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Lemon Problem

What is the 'Lemons Problem'

The lemons problem refers to issues that arise due to asymmetric information possessed by the buyer
and the seller of an investment or product, regarding its value. The lemons problem was put forward in
a 1970 research paper, "The Market for Lemons," written by George Akerlof, an economist and
professor at the University of California, Berkeley. The tag phrase identifying the problem came from the
original example of used cars that Akerlof used to illustrate the concept of asymmetric information, as
defective used cars are commonly referred to as "lemons."!--break--The lemons problem is recognized
as existing in the marketplace for both consumer and business products, and also in the arena of
investing, related to the disparity in the perceived value of an investment between buyers and sellers.
The lemons problem is also prevalent in financial sector areas, including insurance and credit markets.
For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal
information regarding the actual creditworthiness of a borrower.

Causes and Consequences of the Lemons Problem

The problem of asymmetrical information arises because buyers and sellers don't have equal amounts of
information required to make an informed decision regarding a transaction. The seller or holder of a
product or service usually knows its true value, or at least knows whether it is above or below average in
quality. A potential buyer, however, typically does not have this knowledge, since he is not privy to all
the information the seller has.

Akerlof's original example of the purchase of a used car noted that the potential buyer of a used car
cannot easily ascertain the true value of the vehicle. Therefore, he may be willing to pay no more than
an average price, which is perceived as somewhere between a bargain price and a premium price.

Adopting such a stance may at first appear to offer the buyer some degree of financial protection from
the risk of buying a lemon. Akerlof pointed out, however, that this stance of the buyer actually favors
the seller, since receiving an average price for a lemon would still be more than the seller could get if the
buyer had the knowledge that the car was a lemon. Ironically, the lemons problem creates a
disadvantage for the seller of a premium vehicle, since the potential buyer's asymmetric information,
and the resulting fear of getting stuck with a lemon, means that he is not willing to offer a premium
price even though the vehicle is of superior value.

Warranties and Information

Akerlof proposed strong warranties as one means of overcoming the lemons problem, as they can
protect a buyer from any negative consequences of buying a lemon. The explosion of readily available,
widespread information disseminated through the internet has also helped to reduce the problem.
Information services such as Carfax and Angie's List help buyers feel more confident in making a
purchase, and they also benefit sellers because they enable them to command premium prices for
genuinely premium products.
Phillips Curve
What is the 'Phillips Curve'

The Phillips curve is an economic concept developed by A. W. Phillips showing that inflation and
unemployment have a stable and inverse relationship. The theory states that with economic growth
comes inflation, which in turn should lead to more jobs and less unemployment. However, the original
concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s,
when there were high levels of both inflation and unemployment.

BREAKING DOWN 'Phillips Curve'

The concept behind the Phillips curve states the change in unemployment within an economy has a
predictable effect on price inflation. The inverse relationship between unemployment and inflation is
depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the
X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing
unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the
following effects. Labor demand increases, the pool of unemployed workers subsequently decreases
and companies increase wages to compete and attract a smaller talent pool. The corporate cost of
wages increases and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of
inflation was established, and fiscal and monetary policies were used to expand or contract the
economy to achieve the target rate. However, the stable trade-off between inflation and unemployment
took a turn in the 1970s with the rise of stagflation, calling into question the validity of the Philips curve.


Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and
high price inflation. This scenario, of course, directly contracts the theory behind the Philips curve.
Stagflation was never experienced in the United States until the 1970s, when rising unemployment did
not coincide with declining inflation.

Demand usually declines in a stagnant economy, since unemployed workers naturally consume less and
businesses reduce prices to re-attract consumers. However, between 1973 and 1975, the U.S. economy
posted six consecutive quarters of declining GDP and at the same time tripled its inflation. Many point
to a mild recession in 1970 coupled with wage and price controls as the reasoning behind this

The controls instituted by Richard Nixon, then president of the United States, mimicked a stop-go
strategy that confused businesses and caused prices to remain high. Stop-go economic strategies are no
longer instituted, and with stringent target inflation rates, future events of stagflation are considered to
be highly unlikely. The Philips curve holds true under most current economic conditions.
Federal Reserve
Most people are aware that there is a government body that acts as the guardian of the economy - an
economic sentinel who implements policies designed to keep the country operating smoothly.
Unfortunately, most investors do not understand how or why the government involves itself in the

In the U.S., the answer lies in the role of the Federal Reserve, or simply, the Fed. The Fed is the
gatekeeper of the U.S. economy. It is the bank of the U.S. government and, as such, it regulates the
nation's financial institutions. The Fed watches over the world's largest economy and is, therefore, one
of the most powerful organizations on earth.

