MONEY AND BANKING CONTENTS

What is MONEY?............................................................................................................3

Characteristics of money......................................................................................................4 Measurements of money......................................................................................................5 Money and the economy......................................................................................................7 Relationship between Prices and Inflation .........................................................................7 Why Money Supply Matters ...............................................................................................8
Banking...........................................................................................................................9

General History..................................................................................................................10 History in United States.....................................................................................................10 Banking basics....................................................................................................................11 Other Financial Institutions................................................................................................12 International Banks............................................................................................................12 Structure of banking industry in U.S.................................................................................12 Interest Rates......................................................................................................................13 Banking Business ..............................................................................................................14 Liquidity management by banks .......................................................................................14 Multiple Deposit Creation .................................................................................................18 Banking services................................................................................................................21
Summary.......................................................................................................................23

Learning Objectives On successful completion of this lesson you will be able to: Understand the role of money and its impact on the economy and measurement of money in an economy. History of banking, liquidity management of banks and banking services and technique of credit creation.

MONEY AND BANKING Money and banking have become an integral part of our lives and one cannot do without it. However, the subtleties of banking and money are not clear to many. This unit aims to introduce you to some of the issues faced in managing a bank. The breadth of such issues is vast and by necessity, this unit concentrates on the financial aspects of bank management. You should be well aware of the rapid developments in banking from media reports in recent years, including criticisms of banking policies and practices. You may even have experienced these changes through dealings with your own bank. This criticism of banks is not limited to one country and generally followed the worldwide trend in the 1980s towards deregulation. This has led to the establishment of Banking Ombudsmen in several countries and the development of Codes of behaviour for both banks and their employees. The period of deregulation is accompanied by one important development - the rapid development of global computer communications that enabled financial institutions to develop new products and to internationalise their business. This brought greater risks, and latterly, the development of techniques to manage these exposures. What is MONEY? I doubt if anybody would ask the question What is money? I you did, here's what is isn't. MONEY is not the same thing as INCOME or WEALTH While in ordinary conversation we commonly use the word money to mean income ("he makes a lot of money") or wealth ("she has a lot of money"), technically money means something quite different: Money = anything that is generally accepted as payment Q: What is money? That is, what counts as money? A: Obviously, cash -- dollar bills, coins -- is a form of money. Q: Is there anything else that counts as money? A: Checking accounts.

Q: Are credit cards money? A: No. They're not legal tender. What a credit-card purchase really represents is just an extremely convenient, pre-approved loan. It's only part of the transaction, since the merchant then goes to the bank that issued the credit card to get money, and the bank sends you a bill which must be paid with money. Characteristics of money The forms that money has taken on depend heavily on how well it performs the three roles, viz., medium of exchange, store of value, and unit of account. The following are some of the characteristics a commodity or specie needs to possess to perform the three roles of money efficiently: (1) Non-perishable in the sense it does not get spoilt by keeping. (2) Divisible into fractions if necessary (3) Widely accepted (in payment of goods and services and for settling other business obligations) (4) Easily standardized, meaning that it can be expressed in standard unit (5) Portable and can be moved from place to place. (6) Limited in supply (7) Supply is relatively stable and does not change frequently. (8) High in value i.e. its physical size is small relative to its value. (9) Not easily counterfeited However, new problems have surfaced with the development of digital cash. Since digital cash is made up of bits of digital information, it can be counterfeited a lot easier than traditional paper money. This becomes a major concern because easy duplication leads to an unlimited amount of digital cash, which makes it valueless. In addition, digital cash is much easier to transport than paper money because it is transferred digitally. This makes transferring money across border a lot easier, which means money from illegal sources (such as drug money) can be easily transmitted out of the country.

Measurements of money Money is considered an important determinant of the condition of the economy of a country. In the eye of the federal government, there is a broader measure of what money is in the U.S and in other parts of the world imply. There are 3 general measures of money used by the U.S. government (or more specifically the Federal Reserve System): M1, M2 and M3. These are often referred to in the context of inflation, recession and interest rate changes. Im sure it sounds familiar. Allan Greenspans, the US Treasury Secretarys, announcements on changes in the Fed interest rate during the last two years is now well known felt even in India. (i) M1 M1 is the narrowest measure of money. It includes the following items:

M 1 = currency in circulatio n (notes and coins) + traveler' s checks of nonbank issues (eg. AMEX) + non - interest bearing checking accounts (ie. demand deposit) + interest bearing checking accounts (ie. other checkable deposits)

Note: 1. Travellers checks issued by banks are grouped under demand deposits. 2. Some examples of interest bearing checking accounts are NOW (negotiable order of withdrawal), ATS (automatic transfer from savings), and credit union share drafts.

