Money really makes us all wealthier because money is a catalyst of overall trading and business. Here I wouldnt like to judge whether it makes our world better place to live or not. Personally, I believe that inventing it was a good thing.
Another question is why this money-and-banking article is placed here on Charming Engineering? Because I am sure this is an engineering thing. Economy is more engineering than people are aware of. Of course, there is much more about money than mentioned in this article, but not everything about money has to do with engineering. In addition, not everything about money is charming.
What is money? Well, money is an item on the market - more or less like any other item on the market (like potatoes, spoons, blankets, oil, airplanes or labor hours). But money is not only coins and banknotes today, money is often a more abstract item.
On the market, generally, any item can be traded for any other item. This includes money. You can trade potatoes for spoons or spoons for money or money for potatoes or any combination you like all this, of course, if you are able to find an interested buyer/seller. But somehow, you notice, money takes part in almost all transactions on the market. Almost no transaction is performed without money (direct barter). This is not only because law requirements, but more importantly, because people like it that way.
Money is so good for trading. Almost everything is tradable for money (but not for spoons or potatoes probably the only item on the market that you can trade for a spoon would be well, money, of course). This makes money wanted. If more items are tradable for one currency, more new people will be interested to trade with it some sort of, as we engineers usually say, positive feedback rules here. At the end, there will be only one (or only few) highly accepted currency on one market.
This is how you can measure the strength of a currency. A strong currency (like US dollar) would be easily tradable on the market and you could trade it for any other item you like (like house on Florida or house on Croatian coast). A weaker currency (like Croatian Kuna) may buy you house on Croatian coast, but hardly can buy you house in Florida. Even weaker currency (like potatoes or spoons) will hardly buy you anything people simply dont want to trade their houses for spoons and this makes spoons a week currency (however, you can easily trade spoons for US dollars, and then buy yourself a house on Florida). The strength of a currency directly depends on how many things you can directly trade for it on a market.
Money is so good for trading because it is designed (engineered) to be good for trading. This is money main purpose - the tool for trading. Having nice properties, money easily beats other potential currencies on the market (like spoons or potatoes) and becomes one single highly accepted trading item (thanks to positive feedback we mentioned above).
So what are these nice properties that make money so easily accepted as a trading tool. There are some of them:
You may think that money is something artificial, something not real and something that has only synthetic value. But this is not so. There is nothing more artificial in money than it is in a knife or a hammer. Like a hammer is a very useful tool for driving nails, money is a very useful tool for trading. It makes trading easier.
Why is money important to our civilization? Money is important because it makes trading easier. Trading is important because it provides us with better/cheaper goods than we could make ourselves. Trading makes specialization and mass production possible and drives it further. Specialized businesses, in turn, make better/cheaper products and so we are all living better. Money catalyzes our wealth.
But there are also other ways money is used. In addition to being used as a trading tool, it is also regularly used as a measuring tool. It makes us easier to understand how valuable is something if we think about how much money it costs. For example, we may find out that a TV set costs approximately as twenty hours of our labor. Thanks to the fact that value of everything on the market is expressed in terms of how much money does it cost, we can easily compare even such un-similar items like TV sets and labor making our choices easier.
There is one more usage of money saving. Due the fact that it is non-spoilable and that it has a stable value, the money is ideal for saving (accumulating). Saving, in turn, enables capital investments that have good influence on our well-being. Some people also choose to save money because they feel more secure when doing so. In addition, government often urges saving or even forces it (like pension funds in some countries).
Inflation and deflation
How much money should there be on the market? Could it be too much or too less of it?
Not really, I would say. If there were more money out there then people will simply be more eager giving larger amount of it to get wanted goods. It means, that price tickets will simply have larger values printed on them, but it doesnt mean that anything will really change still people will be able to buy the same amount of goods. An analogue thing also happens if there is less money on the market.
It means that the amount of money on the market defines only how big numbers will we see on price tickets and how big numbers represent our wages/salaries, but nothing more the buying power will not change.
Even if the amount of money continually increases over time, nothing dramatic will happen. The overall price level of all goods will follow and the prices will rise. The rising of overall price level is called inflation (and it is mostly, but not always, caused by increasing amount of money on the market).
Small or even medium levels of linear inflation are not considered destructive for economy. In fact, some inflation is believed to be beneficial. It urges people to turn their money because if money is held too long it will lose its value. (Hyperinflation, on the other hand, is not good at all making people crazy how to spend their money as soon as possible.)
Deflation (lowering of the price level) occurs much less common. And is not considered beneficial at all. In deflation times nobody wants to spend a cent, waiting for prices to fall further. This effectively slows the economy.
