Money Money Money....Money

Unless you have a curiosity about how "money" evolved or how it works, dont read this blog. I forget a lot of things that I learn. For some reason, I have this unique habit of forgetting what I should remember and remember what I want to forget. Anyway, I have always wondered about what money is and recently had a discussion with a friend of mine (Sarin) about it which clarified a lot of things. This effort is to collate the thoughts and present it, hopefully, in a clear and concise format.

Well, let us go back several hundreds of years back, but not too back where bartering did not exist. Bartering just means trading by exchanging one commodity over another. Over time, the bartering system needed a standard way of dealing with exchange of commodity. Based on which civilization you look at, you will get pointers that people used shells, leather, silver and gold as a way to standardise the commodity exchange.

But then, there came the concept of a gold smith who would give you a receipt for the amount of gold that you have in store. You can go to the gold smith and deposit gold and get a receipt which you can later use to trade stuff. The assumption is that, the receipt is an entity which anyone can take back to the bank and get the corresponding worth of gold. Over time, the gold smiths realised that people rarely came back to them asking for gold since everybody started using just the receipts to get the stuff they want. Later, there were folks who did not have money and they needed some...who wudnt.. The gold smith figured that he can float receipts as a loan to an individual assuming that not everyone who has gotten receipt from him is going to come back and ask for gold. This is how money gets multiplied.

You should be able to map the gold smith analogy to the modern world as well. Here, the government is the person holding the gold. Banks are the guys who do money multiplication by giving away loans. The only criteria being, the fed controls banks in terms of how much reserve ratio that they should hold. Basically, fed sets the multiplication factor. To understand this better, think of a guy depositing $100 in a bank. Fed will say that 20% of the deposited amount should be paid back to the fed. In other words, the bank can do anything with the remaining $80. Now, if someone asks for a loan, the bank can give away upto $80. Let us say, the person who took the loan buys an item through which the $80 comes back to the bank through the shop. Now, bank gets $80 of which it should again give 20% to the fed ($16). This would mean that they can lend $64 back again in the market. This follows an infinite geometric progression and essentially, for every $100 start money, the bank can eventually give loans of upto another $500 (a/(1-r)). Sounds strange, but thats how it works. On top of it, the bank can get loans from the fed as well...think about that.

The next big question is how does government control money flow ? More money in market would make everyone rich, but the prices would increase proportionately, a condition called inflation. The other way would cause deflation. Controlling inflation is easier. So, most governments try and control inflation than let economy deflate.

Everything in the economy has a cyclic effect. This is the main reason why deflation is bad. If businesses dont do well, they lay off people which in turn would mean that people get less richer which would mean that they reduce spending which would mean that businesses wont do well... The common way through which fed solves this problem is to inject money into the system by relaxing the interest rates and reserve ratio requirements. By doing that, they create money which in turn would make the economy do better. At the sametime, when things go out of control and inflation sets in, they tighten the interest rates, reserve ratio requirements, and supply bonds to get the money out of the market.

In summary, money flows out of fed through the banks to the consumers in the form of loans. Money comes back to fed through banks by repayments and savings and bonds. Anyway, the juggling that fed chairman does is to look at both ends of money flow and make sure that balance exists (increase or decrease interest rates). Remember that if you save money in a bank, you are allowing the bank to multiply it by a big factor! So, having gold and other such immovable assets is not bad after all !!