What Determines the Value of Money?

We invented the money as medium of exchange but how are we going to determine the value of money? What do we mean by $1? What do we mean by $100? Who is in charge of determines the value of money?

The value of money has really no meaning at all until we know what is the capability or we call it purchasing power. Technically speaking, only goods or services has value and whether how much the goods or services are worth to you are very subjective from one person to another. Eventually, it is still back to the basic fundamental of economy, supply & demand to determine the value of the goods or services. Let's look at some history how we determine the value of the money...


Very Brief History of Money

Before paper money was introduced, money used to have its value when gold was still used as money (e.g. coins that made by gold). Then later the paper money was introduced to represent the gold. Thus, the Gold Standard Act was introduced, let's say $100 represent 1 ounce of gold. Having $100 is equivalent having 1 ounce of gold. You can basically exchange your $100 with 1 ounce of gold anytime as you wish. This is what it means by “Money is Backed By Gold”. So at that point in time, the value of money is determined by how many the gold you have.

The gold standard was then lasted until 1971 when “Fiat Money” was introduced. The key concept of “Fiat Money” system is money is no longer backed by any commodity (i.e. gold). This is the system that we're still using until today and it is totally based on our confident on the money itself. In other words, the value of money is now determined by your perception, impression or confidence on it. As long as WE THINK, how much money is worth, the money will worth that much. Of course, the “WE” here is not you and me but “EVERYONE” in the globe.


Simple Version (I hope) of Money History

1. Everyone used gold as money (i.e. medium of exchange).
2. Bank came out a standard way to represent the gold (i.e. coins)
3. Coins too heavy to carry around, bank introduced paper money to represent gold (i.e gold standard).
4. Later on, we all confused with this piece of paper is valuable. We forgot that the paper money has value because it is backed by gold. We all started to love money...
5. Bank created more paper money to satisfy our needs even without the actual gold they have.
6. Sooner or later, money was no longer backed by the actual gold. “Fiat Monetary” is born.
7. “Fiat Monetary System” works until today which means the money now gains its value through our impression and perception.

Summary

Money in fact is a very complex topic and until today I'm still learning a very basic question of money: What is money? How money works? I try my best to make it as simple as possible.

To summarize this in few words, the value of money was used to determined by actual gold. However until now, the value of money is getting more complex in a sense that it no longer tights to gold but our impression or perception toward the money. That's why according to economist, only 8% of the world's currency exists as physical cash.

P/S: I talked about perceptive reality few years back and now this topic kind of links it back although my original intention has nothing to do with money. Think of it again, can I say the value of money is perceptive reality?

What is Money and Why It was Created?

In my previous post - simple way to explain the economy, I clearly explained that why people want to trade not only for the benefit of 2 parties but SYNERGY. So, no way we can stop trading. Because of trading, economy exists and so does the money was created too.

A lot of people in fact has already forgotten or have no idea of what money is and why it was created? These are the 2 top answers that I get when I throw the questions out:

1. Money is just a piece of paper.
2. Money was created to make you rich.

I combine these 2 statements and it becomes:

• Money is just a piece of paper to make you rich!

It sounds like money is magic because it is paper that can make you rich. Wow! Don’t you think so? But, are these answers correct? In some ways, perhaps yes?


What is Money?

Money is an agreement by everyone of us to be used as a medium of exchange. If you would like to use stone as your medium of exchange, then you can call the stone as money. Of course if you want to use a piece of papers as your medium of exchange, you can call this piece of paper as money. It was all started with stones, then gold, follows with coins and finally papers. But, why we want this medium of exchange?


Why Money Was Created?

The most direct precise simple answer is – money was created to make our life easier for the following reasons (that I can think of):

• Goods are too Heavy - If I want to trade my cow with your chickens, I need to bring along my cow to you and carry your chickens back. Therefore, money was created to solve this. E.g. I just need to carry a stone instead of cow to make a trade.
  

• Lack for Transferability - I have cow and you have chickens but you don’t want my cow and you want ducks. Then I need to look for people who have ducks that want my cow and exchange with them. Then, I only can use the ducks to exchange with your chickens. It goes very complicated when we involve more and more people. E.g. What if the one who has ducks wants only exchange with goats? So giving all this complication, a medium of exchange is defined which is called money.

• Difficult to Divide - I have 1 cow and I want to exchange 10 chickens with you but the fact that you only have 4 chickens. On the other I want to have ducks as well but the one has ducks agrees only to exchange 7 of his ducks with 1 cow. How can I chop my cow to both you? It is difficult or troublesome to divide my cow. So, a medium of exchange is later invented.
  

To summarize all these, instead of saying money is a piece of paper to make you rich, technically speaking to be more precise - money is an agreement that everyone agrees to be used as a medium of exchange to make your life easier.

P/S: You may also want to read the Financial Big Bang Theory by Michael which I find it quite interesting on how the money was all started. I also like when he described the stranger house as bank.

Having said that, I don’t really sure if I agree when he mentioned the money is born due to the inconsistent trading. Can't we still define or standardize the trading agreement even without money existence?

I think money is born because the goods are too heavy (we don't want to carry them around) and trading with goods (i.e. technical term is known as barter trading) is lack of transferability and ability to divide.