Tuesday, August 4, 2009

Dollars and Sense- What is Money

This is the first article in a series. If you have questions on this article or would like me to discuss a money issue let me know either in the comments, by email, or facebook.

What is money? It’s a question that is rarely asked. What does it really represent? I want to give a brief overview of what money is and how this affects the risks associated with investing. Note this is far from complete or exhaustive, as the valuation of currency is very complicated. As an example things not mentioned here in depth trade deficits, government assets, etc.

What Money is Not
All of us have the image in our minds of the US hoarding a bunch of Gold at Fort Knox. Our money is at least partially tied to this right? The answer is no; gold does not factor into our currency. It’s symbolically meant to serve as some sort of hedge for the US Government, but in reality does not affect the value today. What the gold does do is represent the floor or minimum amount a US Dollar would be worth in the case of an economic meltdown. Truthfully though if the markets did collapse what little value the gold offered would be negligible.

What Money Is
What is money? This is a rather complicated topic so let me briefly touch on the main points.

Money Is the Value of Our Economy
Let’s talk about what that currency is ultimately tied to. The strength of the dollar is tied to our economies value as well as the relative value of our economy when compared to the economies of other world powers. As our economy becomes more globalized we are essentially benchmarked against the other world economies. If our economy (GDP, employment rate, world perception, etc.) increases relative to other countries then their products will become cheaper to us and thus the dollar is stronger. Additionally, if we have a large trade deficit then as our dollars are shipped overseas the dollar becomes slightly weaker as well. On the home front as Americans spend more, build more, create more our own demand for currency increases thus strengthening the value of the dollar. This is why you see consumer spending affecting the stock market. If fewer people are spending then the dollar is less in demand.

Money Is the Amount of Currency In Circulation
The amount of money in circulation is constantly changing, and circulation is controlled by the Federal Reserve and other branches of government through monetary policy. Examples of monetary policy include: changing the monetary base, reserve requirements, and interest rates. Through the use of government bonds the Federal Reserve can increase or decrease the amount of currency in circulation. If dollars are removed from the economy in place of bonds then the value of the dollar will increase and vice-versa. This is obviously done on a large scale and the mere act of doing it will cause the economy to react accordingly.

The Federal Reserve mandates a reserve requirement for all banking institutions. The reserve requirement is the percentage of deposits a bank is forced to maintain in liquid reserves. The reserve decreases the amount of funds available for lending by banking institutions. Reserves were initially created to prevent another Great Depression. Today it is used to increase or decrease the dollars available for lending and thus affect the value of our currency.

Finally, the Federal Reserve issues a discount rate. The discount rate is the interest rate that the Federal Reserve charges to loan to other banks. When you hear on the news: “The Fed today raised interest rates…” the discount rate is the rate the Reserve is raising. The market tends to adjust accordingly based on the new interest rate. The lower the rate is the more banks will loan from the Fed which puts more money in circulation. Additionally, as banks have access to more money interest rates go down and more people borrow.

So now that we know what money, should we really be afraid of investing in the stock market? The answer in short is no. You are entering into a low risk transaction because a large part of the value of the money you carry is tied to the economy you are investing in. What investing does do is say “I’m not using this money right now, I believe that American business will continue to develop and my dollar will be worth more later. Please use my dollar to create value and I will get the dollar back when it is worth more.”

What About Total Collapse?
If you are a Chicken Little then yes if the market did totally collapse you would be screwed, but so would your money. To hedge against this you should actually buy commodities (gold, oil futures, etc.) as opposed to keeping your money in cash because if the market goes so does your money. But really ask yourself, if the currency markets were destroyed do you really think people will take your flakes of gold for groceries. If it gets to that point you have A LOT more to worry about then your investments.

In part 2 we will give a brief overview on what the stock market is and further discuss implications of investing.

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