The cycle of money and its importance for the economy

A small, hardly noticed story describes a situation that seems simple and harmless at first glance, but in reality has a profound meaning for the understanding of economic connections. It is a narrative that is intended to illustrate the functioning of money in a small village and shows how money is caused by variousactors in a cycle. This story vividly reveals how money circulates within a community, debts are compensated and ultimately the economy remains in motion. It serves as a metaphor for the complex processes that also take place in larger economic systems and makes it clear what role money plays in living together andto control economic development.

A simple exchange in the small village

Let’s imagine a hiker comes to a small village and enters the “Zum Löwen” inn to rent a room there. He decides to pay 100 euros for two nights, including a breakfast included in the price. He immediately hands over the money to the innkeeper in cash, but in the background the two made a special agreement: The hiker wants himselfstill look around in the neighboring town and reserves the right to cancel his stay if he finds better accommodation there. This agreement is intended to give the wanderer flexibility, while the landlord first receives the money and has a certain security. This is an example of a transaction that looks simple at first glance, but on closer inspection a multitude ofrevealed to economic contexts. The money that plays a central role here becomes a symbol of the exchange of value and trust between those involved at this moment.

The way of money through the village

After the hiker has left the place again, the innkeeper rushes to the beverage supplier to pay a final outstanding bill. He still has debts from the butcher, who in turn receives a coin that he redeems at the meadow farmer. The farmer uses the money to buy a beer mat at the “Löwen” that he needs for the next celebration. So the money in a cycle moves by handHand until it finally ends up in the inn, ready to pay the next guest. This example shows how money is circulated in a community and debts are compensated without constantly creating new money. A flow is created that keeps the economic exchange going and ensures the functioning of the system. The money will be used in this processconnecting force between the individual actors who are dependent on each other to continue their economic activities.

The three functions of money

In economics, money is traditionally understood as a means that fulfills three central functions. First, it is a medium of exchange that facilitates trade by replacing the direct exchange of goods and services. On the other hand, it serves as a general unit of calculation, in which values are made comparable in order to make the processes more transparent.Third, money is a store of value, meaning it is able to store assets and retain their value over time. For the small village example, this means that the money was initially only available in the form of a cycle without it being necessary to use it as a store of value. The actors exchanged goods for goods and the moneyinitially only played a role as a symbolic witness of this exchange. Only later can you imagine how money could also be used as a means of storing value or investment in order to increase production or finance projects in the long term.

The natural exchange in the community

In this example, the exchange takes place initially without the use of money, because the goods directly compensate for the value. The farmer brings meat that he offers while the drinks supplier brings beer. The relationship of the goods to each other is so balanced that no money is necessary to regulate the value. This principle of in kind exchange shows how in a functioningCommunity is initially focused on direct exchange to meet needs. The parties involved know the value of their goods relatively well and the transactions are uncomplicated. The money that comes into play later is just a formal addition in this scenario that simplifies the handling of the business. It is a kind of tool to make the exchange more efficient withoutthat the actual value creation suffers. In this context, it becomes clear that money is not always necessary to get trade in motion, but only plays a role when the transactions of complex or longer distances have to be bridged.

The functions of money in detail

If you look more closely at the individual functions of money, it becomes clear that although they are connected to each other, they play different roles in the economy. The first function, as a medium of exchange, allows goods and services to be exchanged for money, which significantly reduces transaction costs. In our example, the parties involved would also have to trade directly with moneyby simply handing each 100 euros into each other’s hands instead of swapping goods directly. The second function, the calculation unit, ensures that the values of the goods remain comparable, for example by assuming that beer and meat are worth around 100 euros. This comparability is necessary to facilitate trade. The third function, value retention, is inour example is not fulfilled because no money was used as a long-term means of storing value. However, if there were a situation where the farmer would keep the money for an investment to start a larger project later, the money would fulfill its function as a store of value. This example shows how the functions of money in different situationscome into play differently and how they influence economic activity.

Money related to investments and cycles

In a real economy, money is not only responsible for the exchange and valuation of goods, but also plays a central role in the cycle of saving and investing. Funds that are currently not required for consumption can be deposited with banks in the form of savings. These banks act as intermediaries who put the money saved to investors orForward companies that use it to expand their production or for new projects. Thus, money gradually becomes an instrument of capital formation. When the money saved is reinvested in the real economy, for example by buying an animal that will be sold later, it will affect gross domestic product. However, the development showsThe financial assets compared to gross domestic product that these two variables do not develop proportionally. Gross domestic product in Germany has increased sixfold for several decades, while financial assets, i.e. the values that are in the banks’ balance sheets, have even increased by a factor of 23. This discrepancy reveals a large difference betweenactual economic growth and virtual capital increase, which is mainly in the financial sector.

Virtual increase in capital and its consequences

The crucial point is that the increasing wealth in the financial markets is mainly caused by speculative activities. More and more capital is being increased in virtual space – through trading in stocks, derivatives and other financial instruments – without investing it directly in real goods. This virtual capital increase means that the assets in theHands fewer players are growing, while the real economy is only slowly or hardly benefiting from it. The financial industry propagates to us that investments can be made in this development, but in truth the majority of the profits are through speculation that has no direct connection to actual production. This development promotes a spiral in whichMore and more money is being directed into the virtual space, while the real economy only has a small share in it. This leads to a growing gap between the actual values of goods and services and abstract financial assets, which is hardly understandable and endangers the stability of the system.

Consequences for society and the economic system

This development has profound consequences for the entire economic system. With the increasing virtual capital increase, the pressure to achieve high returns on the capital invested is also growing. The financial industry is forced to constantly develop new products, investment models and business ideas to maintain growth. The balance betweenreal economic stability and speculative expansion increasingly out of balance. The result is a kind of suction, in which more and more capital flows into the virtual space, while real production is only slowly growing or even stagnating. This imbalance makes the system vulnerable to crises because actual values and financial assets are becoming more and more divergent.Trust in the system is based on an illusion because the assets listed there reflect only a small part of actual economic production. The example of the small village may seem harmless, but the mechanisms behind it are globally effective and influence the entire economy. The challenge is to find ways toRepair imbalance to restore stability and put society on a sustainable basis to ensure long-term prosperity and stability.