How Does Money Work?

Money has always been one of the most important aspects of human societies. We use it every day to purchase goods and services. We even work tens of hours every week for it. The truth is that our lives revolve around obtaining and using this object.

Money

But how exactly does money work?

Who produces it and who decides its value?

Is it possible to manipulate it to generate changes in an economy?

Let’s find out.

The Evolution of Money

Barter and Commodity Money

Before the existence of money, primitive communities had a survival economy. People consumed what they found and produced. Money had little to no use to them since the concept of trading didn’t exist yet.

Primitive Economy

With the invention of agriculture, people had more than they needed to survive. This opened the doors to trading their leftover products for other goods they needed (a.k.a barter). Barter was the simplest form of exchange but without it, money would’ve never been born.

Barter

But barter wasn’t efficient. If you wanted to trade apples for wood, but the person that had wood wanted wheat not apples, you would need another party that wanted apples for wheat. Imagine how hard and inefficient barter was.

So we needed something of value that most people would accept as payment.  And that’s why commodity money was born.

Commodity money is something that has a real value, which can be used as a medium of exchange. They were usually non-perishable products such as metals and salt. Nowadays, commodity money is still present in some places, especially prisons. Products like cigarettes and liquors are used as commodity money in prisons.

Commodity money was usually precious metals like gold and silver. People determined the value of a piece of metal by its weight. But under this system, it was common for some people to try to defraud others by paying with metals that had less value than they appeared.

Commodity money definitely worked better than barter. But people realized they needed a system that certified the value of metals.

Coinage and International Trade

Governments started molding these metals into coins. This made sure that each coin had a certain amount of metal, thus a more accurate value. This system greatly improved the security of trading and reduced fraud.

Coinage

Coins were incredibly useful for local transactions. But with the end of the Middle Ages and the expansion of international trade, traveling long distances with all your hard-earned coins was unwise. Aside from its weight, you would be prone to robbery.

So how can people keep their fortune safe even if they travel great distances?    

This problem was exactly why banks and “notes” started to appear.

Let’s say you’re an Italian merchant from the city of Venice. You wanted to travel to Genoa to buy textiles but bringing all the coins you need wasn’t safe. Your boat could sink or pirates may even attack you. Goodbye to your fortune when that happens…

Banks solved this problem. You could now visit a bank near you and deposit your gold in exchange for a promissory note for the value you deposited.

Promissory Note

Eventually, you arrive in Genoa and go for your textiles. You give the promissory note to the seller and receive your textiles. You happily return home with the merchandise. The seller goes to the bank of Genoa where he delivers the promissory note.

If the bank belongs to the same family as the bank in Venice, the seller can withdraw the gold with the same value. But if the bank belongs to another family—and the bank of Venice is reputable, they would buy your promissory note for a value lower than the one given in the note.

But what if the seller does not change the promissory note for gold?

What if he used it to pay someone else?

And that person does the same with the note, passing it to someone else.

That note allows its holder to claim a certain amount of gold, but no one claims it. The note effectively takes the value of the metals it represents, as long as the reputation of the bank that issued the note is maintained and that its holder is sure that he can withdraw his gold anytime.

That’s how paper money was invented.

Banknotes and the Gold Standard

Promissory notes can have any value but its value is always equal to a person’s deposit. This made trading somewhat inefficient and complicated. To simplify the system and make trading more efficient, banks created the banknote.

A banknote is a promissory note with a standardized value. So instead of giving you a note worth (e.g.,) 260 coins that represented 1000 grams of gold, they would give you ten bills with a value of 100 grams of gold each.

This system allowed people to use a few notes at a time for every transaction. Buying goods and services was now easier and more convenient.

Gold Standard

As soon as banknotes were invented, banks started issuing their own banknotes. Eventually, different currencies circulated the economy but most were only accepted locally. Well, except for the largest and most recognized banks.

Governments across the globe then started limiting the right to produce money to the central bank. This forced all commercial banks to operate with the same currency. Still, money represented a fixed value in gold. Banks gave faith that their customers could withdraw their gold when they wanted to.

This system was called the gold standard. However, it collapsed during the twentieth century. Switzerland was the last country to abandon the gold standard in 1999.

But what happened?

The End of the Gold Standard

The gold standard was pretty stable—well, most people thought so. Having your money tied to a precious metal limits government spending to their gold reserves, which is completely fine in normal times.

But what if a country needs a large sum of money to face a crisis? Such as war? This was the problem the world faced during the first half of the twentieth century…

The World Wars forced many countries to stop the convertibility of gold. Why? Well, most countries didn’t have enough gold to finance their military defense. They stopped the convertibility of gold to print as much money as they needed to finance their military efforts.

