What They Don’t Teach You About Money – Part 1.

The following article will uncover some basic things that you will need to learn about money if you are serious about making it rich out there in the real world. Learning how money works, how it is created and how it is manipulated in the economy. Becoming rich isn’t just about the money. But, money forms the most basic framework with which you can set out to become rich. So, let’s get started.

BEFORE MONEY:

Before paper money, the world was different. In that era, the economy was not like how it is right now.

First, there was subsistence economy in which everyone consumed whatever they themselves had produced. It was a world where a farmer who produced berries would eat berries; a fisherman who caught fish would eat fish. 

It wasn’t an ideal world. It was a boring world where a farmer could eat only berries, and a fisherman could eat only fish. So, people came up with an idea to change the boring situation. They started trading. In such an economy (trade based economy), if someone happened to want something that someone else had produced and vice versa, an exchange was possible. In most cases, exchanges were done. 

In an ideal world, this should have been okay. Only that it wasn’t. You see, a farmer who grew berries was able to exchange some berries for some fish from the fisherman who caught fish. But, let’s say the farmer wanted his motor pump repaired from a mechanic. He goes to the mechanic and offers him his berries in exchange for his service of repairing the motor pump. Now, the trade doesn’t sound fair. The mechanic may want totally something else altogether. So, what do you do when a person doesn’t want what you have to offer, and wants something else altogether? Let’s say the mechanic wanted some tools. The farmer couldn’t have given him the tools because the farmer doesn’t produce tools. He produced berries. This is the first scenario. The mechanic offering his service to repair the motor and the farmer giving berries to the mechanic does not sound like a good trade. Guess why? Coz, it’s NOT FAIR.

exchanging berries for getting your machine serviced

Berries are basically perishable items which will go waste in a day or two. The mechanic may not consume berries for the next 3 days. What then? 

So, a new form of the economy came into place wherein something called an IOU (I owe you) took an important position in the trade. Initially, IOU was more like a receipt. Let’s say you’re a farmer and you produce wheat and rice. In this scenario, if you want to buy groceries, you go to the grocery shop and get the groceries. And you want to offer wheat and rice in return. The grocery shop owner already has the wheat and rice needed for his family, stocked for the next one full year. So what do you do? You write and give him an IOU, kind of like a receipt stating that you owe him and that you will repay him with wheat and rice next year when he needs the same. Next year, you end up paying with wheat and rice and you will then cancel your IOU. 

If only things were this simple!

When this system of exchanging IOUs started, it soon became pretty complicated. I mean, think about it. When everyone starts giving everyone else IOUs for many different items, the only thing that’s governing the entire trade was TRUST. Again, in a perfect world, it would have been nice, cute, and great to trust each other with the IOU. But, the world isn’t perfect. So, trust is not everyone’s strongest forte. This led to further change in the economy.

Soon enough, the concept of money as an IOU came into place.

BASICS OF MONEY:

So, let’s start with the roles of money.

There are three roles that anything that can be used as money should fulfil.

  • Store of value.
  • Unit of account.
  • Medium of exchange.

While you can store data in your hard disk and carry it everywhere, what can be considered as money, has an eligibility criterion. That criterion is that it stores VALUE. If something carries its value over an extended period of time in a predictable way, it fulfills the “store of value” role that it has to perform.

Let’s take an onion. Let’s say you bought an onion today for 30 rupees. Would it carry the same 30 rupees’ value 2 months down the road? No. Why?  Coz, it’s perishable. No one would buy the same onion from you 2 months down the road.

selling onions.

Let’s take a piece of gold or probably a diamond stone. Let’s say you buy it for $10000 today. Would it carry the same $10000 value two months down the road? You bet! Would it carry the same value 2 years down the road? More or less.

You get the point right? Perishable items are unfit for storing value. Some non-perishable items like gold, silver, platinum, etc., are really good enough to store and carry value over a long time.

