If you want to build wealth, you need to understand some money basics. Our day to day interaction with money is in the form of currency notes, rupees, dollar etc.
Initially when man started the process of trading, it was based on barter. Overtime it was found that barter was not very good. It had a number of problems,
- There was not standard way to arrive at relative value of things for barter
- It becomes a problem if people do not want what you have for barter.
So thus was born the idea of a common standard way to pay for stuff, ie. money. Many things have been used as money starting from sea shells to printed paper that we use today. But till very recently, money was still based on a commodity (a physical entity). The most commonly used commodity was some type of precious metal, gold or silver. Till very recently the world actually used what is called as the Gold Standard. That meant that you could take your currency to the central bank and they will give you the equivalent in gold. So gold was the currency, but instead of bartering gold, you exchanged notes that represented the physical gold. So a country could only print the amount of currency based on the amount of gold the country has.
A pure gold standard was used between the 1879 and 1914 by many modern trading nations. Under the gold standard system, all participating currencies were convertible based on its gold value. For example, if currency x was equal to 100 grains of gold, and currency y was equal to 50 grains of gold, then 1 x was equal to 2 y.
Because currencies were convertible in gold, then nations could ship gold among themselves to adjust their "balance of payments." In theory, all nations should have an optimal balance of payments of zero, i.e. they should not have either a trade deficit or trade surplus. For example, in a bilateral trade relationship between Australia and Brazil, if Brazil had a trade deficit with Australia, then Brazil could pay Australia gold. Now that Australia had more gold, it could issue more paper money since it now had a greater supply of gold to support new bills. With an increase of paper bills in the Australian economy, inflation, i.e. a rise in prices due to an overabundance of money, would occur. The rise in prices would subsequently lead to a drop in exports, because Brazil would not want to buy the more expensive Australian goods. Subsequently, Australia would then return to a zero balance of payments because its trade surplus would disappear. Likewise, when gold leaves Brazil, the price of its goods should decline, making them more attractive for Australia. As a result, Brazil would experience an increase in exports until its balance of payments reached zero
The gold standard basically ended around 1971. So the money you use is actually not backed by any commodity. It is based on the backing of the government of the country that printed that currency. The US Dollar is the most trusted currency and is held as the backing by most countries. Most countries also hold large amounts of gold as hedge against the dollar and also to have an alternate backing for their currency.
This is usually called Notional Currency or Fiat Currency.
The terms fiat currency and fiat money relate to types of currency or money whose usefulness results not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government's order (fiat) that it must be accepted as a means of payment.
Why is this important on how you build wealth. Because since banks can now print currency unrestricted by the amount of gold they held, most countries now just print money for so called government spending(including in India, where we do a lot of this. US is also doing this to get out of the current recession).
This leads to what we call Inflation. Inflation is one of the most important things to consider when you think about wealth creation. Inflation will be our next topic.
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