History of Money + Basics of Monetary

Policy

Why does something have value?

Scarcity and perceived value (which gives rise to demand) is the
source for all value.

For instance, since time immemorial, gold is something that has

been considered valuable. Gold is something we all consider
valuable. Hence, everyone wants it - that is to say, the demand
for gold is high. Whereas, gold is a scarce natural resource - that
is to say, its supply is constrained.

Hence, any commodity in high demand but with scarce supply has
value. More the discrepancy between the demand and the supply,
more the value - and hence, the price - of such commodity.

In simpler terms, the more we want something, and the

more scarce it is, the more valuable it is to us. This forms
the basis of the laws of demand and supply in Economics 101.

Note: Value is very, very subjective. With the exception of

commodities like gold, which everyone considers valuable, most
commodities have different value to different people.

The Fundamentals of Monetary Policy

Why don’t countries print all the currency they want? This is a
very fundamental question which had troubled me for a long, long
time. A grossly simplified example is the best way to answer not
only this question but also understand the entire shebang called
monetary policy.

Say there exists an economy consisting of only two things:

● 2 Consumers
○ Athul has only ₹ 200
○ I have only ₹ 100
● 1 Product: 300 kg of rice

Hence, the total money supply in the economy is ₹ 300. This

entire money supply may be used to buy only 300 kg of rice.
Hence, in this status quo, ₹ 1 can buy 1 kg of price1 - that is, the
price of rice is ₹ 1/kg. If Athul and I require 30 kg of rice every
month (which is fixed by our dietary requirement), we both need
to spend ₹ 30 per month.

Now suppose Athul and I get hold of a currency printing machine.

Hihihihihi. Fun times, it seems. We decide to print more currency
for ourselves - for the purpose of simplification, free of cost. Say
the currency in our possession thus becomes:
● Athul: ₹ 400
● Me: ₹ 200

Hence, the total money supply in the economy is now ₹ 600. The
maximum commodity this entire money can buy is 200 kg of rice
(let’s assume we haven’t eaten any of it). Hence, in this status
quo, ₹ 1 can buy only 0.5 kg of rice - that is, the price of rice is
now ₹ 2/kg!
At this rate, if we both need 30 kg of rice per month, we need to
now pay ₹ 60 for it, as opposed to ₹ 30 earlier! We thought
printing more currency would take us to heaven? Hell, no! This is
exactly what happens in the world economy, albeit on a far larger
and much more complex scale.

1 This is a tremendously simple calculation one may arrive at using unitary method.
This is a consequence of printing more currency. Without any
increase in the supply – that is, the economic output of the
country, if you continue to print more currency, it thus
decreases the purchasing power of that currency, thereby
increasing the price of commodities. Hence, it leads to
inflation.

For instance, if the rice available had increased to 600 kg, with
the new currency we had printed (total money supply being ₹
600), the unit price would have remained the same - ₹ 1/kg.

Similarly, pulling money out of the system has the exact opposite
effect - it increases the purchasing power of money, leading to
lowering of prices, and thus deflation.

We are aware that neither too much inflation nor deflation is good
for the economy. However, a little inflation is desirable. Hence,
the key to a proper economy is this:
● If production increases, money supply should be increased to
keep deflation in check.
● If production decreases, money supply should be decreased
to keep inflation in check.
● If production remains the same, no more money should be
printed. Neither should any money be taken out of the
economy.

Hence, the key is to measure changes two things:

● Economic productivity of the country: This is most
commonly done by measuring the changes in the GDP of a
country over the years, adjusting it for the simultaneous
inflation. Thus, the increase in production is calculated. GDP
data is compiled in India by the Central Statistics Office
under the Ministry of Statistics and Programme
 Implementation, which collates data from various sources to
arrive at these calculations.
● Money supply in the country: These are are the types of
values of money supply - M0, M1, M2, etc. The values of
these types of monies in circulation are regularly compiled
and released by the RBI.