M1 is considered by the Federal Reserve as transaction balances. In other words, they are perfectly liquid assets, i.e. pure medium of exchange. (ii) M2 M2 is a broader measure of money than M1. It includes items that are contained in M1 and a few other items:

M 2 = M1 + savings deposits and money market deposit accounts + small time deposits (CDs) + money market mutual funds shares (non - institutio nal) + overnight repurchase agreement + overnight Eurodolla r + consolidat ion adjustment

Note: 1. You can write a limited number of checks on money market deposit accounts (i.e. interest bearing account). 2. Small time deposits are CDs with amount less than $100,000. 3. Money market mutual funds are interest-bearing shares in pools of funds accumulated by investment companies. The funds are invested in short-term securities. 4. The consolidation adjustment is included to avoid double counting of short-term repurchase agreement and Eurodollars held by money market mutual funds. The components of M2 (other than M1) are considered as nontransaction balances. In other words, the assets emphasize the function of money as a store of value. However, they can also be used as medium of exchange (with some delay). (iii) M3 M3 is the broadest measure for money and it includes some of the longer-term money market instruments.

M3= M2 + large time deposits (more than $100 ,000 ) + term repurchase agreements (longer than overnight) + term Eurodolla r deposits (longer than overnight) + money market mutual funds shares (institutions)

The components of M3 (other than M2) are assets of mostly large businesses and institutions. They are very non-liquid assets, and hence not used as medium of exchange. (iv) L Data on M1, M2 and M3 are collected and distributed by the Federal Reserve System (i.e. the Fed), and they are known as the monetary

aggregates. In addition, the Fed also collects information on a broader concept of liquidity known as L.

L = M3 + short term Treasury s ecurities + commercial papers + savings bonds issued by the U.S. government + banker' s acceptance

The components of L (other than M3) are highly liquid assets (i.e. shortterm money market instruments). Money and the economy Since money has an impact on a number of economic variables, it is sometimes helpful to use money to determine how the economy is performing. Which monetary measure do we use to predict inflation, business cycles, etc.? Historical evidence shows that M1, M2 and M3 do not move in tandem. An alternative way is to use a weighted average of the monetary aggregates, but how successful it will be is still unknown. Relationship between Prices and Inflation Index of the average prices of goods and services in the economy are Consumer price index, Wholesale price index, and GDP deflator. These are indices that measure the value of money at different levels- wholesale and consumer levels. Inflation rate: the yearly percent change in the price level. It is measured using the formula: (New value) - (Old value) Percent change = --------------------------------- (x 100%) (Old value)

Q: Suppose the Consumer Price Index was 150 in 1979 and 169.5 in 1980. What was the inflation rate in 1980? A: Inflation rate = (169.5-150)/150 = 19.5/150 = 0.13 * 100 = 13%

Why Money Supply Matters Money supply is the total amount of currency in circulation plus bank account deposits. At the national level, the money supply and national income (GDP) are not the same thing, either. GDP (gross domestic product -- the total value of final goods and services produced in a given year; about $10 trillion) is often used as a bottom-line measure of how the nation's economy is doing. The money supply (e.g., M2 - cash + virtually all bank deposits and money-market-fund shares held by individuals; about $4.5 trillion) is not used as a bottom-line measure of the state of the economy, nor should it be. Why, then, do we bother to learn about the money supply and to keep track of it?

The Federal Reserve measures the money supply once a week, whereas GDP is measured only once every three months, because the money supply (Ms) affects three very important aspects of the economy: (a) GDP: steep declines in the Ms Growth rate can cause recessions -- In the past 50 years, there have been eight recessions, and every single one of them was preceded by a notable decline in the money (M2) growth rate. Then again, not every decline in the M2 growth rate was followed by a recession -- thus the old joke that "economists have predicted twelve of the last eight recessions." (b) Inflation: faster Ms growth rates tend to cause higher rates of inflation -- Likewise, increases in the money supply tend to cause the general price level to increase. -- Inflation is often described as "too much money chasing too few goods." When the money supply increases faster than the productive capacity of the economy, inflation is the usual result.