Yes, countries were able to buy guns, soldiers, and machines… But having too much money circulating the economy caused hyperinflation. Money rapidly lost its value.

Fearing people would start claiming their gold before money lost more value, governments proclaimed that money could no longer be exchanged for gold.

End of Gold Standard

After the Second World War, the United States was the only world power that had preserved the gold standard. During the conference of Breton Woods, the participant countries agreed to tie their currencies to the value of the dollar which was still tied to the value of gold.

This allowed other nations to buy dollars and trade it for gold in the United States. This system worked well for a while. After all, the United States owned more than half of the world’s gold reserves.

But by the early 1970s, the Vietnam War and a negative balance of payments increased the United States’ debt. This made the dollar overvalued at the exchange rate at that time ($ 35 per ounce of gold ).

In 1971, several European governments began to lose confidence in the dollar and started trading all their dollar reserves for gold. President Richard Nixon halted the convertibility of the dollar for gold, fearing a financial crisis for the United States. The Breton Woods agreements needed to be modified.

But this attempt of change, called the Smithsonian agreement, was a complete failure. The dollar was eventually detached from gold in 1976. This ended the gold standard as the international financial system.

Think about it. If today’s money isn’t backed by gold, what is its value based on?

How Modern Money Works

All the bills, coins, and electronic money we use today are called fiduciary money. This type of money is based on the public’s trust and confidence in the currency. What does that mean?

Modern Money

The state proclaims that its currency (Dollar, Euro, Yen, etc.) is the only currency that can be used to exchange goods and services. This decree by the government gives the public confidence that the money they have now will be useful to buy things in the future.

But are currencies assigned a particular value?

What makes a gallon of milk cost X dollars?

And why do prices tend to increase over time?

If you want to know the answers to these questions, you need to familiarize yourself with the quantitative theory of money.

The Math

The quantitative theory of money states that there is a direct relation between the level of prices and the quantity of money in circulation.

This theory is represented by this equation:

M * V = P * Q

Let’s take a closer look at each of these variables…

M = The amount of money in circulation.

V = The speed of money circulation or how quickly money changes from one person to another. As far as the quantitative theory is concerned, the speed of money is constant.

P = The price level or a general measure of the prices of certain products on a given day.

Q = The real value of goods and services produced. This variable changes over time, but we’ll assign it with a constant value.

Under this formula, prices together with production (which is the same as the nominal GDP of the nation) are equal to the amount of money multiplied by the speed at which it moves.

Let’s assume that the speed of money is constant and that production changes too little in the short term to the point of being negligible:

M = P

As the amount of money (or money supply) increases, prices will rise in the same way. This reduces the value of money. A $ 100 bill can no longer buy the same things as before the price increase, i.e. there is inflation.

Inflation

But who is responsible for increasing the money supply?

Is there any benefit in doing so?

Here we will enter into what is called monetary policy.

Monetary Policy

Monetary policy refers to the economic policies that use the money supply to control the stability of an economy. These are usually made by the central bank of a country (such as the United States Federal Reserve) or group of countries (such as the European Central Bank).

Central banks are the entities responsible for printing money, controlling the money supply, regulating interest rates, and supervising the activity of commercial banks.

Who controls central banks?

Well, it depends. In some countries, the central bank is an independent entity where the government has a limited number of votes on the board. But there are also countries where the government has total control of the bank.

What is the central bank’s highest priority?

Every bank sets that. But most of them prioritize on controlling inflation. Why inflation? Simply because it’s one of the factors that have the greatest influence on the economic stability of a nation.

Now, let’s get back to the formula…

Recall that M = P.  When the money supply increases, prices of goods and services rise.

So controlling inflation is as simple as not producing too much money, right? Just enough to replace damaged bills and such.

Not necessarily. While limiting money supply helps control inflation, it also has certain adverse effects to consider. Yes, it’s the job of the central bank to maintain economic stability, mainly preventing inflation. But this isn’t the only factor for a healthy economy…

In the next section, we’ll discuss the mechanisms central banks use to control the money supply and the two types of monetary policies.

Monetary Policy Instruments

1. Interest Rates

The central bank is the only bank authorized to print money. But what do they do with the money they print? Do they give it to the government?

In countries where the central bank is controlled by the government, that could happen. For most cases, that money is lent to commercial banks.

Truth be told, even banks suffer from liquidity problems from time to time. It could be that an unexpected number of people are withdrawing money at the same time or there are a large number of loan requests.

