Money is a fascinating and complex topic that can be intimidating for new investors. However, understanding how money works is essential for anyone who wants to make smart investment decisions. Famous economist John Maynard Keynes once described money as “that by delivery of which debt-contracts and price-contracts are discharged, and in the shape of which a store of General Purchasing Power is held”(Treatise on Money, Vol 1). Essentially, money settles contracts and allows for purchasing power through time. Building off this core thesis, let’s explore the multifaceted functions of money, from its role as a store of value to its impact on interest rates, inflation, and more. So, grab your metaphorical financial compass and let’s navigate the foundational landscape of money!
Money as a Store of Value
Money isn’t just about immediate transactions; it’s also a powerful tool for preserving purchasing power through time; it is a store of value. Storing something is a means of saving that thing for the future. Value is a shared desirability bestowed on something. Money was born out of a need to standardize barter and trade. Farmers, for instance, create value through their crops but crops are a poor store of value since they are perishable. So, money allowed farmers to trade their perishable crops for non-perishable dollars. In the beginning money as a storage was for relatively short periods. Nowadays, money is used to plan for decades—retirement.
Unit of Account: Decoding Financial Conversations
A unit of account is a measurement of value that possesses 3 key characteristics: divisible, interchangeable, and countable. Money is divisible meaning it can be broken down into smaller units (cents). Each unit of money is interchangeable with any other unit of the same value. Mathematical calculations can be performed using it. Essentially, It acts as a standard unit of measurement for prices and transactions, and it simplifies comparisons enabling efficient economic exchanges. For instance, you can compare a $4 coffee from one place with a $2 coffee from another place and this allows for a comparison in the difference in “value”–maybe the $4 coffee tastes better, and that taste factor is worth an additional 2$.
Money in Motion: The Medium of Exchange
Have you ever wondered how transactions happen without bartering? That’s where money as a medium of exchange comes into play. Instead of directly swapping goods (e.g., trading chickens for shoes), money was introduced to standardize the barter process. Under capitalism, division of labor (specialization) dominates. However, the downside to specialization is that individuals only produce a specific good/service. Money allows people to trade their singular expertise for a universally accepted good. Imagine an individual selling oranges and wanting a haircut. Instead of bartering directly (finding someone willing to exchange oranges for a haircut), they can sell oranges for money and then use that money to pay for the haircut. It’s the grease that keeps the wheels of commerce turning smoothly.
Interest Rates: The Pulse of Borrowing and Saving
Interest rates are the cost (return) of money. It is the premium paid on borrowing or the premium received for lending money. If you lent someone $100, then you would expect to receive compensation for deferring your ability to spend it. This is why when you take out a mortgage, the interest rate affects your monthly payments and the overall cost of the loan. Similarly, interest rates represent the rate of return on an investment over its lifetime. This leads to what Einstein called the 8th wonder of the world, compound interest; returns in turn earn more return. Central banks control the interest by determining what rate banks can borrow at–and by extension what you can borrow at. This affects the economy because if interest rates are low, people are more likely to borrow, spend, and invest. Interest rates are critical in making informed investment decisions because you’re deferring spending and risking loss in exchange for a rate of return.
Time Value of Money: Why Timing Matters
The time value of money recognizes that a dollar today is worth more than a dollar in the future. Meaning, money grows and compounds through time at the appropriate interest rate. Thus, $100 today is worth more than $100 in the future. Interestingly, since money’s value can be determined forward through time, it can also be discounted back in time. Therefore, money can be valued at any point along the time continuum. This is important for making investment decisions because you can assess what value you can expect to receive in the future based on, among other things, the interest rate.
Inflation: The Erosion of Wealth
Inflation refers to the general increase in prices over time. It erodes the purchasing power of money. Inflation is the balance between growth and stability. Growth is necessary for economic progress; it is essential for a healthy economy as measured by Gross Domestic Product (GDP). But, growth also leads to inflation because as more value is created then there is more money to buy goods/services, which in turn creates competition, which raises prices. Central Banks understand targeting a low stable inflation rate is key to long-term growth in the economy. But, this also means, that this low stable inflation degrades the value of money. So, although a dollar today is the same as a dollar tomorrow, the actual value of that same dollar in the future will be less than it is today. For instance, a bottle of Coca-Cola was about $0.05, today it is approximately $2.7. This is why it is important to invest excess capital because otherwise, it will slowly degrade, at the average rate of inflation over long periods.
Investing and the Stock Market
The stock market is a market where stocks and other securities are bought and sold. It is a place where companies can raise capital by selling either debt (bonds), or ownership shares (Equity). The stock market is a simplified hub where borrowers/lenders come together. People with excess capital want to invest to produce a return above inflation, and borrowers need capital to create value. This system is also very efficient and offers other benefits such as price discovery, regulation, liquidity, diversification, and opportunity. Anyone with excess capital can open an investment account and have access to this market. This system has developed into a fundamental means of saving for the future. The stock market (S&P 500) has a proven historical track record of providing an average annual return of approximately 10%, so it makes sense to allocate some capital there over long periods. As a simplified example, $100 invested in the stock market today would return $673 (100*[1.1^20]). The dollar amount may not seem overly compelling, but that’s roughly a 700% return!
Conclusion
In conclusion, understanding how money works is essential for making smart financial decisions. Money is not just a means of immediate transactions, but it also serves as a store of value, a unit of account, and a medium of exchange. It is affected by interest rates, inflation, and the time value of money. By understanding these concepts, you can make informed decisions about borrowing, saving, and investing. The stock market provides an opportunity to invest excess capital and produce a return above inflation. Therefore, you can shape your financial future by learning about the basic principles of money and investing wisely. Thank you for reading!
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