-- From international comparisons we see a tight relationship between money (M2) growth rates and inflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per month, or well over 1000% per year) is impossible without extremely rapid money-supply growth.

Q: Since money supply growth is inflationary, and perfect price stability (0% inflation) seems like an ideal, wouldn't we be better off keeping the money supply perfectly stable, and not increasing it at all? A: No. Money demand (people's demand for money for their transactions and savings) increases virtually every year as the volume of transactions (real GDP) increases, and if the money supply did not keep pace with money demand, then the economy would run into serious problems -- cash shortages, sky-high interest rates, and probably recession. (c) interest rates: other things equal, an increase in the Ms causes interest rates to fall, enabling borrowers to get cheaper mortgages, cheaper student loans, cheaper car loans, etc. (Likewise, a decrease in the Ms causes interest rates to rise.) -- On the other hand, if a particular increase in the Ms is expected to be inflationary, then interest rates will tend to increase, since higher inflation rates induce lenders to demand higher interest rates and induce borrowers to accept higher interest rates. The interest rate that really matters to borrowers and lenders is not the nominal (posted) interest rate but the real interest rate, which is the inflation-adjusted interest rate: Real interest rate = (nominal interest rate) - (inflation rate) Ex.: In 1980, the inflation rate was about 13%. The (nominal) interest rate, was only about 8%. Thus, in 1980, Real interest rate = 8% - 13% = -5%, so bonds were a terrible investment, because the amount repaid had less purchasing power than the original amount loaned out. Banking A bank is an institution which deals in money. It means that a bank receives money in the form of deposits from public and lends money to development of trade and commerce.

General History A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and Greece, which loaned at high rates of interest the gold and silver deposited for safekeeping. Private banking existed by 600 B.C. and was considerably developed by the Greeks, Romans, and Byzantines. Medieval banking was dominated by the Jews and Levantines because of the strictures of the Christian Church against interest and because many other occupations were largely closed to Jews. The forerunners of modern banks were frequently chartered for a specific purpose, e.g., the Bank of Venice (1171) and the Bank of England (1694), in connection with loans to the government; the Bank of Amsterdam (1609), to receive deposits of gold and silver. Banking developed rapidly throughout the 18th and 19th cent., accompanying the expansion of industry and trade, with each nation evolving the distinctive forms peculiar to its economic and social life. History in United States In the United States the first bank was the Bank of North America, established (1781) in Philadelphia. Congress chartered the first Bank of the United States in 1791 to engage in general commercial banking and to act as the fiscal agent of the government, but did not renew its charter in 1811. A similar fate befell the second Bank of the United States, chartered in 1816 and closed in 1836. Prior to 1838 a bank charter could be obtained only by a specific legislative act, but in that year New York adopted the Free Banking Act, which permitted anyone to engage in banking, upon compliance with certain charter conditions. Free banking spread rapidly to other states, and from 1840 to 1863 all banking business was done by statechartered institutions. In many Western states it degenerated into wildcat banking because of the laxity and abuse of state laws. Bank notes were issued against little or no security, and credit was over expanded; depressions brought waves of bank failures. In particular, the multiplicity of state bank notes caused great confusion and loss. To correct such conditions, Congress passed (1863) the National Bank Act, which provided for a system of banks to be chartered by the federal government. In 1865, by granting national banks the authority to issue bank notes and by placing a prohibitive tax on state bank notes, an amendment to the act brought all banks under federal supervision. Most banks in existence did take out national charters, but some, being banks of