Commercial banks can loan from the central bank to cover their short-term cash needs. These loans are usually for one day and have an interest rate like any other loan. Yes, asking the central bank for money has costs for commercial banks.

The interest rate at which the central bank lends money to the commercial banks is the primary mechanism used to control the money supply.

A low-interest rate encourages commercial banks to borrow more often. This allows commercial banks to offer more credit to their customers. increasing the amount of money circulating in the economy.

A high-interest rate makes commercial banks more careful with the money they have because they don’t want to borrow money and pay interests.

2. Reserve Requirement

The second mechanism to control the money supply is the reserve requirement. A high requirement obliges banks to keep a larger proportion of the money they receive, while a low requirement allows banks to use a large part of their customers’ deposits to make loans.

Reserve Requirement: What happens to the money we put in the bank?

3. Purchase and Sale of Assets

The third mechanism is the purchase and sale of assets. These assets can be foreign currencies, gold, or debt.

When the central bank buys assets, they’re increasing the money supply as well by using money to buy these assets. On the other hand, selling assets reduces the money supply because it receives money in exchange for them.

Now that you’re familiar with the instruments used to control the money supply, we can talk about the two types of monetary policies:

Expansionary Monetary Policy

An expansionary monetary policy seeks to increase the money supply. But if an increase in the money supply generates inflation, why would we want to increase it? Well, because a moderate growth in the money supply stimulates economic growth.

Let’s say that inflation is low. The central bank would decide to increase the money supply to stimulate the economy. As we saw in the previous section, this is done using the interest rates. In this case, the rates would be reduced.

By reducing interest rates, commercial banks can now borrow from the central bank at a lower cost. This encourages commercial banks to offer more credit to their customers at lower interest rates.

This affects both the supply and demand in the country. Supply increases because companies and startups can borrow money easier. Demand also increases since consumers can ask for better credits to buy what they want.

The result?  A growth in the economic activity of the country.

Expansionary Policy

This also means that more money will circulate the economy and, as we saw in the quantitative theory of money, an increase in the money supply generates a rise in prices.

More economic activity reduces unemployment and increases wages. But only if the purchasing power of the population increases faster than prices go up. When this happens, the expansionary policy was successful in generating a healthier economy.

In some countries, the central banks have the priority to generate economic growth and keep unemployment low, even if this means neglecting inflation.

Contractionary Monetary Policy

On the other hand, a contractionary monetary policy seeks to reduce the money supply. Since an increased economic activity can have numerous benefits, contractionary policies are only used when inflation is above the central bank’s target.

In this case, the central bank would raise the interest rates for commercial banks. This makes commercial banks less likely to borrow money from them.

If the central bank wanted not only to slow the growth of the money supply but also to reduce it, they would sell foreign currency, gold, and other assets to acquire money and take it out of the economy.

A higher interest rate (or an increase in the reserve requirement) would make commercial banks more careful with their loans. They would also raise the interest rate on credits directed at consumers and companies.

As loans become less beneficial, businesses and people will prefer to save money rather than pay high interests on loans. This makes supply and demand grow at a slower rate.

High Interest Rates

In other words, there would be a slowdown in the economy. This makes it possible to control the amount of money circulating, reduce inflation, and prevent prices from rising.

Summary

  • Before modern money existed, certain metals were used as a means of exchange. When bills were created the value of these were tied to a certain amount of metal, mainly gold. This system lasted until the twentieth century when various situations of economic instability forced nations to detach their currencies from gold.
  • Modern money is also called fiduciary money. Its value comes from being the only means of exchange endorsed by the state.
  • The quantitative theory of money states that there is a direct relation between the level of prices and the quantity of money in circulation. With this theory comes the formula that shows the interactions between the economy, prices, and the money supply.

M * V = P * Q

  • The more money in the economy, the higher the prices of goods. The generalized increase in prices is called inflation. High inflation is a sign of economic instability.
  • The entity in charge of printing money and maintaining economic stability is the central bank. The central bank controls the amount of money circulating in the economy using the interest rate at which it lends money to commercial banks.
  • Low-interest rates make credit more attractive, boosting supply and demand. This generates economic growth, reduces unemployment, and increases the purchasing power of people. However, this economic growth is accompanied by higher inflation.
  • High-interest rates make credit less attractive, so people and companies would prefer saving than borrowing money. This makes the economy slow down but is also an effective way to control inflation.

Money keeps our world functioning and understanding it at its core can help you appreciate its value. I hope this article has been helpful to those who want to know how money works.

Share your thoughts, suggestions, or questions in the comments below! Or follow me on Twitter at @Davkett1 for new articles and stuff.

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