The Central Bank - in our case, the Reserve Bank of India -

then uses the instruments of credit control to pull money
from or inject money into the system.
● Pulling money from the economy
○ By increasing CRR and SLR. At present, CRR is 4%
and SLR 19.5%. More CRR and SLR means banks can
use a far lesser proportion of the money in their
possession. Hence, money supply decreases.
However, values of CRR and SLR more or less remain
constant as changes require significant changes in
banking practices, which affect the efficiency of banks.
○ By increasing the repo rate and the reverse repo
rate. Hence, it is far more profitable for banks to park
funds with the RBI than to borrow money from it.
Hence, banks park money with the RBI. This pulls
money out of the economy.
● Injecting money into the economy
○ By decreasing CRR and SLR. Banks are then able to
use a greater proportion of their money. Hence, money
supply increases.
○ By decreasing the repo rate and the reverse repo
rate: Hence, it becomes far more profitable for banks
to lend money from the RBI than to park funds with it.
Hence, money comes back out into the economy.
○ Printing more currency notes.
A Brief History of Money
Based on articles on Investopedia, The Balance and Wikipedia.

(i) The Barter System

Humans began exchange of goods first through the barter
system. A rather crude example is that I want 2 cows in exchange
for giving you 1 bullock.

The barter system came into existence because humans realised

that the mutual benefit in the exchange of commodities one is in
surplus of and one needs is a far effective way to satisfy our
needs than to engage in outright aggression and war for the
same.

(ii) The Rise of Currency

Eventually, the concept of the use of currency began to take hold.

A currency is just a benchmark with which to compare

goods. For instance, previously, if 2 cows equal 1 bullock, and
today a cow costs 6 standard gold coins, then a bullock would
cost 12 standard gold coins. If I have some gold coins and I want
to buy a cow, I could pay the seller 6 such gold coins in exchange
for a cow in lieu of half a bullock. It is effectively a replacement
for the barter system, since with those gold coins, half a bullock
can be bought.

The major advantage of a shift to currency is that it made

trade and commerce - and therefore more varieties of
human endeavour - far more easy to conduct, for the
barter system is not always feasible. For instance, the
possibility of paying half a bullock in the above transaction is
obviously impractical. Further, even if I could pay a whole bullock
in a particular transaction, I would need to have a bullock - itself
far more difficult than dealing with currency. Hence, currency
replaced the barter system because of its convenience.

Throughout history, a variety of things have been used as

currency, such as cows, cowrie shells, animal skins, and
eventually coins and paper notes.

(iii) The Reign of Gold

However, there was one commodity which has fascinated
mankind since its discovery - gold. Throughout history, gold
has been intensely attractive to humans but scarce in supply, and
thus valuable. Paper notes originated as promissory notes in lieu
of a valuable commodity, such as gold, kept in the safe
possession of someone. At any time, the bearer of the promissory
note could take it to such person and redeem the equivalent
amount of gold.

In the modern economy with a plethora of currencies, gold soon

assumed significance as the currency of international trade
between nations.

This soon gave rise to the gold standard - a system in

which the value of currencies was pegged to a particular
amount of gold. For instance, if 1 oz. of gold costs $35, it would
imply that the value of $1 would be 1/35 the price of 1 oz. of gold.
The UK was the first country in the world to adopt it. With the
introduction of the gold standard in countries all across the world,
currency notes essentially became promissory notes which could
be redeemed by the bearer for its equivalent amount in gold
bullion.
The gold standard came into existence because physical gold
coins and bullion were extremely inconvenient to exchange.
Paper currency linked to a fixed value of gold, as the gold
standard established, was a very convenient alternative.

This system worked very well because it was:

● An effective way to control the capricious tendencies of
nations to print more currency notes (which leads to
inflation), because the ability of a country to print more
currency notes is restricted by its gold supply.
● Imbalances in international trade could be automatically
rectified. A country with a trade deficit (imports > exports)
would have depleted gold reserves and would thus have to
reduce its money supply. The resulting fall in demand would
reduce imports and the lowering of prices would boost
exports; thus correcting the trade deficit.
Hence, the gold standard was a major stabilising force in the
world economy.

