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Financial Literacy | Food for Thought | Why We should Learn Finance?

January 24, 2017

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Financial Literacy | How Money Works? (Part1 | Chapter3)

February 15, 2017


Part 1                      Finance, the Big Picture


Chapter 3              How Money Works?



Money… What is money and how does it work? What functions does money serve? Although this piece of paper doesn’t have any intrinsic value, it serves various purposes in our society.


First of all, money is a medium of exchange. Before the invention of money, barter was the only way of making any transactions. If you wanted something that you didn’t own, you had to find someone with the exact opposite need. For example, if you harvested a bushel of wheat and wanted to exchange for a pound of meat, you had to find a butcher who wanted a bushel of wheat for this meat. However, after emergence of money, you don’t have to knock on every butcher’s door in town, but rather simply buy meat using money that you earned by harvesting wheat.


Money also measures the value of goods and services.


By comparing the price of goods and services that are expressed in unit of money, you can compare the price, and decide whether it deserves its price.


Lastly, money stores value.


You can accumulate wealth through saving excess money, and prepare for the future.


As you can see, money serves various functions in the modern society, and is a vital part of our daily lives.


Now, the question is: who creates money? And how does it circulate?


In the United States, Federal Reserve is the only entity that prints real money, which is called the base money.


After creation, this base money is injected to various financial institutions, but mostly to depository institutions such as commercial banks, thrift institutions and credit unions. This base money then gets multiplied by these depository institutions.


Let me explain what I mean by “money getting multiplied”. Let’s say you are trying to buy a house.


And you go to a bank to apply for a mortgage loan.


When your application gets approved, you either wire transfer or write a cheque to the seller of the house. In this case, no base money, or physical cash is involved in the transaction, but only the numbers in your and seller’s bank accounts change.


Or let’s think about our pay cheques. Nowadays, most people get their salaries via cheques or bank transfer, not cash. Companies use their ‘virtual money’ in their accounts to pay out to their employees.


Similarly, more and more daily transactions are processed through credit cards and debit cards. When you buy goods and make payments with your credit card, the credit card company pays to the retailers with ‘virtual money’ to their accounts. No base money again.


In modern world, a lot of transactions occur without real physical cash or base money, and this trend will continue. Due to this lack of need of physical cash, the depository institutions don’t need to hold all the base money.


Although they still need to hold some portion of the base money in Federal Reserve System to fulfil reserve requirements, they can freely lend and borrow without the physical cash in hand. This is an important function of depository institutions, and how money gets multiplied.

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