Understanding Money - A Chocolate Story
Using a purchase of chocolate to understand how money works in a non-technical way
I started writing this as an explainer into money printing and how to understand it in the context of Sri Lanka’s crisis and recovery. However, the introductory part of that piece that explained different types of money ended up being longer and longer. Instead of having one super-long article (even this one is quite long), I’ve instead split the article into two. This first piece will focus on the basic explanations of money focused at a non-technical audience, while the second will look at money printing in Sri Lanka from a more technical viewpoint. The second piece is likely to be over at
so give that a follow to keep up.Despite taking some of the first steps in what is likely to be a long road for recovery for Sri Lanka, money is one of the many things that Sri Lankans still do not have in full. We can see this in the amounts of items bought, in the amount of loans that are renewed, and the wallets that are both thicker but also more empty at the same time.
But what exactly is this “money” and how does it work?
The basic definition - it’s boring and abstract, let’s bring some chocolate into it
Of course, there are a hundred and one “fun” definitions for money (freedom, wisdom, belief, hope, goodness, credit, enterprise, respect, time, and too many others) - which all have some degree of truth in them. The traditional definition of money however is something like the below definition from Encyclopaedia Britannica:
“Money is a commodity accepted by general consent as a medium of economic exchange. It is the medium in which prices and values are expressed. It circulates from person to person and country to country, facilitating trade, and it is the principal measure of wealth.”
This is boring, but other than putting this in simple language, there’s not much we can do.
Let’s try and understand money in an easier way though, and that gives a good enough sense of what it is in Sri Lanka.
Probably the simplest way to understand money is as something that can be easily used to buy (or sell) something else. This can also tie into the popular understanding of money as cash - the 500 rupee note in your wallet can be used to buy something that is priced at 500 rupees. For the sake of simplicity, and for some levity, let’s assume that you’re trying to buy chocolate.
Money, then, is whatever allows you to easily buy chocolate.
What makes something money - levels of “chocolate moneyness”
When we’re talking about a 500 rupee note, it’s clear that this is money - you can use it to buy the chocolate for sure. It’s extremely unlikely for someone to say no, I can’t accept 500 rupees for this 500 rupee chocolate
But what about a 500 rupee gift voucher at a supermarket? Is that money?
Within the context of the supermarket, it basically is. It can be used to buy anything in the supermarket that is worth 500 rupees. So in the context of the supermarket, it behaves basically like a 500 rupee note would. That is, the 500 rupee gift voucher has high “moneyness” (or you can easily use it to buy things). Since what we’re trying to buy is chocolate, it has high “chocolate moneyness” in the supermarket.
How about a gift voucher for a chocolate shop instead? In the context of the chocolate shop, again it behaves as money, and has high moneyness, and has high “chocolate moneyness”.
Outside these specific locations, however, can the gift vouchers be considered chocolate money? Clearly, not everywhere, but by how much is it lower? That’s hard to measure of course, but if the supermarket is a widely visited supermarket, perhaps someone might be happy enough to accept the gift voucher (as long as they can verify it) as worth 500 rupees. But since at least some people will not accept it, I think it’s fair to say that the supermarket voucher has lower chocolate moneyness than a 500 rupee note - i.e. people would prefer to hold 500 rupees in cash in order to buy their chocolate as opposed to holding a supermarket gift voucher.
Since there are likely more branches of the supermarket than the chocolate shop, I think it’s fair to say that chocolate moneyness is higher in the supermarket voucher compared to the chocolate shop - but not as high as in the 500 rupee note which can be used to buy chocolate from anywhere (not limited to the supermarket or the chocolate shop).
All that is nice and interesting in the context of gift vouchers, but (chocolate) moneyness matters outside of this situation as well. For that, let’s take a move into the financial system.