As an investor, it is essential to acquire a basic knowledge of the Federal Reserve System. The Fed
dictates economic and monetary policies that have profound impacts on individuals in the U.S. and
around the world. In this tutorial, we'll learn about how the Fed is structured, find out who Alan
Greenspan and Ben Bernanke are and talk about monetary policy and the Federal Open Market
Committee (FOMC) rate meeting.

The Federal Reserve was created by the U.S. Congress in 1913. Before that, the U.S. lacked any formal
organization for studying and implementing monetary policy. Consequently markets were often
unstable and the public had very little faith in the banking system. The Fed is an independent entity, but
is subject to oversight from Congress. Basically, this means that decisions do not have to be ratified by
the President or anyone else in the government, but Congress periodically reviews the Fed's activities.

The Fed is headed by a government agency in Washington known as the Board of Governors of the
Federal Reserve. The Board of Governors consists of seven presidential appointees, each of whom
serves 14 year terms. All members must be confirmed by the Senate and can be reappointed. The board
is led by a chairman and a vice chairman, each appointed by the President and approved by the Senate
for four-year terms. The current chair is Janet Yellen, who took over for Ben Bernanke on February 3,

What is the 'Federal Reserve System - FRS'

The Federal Reserve System (FRS) is the central bank of the United States. The Fed, as it is commonly
known, regulates the U.S. monetary and financial system. The Federal Reserve System is composed of a
central governmental agency in Washington, DC, the Board of Governors and 12 regional Federal
Reserve Banks in major cities throughout the United States.

BREAKING DOWN 'Federal Reserve System - FRS'

The Federal Reserve's duties can be divided into four general areas: conducting monetary policy,
regulating banking institutions and protecting the credit rights of consumers, maintaining the stability of
the financial system, and providing financial services to the U.S. government. The Fed also operates
three wholesale payment systems: the Fedwire Funds Service, the Fedwire Securities Service and the
National Settlement Service.

The Fed is a major force in the economy and banking.

Role and Authority

The Fed was established by the Federal Reserve Act, which was signed by President Woodrow Wilson on
Dec. 23, 1913 in response to the financial panic of 1907. Before that, the United States was the only
major financial power without a central bank. The Fed has broad power to act to ensure financial
stability, and it is the primary regulator of banks that are members of the Federal Reserve System. It acts
as the lender of last resort to member institutions who have no place else to borrow.

Banks in the United States are also subject to regulations established by the states, the Federal Deposit
Insurance Corporation (if they are members) and the Office of the Comptroller of the Currency (OCC).
FOMC Sets Monetary Policy

The Federal Open Market Committee (FOMC) is the monetary policy-making part of the Fed. It's
comprised of the seven members of the board of governors of the Fed, the president of the New York
Fed and four of the remaining 11 regional Fed presidents, who serve one-year terms on a rotating basis.
The FOMC meets eight times a year on a regularly scheduled basis and additionally on an as-needed

The FOMC adjusts the target for the overnight Fed Funds rate at its meetings based on its view of the
strength of the economy. When it wants to stimulate the economy, it reduces the target rate.
Conversely, it raises the Fed Funds rate to slow the economy. On Dec. 15, 2015, the Fed raised the
target rate to a range of 0.25 to 0.5%. This was the first rate hike in almost 10 years.

Fed Payments System

The Federal Reserve payments system, commonly known as the Fedwire, moves trillions of dollars daily
between banks throughout the United States. Transactions are for same-day settlement. In the
aftermath of the 2008 financial crisis, the Fed has paid increased attention to the risk created by the
time lag between when payments are made early in the day and when they are settled and reconciled.
Large financial institutions are being pressured by the Fed to improve real-time monitoring of payments
and credit risk, which has been available only on an end-of-day basis.

