‘What is Money?’ — Explained to a 5 year old
A non-economist explanation of Money, how it is manufactured and by whom
Money — it is the motivation behind all human efforts. Those who do not possess it, need it; those who do, want it even more.
But what actually is money? And how come it fulfils all the above desires i.e. how does it manage to increase its volume constantly? And finally, who manufactures it?
Well, if these questions boggle your mind and the economic explanations fail to reconcile you with these elusive concepts, then try to understand it like a 5 year old — through a long and interesting story.
From Barter to Currency:
Let us take a journey to ‘Goodsland’ — a remote island inhabited by 2 tribes — Grainmen and Woolmen. The grainmen are cultivators and produce 10 kg of grains from their farms and the Woolmen are sheep herders and produce 10 kg of wool from their sheep. The measure of wealth at this time is the quantity of ‘useful’ commodity available with someone.
Grainmen, after fulfilling the requirement of their tribe, are left with 5 kg of surplus grain. The woolmen, after clothing their tribe are left with 5 kg of wool.
The grainmen require clothing for their tribe — for which they are willing to give away the surplus grain available with them; similarly, the woolmen are willing to exchange their surplus wool for grains to feed their tribe. So, the leaders of the 2 tribes come to an agreement — exchange of 1 kg grain for 1 kg of wool.
This is the barter system — exchange of 1 usable commodity with another usable commodity at a mutually accepted exchange rate.
The tribes continued to live a harmonious and mutually complementary lives based on this agreement. However, one eventful day, the tribes witnessed that 10 ‘shiny green sheets’ descended from the sky in Goodsland. On witnessing this supernatural event, they perceived these sheets to be valuable, even though the sheets by themselves had no specific utility.
The leaders of the tribes were intelligent people and found an innovative purpose for these ‘shiny green sheets’. They already perceived it to be valuable, they decided to distribute the 10 sheets equally among themselves i.e. 5 sheets each for both the tribes, and came to an agreement — that they could exchange 1 sheets for 1 kg of their respective surplus produces.
This effectively put this newly found commodity — the shiny green sheets — at one side of barter in each transaction. Owing to this, the measure of wealth shifted from ownership of goods to ownership of these ‘shiny green sheets’. This arrangement was convenient — now, the tribe looking for a commodity need not carry their produce along with them — instead, they could simply carry these light weight, compact sheets as a medium of exchange.
These shiny green sheets in the current lingo are called currency, and can be defined as a commodity, although with no specific utility but have been ‘agreed’ to be valuable and acceptable as for exchange with usable commodities by ‘all the people’ living in a geographical area.
Emergence of Banking and Account balances:
Over time, owing to this agreement, the tribes of Goodsland internalised this currency as a valuable commodity, and they felt that these need to be secured. They decided they will store it with someone capable of protecting them who are trustworthy, so that they return it when asked for it. They knew, just the right tribe for this — the Cavemen. The cavemen were known for their strength, intelligence, honesty, and people of the Goodsland used to store their valuables with them.
The Cavemen agree to do 3 things for the Grainmen and Woolmen –
i. storing their currency with them safely
ii. providing them with a tally of the currency stored with them
iii. and returning the currency to them whenever asked for it
As time progressed, the Cavemen proved to be sincere and correct in maintaining the tally of currencies stored with them and honest in returning the currency to the depositor whenever asked for it.
In fact, the correctness of their record keeping and their honesty in returning the currency back to them was so widely acknowledged that the tally provided by them was sufficient proof of the wealth of the account bearer even though the actual currency was not physically available with the account holder. Therefore, after the introduction of cavemen, wealth had 2 forms — currency as tangible form as and an invisible form as records of account balances.
The cavemen in modern times are called Banks and can be defined as organisations in which ‘all the people’ living in a geographical area ‘trust’ to keep correct account of their wealth. Owing to this, the account balance provided by the bank itself is considered as wealth. Like currency, the source of value of this account balance is the ‘faith of all the people’ in the correctness of records provided by the banks.
Money: Defined
Money is a medium to measure and exchange wealth. Initially, the goods themselves were money, then the currencies became money and in the current time, the sum total of currency and account balances is money.
But why money keeps growing? and who manufactures it?
For this let us revisit what happened immediately after introduction of currency (the shiny green sheets) — the currency was at one side of barter in each transaction. Therefore, once the production of goods increase, money needed to exchange them must also increase. Let us look how the tribes of Goodsland solved this.
As time passed, the population of sheep with woolmen increased and they were able to have 10 kg of surplus wool instead of 5 kg. Incidentally, the population of Grainmen also increased so, their clothing requirement also increased to 10 kg. However, they had only 5 kg of surplus grain to offer. They knew they needed some wealth which they currently did not possess. However, they also knew that their children from next year will be capable of farming and they would be able to increase their surplus grain.
So, they approached the cavemen with their problem. The empathetic cavemen understood the capacity of the grainmen to generate surplus grain from next year and were convinced that they will be able to repay them next year. However, the cavemen were conscious of the following points:
i. The cavemen were only storekeepers of wealth and not the actual owners. They did not possess any money of their own.
ii. The creation of wealth for the grainmen must not disturb the balances of any other account holders.
iii. How to create money which is not there?
The intelligent cavemen came up with an innovative solution for this. They started their own tally with an account balance of zero. Then, they increased the tally of money in the grainmen account and simultaneously reduced an equivalent amount from their newly opened account balance. This effectively turned the bank balance of cavemen as negative.
This increase of the tally of grainmen on a promise of repayment within a prescribed time limit is called borrowing or loan.
By doing this, there has been no increase in the sum of account balances due to this additional money provided to grainmen temporarily. Once the grainmen repay the money to cavemen, the account balance of cavemen increases and making their originally negative account balance as zero.
This is how additional money is manufactured. Simply an increase in the account holders balance on a promise of repayment at a later date.
Therefore, money is actually manufactured by ‘commercial banks’ (eg SBI, AXIS Bank) when they give out loans to their customers.
This is often confused with currency printing, which is altogether a different task performed by the Central Bank of a country (RBI in India, FED in USA).
Money manufacture versus currency printing:
The cavemen are also aware that some additional shiny green sheets need to be printed to facilitate the increased money circulation in Goodsland. Based on their experience, they arrive at the fraction or percentage of the currency that is needed to be manufactured due to the increased money circulation. The printed sheets must look identical, and it should contain certain special markings so that it is difficult to manufacture elsewhere. For this they approached the mintmen.
The Mintmen are the in modern times called the central banks of the country like RBI for India, FED for USA.