The Economic Advisor

Cash Reserves

Money is measure of value, and cash being the representation of physical money is a store of that value.

According to the fundamental rule of demand and supply, when more of a commodity exists it becomes more common place and so its value decreases. On the other hand, when a commodity is rare, it becomes more sought after and so its value increases.

If a government were to print more money whenever it needed it, there would be more money available and so its value would decline. Therefore, in order to maintain the value of currency, there are strict controls on the printing of money.

Given there is a certain amount of money flowing within the economy at any one time, the only manner in which the value of cash can be controlled is through interest rates. Many may argue that debt is a bad thing, but the simple fact remains that debt is the cornerstone of a modern economy, and the lubricant of the everyday life of its citizens.

The Central Bank; the Bank of England controls the economy by issuing debt instruments to the market. If they do not control the economy in this manner, the insatiable and inherent urge of human nature to consume more and more will drive demand for goods and services to the point where the goods and services are in insufficient supply, and so their value increases. This could occur to such an extent that the ordinary needs of citizens for everyday existence like food and water may not be able to be met because of their escalating price.

Therefore, to curb demand, the Bank of England will increase interest rates by issuing notes with a higher return. This induces institutions to take advantage of these higher rates by purchasing these debt instruments.

As these institutions are in the business of making profit, they will in turn offset this investment by borrowing money from others in the economy at a higher rate of interest, and this has the effect of taking money out of the financial system. With less money within the system, peoples demand decreases as they prioritize their needs over their wants.

When people stop buying goods and services, this may lead to a contraction in the economy as companies produce less in order to avoid wasted resources. However, this also means a reduction in their profit and so this also follows a chain reaction through the economy, as people lose their jobs and the overall plight of the citizens of the UK worsens.

Therefore, what the government attempts to do is to use methods of taxation to keep a balanced economy, while still providing the people of the UK what they need, by spending the taxes they collect. If the government spends too much they may themselves cause too much money to flow into the system and then the economy to overheat with demand, so often they will save more taxes than they re-spend, or sometimes may spend more than they receive from taxes. If this is the case, the government has to borrow from the market, and like any corporation is susceptible to changes in interest rates, which directly affect public monies.

Therefore, cash becomes a sought after commodity in times of economic distress. The recent credit crisis is reflective of such a position as numerous institutions and corporations seek credit and finance to continue their operations, but are unable to get it. Due to the fact that this will cause an erratic downturn in the UK economy, the Bank of England has reduced interest rates through reducing the rate on its note issue, but this takes time to flow into the economy, which today is part of a larger global economy.

So to address the urgent need to prevent an economic collapse, the government has provided its own finance to those institutions in the UK that are desperate for finance, in return for an investment in the institution and with a view to restore confidence in the economy and the act of providing credit to one another.

Indeed this confidence in providing credit and thereby attributing a balanced value to cash is the stuff that our society is made of.

In wealth management this is a crucial matter to bear in mind, as every financial investment has its origins in the value of cash, and the recent stock market collapses around the various exchanges of the world are reflective of such a proposition.

This article was provided by the money and debt expert Fred Ballentine. He provides advice and information about UK debt management solutions. If you need help contact him today.