Your money in the financial system - different levels of chocolate moneyness
As explained previously, cash clearly has very high levels of chocolate moneyness (ability to buy chocolate using it) - we can definitely buy 500 rupees of chocolate using that. However, what if the 500 rupees is in a savings account? As long as you can use a debit card to access the 500 rupees in savings, then the moneyness remains high. But you can’t pay using a debit card EVERYWHERE in Sri Lanka - some places will only take physical cash (like say if you are buying chocolate at a roadside stall). This means, that in order to use the 500 rupees in the savings account, there needs to be a “translation” - you need to withdraw the money from the bank into physical cash. Since this is by definition harder than not doing it, the chocolate moneyness of 500 rupees in a savings account in Sri Lanka is lower than the chocolate moneyness of 500 rupees in physical cash - though not by a lot.
Using this same idea, if your 500 rupees is in a fixed deposit, there are additional steps needed to use the 500 rupees to buy the chocolate with. You need to close the FD, then take it into your savings, then withdraw it and finally buy the chocolate. Thereby, the moneyness is once again lower - and this time, more significantly.
Once you move further into the financial system, however, moneyness reduces even further. Let’s say you buy a Treasury Bill issued by the government with your cash. Now, in order to buy chocolate, you can’t just give the chocolate seller a T-bill over the counter. There is more of a process in order to do so, which means T-bills don’t have very high chocolate moneyness. What if in addition to the T-bill, you get a loan against the T-bill? Can you use the loan contract to buy chocolate with? No - you’ll have to translate it across the system before you have access to physical cash to pay the chocolate seller with - either by repaying the loan, and selling the t-bill, or by using the money from the loan directly (but now you’re in chocolate debt!).
All of this, however, is about money you have access to since it's yours. Let’s look then at money that you don’t have but is in the financial system anyway.
Bank money - out of sight and out of mind?
Of course, banks also have money of other people that is not your own money, and let’s assume that these people don’t want to buy chocolate just now. For simplicity’s sake, let’s assume that banks can do one of 3 things only with this other people’s money (and the bank is at the edge of its regulatory requirements so they can’t multiply the money). They can either lend the money out to you, they can put it in a T-bill, or they can just keep it without doing anything
How much “chocolate moneyness” is in each of these options?
The first option has the most chocolate moneyness in a way - once the money is lent to you, now you have 500 rupees, either in a savings account or if you withdrew the money, as physical cash. So if you want to go buy chocolate, you are able to do so.
This point is pretty critical - if money is lent out, then that money can be used in the real economy to buy things. This is a key way that money enters the economy (more on this in the next piece), and thereby can cause inflation (more money chasing the same amount of chocolate).
The second option has lower levels of chocolate moneyness than the first. By putting the money in a T-bill, the bank can now use only the T-bill for any of their own (non-chocolate related) money needs. If you wants to borrow from the bank, the bank can’t give the T-bill to you directly to buy chocolate with, but maybe it could use the T-bill as collateral to borrow some money from another bank, and give that borrowed money to you as a loan. Alternatively, if the money that the bank used to buy the T-bill is now with the government (ie, if the government doesn’t use the money to pay back some other loan), then the government can give you some chocolate money (let’s call it a chocolate salary). In either of these ways, you can go and buy your chocolate, but because there are additional steps needed (and unless you have an understanding of the financials already, you’l probably feel how complex it is), the chocolate moneyness is lower than in the first option.
The third option has the least amount of chocolate moneyness compared to the others. By “not doing anything” a bank would essentially keep the (non-chocolate related) money as “bank reserves”, mostly in a deposit at the central bank. In practice, depending on how much of these reserves are mandatory, banks might earn some interest on this deposit facility (for example, extra reserves might be deposited in the overnight deposit facility of the central bank which would earn interest). Especially if we’re talking about the mandatory reserves, then you can’t use them to buy chocolate. No banker can go to a supermarket and say, hey, I have 500 rupees in bank reserves, give me chocolate. In order to buy chocolate, the bank will need extra reserves, which it has to then choose to either lend out or invest in t-bills (assuming those are the only 2 options), and then the processes in option 1 and 2 come into play, and only at the end of all that can you buy your chocolate. There’s a lot of translation needed to get there. The chocolate moneyness of bank reserves is quite low that way.
Of course, in this explanation, we’re talking about chocolate moneyness. If we’re talking about moneyness from the point of view of buying T-bills (T-bill moneyness?), the moneyness levels change. If we’re talking about moneyness from the point of view of maintaining bank reserves (bank reserve moneyness?), it changes again.
