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What Is Money?
The most common answer would probably be something along the lines of “something you buy stuff with”. While that answer is not wrong, it’s only a very very limited view of what money actually is. For example, did you know that if you leave your money in the bank gathering interest, you actually lose a little bit of it every year? Huh what? Yes, you actually lose money by keeping it in a savings account while your account balance gets higher (I’ll explain this later). Or that money is printed and destroyed at will by the Federal Reserve Bank? Yes, money magically comes out of a hole when people ask for a loan from the Federal Reserve Bank and then magically disappear again into a hole when they return it. Confused? Read on.
Beginning of Money
To examine the nature of money, we should start at the beginning. At one time, there were a bunch of people. Some people have stuff A and need stuff B, while other people had stuff B and need stuff A, so they traded with each other. But then along comes some other people who have stuff C, and want stuff A, but don’t have any stuff B, and since the people with stuff A doesn’t want stuff C, they have to go find people who have some stuff B. Obviously, this is kind of annoying, cause you might have to go through tons of people just to get the stuff A.
At some point, people discovered that hey, everyone wants stuff G, so they kept some stuff G around to buy stuff with. Well, since they’re buying stuff with stuff G anyway, might as well sell their stuff for stuff G. This really simplified things since you only had to do at most two trades to get what you wanted. Historically, there have been many stuff Gs such as shells, rocks, dollars, etc.
As time went on though, people discovered that lots of stuff G is kind of hard to carry around if G is big, so they picked smaller and smaller stuff Gs. Stuff G today is as small as it can get (it has no physical form) – a number we call dollars (in the US). So the concept of stuff G is the actual currency. What about the dollar bill you hold in your hand you ask? Well, that’s just one representation of the dollar. In fact there are many representations of a dollar such as the balance of your bank account, or an IOU. Keep in mind that the dollar is just one type of stuff G though. There are physical stuff Gs today like silver, gold, etc.
Looking at the dollar/currency as a number raises some interesting questions. Since it’s a non-tangible substance, can’t I just say I have a couple billion dollars? You see, stuff G is kind of a problem when it’s not a limited supply, since the premise of stuff G is that everyone wants it. If there’s an infinite supply of it, then no one would want it and it would become worthless. This is where the Federal Reserve (or some Central Bank for another country) comes in. It controls the supply of stuff G, so that two things happen:
Properties of Money
-There is enough stuff G to go around so that people can find stuff G to trade with. If there is only one bar of gold and that’s the currency, that’s not very useful because I can’t really transfer 1/10000000th of a bar easily to the next person. Same thing if there is only one dollar. Sure, we can all have 1/10000000th of a dollar to trade around with, but human beings tend to like to count in whole numbers This is called liquidity – stuff G must be readily available so that people can get it and get rid of it easily.
-Stuff G has to stay fairly consistent or predictable. If we look back to our example, we want some stuff other than G, say stuff A. We’re only holding on to stuff G so that we can get to stuff A later. However, this only works well if I can always trade X amount of stuff G for Y amount of stuff A. Imagine if you want to get 10 apples, so you trade some of your stuff into $10. Right now, apples are at $1/each. Then suddenly, an hour later, apples are $100/each, and another hour after that, apples are $.01/each. That’d be pretty confusing.
How the Economy Works
That’s why the Central Bank needs to keep the amount of money in the economy relatively consistent on a per person basis. A $1 apple today should be around a $1 apple tomorrow. Obviously, since the number of people is increasing, the $$/person would be going down, so the bank always needs to print more money to make sure that everyone still has access to approximately the same amount of money.
However, due to the nature of people, who feel better when they make more and don’t feel as good when they make less, the government actually prints more money than is needed to keep an equilibrium of $$/person, resulting in inflation. To see this, consider the following example: Let’s say you are a waiter making $10/hour.
- Suddenly, the government gives every single person an extra 10% an hour. In this case, even though no one has actually gained any money, pretty much everyone is happier, because their perception is that they have an extra dollar to spend “for free”. That perception will make people spend more money, so that more things/services are traded, and creates the happy perception that money is pretty easy to get, which in turn will make people spend more. This is a good thing and what the government strives for. This is why the government tries to keep inflation at a nominal percent, so that a dollar next year will always be easier to get than a dollar this year, but it’s barely noticeable to the common populace.
- Of course, if the inflation rate is set too high, say 1000%, that would mean if you hold a dollar this year, that dollar next year will buy you what 10 cents would buy you now. That would be a hirely undesirable situation as no one would want to hold on to any money. For all intents and purposes, the money becomes worthless because no one wants it anymore.
- Now, let’s take the opposite situation above and say the government takes 10% an hour away from everyone. Suddenly, you’re a short a dollar an hour and “making less” than what were just making. People are in general afraid that they will no longer be able to make enough money to survive (see my meaning of life article – people want to exist!), and hence will cut down on their spending. The irony is that you can still buy exactly the same amount of stuff with your $9 as you could with your $10. However, this perception leads people into not spending money, which creates the perception that money is hard to get (since people are less likely to spend money on you), which just leads to less spending. This is a situation that the government tries to prevent as that is exactly what a recession is.
So how does the Central Bank accomplish this?
How the Central Bank / Federal Reserve Works
The general idea is that when there’s too much money, they take some out of circulation, and when there’s not enough money, they make more. The actual way this is done is through interest rates. When there’s too much money, they raise interest rates so that people borrow less, making the money supply shrink as previous people who borrowed money start paying it back. When there’s too little money, they lower the interest rates so that people borrow from them more, putting more money into circulation and increasing the money supply.
What It Means For You
Yes, this is all very interesting, but how does it help you? Well, for starters, you should keep an eye on the inflation data. Typically, the money supply is expanding at around 2-3%/year, so you should know that your dollar is automatically worth about 97 cents next year. The bank interest is usually around the inflation %, technically preserving your dollar’s value (so your $1.03 next year can buy the same stuff as your $1 this year), except there’s taxes. So that 3% interest you get, after taxes, is more like 2.1%. So basically, you lose 0.9% of the value of the dollar if you keep it in your savings account. No wonder people who save up can’t get really rich! It’s like adding to a pile that is constantly shrinking. The bigger you make the pile, the faster it shrinks. That’s not a good way to make money if you ask me. That is why you should invest wisely and start saving money today. Through the magic of compounding, you can make your grow your pile of money faster the bigger it is!
For the next few weeks, I will be continuing this series on getting money. Stay tuned!
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