However, cracks began to appear in this system in the lead up to

and during World War I. The militarisation of Europe meant that
most countries were driven by perceived necessity to print more
and more currency to finance their war efforts. However, there
wasn’t enough gold to back the increased currency. This lead
them to suspend the gold standards and print currency in excess.
This had a brutal but expected effect - hyperinflation. Hence, after
the end of World War I, most countries moved back to the relative
security of the gold standard.

But gold supply was increasingly falling short of the required

growth of global currency. Expectedly, only large countries such
as Britain, France and USA had enough gold to back their
currency; the smaller countries didn’t. Hence, the smaller
countries sold their gold and held USD and GBP as their reserve
currencies instead of gold. This lead to the hoarding of gold in the
hands of few nations.

Why did the smaller countries do this? Back then, Britain and USA
had large gold reserves, and both these currencies were
convertible to gold. Also, their large economies meant that the
purchasing power of the USD and GBP would only increase. In
effect, the USD and GBP, by virtue of their value because
of their respective home economies, became the
replacement for gold across the world.

Then, in 1934, the US Govt. devalued the USD to give a stimulus

to its economy. This meant that countries with gold could get a
larger number of USD with the same amount of gold. The USD
was already one of the reserve currencies of the world. Hence,
this drove more countries to sell their gold to the US in exchange
for USD. The US thus cornered almost the entire world’s gold
bullion.

Soon, the Great Depression hit the world. With rising inflation and
failing world economies, people lost confidence in the USD and
GBP. People made a run for gold - they wanted their gold back;
since the in gold we trust, not governments. This raised the
demand for gold and therefore its free market price. This only
stimulated more people to exchange their currency for gold.
Consequently, Britain dropped the gold standard in 1931
completely. In the US, President Franklin D. Roosevelt gradually
got rid of the convertibility of the USD into gold to deal with this
problem. Eventually, by law, all gold owned by banks and
individuals in the US were turned into Fort Knox - the largest
depository of gold bullion in the US. The USD was still pegged to
the value of gold, but people could no longer turn in their USD to
get the proportionate amount of gold back.
(iv) The Bretton Woods System (1945-1971)
Based on articles on Wikipedia and The Balance.

As World War II drew to a close, major world powers met in a

conference at Mt. Washington Hotel in the town of Bretton Woods
in New Hampshire, USA. The resultant Bretton Woods Agreement
set up the IMF and what we today know as the World Bank Group.

The new Bretton Woods System, as it came to be known,

set up the new international monetary order post World
War II. With the renewed focus on stability after two
devastating wars and the Great Depression, the Bretton
Woods System set up a fixed exchange rate system.

The world could not return to the gold standard, because gold
production was woefully short, and anyway, most of the world’s
gold was with the US and the USSR, and the west was not
comfortable with the communist leanings of the latter. GBP was
rejected as a reserve currency, because two World Wars had
taken its toll on the British economy.

The USD was set as the world’s reserve currency, and countries
were required to peg their currency exchange rates to the USD.
This exchange rate, for all practical purposes, was fixed. A 1%
revaluation was allowed only with the approval of the IMF to
correct serious problems with fundamental economic equilibria
(viz. Balance of trade). Further, in order to bolster the confidence
of world powers, the US pegged the USD to gold - setting $1 as
1/35 of the price of 1 oz. of gold.

For this system to remain workable, the challenge was to

maintain the official exchange rates close to the free market rate.
This was because “the greater the gap between free market gold
prices and central bank gold prices, the greater the temptation to
deal with internal economic issues by buying gold at the Bretton
Woods price and selling it on the open market.” Hence, Central
Banks needed to have mechanisms to deal with the forces of
demand and supply, which fluctuate from time to time and hence
lead to a dichotomy between the official and market forex rates.
Under the Bretton Woods System, the concept was that Central
Banks would hold large reserves of their own currency. If there
was an excess of their own currency in the market, the Central
Bank would buy up its own currency from the market. If there was
a deficit, the Central Bank would sell some its reserves into the
market. Thus the Bretton Woods System envisioned a mechanism
by which Central Banks could keep the market rate of their
currency close to the official rate.

This system of fixed exchange rates - the pegged regime -

lasted from 1945 until 1971.

