Principles Of Money

[Home]

We all handle money every day. On the surface, it seems pretty simple. It's not as simple as you might like, but it's simpler than you're probably thinking by now. There's some subtleties that, once understood (and perhaps experimented with), can lead to a real mastery of money. Over the next few articles we'll go over what money is, the principles under which it operates, some more complex systems we've built on top of it, and finally we'll look at some of the wisdom surrounding money from different cultures and eras throughout the world.

Click for more details.

Money is bound by several principle factors which determine its functioning, including but not limited to:

With these factors laid out, we can now begin to look at how money flows through the economy.

Principally, money begins its life being created at one of the following:

  • A mint.
  • A national treasury.
  • A central bank.
These entities are generally also responsible for destroying money as well.

Money is generally created and destroyed by these organizations according to supply and demand in order for the money to maintain a stable or target value. This is done by:

  • Giving or collecting on loans.
  • Buying securities and assets from banks.
  • Physically printing or destroying cash bills and coins.
Or any combination thereof.

Overprinting of money should be avoided as it causes inflation, throwing off the balance of supply & demand and devaluing the money. There are exceptions, circumstances under which the government needs the extra cash, such as war or some other crisis with serious economic impact.

A mint is an entity that prints/issues money; this is the root source of the money supply in nearly all systems. A mint may only create new money under certain circumstances; supply and demand dictates that embiggening the supply of a commodity will ultimate reduce the market valuation, and the same applies to the value of money no matter what it is based on, so it follows that the mint will generally only issue new currency when absolutely necessary or when told to do so by its parent organization.

A national treasury is a government agency that sets the value of the nation's money, as well as issuing bonds and other financial instruments to help secure funding for the government. Most nations have a treasury, though not all have a private sector market. In addition, the treasury is generally responsible for collecting taxes (which generates revenue for the government), managing the government's account with the central bank—if the nation has one—by taking out and repaying loans, and investigating and prosecuting tax evaders.

Central banks can further increase or decrease the money supply by raising or lowering their reserve requirements, which dictate how much of their funds banks must hold in reserve. This inversely changes the amount of money banks are permitted to loan out, which effectively changes the money supply.

They can also adjust the money supply by adjusting their interest rates on loans; lowering the interest rate encourages borrowing—thus increasing the money supply—while the inverse is also true.

The money circulation equation is defined as MV = PY, where:

  • M is the money supply.
  • V is the money velocity.
  • P is the price index.
  • Y is the economic output.
This equation—roughly translated—means, The money supply times the money velocity is equal to the price index times the total economic output. What this essentially means is that over a given period of time, an increase in the money supply will mean more money being used in the economy, while an increase in the money velocity will mean that money is moving through the economy faster (i.e., it's changing hands more) which will increase the apparent money supply.

The output is the amount of goods produced in the economy over the given period. To get the total price of the output, multiply it with the price index, which is a normalized average of price relatives for goods, assets, and services in a market. If this number does not equal the other side of the equation it means that somewhere along the line, production did not occur.

The laws of supply & demand are a sort of self-limiting mechanism in the economy, and say that as the supply increases relative to demand, the price decreases; conversely, if the demand increases relative to supply, the price increases. The higher the price of a good, the less people will demand that good, and the inverse is true as well. Governments/other entities who fail to observe this principle ultimately see their currency hopelessly devalued from inflation; see Venezuela and observe their inflation rates.

Inflation is what you get when you ignore the law of supply and demand, and print money when you want more of it in your bank account. Make no mistake, this does not work! All it will do is increase the money supply, which as we've already seen will devalue the money. This will always happen because no economy exists in a vacuum.

Inflation is particularly destructive because it devalues the savings of the people and causes them to become impoverished through factors outside of their control.

As can be seen from what we've gone over, while in theory money can obey the whims of either its users or its creators without restriction, in practice it always obeys a set of laws that are intrinsic to its nature and purpose. If one tries to break these laws, it invariably leads to ruin in all levels of a society.

I hope you've enjoyed this article. If you did, please consider subscribing via RSS so you can be notified of future posts. If you're a Brave user, please consider sending me a tip or adding me to your monthly contributions.