Where does Money get its value from?
Have you ever pondered how money itself obtains its value? You probably have but you didn’t ask yourself that question in that way. You would’ve asked it like this, “How is it that I can go to Mexico and buy 10 times as much for $1 as I could in the US? I will attempt to enlighten you on this subject.
Up until 1971, The US Dollar was backed by gold. This means that at any point you could trade your Dollars in for gold (in theory). Today, Dollars are tied to a system called Fiat Money (Fiat-Latin for Faith). The reason for this was because the US economy was far exceeding the world’s gold supply. Today, it’s backed by the fact that if you use a Dollar, you have faith that you will receive a product in return. That product is the called Gross Domestic Product.
You learned that wealth is assets, not money in chapter 1. The US Dollar is based Gross Domestic Product (GDP). GDP is the total amount of products and services produced within a country’s borders in a certain time, usually one year. Click here for the specific definition.
Currency is directly tied into a country’s GDP. Also known as Production. How’s that? Well, imagine that four people started a country. They obviously need a form of currency for their respective countries. The first guy named Adam names his currency the Alpha Dollar and his country produces one fork. The second guy named Ben names his currency the Bravo Dollar and his country produces one spoon. The third guy named Chuck names his currency the Charlie Dollar and his country produces one knife. The last guy named Don Names his currency the Delta Dollar and his country produces nothing. Remember, Currency is based on goods produced.
Adam might want to buy Ben’s spoon with Adam’s own currency, the Alpha Dollar. Will Ben accept Adam’s currency? Yes. Ben might want to buy Chuck’s knife with Ben’s own currency, the Bravo Dollar. Will Chuck accept Ben’s currency? Yes. Chuck may want to buy Adam’s fork with Chuck’s own currency, the Charlie Dollar. Will Adam accept Chuck’s currency? Yes. This scenario may continue to play out each year. It may get to the point that although each country has their own form of currency, they never actually make purchases with their own currency because one of the other guys will have current possession of their currency.
So what of Don’s currency, the Delta Dollar? Don wanted to purchase products, but did Adam, Ben or Charlie accept his currency? No. The reason was because they didn’t have any faith that they would be able to receive a product if they went to Don’s country to exchange the Delta Dollar. In other words, there was no production activity in Don’s country during that year. Don’s money was worthless.
On the other hand, Adam gets a bright idea to make two Alpha Dollars so he could buy more products. What happens? Well, Ben and Chuck catch on to the trick and now demand that Adam pays two Alpha Dollars instead of one. Why? The reason is the same as the situation with Don. They don’t have faith that they will receive two products from Adam’s country. They’re right because if Ben and Chuck tried to exchange each of their Alpha Dollars for one fork, one would get the fork while the other gets stuck with a worthless Alpha Dollar in their hand. Adam attempted to inflate his Alpha Dollar. This is commonly known as inflation.
Ben’s country decides to produce two spoons thereby doubling production in his country. What happens? Ben’s Bravo Dollar has double the buying power it once did. Now Ben can go to another country Such as Chuck’s country and buy his knife for half a Bravo Dollar or 50 Bravo Cents. The reason is because Chuck has faith that he will still get two of Ben’s spoons for 50 Bravo Cents each.
Now the United States today has a $15 Trillion GDP. The next five biggest Country’s in terms of GDP added together wouldn’t match the United States. That’s why US Dollar is the strongest and most stable currency on Earth. But, it’s being threatened by bad economic policies. We will dive into these bad policies in the future chapters.
Why does a pack of gum cost 89 cents, not 89 Dollars?
The simple answer is called Supply and Demand. But, this isn’t so simple because a wide swath of the US population has no clear understanding of what supply and demand is and how they interact with it on a daily basis. We will attempt to tackle this in Chapter 2.
There is no resource in this world that is infinite. All resources have to be rationed to one degree or another. This happens through the economy. Economy is just way to move products, goods, and services from the people who are will to provide them (supply) to the people who want them (Demand).
You demand gum and someone agrees to sale you gum for $1. You buy the gum and all is well. Your demand for gum is satisfied, therefore your demand for gum is gone. Tomorrow, however, you want gum again. Now your demand for gum has returned. There is a twist this time. Someone else wants gum as well. What’s going to happen? The price will rise until one of the two individuals says they no longer want gum at the higher price. The first individual who no longer wants the pack of gum ceases to have demand for it. The second individual will purchase the gum at a higher price. We’ll say $2. Remember, the first individual only ceased to have demand because of price, therefore if the price comes down the first individual’s demand for gum will resume. That means the price of gum has to stay at $2. Value as explained in chapter 1 is the how much money it would take for you to part ways with it versus how much another person is willing to spend to part it from you. The value in this case is $2. Does the price of gum have to stay at or above $2? No. There are ways to bring the price of gum back down to $1 and satisfy both individuals demand for gum.
