How does Money work?

One of the things that most of us never understand though we deal with it regularly in our day to day life is Money. Though I think that I have an understanding of it, the complex mechanism of how it function makes it a difficult proposition. So, I start writing this article to elaborate my understanding of money with the knowledge I have garnered from various sources.

The intention is more to crystallize my understanding of the functioning of money as a system.

We all have studied in school how trading happened at the early parts of the civilization - The Barter system where people used to exchange material. A fisher would give his fishes to a farmer who gives Rice in return and so on. One can imagine the confusion people would have had, What is the quantity rice that should be given away for 10 fishes ?

So, I think it made a lot of sense to have gold as a standard to value commodities since it is one metal that could never be duplicated. From thereon, I imagine the reason they shifted to a currency is because Gold is a metal that is available limited in quantity.They moved to Copper and Aluminium coins. At some point they had to switch to something that is not scarce and that was Currency notes. Its interesting how they made a piece of paper so valuable. It will be interesting to see how these currency notes transform into digital form and the advent of Block-Chain technology has many interesting things for the future.

But now let us concentrate on money in the form of currency notes.

How did this All start?

If someone wants to borrow Rs.1,000 for a day and promises to return Rs.10,000 the next day, you might not believe him, as magic only happens in Harry Potter movies.

But if that someone is a bank, you better take it seriously. I will try to explain how this magic works.

Suppose there were no banks in the world and the first bank opened today. You go to the bank and deposit Rs.1000. The bank sets a rule that at least 10% of the deposit amount should be kept as reserve and rest can be lent out. It is easy to understand why this rule is set. If banks lend out the entire deposit amount, it will have no money left to meet depositor’s withdrawal requirement. So, banks retain some part of the money to meet their liquidity requirements, before lending out the remaining amount as loans.

Lets say you deposit Rs.1000 with the bank, bank retains Rs.100 (10% of 1000) and loans out the rest to a company seeking a loan of Rs.900 to fund its business. Company uses this amount to buy tools and machinery, from a supplier. This supplier, after receiving the money from company, goes to the same bank again and deposits Rs.900.  In this way, money again comes back to the bank in the form of deposit, but it was 10% lesser than the original deposit amount. The below chain explains this process.

Now again as per thye rule, bank will have to retain 10% of the deposit and can lend rest of the amount as loans. This time bank will retain Rs.90 (10% of Rs.900) and will lend out only Rs.810. Let’s suppose bank lent Rs.810 to a farmer, to buy seeds and fertilizers. The farmer bought these from a fertilizer manufacturing company. The company, after receiving payment from the farmer, returns to the  bank to deposit the money. Thus money again came back to the bank in the form of deposit, but it is 10% lesser than the deposit amount of Rs.900.

The process can be seen in the following flow chart.

This process will keep on repeating. Every time bank receives a deposit, it will retain 10% of the deposit amount and lend out the balance.Sum of all these deposit amounts (Rs.1000+ Rs.900 + Rs.810 …) will at some point add up to Rs.10,000.

When the Magician(Banks) says they will convert Rs.1000 to Rs.10,000, you better take it seriously.

So, Imagine a network with many banks, companies producing products and services, Consumers of products in different countries with so many transactions. This way the economic activity keeps multiplying across countries and currencies in complex ways to create enormous value of Money within the world.