There are 12 regional Federal Reserve Banks located in major cities around the country that operate
under the supervision of the Board of Governors. Reserve Banks act as the operating arm of the central
bank and do most of the work of the Fed. The banks generate their own income from four main sources:

 Services provided to banks

 Interest earned on government securities acquired while carrying out the work of the Federal
 Income from foreign currency held
 Interest on loans to depository institutions

The income gathered from these activities is used to finance day to day operations, including
information gathering and economic research. Any excess income is funneled back into the U.S.

The system also includes the Federal Open Market Committee, better known as the FOMC. This is the
policy-making branch of the Federal Reserve. Traditionally, the chair of the board is also selected as the
chair of the FOMC. The voting members of the FOMC are the seven members of the Board of Governors,
the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks who
serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions
whether they are voting members or not. The FOMC makes the important decisions on interest rates
and other monetary policies. This is the reason why they get most of the attention in the media. We'll
talk about the FOMC in detail later.

Finally, all national banks and some state-chartered banks are part of the Federal Reserve System. They
are referred to as member banks.

The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to
help preserve the purchasing power of the dollar and moderate long-term interest rates."

In other words, the Fed's job is to foster a sound banking system and a healthy economy. To accomplish
its mission, the Fed serves as the banker's bank, the government's bank, the regulator of financial
institutions and as the nation's money manager.

Banker's Bank
Each of the 12 Fed Banks provide services to financial institutions in the same way that regular banks
provide services to individuals. This helps to assure the safety and efficiency of the nation's payments
system. For example, when you cash a check or have money electronically transferred, there is a good
chance that a Fed Bank will handle the transfer of money from one bank to another.

The Government's Bank

The biggest customer of the Federal Reserve is one of the largest spenders in the world - the U.S.
government. Similar to how you have a checking account at your local bank, the U.S. Treasury has a
checking account with the Federal Reserve. All revenue generated by taxes and all outgoing government
payments are handled through this account. Included in this service, the Fed sells and redeems
government securities such as savings bonds and Treasury bills, notes and bonds.

The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the
Fed Banks distributes it to financial institutions. It's also the Fed's responsibility to check bills for wear
and tear and to take damaged currency out of circulation.

Regulator and Supervisor

The Federal Reserve Board has regulatory and supervisory responsibilities over banks. This includes
monitoring banks that are members of the system, the international banking facilities in the U.S., the
foreign activities of member banks and the U.S. activities of foreign-owned banks. The Fed also helps to
ensure that banks act in the public's interest by helping to develop federal laws governing consumer
credit. Examples are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage
Disclosure Act and the Truth in Savings Act. In short, the Federal Reserve Board acts as the policeman for
banking activities within the U.S. and abroad.

The FRB also sets margin requirements for investors. This limits the amount of money that an investor
can borrow to purchase securities. Currently, the requirement is set at 50%, meaning that with $500,
you have the opportunity to purchase up to $1000 worth of securities.

Money Manager
While all the previously mentioned duties are important, the primary responsibility of the Fed is devising
and implementing monetary policy. This function is so important, in fact, that we'll talk about it in detail
in the next section.
Mutual Funds
As you probably know, mutual funds have become extremely popular over the last 20 years. What was
once just another obscure financial instrument is now a part of our daily lives. More than 80 million
people, or one half of the households in America, invest in mutual funds. That means that, in the United
States alone, trillions of dollars are invested in mutual funds. (For more reading, see A Brief History Of
The Mutual Fund.)

In fact, to many people, investing means buying mutual funds. After all, it's common knowledge that
investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a
savings account, but, for most people, that's where the understanding of funds ends. It doesn't help that
mutual fund salespeople speak a strange language that is interspersed with jargon that many investors
don't understand.

Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of
spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was
buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's
not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered.
Not all mutual funds are created equal, and investing in mutuals isn't as easy as throwing your money at
the first salesperson who solicits your business. (Learn about the pros and cons in Mutual Funds Are
Awesome - Except When They're Not.)

In this tutorial, we'll explain the basics of mutual funds and hopefully clear up some of the myths around
them. You can then decide whether or not they are right for you.

The Definition
A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund
as a company that brings together a group of people and invests their money in stocks, bonds, and other
securities. Each investor owns shares, which represent a portion of the holdings of the fund.

You can make money from a mutual fund in three ways:

1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the
income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also
pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in
price. You can then sell your mutual fund shares for a profit.