deposit, were unaffected by the tax and continued under their state charters, thus giving rise to what is generally known as the dual banking system. The number of state banks expanded rapidly with the increasing use of bank checks. Recurrent banking panics caused by over expansion of credit, inadequate bank reserves, and inelastic currency prompted Congress in 1908 to create the National Monetary Commission to investigate the banking and currency fields and to recommend legislation. Its suggestions were embodied in the Federal Reserve Act (1913), which provided for a central banking organization, the Federal Reserve System. Banking basics We know banks play a major role in the economy. They accept deposits from individuals and use the funds to make loans to other individuals and companies. As a result, banks channel money from one source to another source. Banking is primarily the business of dealing in money and instruments of credit. Banks were traditionally differentiated from other financial institutions by their principal functions of accepting depositssubject to withdrawal or transfer by checkand of making loans. In the process of channelling money from savers to borrowers, banks can also create more money than those initially deposited with the banks. This dealt under credit creation. As a result, banks are targets of monetary policies in terms of controlling the money supply in the economy. Banks have traditionally been distinguished according to their primary functions. Commercial banks, which include national and state-chartered banks, trust companies, stock savings banks, and industrial banks, have traditionally rendered a wide range of services in addition to their primary functions of making loans and investments and handling demand as well as savings and other time deposits. Mutual savings banks, until recently, accepted only savings and other time deposits, and offered limited types of loans and services. The fact that commercial banks were able to expand or contract their loans and investments in accordance with changes in reserves and reserve requirements further differentiated them from mutual savings banks, where the volume of loans and investments was governed by changes in customers' deposits. Membership in the Federal Deposit Insurance Corporation is compulsory for all Federal Reserve member banks but optional for other banks.

Other Financial Institutions There are financial institutions that have not traditionally been subject to the supervision of state or federal banking authorities but that perform one or more of the traditional banking functions are savings and loan associations. These could be Mortgage companies, finance companies, insurance companies, credit agencies owned in whole or in part by the federal government, credit unions, brokers and dealers in securities, and investment bankers. Savings and loan associations, which are state institutions, provide home-building loans to their members out of funds obtained from savings deposits and from the sale of shares to members. Finance companies make small loans with funds obtained from invested capital, surplus, and borrowings. Credit unions, which are institutions owned cooperatively by groups of persons having a common business, fraternal, or other interest, make small loans to their members out of funds derived from the sale of shares to members. International Banks There are also banks that lend mostly to Governments of countries. The International Bank for Reconstruction and Development (World Bank) was organized in 1945 to make loans both to governments and to private investors. The discharge of debts between nations has been simplified and facilitated through the International Monetary Fund (IMF), which also provides members with technical assistance in international banking. The European Central Bank (see European Monetary System) was established in 1998 to help formulate the joint monetary policy of those European Union nations adopting a single currency. Structure of banking industry in U.S. There were once over 15,000 banks in the U.S. There are still about 10,000 banks in the U.S, thanks to mergers and amalgamations, a few hundred with assets over $1 billion and lots and lots of small banks that survive because of their expertise in evaluating risks in a local area or an industry or in an ethnic community. This structure arose because inter-state banking was restricted severely until very recently. Changing banking business: Distribution of commercial bank assets and liabilities in 1960 and 1989.

% Assets Cash US Govt. State and Local securities Other securities Business loans Mortgages Consumer loans Other loans Miscellaneous 196 0 20 24 7 1 17 11 10 8 2 198 Liabilities 9 8 Demand deposits 12 Savings and time deposits 3 Large negotiable CDs 2 Miscellaneous 20 Capital 23 12 7 13 196 0 61 29 0 2 8 198 9 20 38 12 24 6

Interest Rates One important place where money and banking intersect is in the determination of interest rates. Interest Rate = the cost of borrowing money; the "price" of money; one's rate of earnings on money loaned out.

We say that Money and Banking intersect in the determination of interest rates because the interest rate is the "price" of money, and interest rates are usually posted by banks. Did you realise banking is a business like any other business involving asset liability management and credit creation. We shall now examine how these two works. Banking Business The balance sheet of a commercial bank is shown: ASSETS Cash/Reserves Loans Securities Other Assets LIABILITIES Deposits Borrowings Capital Loan loss reserves

Management of balance sheet in order to maximize profits is subjected to these constraints:

liquidity management capital adequacy credit risk management interest rate risk management

Liquidity management by banks Balance Sheet of Safe Manhattan Bank ASSETS LIABILITIES Cash/Reserves Loans Securities 20 Deposits 80 Borrowings 10 Capital 100 0 10

Other Assets Total

0 Loan loss reserves 110 Total

0 110

What can this bank do if there is a deposit outflow of 20? Asset management - Can't very well allow reserves to go down to 0, so sell securities of 10 and let reserves fall to 10:

ASSETS Cash/Reserv es Loans Securities Other Assets Total (20-10=) 10

LIABILITIES Deposits (100-20=) 80 0 10 0 90

80 Borrowings (10-10=) Capital 0 0 Loan loss reserves 90 Total

What happens if there is a further deposit outflow of 10? Liability management - Can't allow reserves to disappear, can't liquidate loans, so borrow (Fed Funds, CDs, etc.):