Governments, generally, do encourage some level of inflation increasing steadily the amount of money on the market. This makes the economy to develop faster. (This, of course, also makes our world is spinning faster than ever before - I hope it is worth it.)
One more note. As people usually produce goods faster than goods are decaying the amount of goods on the market generally increases over time (there are more houses or cars that wait to be purchased, there are even new services emerging). The amount of money on the market must follow this up - otherwise deflation would occur. The government must compensate for this deflation tensions and even add some extra money to generate appropriate, wanted inflation.
What a great invention a bank. On one hand it pays for deposited money. On the other hand it charges for lent money. Sounds a bit odd isnt it?
Okay, first things first.
Lets think about people that want to make a capital investment (like a farmer that wants to buy a new combine). In normal circumstances they dont have that kind of money. If they want to make the investment they will either have to save that money or get a loan. Saving is cheaper but takes much longer. Getting a loan, on the other hand, is more expensive (have to pay interests to a bank) but you can have the money promptly. Which way is better depends on circumstances there will always be people that want to save and people that want to get loans.
In both ways they will use a bank. Saving in a bank is better because the bank pays interests to your saving deposit so you will earn a little or at least compensate for inflation. Similarly, you will go to the bank if you want to get a loan (the only exception being people that have nice, wealthy uncles).
This fact, that there are always people who want to save and people who want to get loan, makes banking possible. Bank, basically, uses money deposited on saving accounts and offers it to people that want loans. In some way, we could say that bank reuses money or that bank enables more efficient money usage.
But this thing about banking gets even more interesting. You probably noticed that you dont need a bank for actions I just described above. Every one of us alone could offer some of their saved money to other people that want loans (plus earn some interests, sure). Why do we need banks at all? Notice that if I lend some of my money to somebody else, then I simply cannot use that money myself as long as I dont get it returned. But the bank can do it better the bank can make a promise that it will return us our savings in full at any moment we want (whenever we need our money).
How can a bank promise something like this if our money is already lent to other people? Well simply, the bank plays a statistical game the bank hopes that not all of its clients will want their deposits back at the same day, so a bank only have to have some small amount of savings held back and everything else can be lent out.
This fact, that a bank can return us our saved money at any moment we want, but still can offer a major part of it to other people is a new quality that banks produce and it is a very important fact. It is important because if we can get our money back whenever we want then we will have the feeling that we really own that money. But not only that we will have that feeling we will also act like money owners (we will allow our selves an impulse shopping for example).
However, please notice that not only people who have saving deposits in banks feel that they have the money for spending. People that got the loans also feel like they really have the money for spending. Whooow! They both simultaneously feel and act like they have money But it gets even more charming once a farmer that got the loan for his new combine buys the combine, its money goes to combine seller. Now the combine seller deposits the received money right into some bank and this bank is now ready to lend it further repeating the cycle. Whooow! This is called money multiplier.
Banks, when present in an economy, perform in the way that they multiply overall money supply on the market. In a sense we could say, banks produce money. Money produced this way is not fake money. The money supply simply increases and this is all real money we all that have that money feel and act as if we have the real money and therefore this is the real money. I like to say that banking makes for more efficient usage of money and this is presented as increased money supply.
(Incomplete analogy imagine that only some people buy cars, but are happy to share them with their non-car-owning neighbors although not many cars would be sold, there would be as many on the streets because neighbors will drive cars around when owners dont need them. This analogy is incomplete because car owner cannot use their cars while neighbors are using them. On the other hand, in banking business you can use your money at any time. That is why banking is so fun.)
I want to stress that this increased money supply (that comes from banking operations) doesnt mean that we automatically become wealthier. Of course not. The effect is similar like printing new money money supply rises but money gets less valuable thus our buying power remains unchanged. The money multiplier is more like side-effect of banking. But banking have some indirect good effect on our well-being. It gives opportunity to people with good business ideas to realize them by getting loans. It also gives opportunity to people that dont have a clue what to do with their money to earn some interest on their deposits. All in all, banks make for more efficient usage of money (but, unfortunately, are also spinning our world faster making us crazy sometimes).
The money multiplier is one interesting thing if you put one dollar into a bank, after some time several dollars will appear on the market. If you withdraw one dollar from your saving account, several dollars will be removed from the market.
Banking is a statistical game. To be successful, a bank must have hundreds of clients. Otherwise it could easily happen that all their clients want to withdraw their money at the same day. The bank would not be able to give them their money a complete disaster situation that can lead to bank liquidation but, even more nasty, can ruin complete banking system (fortunately, there are government bodies that should react quick enough in this case).
