Money and Finance
Views : 185
Category : Explainer Series
Author : Arshad Shaikh
Money and finance is not just about earning and spending. There are some fundamental truths associated with these terms irrespective of our financial status and ‘monetary value’ in the economy. We can protect our hard-earned savings if we develop a sound understanding of the different concepts related to money and finance. Every domain/body of knowledge has its own language that is expressed through certain key terminologies. You remain ignorant about that specialized discipline unless you learn the language used by its practitioners. We must try to acquire the required ‘financial toolkit’ that enables us to become participants or at least keen observers of all things monetary/financial. There is an organized effort to promote ‘financial literacy’ that develops the ability to exercise various financial skills like managing one’s personal finance, budget and investments. Financial literacy is a perpetual journey of learning and is highly enjoyable and comforting once you are able to steer and move your ‘vehicle of finance’. This explainer is a small primer to accelerate your financial voyage towards becoming financially literate and ‘money-wise’.

Money

Money is something so commonly seen and used by everyone that we hardly think about what it actually is. To understand money, we need to learn the functions or roles that it plays in our lives. (1) Money is a medium of exchange that settles payments. You can purchase goods and services if you have money. (2) It is a medium of account. It means money can act as a measurement tool for finding out the price of a commodity at which it can be purchased or sold. For example, apples are priced Rs 100/- per kg whereas almonds are priced at say Rs 700/- per kg. This price difference in the money required to buy apples and almonds permits you to measure how cheap or expensive the commodity is. (3) Money is also a store of value over time. This means that it can be stored and retrieved later without losing value. You have heard stories about gold being buried in a pot and retrieved later.

Types of Money

Money broadly comes in three kinds. (1) Commodity money includes naturally scarce precious metals like gold, silver and sometimes even conch shells. The barter system that was prevalent in earlier days worked on commodity money and financial transactions were physically cumbersome and limited in scope. (2) Fiat money is something (for example – paper currency) that derives its value from a government order (fiat). The government declares the fiat currency to be legal tender, which makes it illegal for someone to refuse to accord it the means to purchase goods/repay debts etc. Similarly, the government can issue a fiat (farmaan) and declare that a particular denomination of currency note will no longer be legal tender. The most famous example is the Rs 500/- currency note that ceased to become legal tender after demonetization. So in this case, it became illegal to accept it as money. They became worthless pieces of paper. (3) Fiduciary money includes the money that is backed by a trust between the payer and the payee. For example, bank cheques and demand deposits or current accounts in the bank.

Finance

If you have understood the concept of money, then finance is nothing but the management of money. This money management involves activities such as investing, borrowing, lending, budgeting, saving and forecasting. There are three main types of finance: (1) personal, (2) corporate, and (3) public/government. The entities that deal with different activities involving finance are clubbed under a broad category known as the Financial Sector. It consists of firms such as banks, investment houses, finance companies, insurance companies, lenders, accounting services, and real estate brokers.

Bank

A bank is the fundamental unit of the financial (money-management) sector. In fact, it has become the most important component of the economy. A bank is licensed to receive deposits and give loans. For receiving deposits (recall fiduciary money), the bank pays money to the depositor and receives interest for issuing loans to the people/firms who take the loan (called debtors). The difference between what the bank earns through loans and pays by way of interest for your deposits is its profit. The main types of banks are: (1) Retail banks – deal with retail consumers. (2) Commercial banks or Corporate banks – offer financial services to firms and businesses. (3) Investment bank – focus on providing specialized financial services to corporates and other financial institutions including pension funds and the government. (4) Central bank is also known as the ‘banker for banks’ or as a ‘lender of last resort’ to other banks. The Central bank does not deal with the public; however, it is responsible for currency stability, controlling inflation, monetary policy, and overseeing a country’s money supply. The Reserve Bank of India (RBI) is India’s Central bank.

Interest rates

It is the amount charged by a lender (bank/financial institution) to the borrower and is usually a percentage of the principal (amount loaned). Interest rates are usually stated in percentage per annum. Most of the time, the financial world refers to increase/decrease in interest rate by the unit of basis points. One basis point is one hundredth of a percentage. So 50 basis points is half a percentage.

