Do You Know What Money Really Is?

People work for money. People kill for money. People steal for money. People give it away in charity. Money is root of all evil. Money is the solution of all problems. But what is money really?

What is Money?

Money, specifically USD (like Euro and other major currencies of the world), is something called Fiat money. This basically means that it’s a piece of paper issued by the government. It's not backed by any physical commodity. It’s not backed by gold, silver, oil, or anything else. The only reason USD is money because the US government has decided to call it so. Period.

Where Does Money Come From?

Because USD is Fiat money, meaning it doesn’t have to be backed by any real commodity, Central Bank or Federal Reserve (Fed for short) can simply print money into existence. Really. They simply print it. Just like that!

What Gives Money It's Value?

Value of money is determined by supply and demand. Just like anything else.

Let’s say you can buy a goat for $20 (Don’t judge me. I have never bought a goat). If government sends a check of $100 to everyone, amount of money available in the economy will increase. More people will be able to buy a goat which will increase the demand for goats. As a result, goat seller may increase the price of goat to say $25. This is called inflation where value of money reduces.

Similarly, if government took away $100 from everyone (say by tax hike), there will be less money available in the economy. Fewer people will be able to buy a goat which will reduce the demand for goats. As a result, Goat seller may have to reduce the price of goat to $15. This is called deflation where value of money increases.

Value of money is determined by what can be bought in exchange for it. Digits printed on the currency are immaterial.

Who Controls Money Supply?

Fed controls supply of money in economy by setting interest rates for borrowing money from banks. Fed lowers interest rate if they want to increase money supply. Fed increases interest rate if they want to reduce money supply.

What Creates Demand For Money?

Demand for money is created by goods and services produced in an economy. Greater the number of products competing for your money, higher is the demand for money. For example, Apple created demand for money by producing iPhone. People needed money to buy an iPhone, but their income was the same. This resulted in increase in demand for money while supply stayed the same.

Why We Pay Taxes?

“..in this world nothing can be said to be certain, except death and taxes..”

– Benjamin Franklin.

If Fed can simply print money, why does government collect taxes from us? While this is a complicated question, let me give you my two favorite reasons:

1. Government steers our spending behavior through taxes. If government wants us to spend less on something, they hike tax on that spending. If government wants us to spend more on something, they give tax breaks for that spending.

Real Estate is the classic example. There is severe shortage of affordable housing in US. Government doesn’t want to build houses. They encourage us to do the job for them by giving huge tax breaks for investments in Real Estate.

2. USD works as money only because we all have agreed to use it as medium of transaction. Government makes sure that we continue to depend on USD by insisting that we pay taxes, and we pay it in USD. That’s why Bitcoin may never be able to displace USD because we will always need USD to pay our taxes.