ASSETS Cash/Reserves Loans Securities Other Assets

LIABILITIES 10 Deposits 80 Borrowings 0 Capital 0 Loan loss reserves (80-10=) 70 (0+10=) 10 10 0

Total

90

Total

90

Say the bank would like to make a loan of 10 to a new customer; it makes the loan by creating a demand deposit for the customer:

ASSETS Cash/Reserv es Loans Securities Other Assets Total

LIABILITIES 10 Deposits (70+10=) 80 10 10 0 100

(80+10=) Borrowings 90 0 Capital 0 Loan loss reserves 100 Total

Of course, the bank must be prepared for a deposit outflow when the loan customer utilizes the loan, so the bank "funds" the loan through additional borrowing that adds to reserves. The bank has now prepared itself for the deposit outflow.

ASSETS Cash/Reserv es Loans Securities Other Assets Total

LIABILITIES 80 (10 + 10=) 20 10 0 110

(10+10=) Deposits 20 90 Borrowings 0 Capital 0 Loan loss reserves 110 Total

The borrower has now utilizes the loan so the deposit balances and reserves of the bank decline by 10.

ASSETS Cash/Reserv es Loans Securities Other Assets Total

LIABILITIES (20- Deposits 10=)10 90 Borrowings 0 Capital 0 Loan loss reserves 100 Total (80 10=)70 20 10 0 100

Further, the bank now discovers that the borrower is unable to pay back the loan and the loan has to be be "written-off." The write off reduces loans and capital: ASSETS Cash/Reserv es Loans Securities Other Assets Total LIABILITIES 10 Deposits (90- Borrowings 10=)80 0 Capital 0 Loan loss reserves 90 Total 70 20 (10-10=) 0 0 90

Alas! The bank has a ZERO net worth. The capital of the bank has been eroded completely. This might lead regulators to worry or close the bank or depositors to worry or start a run on the bank. What might the bank do: 1.Sell more equity: convince new investors that the deposit base is loyal and the remaining loan assets are sound and that an equity investment will pay off. 2. Allow itself to be acquired or merged with another bank. 3. Make some very large risky loans with the hope that the earnings will build up capital and if it doesn't work out - well the net worth is zero already. Multiple Deposit Creation Suppose that banks keep 1/5th of their deposits as reserves either as a legal requirement or by choice in order to be prepared for withdrawals. Imagine that someone comes along and deposits $10,000 in currency in Safe Manhattan Bank. Lets see what might happen. Safe Manhattan Bank experiences an increase in its cash (asset) and its deposits (liabilities) of $10,000. The cash is placed in the vault and there is an increase in the reserves (cash in the vault) and deposits of the Bank. Changes in Safe Manhattan Banks Balance Sheet *BANK RECEIVES DEPOSIT Reserves +10,000 Deposits +10,000 Loans and Investments No change Net worth No change Total +10,000 Total +10,000 *BANK MAKES LOAN TO MS. SMITH Reserves No change Deposits +8,000 Loans and Investments +8,000 Net worth No change Total +8,000 Total +8,000 *MS. SMITH SPENDS Reserves -8,000 Loans and Investments No change Total -8,000 **Banks SUMMARY** Reserves +2,000 Deposits -8,000 Net worth No change Total -8,000 Deposits +10,000