Funds will also usually give you a choice either to receive a check for distributions or to reinvest the
earnings and get more shares.

Advantages of Mutual Funds

• Professional Management - The primary advantage of funds is the professional management of your
money. Investors purchase funds because they do not have the time or the expertise to manage their
own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time
manager to make and monitor investments. (For more reading see Active Management: Is It Working
For You?)

• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your
risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in
any particular investment is minimized by gains in others. In other words, the more stocks and bonds
you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own
hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build
this kind of a portfolio with a small amount of money.

• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its
transaction costs are lower than what an individual would pay for securities transactions.

• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be
converted into cash at any time.

• Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and
the minimum investment is small. Most companies also have automatic purchase plans whereby as little
as $100 can be invested on a monthly basis.
Disadvantages of Mutual Funds
• Professional Management - Many investors debate whether or not the professionals are any better
than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money,
the manager still gets paid.

• Costs - Creating, distributing, and running a mutual fund is an expensive proposition. Everything from
the manager's salary to the investors' statements cost money. Those expenses are passed on to the
investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative
long-term consequences. Remember, every dollar spend on fees is a dollar that has no opportunity to
grow over time. (Learn how to escape these costs in Stop Paying High Mutual Fund Fees.)

• Dilution - It's possible to have too much diversification. Because funds have small holdings in so many
different companies, high returns from a few investments often don't make much difference on the
overall return. Dilution is also the result of a successful fund getting too big. When money pours into
funds that have had strong success, the manager often has trouble finding a good investment for all the
new money.

• Taxes - When a fund manager sells a security, a capital-gains tax is triggered. Investors who are
concerned about the impact of taxes need to keep those concerns in mind when investing in mutual
funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual
fund in a tax-deferred account, such as a 401(k) or IRA. (Learn about one type of tax-deferred fund in
Money Market Mutual Funds: A Better Savings Account.)

No matter what type of investor you are, there is bound to be a mutual fund that fits your style.
According to the last count there are more than 10,000 mutual funds in North America! That means
there are more mutual funds than stocks. (For more reading see Which Mutual Fund Style Index Is For

It's important to understand that each mutual fund has different risks and rewards. In general, the
higher the potential return, the higher the risk of loss. Although some funds are less risky than others, all
funds have some level of risk - it's never possible to diversify away all risk. This is a fact for all

Each fund has a predetermined investment objective that tailors the fund's assets, regions of
investments and investment strategies. At the fundamental level, there are three varieties of mutual
1) Equity funds (stocks)
2) Fixed-income funds (bonds)
3) Money market funds

All mutual funds are variations of these three asset classes. For example, while equity funds that invest
in fast-growing companies are known as growth funds, equity funds that invest only in companies of the
same sector or region are known as specialty funds.

Let's go over the many different flavors of funds. We'll start with the safest and then work through to
the more risky.

Money Market Funds

The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to
park your money. You won't get great returns, but you won't have to worry about losing your principal.
A typical return is twice the amount you would earn in a regular checking/savings account and a little
less than the average certificate of deposit (CD).

Bond/Income Funds
Income funds are named appropriately: their purpose is to provide current income on a steady basis.
When referring to mutual funds, the terms "fixed-income," "bond," and "income" are synonymous.
These terms denote funds that invest primarily in government and corporate debt. While fund holdings
may appreciate in value, the primary objective of these funds is to provide a steady cashflow to
investors. As such, the audience for these funds consists of conservative investors and retirees. (Learn
more inIncome Funds 101.)
Bond funds are likely to pay higher returns than certificates of deposit and money market investments,
but bond funds aren't without risk. Because there are many different types of bonds, bond funds can
vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk
bonds is much more risky than a fund that invests in government securities. Furthermore, nearly all
bond funds are subject to interest rate risk, which means that if rates go up the value of the fund goes

Balanced Funds
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation.
The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical
balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be
restricted to a specified maximum or minimum for each asset class.

A similar type of fund is known as an asset allocation fund. Objectives are similar to those of a balanced
fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The
portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves
through the business cycle.

Equity Funds
Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment
objective of this class of funds is long-term capital growth with some income. There are, however, many
different types of equity funds because there are many different types of equities. A great way to
understand the universe of equity funds is to use a style box, an example of which is below.