(v) The Transition to Fiat Currency and a Floating Rate

Exchange System
Based on articles on Wikipedia and The Balance.

With the Bretton Woods System, there existed just one problem -
there was too few USD outside of the US. The US was running on
a trade surplus - it exported far more than it imported, thus
sucking out USD from the world. It was necessary to reverse this
situation to ensure that there was enough USD in the world
market, since it had been envisioned by Bretton Woods to be a
global reserve currency.

One way to do this was to increase US imports. But with its

cutting-edge industry and tech, nobody in the US had any reason
to increase imports. The other more feasible alternative was to
directly send USD to foreign countries as capital. Owing to the
increasing difficulties of Europe in rebuilding itself after the War,
the US came up with the Marshall Plan. This was a calculated
move to send in USD as foreign aid to European nations to rebuild
themselves, and - at the same time - create liquidity for the USD
in the world market. Thus, the USA was deliberately running on a
balance of payments deficit.

This led to what became known as the Triffin’s Dilemma. Robert

Triffin, an economist, pointed out that the entire Bretton Woods
System works because there is enough USD in the world market.
To ensure that enough USD remains in the world market, the US
must continue to maintain a balance of payments deficit some
way or the other. But a continuing balance of payments deficit is
bad for the economy, and affects the confidence of the people in
the US economy. It was feared that, in such a situation, countries
would want to sell their dollars for gold, as in gold we trust, and
not governments.

Hence, several countries created the London Gold Pool. The

concept was that if the prices of gold rose in the free market, they
would sell off from gold from the Pool into the market to bring
down the free market price to the USD-gold peg of $35/oz. When
the prices dropped, this gold would be brought back in the pool.
Indeed, this presumption was well-founded, as economic and
geopolitical upheavals that affected public confidence in the US
raised the price of gold. This general trend continues to this
day - when public confidence in the economy drops, the
prices of gold rise as more people want to fall back on
gold, an evergreen investment (thus raising demand). 2
Ultimately, the Gold Pool later collapsed.

Indeed, this continuing balance of payments deficit lead to a

precarious situation in the US - an inflationary economy. Public

2 This is because of the widespread (and mostly true) perception that gold is an evergreen investment,
for gold bought today can later be sold to get back currency when the economy transforms itself into
better shape.
debt due to a huge welfare state programme and the continuing
foreign involvement of the US in foreign wars further exacerbated
this situation. To counter this, President Nixon devalued the USD,
expecting a rerun of the 1934 dollar devaluation, which pushed
people and countries to sell their gold to get more USD. But this
plan backfired, for it only reinforced the widespread public
perception that the US economy was crumbling.

People naturally made a run for gold, and Fort Knox began to be
emptied! President Nixon was forced to impose controls.
Ultimately, Nixon unhooked the USD from the gold, thus bringing
an end to the last orifices of the gold standard in the world. In the
free market, the price of gold quickly shot up to $120/oz - itself
testimony to the horrible shape of the US economy.

With this, the Bretton Woods System officially collapsed. Post

Bretton Woods, countries were allowed to peg their currency (and
revalue it, from time to time) to some other currency, or let them
float in the free market. The major economic powers adopted the
latter approach, letting the forces of demand and supply influence
their forex rates. Today, the world relies on a largely floating-rate
forex rate system.

The World Today

Once upon a time, currency had intrinsic value. One could
exchange it for gold or some other commodities that are valuable
to humans. In many cases, the currency - viz. Gold and Silver
coins - was this valuable commodity itself.

With the collapse of Bretton Woods and the advent of the floating
forex rate system, currencies no longer have any value.
Currencies are now fiat currencies - they have value merely
because they are accepted as legal tender by the fiat - that is, the
decree by law - of the government. Fiat currencies have no
intrinsic value. Rather, they have value because they serve as a
standard reference with which to value goods and services.

Previously, governments struggled to keep free market rates

close to the official rate. Today, forex rates float. The only thing
that determines forex rates today is the confidence of the people
in the particular government in question. If confidence increases,
so does the purchasing power of that country’s currency in the
free market, and vice-versa. If things get really bad, there’s
always gold to fall back on. ;-)