Someone out there sees that you are in demand for gum and he recognizes an opportunity to sale it to you. He also sees that you lost demand at $2. He’s going to sale it to you at $1. He accomplishes 3 things at that moment. First, he satisfies your demand for gum. Second, He undercuts the competition’s price because the competition can no longer sale at the higher rate. Lastly, he increases overall supply of gum.
The job of the supplier is riskier. Unlike the person who can just wake up and simply demand gum out of clear blue sky, the supplier has to calculate how many people are demanding a pack of gum. He also has to anticipate for how long the demand will last. Is this demand a fad, therefore it only last days or weeks, or is it long lasting and people will depend on these packs of gum for years to come?
Also, we think that demand comes before supply but sometimes it doesn’t. What if gum was invented today? Would you be in demand for it? Probably not. However, demand would grow over time as people tried gum, it becomes beneficial to their daily lives, and the benefits of gum spreads to others.
What would the initial price of gum be if it entered the market today? It would be high. Let’s say $10 per pack of gum. The reason is because the supplier had to risk his own capital (means money) to put gum on the market. Who would buy a pack of gum at $10 per pack? The rich, of course. However, the price of gum will fall as the supplier is able to get back his return on his investment, up production, and as other suppliers enter the gum market.
You might think that you have never seen this phenomena but you have. Think about the first iPhone when it entered the market and the subsequent competition that followed such as Androids. Think about limited availability of smartphones in 2008 versus the availability today in 2013. What is the overall effect of Supply and Demand on the Economy? We will continue to explore this phenomena in subsequent chapters.
Invariably, this question always comes up. Why can’t money just be printed and given out to people who need it? This question shows that most people have no fundamental understanding of how money works. The lack of knowledge in this subject is very understandable given the huge debacle in Public Education today. I will attempt to give you a better understanding of why this doesn’t happen without consequence. I will also explain why this shouldn’t happen in my multi-chapter series.
Chapter 1 – What is Wealth?
Today I’m talking about wealth and what it means to have it. If we were having a conversation face to face I would ask you, “What is Wealth.” You would think about the question for a minute or two and you would answer, money. I would then have to tell you that you’re wrong. People say that wealth is what they have in their wallet. No! Wealth is not what’s in your wallet; Wealth is your wallet.
Your wallet has wealth because you, the owner, assign it value. You value it because your wallet is an asset to your daily life. It makes you more organized. Think about how you would maintain your money if you lost your wallet for some reason. Coins, credit cards, and cash would fumble around in your pockets. You may lose your money. No matter what, you would wish you had your wallet back. That wish to have it back is you understanding the value of that wallet. It’s valuable simply because your life is better with your wallet than without.
I used a wallet as an example but it’s not just a wallet. It’s everything we have in life. It’s your iPhone or Android, your car, electronics, and other things. All of these things are valuable to you. The biggest purchase most people ever make in their lives is a home. It’s the most valuable possession most people have. We commonly refer to our homes as an asset but all items we possess is an asset. That’s why you can borrow money against your home. It’s your most valuable possession or largest asset. The bank takes the home if you don’t pay the bank back. You become wealthier as you accumulate more assets. When the news speaks of rich people’s wealth (such as Bill Gates, Warren Buffet, and Jay-Z), they are talking about their assets, not their money in the bank. Their assets are usually investments or companies they own.
Other people want the same items you have to help improve their lives and are willing to negotiate an agreement to acquire what you have. They would’ve bartered in ancient times because there wasn’t any currency. The problems with bartering are it’s usually a one for one swap. For example, you want to make a hot dog. You only have a Weiner but no bun. You go to your neighbor and trade him your Weiner for a bun. How did that work out? It didn’t. Now you’re stuck with a bun but no Weiner. Or, you want to trade your bun with your neighbor but your neighbor is asking for your house. That’s not a good deal. This is why currency was invented.
Currency (or money) is simply a means of exchanging wealth without having to give up assets. Now I can go to my neighbor to buy a bun from him in order to make a hot dog for lunch. Also, the advantage of having currency is you can assign value to your asset using an exact point system. It’s called Dollars and Cents in the United States. The value of your wallet in Dollars is simply how much money would it take for you to part ways with it versus how much another person is willing to spend to part it from you.
There has been a number of currencies in the world since the beginning of time. You’ve had beads, silver, gold, paper, plastic, and now digital. Cows are even currency in parts of Africa. These forms of currency, however, aren’t wealth, they represent wealth. We will explore that in Chapter 2.
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