Understanding Money: Part 1 – Introduction

Money is one of the few fundamental creations or discoveries that has shaped human culture over several thousand years. It motivates and facilitates most of our daily activity. It has an apparent simplicity – everyone ‘knows’ what money is – but a surprising complexity when all its aspects are explored in depth.

Wikipedia defines money as “any object or record that is generally accepted as payment for goods and services and repayment of debts“. Wikipedia classifies three main types of money that have been used over time as commodity money, representative money, and fiat money. Further, it identifies three main functions of money, a medium of exchange, a unit of account, and a store of value, but notes that any kind of object or secure verifiable record that fulfills these functions can serve as money. In this part, we consider the common daily form that money takes, that of currency or cash, and what it means.

Until recent times, money consisted of some commodity, be it bushels of wheat or tokens made out of gold, silver, or copper. It had a real or intrinsic value. The unit of money was the store of value in itself. One did not have to go elsewhere or make some reference to something else that had value. One could eat the wheat and hammer the gold into jewelry for the wife.

More recently, when Western countries were on a gold standard, we had representational money, money that represented and could be exchanged for an asset such as gold that had an intrinsic value of its own. This money had no appreciable intrinsic value but had a well-defined extrinsic value being some specified amount of an underlying commodity. In this case, the value of a paper note existed outside or extrinsic to the note itself.

Now we have fiat money that has no intrinsic value and as we shall see, questionable extrinsic value. We begin with this question.

How Much Money Do You Have?

To answer this you probably counted the change in your pocket, the cash in your purse and the change in your cookie jar – all part of what is called currency in circulation. You may then have thought “I’m worth much more than this. Last Thursday, I went to my bank with $23,000 in cash and opened a chequing account with $1,000 in it, a savings or demand deposit account with $2,000 in it, and a $20,000 guaranteed investment certificate (GIC) whose funds are locked in for 1 year.”  A number of important observations come from this simple example.

First, there is a distinction between the money as cash that you have and your net worth. The former is the cash that you actually have in your physical possession. The latter is the amount of cash that you would have if you sold all your assets at their market value and paid all your debts today.

An important concept that comes into play here is called liquidity. Liquidity refers to the ability of an asset to be converted into cash quickly and without any price discount. Some of your assets, namely your bank accounts, are highly liquid – they can be converted into cash in your pocket very quickly and without any cost or loss of value to you. Other assets such as your GIC are not liquid. The bank may refund the amount of the GIC by charging a redemption penalty or it may refuse to refund your money as cash until the year has passed.

Secondly, where is your $23,000? The first thing to understand is that you loaned the money to your bank and your bank has a great deal of latitude with what it does with that money. Our post Understanding Debt gives some background terminology on loans and debt. Since the nature of a savings and chequing accounts is that after depositing (loaning) money, you have the right to withdraw it at any time without notice. The deposit is effectively a debt of the bank’s with zero maturity. This is also

So where is your $23,000? Since banks don’t make money from cash sitting in their vaults they are eager to loan money out at a higher rate of interest than they are paying you to borrow it. They have to retain some money to repay depositors who ask for their money back and for other aspects of general daily business, but the bulk of your money is lent out as fast as the bank can find credit-worthy borrowers. This briefly describes the notion of fractional-reserve banking which we discuss further in Understanding Money: Part 2 – Money Creation.

In summary, you have none of the $23,000 as cash although your net worth, assuming no debt or other assets, remains at $23,000. Your assets are a loan with zero maturity of $3,000 comprised of a savings account and a chequing, and a loan of $20,000 with one year maturity. Your cash position remains your pocket change and piggy bank. Your cash has been transformed into debt.

Next

We look at where money comes from in Understanding Money: Part 2 – Money Creation.

The Series

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