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Monday, May 14, 2012

So, What's Money, Anyways?

Most people know that money is coins and paper bills issued by a government. But what exactly is money? What's the difference in a coin and a paper bill? Does it make any difference when a coin is replaced by a note of the same denomination by a government? What is inflation, and why should I care? This short introduction might be beneficial if you are not sure about the answers to some of the above.


So, let's start with the difference in coins and paper bills. A 1 dollar note is made up of 100 cents. So, theoretically (or to some extent practically) there shouldn't be any difference in 1 USD and 100 cents; isn't it? Read on to surprise yourself!


A coin has an inherent value. It's usually made of metal of "some" worth. The £1 coin (British one pound) is currently (as in 2012) worth about 4 pennies (or in other terms, the coin's price is 24 times its metallic value).


A paper bill (also known as currency note), on the other hand, is just like a cheque---a promise to deliver you the "thing" of value on demand/ presentation. A £50 pound sterling note cannot be "compared" in any way to its inherent value.


That's why you can "feel" the difference in the weight of a coin of the same denomination over a period of a few years. It's inflation affecting your coins! Sometimes, government replace paper notes with coins. This usually happens when the cost of printing a banknote exceeds the cost of minting a coin out of metal. Again, inflation at work!


So, what exactly is inflation? Most people think of inflation as the phenomena of rising costs of goods. But it's more than that. Inflation is a tool employed by the government to make money out of thin air. Let's take an example out of government bonds issued in a hypothetical currency


Let's say you buy a government bond for 100 cents and the government promises to pay back 127 cents after a period of 5 years (i.e., an interest of 5% per annum). Further, assume that the government doesn't have enough money to pay you back this promised 5% extra money. What it can easily do is to increase the inflation by the same percentage and give you a whooping 27 cents as interest, which in effect makes no difference to your initial wealth [1].




"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens”  - John Maynard Keynes


So, you think that your saving accounts are earning you money? Think again; they are just covering some part of your loss.


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[1] This is, of course, an oversimplification. A government has to go through an awful lot of factors (out of which several are external) before it does something like that.