The idea is to classify funds based on both the size of the companies invested in and the investment
style of the manager. The term value refers to a style of investing that looks for high quality companies
that are out of favor with the market. These companies are characterized by low P/E and price-to-book
ratios and high dividend yields. The opposite of value is growth, which refers to companies that have
had (and are expected to continue to have) strong growth in earnings, sales and cash flow. A
compromise between value and growth is blend, which simply refers to companies that are neither
value nor growth stocks and are classified as being somewhere in the middle.

For example, a mutual fund that invests in large-cap companies that are in strong financial shape but
have recently seen their share prices fall would be placed in the upper left quadrant of the style box
(large and value). The opposite of this would be a fund that invests in startup technology companies
with excellent growth prospects. Such a mutual fund would reside in the bottom right quadrant (small
and growth). (For further reading, check out Understanding The Mutual Fund Style Box.)

Global/International Funds
An international fund (or foreign fund) invests only outside your home country. Global funds invest
anywhere around the world, including your home country.

It's tough to classify these funds as either riskier or safer than domestic investments. They do tend to be
more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a
well-balanced portfolio, actually reduce risk by increasing diversification. Although the world's
economies are becoming more inter-related, it is likely that another economy somewhere is
outperforming the economy of your home country.

Specialty Funds
This classification of mutual funds is more of an all-encompassing category that consists of funds that
have proved to be popular but don't necessarily belong to the categories we've described so far. This
type of mutual fund forgoes broad diversification to concentrate on a certain segment of the economy.
Sector funds are targeted at specific sectors of the economy such as financial, technology, health, etc.
Sector funds are extremely volatile. There is a greater possibility of big gains, but you have to accept
that your sector may tank.

Regional funds make it easier to focus on a specific area of the world. This may mean focusing on a
region (say Latin America) or an individual country (for example, only Brazil). An advantage of these
funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and
expensive. Just like for sector funds, you have to accept the high risk of loss, which occurs if the region
goes into a bad recession.

Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain
guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic
beverages, weapons or nuclear power. The idea is to get a competitive performance while still
maintaining a healthy conscience.

Index Funds
The last but certainly not the least important are index funds. This type of mutual fund replicates the
performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA). An
investor in an index fund figures that most managers can't beat the market. An index fund merely
replicates the market return and benefits investors in the form of low fees. (For more on index funds,
check out our Index Investing Tutorial.)

If you are looking for information about the best 401k investment funds, Investopedia's Ask an Advisor
tackles the topic by answering one of our user questions.
What is 'The World Bank'

The World Bank is an international organization dedicated to providing financing, advice and research to
developing nations to aid their economic advancement. The World Bank was created out of the Bretton
Woods agreement as a result of many European and Asian countries needing financing to fund
reconstruction efforts. As of 2016, the Bank predominantly acts as an organization that attempts to fight
poverty by offering developmental assistance to middle- and poor-income countries.

BREAKING DOWN 'The World Bank'

The World Bank is a provider of financial and technical assistance to developing countries around the
globe. The bank considers itself a unique financial institution that provides partnerships to reduce
poverty and support economic development by giving loans and offering advice and training to both the
private and public sectors. The World Bank was established in 1944, is headquartered in Washington
D.C., and has more than 10,000 employees in over 120 offices worldwide.

The Structure of The World Bank

The World Bank has expanded from the single institution that was created in 1944 to a group of five
unique and cooperative institutional organizations. The first organization is the International Bank for
Reconstruction and Development (IBRD) , an institution that provides debt financing to governments
that are considered middle income. The second organization within The World Bank is the International
Development Association (IDA), a group that gives interest-free loans to governments of poor countries.

The International Finance Corporation (IFC), the third organization, focuses on the private sector and
provides developing countries with investment financing and financial advisory services. The fourth part
of The World Bank is the Multilateral Investment Guarantee Agency (MIGA), an organization that
promotes foreign direct investments in developing countries. The fifth and final organization is the
International Centre for Settlement of Investment Disputes (ICSID), an entity that provides arbitration on
international investment disputes.

The Goals and Benefits of The World Bank

The World Bank has two stated goals that it aims to achieve by 2030. The first is to end extreme poverty
by decreasing the amount of people living on less than $1.90 a day to below 3% of the world population.
The second is to increase overall prosperity by increasing the income growth in the bottom 40% of the
world's population.