Okay. You found something that stores value. Now what? The second role for money to play is to act as a unit of account. Basically, you need some measure to weigh the value of any items, services, goods, etc. We call it PRICE. In our current economy, we use currencies like rupees, dollars, euros, etc., in order to denote the value of things and services.

Basically, if we don’t use this measure, we won’t be able to reward the hard work that goes into creating something or providing some service, depending on the work involved. Think about this scenario. You’re a software engineer. You create the world’s best AI and you install it in a robot and make it a completely family friendly robot which will do all the work.  Now, you want to sell it to people all over the world. You spent 9 years for creating this. If there was no unit of account, no price to measure the value of this particular robot, how would people know what its value is? Would you want someone to buy your robot by giving you a bag of strawberries? You probably won’t. So, money should also be something that can be used to measure the value of goods and services.

The last role that a thing should fulfill in order to be considered as money is that it should be a medium of exchange.

A medium of exchange is something that people can have so that they can swap it for anything that they want to buy. It’s not something that people have for the sake of having it.

Let’s assume that you time travel back to the Second World War era. You’re a prisoner there in a Nazi camp. Now, imagine that you had to swap something inside the prison camp. You don’t have currency; you don’t have gold, silver or anything else. It is cold. It is freezing. Most prisoners at that time want to smoke. So, they started getting cigarettes. Whoever had a cigarette was able to swap it for what they want from a person that wanted to smoke the cigarette. Let’s assume that you don’t smoke. If you were to grab ahold of a cigarette, would you throw it out and walk away? Nope. You wouldn’t. Why? Coz, you could probably be able to swap that cigarette for something that you want, like fruits, bread, or something else.

All these three roles are important and should be fulfilled for something to be considered as money.

Now, let us look into this in further detail.

First, let me ask you a question. You have gold. Gold can fulfill all of these three requirements right? It can be a great store of value, you can exchange gold for what you want, and you can also use number of grams of gold to measure the value of a thing or a service. So, gold can be money, right? Not quite.

It is a form of money nonetheless. It’s called as commodity money. Whenever something that can be used for other purposes is used as money, it’s considered as commodity money. For instance, in our example, gold can be used to make jewelry. Ancient civilizations used iron, copper, then gold, silver, etc.

So, what happens when you use these kinds of items as money? Well, you can use them to buy or exchange things. But when they are also used for creating something else altogether (jewelry in the case of gold, railings in the case of iron), there’s a cost to using them as money. That is exactly why we don’t use non-financial assets (like gold, copper, silver, etc.) as money in our current economy. We don’t use them as money also because of one more thing. If we are going to limit money creation based on the availability of gold, silver, iron, copper, etc., then there would be a limit to how much can be created and circulated. When we run out of all that is there, there will be chaos. This is one of the most important reasons that we don’t use such non-financial assets as money.

Money is basically a kind of solution to the lack of trust amongst people. Earlier, when someone gave you an IOU, you basically trusted that the other person would fulfill what he owes you, now or in future. Nowadays, it doesn’t work like that. We lack trust between each other. Therefore, we started using one particular form of money as the common medium of exchange, store of value and unit of account – Currency.

There are three different types of money in our current economy.

  • Currency
  • Bank Deposits
  • Reserves of the central bank (Reserve Bank)

Before you learn more about the different types of money, you have to know how the economy of any country is split up. There are three main groups – central bank, commercial banks, and consumers. Private companies and households are collectively called as consumers.

There is also a different classification of money – broad money and base money.

Broad money is what consumers (like you, me, private companies like Google, Facebook, Apple, etc.,) have available and use for transactions, purchases, etc. Predominantly, currency and bank deposits are considered as broad money.

Base money comprises of central bank reserves and currency. Here, central bank reserves are what the central bank owes to the commercial banks. Currency is what the central bank owes the consumers. Let me explain. Consumers like private companies and normal people of the country need to have money in order to do transactions and purchases. So, that money is given in the form of currency by the central bank. In the case of India, RBI is the central bank. It prints currency and that currency is then given to the consumers. It also has reserves a part of which is given to the commercial banks for them to make use of it. Let’s look at this in detail.