Loans and Investments +8,000 Total +10,000 Total

Net Worth +10,000

No change

Bank realizes that it does not need to use all of the $10,000 in additional cash as reserves. Since it only needs or wants to keep 1/5 of the additional deposit as reserves, it finds that it only needs to keep $2000 as additional reserves. It then has excess reserves of $8,000, which it can use to buy other assets -- make loans and investments. Customer, Ms. Smith, now comes to the bank to take out a loan to finance an increase she would like to make in her business inventories. The bank judges this to be a good loan and it lends Ms. Smith the funds ($8,000) and creates a demand deposit for her. That is, it simply writes up an additional balance in Ms. Smiths checking account. She can then write a cheque to Ms. Jones, her supplier, to pay for the new inventories. Ms. Jones then deposits the check in Highfly Bank then presents the check to Safe Manhattan for payment. The check is cleared through the Federal Reserve System where the deposits (reserves) of Safe Manhattan are decreased by $8,000 and the deposits of Highfly Bank are increased by $8,000. As a result of the increase in deposits of $10,000, Safe Manhattan is able to expand its loans and investments by an additional $8,000. In addition, the money supply has been expanded by $8,000 since Ms. Jones now has a demand deposit in Highfly Bank of that amount which did not exist before. Next, we follow the process to Highfly Bank where Ms. Jones has deposited the check from Ms. Smith. Highfly Bank has cleared the check through the regional Federal Reserve Bank and finds that it has both deposits and reserves that have increased by $8,000. Highfly Bank does not need or want to keep the full $8,000 as reserves. Highfly Banks increases its by only $8,000/5 or $1600; the reserve ratio is 1/5. Highfly Banks now has excess reserves of $8,000 - 1,600 = $6,400 which it can uses to make loans and investments. Suppose that the bank decides to buy $6,400 of bonds from a depositor, Mr. Green. The bank credits Mr. Greens account by $6,400 in return for the bonds, and Mr. Green uses the proceeds of the sale to buy some furniture from Ms. Stones furniture store. Ms. Stone takes the check from Mr. Green and deposits it in Sparklays Bank. We can see several things from the T-accounts for Highfly Bank. The inflow of deposits of $8,000 Highfly Bank required this bank to increase

its reserves by only $1,600. The bank found that it had excess reserves so that it was able to expand loans and investments by $6,400. When it did so, it increased the deposits of Mr. Green by that amount, increasing the quantity of money held by the public by an equal amount. Thus Highfly Bank has contributed to an expansion of money by $6,400 -- this amount eventually becomes additional deposits in Sparklays Bank. The money supply has increased by $8,000 due to Safe Manhattans activities and by $6,400 from Highfly Banks activities. Changes in Highfly Banks Balance Sheet *BANK RECEIVES DEPOSIT (CHECK WRITTEN BY MS. SMITH) Reserves +8,000 Deposits +8,000 Loans and Investments No change Net worth No change Total +8,000 Total +8,000 *BANK BUYS BOND FROM ONE OF ITS CUSTOMERS - MR. GREEN Reserves No change Deposits +6,400 Loans and Investments +6,400 Net Worth No change Total +6,400 Total +6,400 *MR. GREEN SPENDS Reserves -6,400 Loans and Investments No change Total -6,400 **BANK B SUMMARY** Reserves +1,600 Loans and Investments +6,400 Total +8,000 Deposits -6,400 Net worth No change Total -6,400 Deposits +8,000 Net Worth No change Total +8,000

The effect of the initial cash deposit of $10,000 at Safe Manhattan has spread beyond Safe Manhattan. You should now try to trace the transactions that result from Sparklays Banks deposit inflow of funds and see that Sparklays Bank will also be able to expand bank credit and expand the money supply. The process goes on indefinitely. An increase in reserves (from the initial deposit of cash) has a multiplier effect on the money supply. In this simple example -- where every bank always holds exactly one-fifth of its deposits in the form of reserves -- it is easy to figure out the total effect of the initial inflow of reserves on amount of money and credit created by the banking system. Because of the initial increase in deposits of $10,000, Safe Manhattan finds that it has excess reserves of $8,000. It was this quantity of excess reserves that started the process of credit creation and set the money supply expansion in motion. Highfly Bank creates money and credit equal to $6400 = (4/5)*8,000. Sparklays Bank is able to create

money and credit equal to $5120 = (4/5)*6400 = (4/5)*(4/5)*8000. The process continues indefinitely, with each successive bank in the process expanding money and credit by 4/5 the amount of the previous bank. The net effect of the process is that the money supply will be expanded by an amount that is 1/(1- (4/5)) = 5 times the initial increase in excess reserves. Banking services A bank is the safest place you can stash your cash because funds in U.S. bank accounts are insured against loss by the federal government for up to $100,000 per depositor. The interest rate a bank offers on any given day is typically only guaranteed for seven days. To earn a rate that's guaranteed for longer than that, you have to lock up your money for three months to five years in a certificate of deposit (CD). If interest rates fall before the CD expires, the bank is out of luck and must give you the high rate it quoted when you opened the account. If rates climb, however, you're stuck with the lower rate that you agreed to accept until the CD matures. And if you take your money out before the CD matures, you'll pay a penalty -typically forfeiting three months' or so of interest. If you aren't careful, a simple checking account could cost you $200 or more a year, after the monthly fee, the per-check fee and the ATM charges are added up. And while most big banks offer "free" checking if you maintain a substantial balance -- typically $2,000 to $4,000 -- the so-called opportunity cost of tying up your money in a low- or no-yield account can be substantial. A number of competitors offer accounts that resemble bank services. The most common: Credit union accounts; mutual fund company money market funds; and brokerage cash-management accounts. Banks are convenient, because you can tap your account at the corner ATM at any hour of the day or night. And they're safe because, in the United States and in many other countries, bank deposits are insured by the federal government: the Federal Deposit Insurance Corporation insures commercial banks and the Federal Savings and Loan Insurance Corporation insures savings banks in the USA. Since banks no longer rely on American's savings as a cheap source of capital that they can turn around and loan out at a fat profit, they have to find other ways to book their profits. That's where fees come in. For example, if you walk into one of the big-name banks and ask to open a