Beyond its specific goals, the World Bank provides qualifying individuals and governments with low-
interest loans, zero-interest credits and grants. These debt borrowings and cash infusions help with
global education, health care, public administration, infrastructure and private sector development. The
World Bank also shares information with world governments through policy advice, research and
analysis and technical assistance.

DEFINITION of 'World Bank Group'

Five international organizations dedicated to providing financial assistance and advice to countries
struggling with poverty and economic development. The World Bank generally focuses on developing
third-world countries, helping them in areas such as health, education and agriculture. This bank
provides loans and grants at discounted rates to these countries.

BREAKING DOWN 'World Bank Group'

The World Bank Group was created on December 27, 1945 as part of the Bretton Woods agreement. Its
five agencies are:

International Bank for Reconstruction and Development (IBRD)

International Development Association (IDA)
International Finance Corporation (IFC)
Multilateral Investment Guarantee Agency (MIGA)
International Centre for Settlement of Investment Disputes (ICSID)
A component of the United Nation's World Bank Group that was established in 1945 with the original
mandate of providing funding towards the post-World War II rebuilding efforts. In the modern era, the
IBRD's main objective is to provide loans and other financial services to less fortunate countries in hopes
of reducing global poverty.

The IBRD raises captial for the loans via the issuance of AAA rated bonds. Around $10-15 billion worth of
bonds are issued on an annual basis. The IBRD has had its AAA credit rating since 1959.

The International Bank for Reconstruction and Development (IBRD) is an international financial
institution that offers loans to middle-income developing countries. The IBRD is the first of five member
institutions that compose the World Bank Group and is headquartered in Washington, D.C., United
States. It was established in 1944 with the mission of financing the reconstruction of European nations
devastated by World War II. The IBRD and its concessional lending arm, the International Development
Association, are collectively known as the World Bank as they share the same leadership and staff.[1][2][3]
Following the reconstruction of Europe, the Bank's mandate expanded to advancing worldwide
economic development and eradicating poverty. The IBRD provides commercial-grade or concessional
financing to sovereign states to fund projects that seek to improve transportation and infrastructure,
education, domestic policy, environmental consciousness, energy investments, healthcare, access to
food and potable water, and access to improved sanitation.

The IBRD is owned and governed by its member states, but has its own executive leadership and staff
which conduct its normal business operations. The Bank's member governments are shareholders which
contribute paid-in capital and have the right to vote on its matters. In addition to contributions from its
member nations, the IBRD acquires most of its capital by borrowing on international capital markets
through bond issues. In 2011, it raised $29 billion USD in capital from bond issues made in 26 different
currencies. The Bank offers a number of financial services and products, including flexible loans, grants,
risk guarantees, financial derivatives, and catastrophic risk financing. It reported lending commitments
of $26.7 billion made to 132 projects in 2011.

The IBRD provides financial services as well as strategic coordination and information services to its
borrowing member countries.[15] The Bank only finances sovereign governments directly, or projects
backed by sovereign governments.[16] The World Bank Treasury is the division of the IBRD that manages
the Bank's debt portfolio of over $100 billion and financial derivatives transactions of $20 billion.[17]

The Bank offers flexible loans with maturities as long as 30 years and custom-tailored repayment
scheduling. The IBRD also offers loans in local currencies. Through a joint effort between the IBRD and
the International Finance Corporation, the Bank offers financing to subnational entities either with or
without sovereign guarantees. For borrowers needing quick financing for an unexpected change, the
IBRD operates a Deferred Drawdown Option which serves as a line of credit with features similar to the
Bank's flexible loan program.[18] Among the World Bank Group's credit enhancement and guarantee
products, the IBRD offers policy-based guarantees to cover countries' sovereign default risk, partial
credit guarantees to cover the credit risk of a sovereign government or subnational entity, and partial
risk guarantees to private projects to cover a government's failure to meet its contractual obligations.

