The use of money and its transmission through the economy by means of a banking system characterise modern economies. Money has been used for thousands of years, but has evolved to more sophisticated forms and its transmission has improved over time. There have long been questions over the effects money and banking have in the economy. Frequently they have given rise to intense debate, and are seldom far from discussion on the economy's performance, prices, exchange-rates and so on. The British economy was the first to industrialize. It developed a sophisticated financial system around the same time. The relationship between the two has been a constant topic of discussion.
Beyond the point thus described changes in money can only do damage. Excess money (in relation to output) can in the long-run only produce inflation. Excess money in the short run confuses people. In the short run, if there is an increase in the quantity of money people feel better off and set out to spend more. Producers imagine that there is a genuine increase in demand for their product and therefore raise their output (employ more workers o work longer hours). In the r long-run output has to return to its trend and all that is left is the higher price level brought about by the initial injection. (See Figure 1)
The beginning of banking
Money is whatever a community accepts as money. In its ideal form it will be a g ood medium of exchange, a store of value, and also provide the unit of account. In primitive societies cattle, shells, tobacco, and other items have been used. The search for more suitable forms gave rise to metals, and more recently to paper based on metals. The form currently in use is paper not based on metals, but based only on government assurances that they will not produce too much of it. The introduction of money to an economy raises welfare. A primitive economy operating on barter can be transformed by the introduction of money. Money removes the inefficiency of having to search for coincident demands. The use of money promotes efficient production and consumption. That does not mean that every increase in money brings an increase in welfare. A point is reached where, in a growing economy, the growth in the quantity of money is optimal. The actual quantity is not important. A number of units of money will give a certain level of prices. If people are opposed to inflation, as in most circumstances they generally seem to be, they will select some commodity in fairly scarce supply, and/or a set of monetary arrangements that will constrain supply. Then once the quantity of money that purchases total output at a desired price level is established, it would be ideal if after that it varied only as output varied. By that means the long-run general price level will stay constant and the only prices changing will be relative prices - e.g. price of video recorders falling and opera seats rising.
The origins of banking can be found in the early goldsmiths and scriveners (money lenders). In England this dates from the seventeenth century. Once metallic coin was in quite widespread use a common practice was to deposit coins with goldsmiths in exchange for a deposit slip or receipt. This led to two important innovations. One was that a depositor could pay another depositor by having the holder of the gold or silver transfer funds from one account to another - no physical movement of the metal taking place. A short step from this was the use of cheques. The deposit receipt could also be used as money. Money transmission became safe and convenient. The second innovation was to create money. This was done by lending out some of the gold deposited - what is called fractional reserve banking : taking deposits, setting aside a fraction as reserves and lending the balance. Settling on the safest and most profitable ratio of reserves to deposits was a matter of trial and error. In this way banks raised the quantity of money. The...