Different types of money behave in different ways - this matters for inflation
Understanding how different types of money affects inflation can change how you think of inflation. To start with, lets take as a fact, that when everything else remains the same (which is a tall ask, but let’s make believe), when the amount of money rises, prices rise. In the context of the chocolate, if you have 500 rupees and the seller only has 1 bar of chocolate, and you are the only person who will ever buy chocolate (remember, everyone else is just keeping their money in the bank), the chocolate will be worth 500 rupees as well. But if you now have 1000 rupees, this suddenly makes the chocolate worth 1000 rupees.
But what happens in each of the different scenarios we talked of? If you have 500 rupees in cash, but 500 more rupees in savings, as long as the money stays in the bank, the price of the chocolate remains at 500 rupees. But because the translation from savings to cash isn’t very difficult, and you can relatively easily take it out as physical cash, then once that happens, the price of the chocolate will rise to 1000 again.
These 2 types of money (physical cash and savings account money), therefore, have a pretty high ability to cause inflationary pressures. We can call this chocolate money since we can easily use it to buy chocolate. Increases in chocolate money is what causes inflation in the price of chocolate (assuming the amount of chocolate remains the same). This is a simple yet critical thing to understand.
What about fixed deposits (and other similar deposits)? Deposits are a bit harder to convert into physical cash, but it’s easier than say - bank reserves or maybe even T-bills (given regulatory constraints). Deposits are less inflationary than chocolate money because it’s harder to take deposits out, and this impact is even stronger if there are non-monetary reasons why people would rather keep their money in the fixed deposit (for example, people know in 1 year’s time, there’s a bunch of special chocolate that’s coming into the country, and they want to save up to buy that later). Because of this, let’s call the money in deposits “maybe-chocolate money” - it CAN be used for chocolate if someone wants, but it isn’t as straightforward. T-bills count as maybe-chocolate money too, but they’re a bit less maybe than deposits due to the regulatory factors mentioned.
Now, bank reserves in particular, ie money that banks have access to that they’re not really doing anything with, doesn’t immediately translate to being chocolate money as explained earlier - there are so many steps to make it chocolate money. Let’s call this none-chocolate money.
Now, none-chocolate money can still be used to buy other things - for example, if there aren’t any regulatory requirements that prevent it, a bank can use their none-chocolate money to buy a T-bill. As long as the none-chocolate money the government gets in return for the T-bill is not used to give people chocolate salaries like earlier (i.e. as long as the government doesn’t convert none-chocolate money into chocolate money), then the amount of chocolate money in the economy won’t rise.
This is another critical point that we will explore in detail later, but the essence is this: You can have a huge increase in none-chocolate money (or even in maybe-chocolate money), and as long as it doesn’t convert into chocolate money (either through the government or through the banks lending to you), the price of chocolate stays exactly the same - 500 rupees.
However, this doesn’t mean that none-chocolate money has no impact on prices. If the none-chocolate money is used to buy, for example, T-bills as described earlier, the price of T-bills will rise (which means the interest rate on the T-bills will fall). As long as lending into the economy from that point is contained, any inflation which happens is limited to T-bills. The impact this has on financial markets is an important area to explore, but not here. For now, chocolate remains uninflated.
Money is complex, but so is chocolate
All of what we discussed was in a very simplistic breakdown - and even still, the money story is complicated. The reality is even more complicated - for example, there is more than 1 person wanting to buy chocolate, and the chocolate seller might also be able to expand instead of staying static. There are also many different types of chocolate that all behave differently. I’ve also simplified the entire financial system to just T-bills and loans, and reality is more complicated. All of this affects how the economy works, and how prices work.
Money printing then comes on top of this complicated situation. Part of the complexity is because there is no simple definition for it, or a simple definition for money either - different types of money behave differently in different contexts, and money printing is a whole new context as well.
But hopefully, this piece gives an introductory story into how money works - and can help with a better understanding of the subject (though ideally it doesn’t affect your relationship with chocolate too much!). In the next piece, we’ll take a look at how this ties into money printing and what that means for Sri Lanka.