The International Development Association (IDA) is an international financial institution which offers
concessional loans and grants to the world's poorest developing countries. The IDA is a member of the
World Bank Group and is headquartered in Washington, D.C., United States. It was established in 1960
to complement the existing International Bank for Reconstruction and Development by lending to
developing countries which suffer from the lowest gross national income, from troubled
creditworthiness, or from the lowest per capita income. Together, the International Development
Association and International Bank for Reconstruction and Development are collectively generally
known as the World Bank, as they follow the same executive leadership and operate with the same

The association shares the World Bank's mission of reducing poverty and aims to provide affordable
development financing to countries whose credit risk is so prohibitive that they cannot afford to borrow
commercially or from the Bank's other programs.[6] The IDA's stated aim is to assist the poorest nations
in growing more quickly, equitably, and sustainably to reduce poverty.[7] The IDA is the single largest
provider of funds to economic and human development projects in the world's poorest nations.[8] From
2000 to 2010, it financed projects which recruited and trained 3 million teachers, immunized 310 million
children, funded $792 million in loans to 120,000 small and medium enterprises, built or restored
118,000 kilometers of paved roads, built or restored 1,600 bridges, and expanded access to improved
water to 113 million people and improved sanitation facilities to 5.8 million people.[9] The IDA has issued
a total $238 billion USD in loans and grants since its launch in 1960. Thirty-six of the association's
borrowing countries have graduated from their eligibility for its concessional lending. However, eight of
these countries have relapsed and have not re-graduated.[2]

What is the 'International Monetary Fund - IMF'

The International Monetary Fund (IMF) is an international organization created for the purpose of
standardizing global financial relations and exchange rates. The IMF generally monitors the global
economy, and its core goal is to economically strengthen its member countries. Specifically, the IMF was
created with the intention of:

1. Promoting global monetary and exchange stability.

2. Facilitating the expansion and balanced growth of international trade.

3. Assisting in the establishment of a multilateral system of payments for current transactions.

BREAKING DOWN 'International Monetary Fund - IMF'

Fixed exchange rates, also known as the Bretton Woods system (named after the original UN conference
at which the IMF was conceived), refer to the value of a currency being tied to the value of another
currency, or to gold. The system of fixed exchange rates was established by the IMF as a way to bolster
the global economy after the Great Depression and World War II. This system was abolished in 1971,
and ever since, the IMF has promoted the system of floating exchange rates, which means that the value
of a currency can change in relation to the value of another. This is the familiar system today. For
example, when the U.S. economy suffers, the dollar's value goes down in relation to that of, say, the
euro of the European Union, and the opposite is also true. The exchange rates established by the IMF
allow countries to better manage economic growth and trade relations. These exchange rates are set in
order to prevent economic collapse, which can occur with runaway exchange rates, which occurs when
the rates continue to rise.

The IMF vs. the World Bank

The primary difference between the International Monetary Fund, or IMF, and the World Bank lies in
their respective purposes and functions. The IMF exists primarily to stabilize exchange rates, while the
World Bank’s goal is to reduce poverty. Both organizations were established as part of the Bretton
Woods Agreement in 1945.

The International Monetary Fund promotes monetary cooperation internationally and offers advice and
assistance to facilitate building and maintaining a country’s economy. The IMF also provides loans and
helps countries develop policy programs that solve balance of payment problems if a country cannot
obtain financing sufficient to meet its international obligations. The loans offered by the IMF, however,
are loaded with conditions. Often, a loan provided by the IMF as a form of "rescue" for countries in
serious debt ultimately only stabilizes international trade and eventually results in the country repaying
the loan at rather hefty interest rates. For this reason, the IMF has many critics worldwide.
The World Bank's purpose is to aid long-term economic development and reduce poverty in developing
countries. It accomplishes this by making technical and financial support available to countries. The bank
initially focused on rebuilding infrastructure in Western Europe following World War II, and then turned
its operational focus to developing countries. World Bank support helps countries reform inefficient
economic sectors and implement specific projects, such as building health centers and schools or making
clean water and electricity more widely available. World Bank assistance is typically long term, funded
by countries that are members of the bank through the issuing of bonds. The World Bank also has a pool
of about $200 billion with which to offer aid to less-developed countries. The bank’s loans, however, are
not used as a type of bailout, as in IMF style, but as a fund for projects that help develop an
underdeveloped or emerging market nation and make it more productive economically.

The IMF works hand-in-hand with the World Bank, and although they are two separate entities, their
interests are aligned, and they were created together. While the IMF provides only shorter-term loans
that are funded by member quotas, the World Bank focuses on long-term economic solutions and the
reduction of poverty and is funded by both member contributions and bonds. The IMF is more focused
on economic policy solutions, while the World Bank offers assistance in such programs as building
necessary public facilities and preventing disease.