One more thing Now, in modern times, nobody caries cache around in our wallets. All we have are small plastic bankcards that we use to pay things. The money is not on the card it is in the bank all the time. This is good for your bank more money in the bank means that more money the bank can lend to other people and earn some interests. It is fun when you think about it: you use your plastic card to pay for pizza. Bank transfers your money to pizza seller account. Likely, the pizza seller has its account in the same bank as you do. For the bank nothing much happened (the bank only earned some money charging the pizza seller for the money transfer service). Now, imagine a monopoly bank in a no cache (only bankcards) world all people and all companies have their accounts in this bank only. Such a monopoly bank would never have to worry about getting any of the deposited money back to their owners it only has to transfer money from one client account to another client account. The monopoly banks can lend 100% of its money further and this money will again settle on this bank accounts. The money multiplier would, in this case, be infinite.
Plying with interests
You know that every bank accounts for larger interests on lent money than on deposited money. The difference is because of two reasons: a) in a real bank not all of the deposited money can be lent out and b) bank owners and employees also want to earn some money on this difference.
Banks earn their money primarily on the difference between active and passive interest rates (spread). Of course, banks also earn considerable amount of money by charging for their services, selling and buying currencies and so on.
Bank, more or less, freely creates its interest rate policy. For example, if a bank has many saving deposits (passive) that require large payments of passive interest to them, but in the same time bank cannot find enough people to lend them all this available money, the bank may be loosing money. In this case the bank can do one of two things. First, it can decrease the passive interest rate to decrease its obligations to deposit owners this will, in longer term, probably decrease overall banks passive because deposit owners will eventually move to a better paying bank. Second, it may decrease the active interest rate to stimulate more people to get loans this will eventually put all banks available money out as loans. Yet, most probably, the bank will decrease both, its active and passive interest rate to some degree.
As overall economy goes through cycles, people may feel more for saving or more for investing. When people prefer saving, they will put their money into banks and will not ask for loans as readily. To cope with such behavior banks regularly decrease their interest rates (both active and passive) to dampen savings and stimulate loaning. On the other hand, when people are more for investing, banks are forced to increase their interest rates.
The overall interest rates are in fact indicating the supply/demand relation of the money on the market. When money is particularly wanted (during investing phase) interest rates tend to grow the one who has the money then can earn a lot by lending it to other people that want it.
Interest rates can show the state of economy cycle. However, it works both ways manipulating with interest rates, banks can govern the economy cycle to some degree.
It is the fact that the economy system, especially with banks around, is generally unstable. There must be a body that will control and stabilize it. This is what Central bank is doing it keeps banking system healthy and keeps inflation in appropriate levels. The Central Bank is usually a government institution.
How? It is not as difficult if you are the one that is issuing the money. Often the Central bank (or a body close to the central bank) is actually issuing the money it owns the money (all we others are only using it). The Central bank can control the amount of money on the market. Also the central bank has the influence on interest rates.
Money normally comes into the market the following way: The Central banks lends the money to other banks (the Central bank charges these banks with some interests). Other banks then offer this money to people that want to get loans (charging them a bit larger interest rate, of course).
Note that considerable amount of money that banks are lending out to loan-askers is actually not from their clients deposits, but is financed from Central bank loans (or even other banks loans). I didnt talk about it earlier, but you probably noticed that primary money had to come from somewhere yes it came from the Central bank.
When the Central bank wants to decrease the supply of money on the market it simply increases the interest rate it charges other banks for lent money. To compensate for this increased money drain, other banks will probably decide to return some loans back to the Central bank, and in same time increase interest rates they charge their own clients. Due to money multiplier the actual reduction in money supply is several times larger than the money returned to the Central bank.
When the Central banks wants to increase the supply of money on the market, it simply deceases the interest rate it charges other banks. As a result other banks see that they can cheaply borrow money from the Central bank and they will probably do so. They also have to decrease their own interest rates in order to lend all that new money to people. Money supply is increased.
Whenever the Central bank sees inflation tensions build up, it decreases the supply of money. This reduces inflation but, unfortunately, can also slow down the overall economy. Whenever the Central bank sees economy slow down it increases the supply of money and reduces interest rates hoping that people will get the loans and start some serious business. This is the primary job of the Central bank walking between inflation and sluggish economy. (But, of course, the Central bank can only influence to some degree if people are not interested in making business, then there will be no benefit from cheap loans, only inflation. Thus all government bodies must be coordinated to achieve optimum result.)
I described very simplified mechanism on how the Central Bank can control interest rates and money supply. There are actually many different ways (open market operations, reserve requirements and other regulations) the Central Bank can issue/withdraw money, but as it seems to me, it is all more or less the same.
The Central bank has all the money in the world the Central bank can create as much money as it wants. Thus earning money is not in Central bank interest. This makes central bank a bit odd institution, different than anything else in the state.
Danijel Gorupec, 2006