What is Money?

In my quest to find wealth, I came across a need to understand the main component that symbolizes wealth, and that is money.

To understand money in today’s context, let me try to illustrate in an easy to understand fashion using Singapore as the main reference.

There is an island on the planet of Gaia called Merlion City. This city is run by a central government under a democratic political system. It has a relatively short history of less than a century, compared to other nations on Gaia which were built on civilizations over millennia.

To run the city, the government needs revenue, which means income/money. This money is used for things that makes Merlion city a better place to live in, things like building of roads, feeding an army, maintaining of law and order, supplying of water, transport and everything nice.

The form that this money takes is called a currency. For ease of reference, let’s just use “$”. Different nation has different types of currency, after millennia of evolution, currency has evolved from sea shells, to ingots, to paper, to today’s synthetic polymer notes and alloy coins. To sum it short, a currency is a medium of exchange that is accepted by the general population. It is redeemable of something else that is of an equivalent value.

Merlion city has an approximately $20 billion worth of notes, coins and demand deposit circulating in the economy.

The nature of this currency is Fiat money, which means money that does not have any intrinsic value determined by a physical commodity, and derives its value by being declared by a government to be legal tender. In another word, the worth of the currency is determined by the government and all will accept it is as a mode of exchange by law.

This is opposed to the original form of money known as commodity money. Basically, money that derives it worth based on a physical commodity (e.g. gold).

My first encounter with this difference between the 2 types of money nature inspired me to further inquire about the differences and the consequences of each nature. 1 of the biggest difference between the 2 types of money is their Seigniorage Gap.

In essence, the nature of fiat money allows unlimited production of money so long as the general population still has faith in the value of the currency as a means for the government to settle its liabilities. This often causes greed for more from nothing, which results in hyperinflation (money becoming worthless, countless civilizations had fallen because of this).

On the contrary, commodity money runs the risk of being converted to their material use when the token is worth more as a commodity than as money (e.g. receipt that redeems 1gram of gold is only worth 0.9gram of gold; owner of 1gram of gold becomes unwilling to exchange it with the receipt and uses that gold as a material instead, resulting in insufficient tokens to represent measurement of exchange)

There are of course many more significant pros and cons for both nature of money, but to list them here would be too space consuming. For the sake of not making this too dry, let’s jump to the optimum nature that money theoretically should take: Fiat money that is strictly monitored and disciplinarily managed by wise government with sound fiscal policies of selfless interest.

Let’s assume that Merlion City has such wise government and the fiat money system is safe. This puts confidence into the people holding onto the currency, and thus encourages people to save. Knowing that the money they possess today can be exchanged for something of similar value in future allows people to confidently deposit the synthetic polymer notes and coins in banks instead of hoarding food, clothes, water, oil and anything tangible in their store.

However, money of today is never equal to the money of future. Value of money rarely remains stagnant. It is either eroded by Inflation; or growing by earning interest.

Inflation: A bowl of noodle that costs 25 cents 20 years ago, costs $2.50 today.

Interest: $100 in a bank account giving 0.1% interest per annum (p.a) will become $101 in 10 years.

Over the past 50 years, Merlion City has an average inflation rate of 2.7% and interest rate of 1.7% (note that the interest rate here refers to the rate of government bonds and not interests given by banks in saving accounts). To simplify, a $100 placed in a fifty years bond will have a future value of $378.90(2.7% growth compounded over 50 yrs) but monetary value equivalent to $60.50(1.7 - 2.7 = -1% growth compounded over 50yrs) of 50 years ago.

We can derive 3 meanings from this calculation:

#1) Future value of money increases as it earns interest in investments.

#2) Intrinsic value of money is eroded over time by inflation from $100 to $60.50.

#3) Purchasing power of money decreases by inflation, $378.90 = $60.50 fifty years ago

This is one concept of money today that we have to understand before we move on other concepts. You have to understand this basic concept which is known as Time Value of Money and realize that $1 today will not be equal to $1 tomorrow.




http://www.tradingeconomics.com/
http://www.singstat.gov.sg/stats/themes/economy/hist/histbop.html
http://www.guidemesingapore.com/relocation/introduction/singapores-economy

http://wfhummel.cnchost.com/unifiedview.html

Sources where data was collected for reference

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