How Does It Work?

The IMF gets its money from quota subscriptions paid by member states. The size of each quota is
determined by how much each government can pay according to the size of its economy. The quota in
turn determines the weight each country has within the IMF - and hence its voting rights - as well as
how much financing it can receive from the IMF.

Twenty-five percent of each country's quota is paid in the form of special drawing rights (SDRs), which
are a claim on the freely usable currencies of IMF members. Before SDRs, the Bretton Woods system
had been based on a fixed exchange rate, and it was feared that there would not be enough reserves to
finance global economic growth. Therefore, in 1968, the IMF created the SDRs, which are a kind of
international reserve asset. They were created to supplement the international reserves of the time,
which were gold and the U.S. dollar. The SDR is not a currency; it is a unit of account by which member
states can exchange with one another in order to settle international accounts. The SDR can also be
used in exchange for other freely-traded currencies of IMF members. A country may do this when it has
a deficit and needs more foreign currency to pay its international obligations.

The SDR's value lies in the fact that member states commit to honor their obligations to use and accept
SDRs. Each member country is assigned a certain amount of SDRs based on how much the country
contributes to the Fund (which is based on the size of the country's economy). However, the need for
SDRs lessened when major economies dropped the fixed exchange rate and opted for floating rates
instead. The IMF does all of its accounting in SDRs, and commercial banks accept SDR denominated
accounts. The value of the SDR is adjusted daily against a basket of currencies, which currently includes
the U.S. dollar, the Japanese yen, the euro, and the British pound.

The larger the country, the larger its contribution; thus the U.S. contributes about 18% of total quotas
while the Seychelles Islands contribute a modest 0.004%. If called upon by the IMF, a country can pay
the rest of its quota in its local currency. The IMF may also borrow funds, if necessary, under two
separate agreements with member countries. In total, it has SDR 212 billion (USD 290 billion) in quotas
and SDR 34 billion (USD 46 billion) available to borrow.

IMF Benefits
The IMF offers its assistance in the form of surveillance, which it conducts on a yearly basis for individual
countries, regions and the global economy as a whole. However, a country may ask for financial
assistance if it finds itself in an economic crisis, whether caused by a sudden shock to its economy or
poor macroeconomic planning. A financial crisis will result in severe devaluation of the country's
currency or a major depletion of the nation's foreign reserves. In return for the IMF's help, a country is
usually required to embark on an IMF-monitored economic reform program, otherwise known as
Structural Adjustment Policies (SAPs). (For more insight, see Can The IMF Solve Global Economic

There are three more widely implemented facilities by which the IMF can lend its money. A stand-by
agreement offers financing of a short-term balance of payments, usually between 12 to 18 months. The
extended fund facility (EFF) is a medium-term arrangement by which countries can borrow a certain
amount of money, typically over a three- to four-year period. The EFF aims to address structural
problems within the macroeconomy that are causing chronic balance of payment inequities. The
structural problems are addressed through financial and tax sector reform and the privatization of public
enterprises. The third main facility offered by the IMF is known as the poverty reduction and growth
facility (PRGF). As the name implies, it aims to reduce poverty in the poorest of member countries while
laying the foundations for economic development. Loans are administered with especially low interest
rates. (For related reading, check out What Is The Balance Of Payments?)
The IMF also offers technical assistance to transitional economies in the changeover from centrally
planned to market run economies. The IMF also offers emergency funds to collapsed economies, as it
did for Korea during the 1997 financial crisis in Asia. The funds were injected into Korea's foreign
reserves in order to boost the local currency, thereby helping the country avoid a damaging devaluation.
Emergency funds can also be loaned to countries that have faced economic crisis as a result of a natural
disaster. (For a better look at how economies make the transition from being state run to free markets,
see State-Run Economies: From Private To Public.)

All facilities of the IMF aim to create sustainable development within a country and try to create policies
that will be accepted by the local populations. However, the IMF is not an aid agency, so all loans are
given on the condition that the country implement the SAPs and make it a priority to pay back what it
has borrowed. Currently, all countries that are under IMF programs are developing, transitional and
emerging market countries (countries that have faced financial crisis).