checking account, you're likely to be offered the most expensive package. Cost per month: $6. Cost per check: 50 cents. Cost per ATM visit: 50 cents. Cost per bounced check: $25. No wonder the average annual price of maintaining a checking account at a bank today is between $190 and $218. You can earn significantly more on your money by putting it into a certificate of deposit, but to do so you'll have to agree not to withdraw it for anywhere from three months to five years. Recently, for example, a typical six-month CD paid 4.9 percent, while a five-year CD paid 5.6 percent. Online banking is gaining popularity world over. Online banking used to require bank-specific software, but today it doesn't have to. What's behind that explosive growth? The simple fact that, for people who are computer-savvy enough to be viewing this lesson, banking online is the simplest and most effective way to keep track of your day-to-day financial affairs. The tasks you accomplish are basic: checking balances of your savings, checking, and loan accounts, transferring money among accounts and paying bills. But doing so electronically saves you a bundle of time and, sometimes, a little money. The bill-paying option, in particular, is much more efficient than doing things by written check and mail. You simply enter the name and address of a recipient the first time you make a recurring payment. Thereafter, your banking program or bank website remembers the address. All you have to do is choose a payee, enter the amount and select the date you want the payment sent. The bank then sends money to the payee by wire, if possible, or prints and mails an old-fashioned check if the payee can't accept electronic payments. Most bill-paying programs allow you to schedule recurring payments by the month, week or quarter, which you might want to do for your cable or mortgage bills. In addition, if you make a mistake in an electronic check, you can usually un-schedule it if you catch the error at least five business days before the check was scheduled to be issued. Bank alternatives It's becoming easier to do your banking without the bank. Here's how. Checking and savings accounts are also offered by several types of nonbank businesses. Here are three of the most common: Credit unions Credit unions operate much like banks, and accounts are similarly insured by the National Credit Union Share Insurance Fund. And since credit unions are non-profit organizations that exist to benefit their

members, interest rates on accounts tend to be higher, and fees and minimums, lower than at commercial banks. On average, for instance, a credit union's yield on a money market account will be 1.25 percentage points higher than at a commercial bank. However, credit unions generally offer fewer services and provide fewer ATMs than commercial banks. To join a credit union, you ordinarily must belong to a participating organization, such as a labour union or a college alumni association. To know whether you are eligible, or to locate a credit union, visit the Credit Union National Association at CUNA.org.

Summary Money is a medium of exchange which is different from income and wealth. There is a common saying that Money is what money does, which says it all. There are four different measures of money referred to as M1, M2, M3 and L. The quantum has a bearing on the health of the economy. Free banking spread rapidly in the U.S. between 1840 to 1863. In 1865, national banks were granted the authority to issue bank notes. Further, an amendment to the Act brought all banks under federal supervision. Banking is primarily the business of dealing in money and instruments of credit. In the process of channelling money from savers to borrowers, banks can create more money than those initially deposited with the banks. Commercial banks, which include national and state-chartered banks, trust companies, stock savings banks, and industrial banks, have traditionally rendered a wide range of services in addition to their primary functions of making loans and investments and handling demand as well as savings and other time deposits. Membership in the Federal Deposit Insurance Corporation is compulsory for all Federal Reserve member banks but optional for other banks. One important place where money and banking intersect is in the determination of interest rates which gives the price" of money for both the savers and the borrowers. A number of competitors offer accounts that resemble bank services. Online banking is gaining popularity world over.