Money makes the world go around. But where does it come from?
Money, as we know it, is more than just a means of exchange; it is a reflection of human civilization's evolution. From bartering to the modern banking and financial system, in this article we’re going to look at all the interesting things around money, where it comes from, how credit is managed and monetary policy.
The origins of money
The concept of money is far from being a recent invention. Historical records trace the existence of money back 5,000 years to the Babylonians, who established a legal distinction between 'exchangeable goods' consisting of commodities like oil and wine and 'non-exchangeable goods.' The idea of money has likely been around even longer than this, predating recorded history, with evidence suggesting the use of cattle as a form of currency approximately 10,000 years ago.
Throughout history, money has ranged from commodity money which are objects possessing intrinsic value, like precious metals to tokens to fiat money represented by the notes and coins in circulation today. Fiat money has no intrinsic value and is not backed by anything of value.
What is money?
Money can be separated from other financial assets as it is a medium of exchange, a unit of account and a store of value. The use of modern money, coins and notes is more efficient than the bartering system where two individuals with precisely matching needs must coincide for a transaction to occur. The store of value functions stems from the face value of physical money remaining constant. Unlike physical assets like machinery, which experience depreciation through wear and tear over time, money does not lose value, save for the real value of money which can erode with inflation. This can however be alleviated by utilizing interest-bearing accounts if the interest earned on that sum aligns with the rate of inflation in the economy during that period. The purchasing power of the quantity will then remain resulting in the real value of this money remaining unchanged.
Banking and Payment Systems
In NZ, money is created by the RBNZ who have the monopoly right to issue physical money and then enters into circulation through private sector institutions such as registered banks. Private sector institutions can also create money by issuing claims on itself e.g., through the acceptance of deposits that can be transferred among members of the public. Customers typically keep their money in the bank for safety and convenience purposes and as electronic transactions become more common, banks can rely on customers only withdrawing a small percentage of their balance e.g., 10%. Keeping this in kind, banks can keep this 10% or a little bit extra for safety on hand and lend out the rest, creating credit. This is more effective than customers lending money to one another the bank performs a useful function in dedicating resources to determine potential borrowers’ creditworthiness which the bank can do more efficiently than its customers. This process of deposits and lending creates new money termed inside money which is generated by the banks.
Money Supply, Inflation and Monetary Policy
The Reserve bank is also responsible for ensuring and maintaining price stability through monetary policy. This function has been performed by the bank since 1999 by adjusting the official cash rate to target and keep inflation within the acceptable grounds. While in the past quantity theory was used, modern monetary policy assesses expected paths of inflation as a consequence of interest. It is typically raised when inflation is pushing up and lowered when inflationary pressures subside. This influences the rates offered by banks as well as supply and demand in the economy and whether incentives exist to save or spend. E.g., when the OCR is increased in response to inflationary pressure, it results in higher interest rates from banks. As the cost of borrowing has now increased, consumer preferences will shift from borrowing to saving. There will now be lower demand for consumption and investment goods easing inflationary pressures. The NZD will also appreciate as demand for NZD interest earning investments will increase.
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