Liquidity

It is the ease or efficiency with which a financial asset can be converted to cash without affecting its market price. When we say gold is one of the most liquid assets you can possess, it means in ‘bad times’ gold can easily be sold in the market to fetch cash. When we say a firm or a bank has a liquidity problem, it means the firm is not able to meet its current financial requirements to run the business. It has many assets or money that other firms owe them, but right now, they do not have that much cash to keep the production lines busy or to be in business. We too face liquidity challenges as we manage our family expenses. It is not that we do not have financial assets or a steady salary but there are situations (usually at the end of the month) when we do not have the cash (money) left to pay for our daily expenses.

Solvency

It is the ability of a firm to meet or pay off its long-term debts and financial obligations. A firm is said to become insolvent when it cannot pay its loans and debt obligations even if it liquidates all its assets. The problem of solvency is bigger than that of liquidity as a liquidity crisis can be overcome by reducing expenses or by borrowing money. However, solvency issues require greater and long-term financial support and lenders are usually very skeptical of helping insolvent firms, as the risk of return of their funds is low. Liquidity problems lead to solvency problems.

Bankruptcy

It is a legal proceeding that allows individuals or firms freedom from their debts as well as allowing the creditors an opportunity for repayment. All of the debtor’s assets are measured and evaluated, and the assets may be liquidated to repay a portion of outstanding debt. Thus, theoretically speaking bankruptcy helps the economy by allowing people and companies a second chance to gain access to credit and by providing creditors with a portion of debt repayment through the sale of the debtor’s assets.

Bank run and NPAs

Occurs when a large number of depositors of a bank or financial institution withdraw their deposits simultaneously fearing that the bank is going to go bust (become insolvent). You must have seen people standing in long queues in front of ATMs and banks in news stories about countries whose economies have collapsed and their currency has devalued. In financial jargon bad/toxic loans given by a bank, which will never be paid back are called Non-performing Assets or NPAs. In accounting, a loan is a liability for the firm whereas the same loan is an asset for the bank as it is a source of revenue. A bank can collapse or may face a bank run if it has too many NPAs.

Inflation

Is the decline in purchasing power of a given currency over a period of time. Inflation implies that the prices of goods and services are going up. Some explain it as too much money chasing too few goods. Inflation erodes the value of your savings. That is the reason, people try to invest their money in the stock market or various financial instruments to ensure that they earn more than the loss of their financial capital that occurs because of inflation. Deflation is the opposite of inflation. Here the prices go down and the purchasing power of money increases.

Nominal and Real

The nominal value of any economic statistic like GDP, interest rate etc. means the statistic is measured in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. If the inflation rate is high then a rise in the nominal GDP is not reflective of the true rise in the economy and must be adjusted for inflation.

Wealth Protection and Wealth Creation

It is the job of every individual or firm to ensure that its financial assets are protected through prudent financial planning. Any emergency/unexpected turn of events in life may become a financial calamity, lead to insolvency, and leave you destitute. Wealth Creation is a more active approach to money management and aims at multiplying your wealth through investments and purchases that involve acceptable risks.

Suggested reading and further course of action

You can start with Chapter 3 (Money and Credit) of CBSE Standard X textbook – “Understanding Economic Development”, if you feel that you are at a very elementary level. Some of the books that are normally suggested for beginners who want to understand more about finance and investing are “Your Money or Your Life”, “Rich Dad Poor Dad”, “The Richest Man in Babylon” and “Finance for Dummies.” Start reading the ‘business section’ of newspapers or if you wish to reach an advanced level then you may subscribe to the Financial Times, the Wall Street Journal or the Economist. For gaining expertise in finance, it is better to join some free online course or you may even enroll for a graduate or post graduate program.

1 Comment

  1. Maryam

    Much needed! JazakAllah khair

    Reply

Submit a Comment

Your email address will not be published. Required fields are marked *