Wikipedia says “Money is any item or verifiable
record that is generally accepted as payment for goods and services and
repayment of debts, such as taxes, in a particular country or socio-economic context.
The primary functions which distinguish money are as a medium of exchange, a
unit of account, a store of value and sometimes, a standard of deferred payment”.
Let’s simplify it: Money is something we pay
when we buy some goods or services. We generally see it as coins, currency
notes or Bank deposits wherein we pay through cheques, debit cards or through
other payment mechanisms including mobile and internet banking.
Let’s create a simple model to understand
money. Assume there are only 26 people on earth with names A to E. These people
have lands, tress, water and other such natural resources. Some possesses lands
and cultivates crops, B is a hunter, Others are trader, gold miner etc. Everyone here likes gold and hence is valued
more than crops or meat and other such items.
Hence many a times D who has plenty of gold, is
robbed by others. Hunter(B) is the strongest of all and hence no one attacks
him. So, D goes to B asking if he can keep his gold safe with him. In return,
he can keep 5 % of gold every year and B agrees as he finds the idea
profitable. B writes on a piece of paper the amount of gold he has in deposit
by D and hands it over to him.
Similarly other members also start depositing
their valuable items like grains, gold and other such items with B and in
return get the piece of paper with the account of their deposited items. Since
everyday many people deposit and withdraw their items, B is not able to keep a
record of who deposited what. So, whoever comes with a note written by B, he hands
over that item to the bearer of the note.
people live very far from each other, but they
identify the handwriting of B. One day, D goes to buy land from A but instead
of paying in form of gold, he hands over to A, one of the gold deposit notes
issued by B. A happily accepts knowing if he goes with this note to B, B will
hand him over that amount of gold. Similarly, everyone who buys something from
others, start paying using the notes issued by B over the deposits of valuable
items made by them.
These notes written by B on a piece of paper
over deposits by others has hence started being used by money and B has started
acting as bank. More people are born and they follow the same increasing the
number of such B issued notes on earth. Other hunters who are also very strong
are amazed by this scheme of getting profits in terms of fee by just storing
others items and they also start accepting deposits and issuing deposit notes.
Thus many banks are born as a result.
People start depositing their valuable items
with the nearest hunter. But people
start finding. It difficult when trading with people from far off places as
people over there prefer to accept notes issued by hunter in that region and vice
versa. So, the people instead had to withdraw gold from these hunter banks in
order to pay for distant trades. The deposits of these hunters start to
decline. So, all these hunters who run such deposit banks decide to meet one
day and agree to accept each other’s notes. At the end of every year, they meet
and settle their accounts. For example, if B has a note issued by P worth 100
grams of gold and P has a note issued by B worth 80 grams of gold, they can
exchange the notes with P paying B additional 20 grams of physical gold. That’s
how when we pay from one bank account to another bank account, these banks
periodically settle their accounts.
These multiple notes created confusion among
people who found difficult to identify and verify the authenticity of notes of
different hunter banks as they could not identify and remember large number of
hunter banks handwritings. So, one day, the strongest of the hunter banks
called a meeting of all hunter banks. Let’s call him R. He gave a proposal that
he will issue a uniform note representing 5, 10, 50 and 100 grams of gold to
all other hunter banks against gold deposits by them which they can in turn
issue to their depositors who now will find easy to identify and transact using
the note.
This in turn created the central banks like
Federal reserve in US and RBI in India, which we see today.
The good thing is that the availability of such
money makes it convenient for us to buy and sell thing. In absence of it, if
you are a farmer and produce crops and you want to buy gold, you will have to
search for someone who wants to sell gold and wants grains in return. In
economics parlance, this situation is called double coincidence of wants. Such
situations limit trade and creates difficulty for the buyer. But everyone is
ready to receive money in exchange of goods and services they sell because they
are confident that they can use this money to buy things they want. Another
significance of money is that it makes easy for us to calculate the value of
any items in terms of its unit. Otherwise, if me and use were exchanging grains
and buffaloes, it would be difficult to calculate and compare the value of one
in terms of others. This feature of money is said as unit of account. In
addition to the above mentioned two prominent functions it also is used to
store value because it is easy to store money instead of storing grains and
buffaloes which can perish with time.
So the money in its current form inherits value
from the fact that we are assured of its acceptance when we buy anything. And
this assurance comes from the central bank of india who promises to pay any
currency holder an equivalent value if he/she takes the currency to him. This
promise is written on the currency notes.But the money and banking didn’t stop
here. It continued to evolve. We will discuss two scenarios to understand the
same.
The hunter bank B now issues notes which is
accepted by everyone. Lets say it currently has deposits of 100 grams of gold
against which it has issued 100 notes representing 1 gram of gold each. Now a
person in need of gold comes to him asking to lend him 5 grams of gold and he
will return it with 6 grams of gold after an year. B has 100 grams of gold in
deposit which is lying idle so he things this is a good opportunity to earn 1
gram or 20 % profit. He knows that not all depositors would come with deposit
notes asking for gold together. And anyway after an year he will be having all
the golds against his deposit notes when the borrower returns it after an year.
He can even choose to issue 5 notes representing 1 gram of gold as his notes
are accepted in the market and hence starts lending to borrowers in need to buy
anything.
So, if he has issued loans to 5 people worth 25
grams of gold by issuing 25 notes, there are 125 such notes in the market but
he has only 100 grams of gold. The borrowers would use this note to buy
something from the market by paying through the notes and the seller in the
market gets those notes. Now imagine what if all the bearer of those notes come
to hunter bank B asking for equivalent amount of gold. He cannot redeem all the
notes because there are 125 notes in the market representing 1 gram each, but
he only possesses 100 grams of gold. This is how the banks are designed and
operate and hence if all the depositors come together asking for their deposits
to be redeemed, the bank is programmed to fail.
But in an economy, the government and the banks
allow this mechanisms because using the borrowed money, people can start
businesses earn profits and repay the loan. This creates more products,
employments and income which can make everyone better of. Also people can
borrow to purchase items now and can pay later using the income later. All this
generates more income, more jobs and more products and survices leading to
expansion of the economy.
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In the
above context everything seems fair and everyone is betterof. But this rosy
picture holds only till the loans are repaid timely. When the borrowers start
defaulting on the loans and do not repay, the bank is left finally with the
same 100 grams of gold against 125 issued notes because the borrowers who
borrowed the 25 notes didn’t pay anything. And so the banks crumble in that
case.
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