Currency is made up of bank notes and coins.

Consumers (you, me and everyone else, and also private companies) have currency (cash) so that they can use physical cash to pay.

The commercial banks also hold some currency. Why? Let’s say you hold the cash in your bank account. When you make a withdrawal using your ATM card or a cheque, you are essentially taking cash. For this purpose, the commercial banks also hold some currency.

Initially, currency was exchangeable with gold and other such commodity money. Then, there came a situation where this put a limit on how much currency can be made available. When such a crisis situation cropped up, most of the countries unanimously declared that they will further disassociate the currency and gold (commodity money in general). Once that was done, people could exchange currency for currency only and nothing else. They could use the currency to buy something and get currency for selling something.

Over a period of time, currency became the most trusted medium of exchange that people could use it as something directly convertible into a real good of some kind. This came into place as more and more people started using currency as the medium of exchange because they trusted it.

Initially, when the governments had to come up with the concept of currency and popularize it among people as the convention, they started taking measures in order to ensure that people will be legally bound to use it. This was first done by the governments accepting currency for tax payments, tenders, etc. Then, slowly and steadily, currency started being the most accepted medium of exchange.

Usually, the central bank of any country will make sure that the availability of bank notes meets the demand from the public for them. The bank arranges the printing, and then swaps them for unusable notes and old notes with the commercial banks. This covers the basics about currency.

Bank deposits form the rest of the money held by the consumers. People like you and me don’t like to carry cash everywhere. We don’t hold much cash at our homes either. Why? It is predominantly because of the safety concern. The most important reason why people don’t hold currency is that it doesn’t pay interest. Consumers like you and me often find it attractive that bank deposits can earn interest by just being there with the bank. We are also promised that we can take it back at any time. What more do we need?

Nowadays, everything is paid in plastic. Most people use credit cards. But I use a debit card/ATM card only. I will cover the importance of using debit/ATM cards later. For now, you just need to know this.

Look at the picture below.

carrying a bulky wallet

Now, would you want to carry your wallet like this today when you go shopping? If you’re like most people, you’d answer a big NO.

Most people use plastic to pay nowadays instead of paying with hard cash. They don’t want to carry a bulky wallet. They also don’t want to risk losing cash. This is exactly where bank deposits come in.

You either have a bank deposit in the form of fixed/recurring deposit, putting it away for a set amount of time, or you deposit the cash in your bank account (which still pays interest on a timely basis), which you can withdraw at any time. So, people just swap the banknotes for deposits. Deposits are for most parts electronic (except for withdrawal), so banks find it easier to deal in deposits.

Nowadays, we get our salaries directly deposited to our account, we transfer money to each other through NEFT (deposits again), etc. Also, when you pay for something, you buy using a debit card. In this scenario, the bank essentially reduces the deposit equivalent of the amount you used to buy in your account. Then, the bank deposits that same amount into the account of the person/shop you bought from.

Central Bank Reserves are used for large-scale purposes.

Why are the reserves needed? Let’s say a bank like SBI or IOB wants to make a payment of 150 crores (or probably $100 million dollars) to HDFC. Transferring the money of that magnitude in currency/cash is difficult and tedious. So, what do these banks do? They simply convey to the central bank which will then deduct the amount of reserves from the bank that wants to transfer and credit the same amount of reserves to the bank (HDFC in this case).

Also, if the commercial banks are lagging behind on the amount of currency they have, they can swap some of the reserves with the central bank for currency. Let’s say everyone starts withdrawing their deposits at the same time in your country. Then, all the banks will run out of the currency they have in stock. So, in such a scenario, they will swap some of their reserves with the central bank for some currency in order to cater to the depositors withdrawing the money.

Up until this point, we covered the basics of money, types of money in our currently existing economy and how money is basically moved and circulated. In the next part, we will cover in detail about how money is created. The next part will also dispel the myths and shed some light on the actual process of the creation of money in today’s economy.

Until then,

Hercules.

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