the world do not rely on physical commodities like gold or silver to exchange products and services to back their currencies. Such forms of money like the US dollar, the British Pound and the Japanese Yen, for example, are known as fiat money, which is a token that is intrinsically worthless but is assigned value by its government.
Fiat money is not backed by another commodity, which contributes to its lack of value. Rather, it acquires its worth based on the confidence the consumers have in it. Governments may assign its worth, but they are not expected to back such currency when that value experiences negative conditions. The lack of depth in confidence in fiat money stems from the fact that such currencies are usually introduced during times of debt and/or financial crisis.
United States history provides an excellent example of the use of fiat money and the effect its unpredictable backing can have on an economy. During the Civil War years, the enormous cost of the military effort led the government, which had previously pegged US currency to gold, to create currency redeemable by gold at a future, unspecified date. In 1862, it began printing "greenbacks" in this vein. This currency was made possible by a Congressional act, which passed overwhelmingly and with President Lincoln's backing, and the Treasury Department, which borrowed about $900 million against US credit in order to give some strength to the greenbacks. Fortunately, the greenbacks program was short-lived, as the paper was discontinued after only one year — the debt created by a slimmed-down appropriation of greenbacks was significant and long-term, requiring bonds and taxes to be issued to help pay down what was owed (Mitchell, 1903).
The US was able to pay down the debt over the course of the next two decades. The country was further able to avoid inflation and price instability of the dollar by once again attaching a gold value to its worth, a trend that lasted until World War I. During that conflict, the US and other countries reintroduced fiat money, as their needs necessitated the...
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