Wednesday, May 4, 2011

Money: Much More Than A Medium of Exchange

One thing is almost certain, we all like money. Some of us would like to have so much money that money would not be something we worry about having enough of. Some people in the world have so much money that they don't worry about having enough money to pay for what they need or want. When you have more money than you need, you can invest your money. You can simply put it in a bank and earn interest, or, you can put it with an investment bank and have the money invested in an assortment of investments that will pay you interest, dividends and/or capital appreciation. Money in this form becomes a commodity. People can borrow your money and pay you interest, or, you can buy equity in a corporation and be paid dividends. But, for most of us money is a medium of exchange. If we want to buy food we use money. We don't take our widgets to the food store and exchange them for food. We need money to buy things. But, when we want to buy something very large and we don't have all the money to make the purchase, or, we don't have all the money on a particular date to buy something, we use credit. Credit is a form of money as it allows us to make a purchase when we don't have the money on hand at that moment. Buying a house or even a car might be a more common occasion to use credit. But, when we use credit, we are essentially renting money for a period of time. That rent is expressed as a percent, and we pay that rent over the life of the loan. When we buy a house, we may pay rent on the money we borrow for as long as 30 years. However, when we rent money to make a purchase on our credit card, we pay no rent if we pay the total sum of the money we borrowed at the end of the month. So, in this situation, we might think we are borrowing money for a month rent free.

Banks collect deposits from people that either have more money than they need to carry in their pockets, or people that choose not to carry money in their pockets, but would rather use credit cards or debit cards. Banks can lend a percent of the money deposited with them, but they are required to keep a small percent of that money as a reserve should people want to withdraw their money. If a bank runs short of reserves, the bank can borrow reserves from the Federal Reserve Bank, or, they can buy reserves from another bank that has free reserves. The Federal Reserve Bank can raise or lower the interest rate they charge the bank for these reserves. When the Fed wants to help the economy as it did in the last financial crisis, the Fed might make the cost of reserves for the banks near to nothing, 0% interest. The bank then can meet its reserve requirement and turn around and lend money at an interest rate above their cost of money. The difference between the interest rate that banks borrow money and lend money is called the spread. At one time, banks made their money on the spread between their cost of money and the rent they charged people for borrowing money from them. That was in the old days. Today banks can borrow at near nothing and invest in government notes and make money on the spread that way. Unfortunately, that form of lending does little to help the private sector of our economy.

People can bet with money too. No, I am not talking about going to a casino and betting your money. Since the world has several different currencies, all of them used as money, people with large pools of money can speculate which currencies might go up in value. If you take your U.S. dollars and exchange them for another currency and that exchange rate changes over a period of time, the move back into U.S. dollars may result in a capital appreciation. So, now we have made money by betting on the changing value of money. We can buy Euros or we can buy any currency we want. If you believe that holding your U.S. dollars is not a good thing to do, you can exchange your dollars for a currency of your choice in the hope of that currency going up in value so when you need your money in U.S. dollars you will not only have the amount you started with, but receive more dollars when you exchange your foreign currency back to U.S. dollars.

So, money can take on many forms. It is important to understand that money is not only a medium of exchange for buying things. Money is a commodity that people can rent for a period of time at a rate of interest. But, more than that money's value can change. Inflation is a word that we use to express the fact that prices have gone up and that it takes more money to buy a product or service than it did a period ago. That period may be just a matter of minutes or a matter of years. But, until we all understand what money is and what it can become, the Federal Reserve Bank and the commercial banks will dictate monetary policy in the United States. We, all of us, are part of our monetary system as we all use money, but we need to change the way monetary policy is made in the United States. And, before that happens, everyone will have to understand a lot more about their money. Money is much more than just a medium of exchange.

Stay tuned.


LceeL said...

Thank you, Fred. You have helped me, over the last few years, grow a greater understanding of money in its rarer forms. I hope you continue to do so - even at the risk of repeating yourself. Just think of yourself as a Professor addressing a new class of students. You'll give the same lectures - but to fresh ears ....

and those of us who need reminding.

hezigler said...

And then there are those people who as the economy went into the crapper at the end of 2008 bought gold, then going for about $870 an oz. Gold is now selling for just a little more than $1.5 an oz.

Cloudia said...

you are a great teacher! thanks

Warm Aloha from Waikiki

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