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Understanding Economics
Why Does Paper Money Have
Value?
By Mike
Moffatt
While
it may be true that money makes the world go around, it is not inherently valuable.
Unless
you enjoy looking at pictures of deceased national heroes, these colorfully
imprinted pieces of paper have no more use than any other piece of paper.
It is
only when we agree as a country to assign a value to that paper — and other
countries agree to recognize that value — that we can use it as currency.
Gold and Silver Standards
It
didn't always work this way. In the past, money generally took the form of
coins composed of precious metals such as gold and silver.
The
value of the coins was roughly based on the value of the metals they contained
because you could always melt the coins down and use the metal for other
purposes.
Until a
few decades ago, the value of paper money in many countries, including the
United States, was based on a gold or silver standard, or some combination of
the two.
The
piece of paper money was simply a convenient way of "holding" that
particular bit of gold or silver.
Under
the gold or silver standard, you could actually take your paper money to the
bank and exchange it for an amount of gold or silver based on an exchange rate set by the government.
Up
until 1971, the United States operated under a gold standard, which since 1946 had been
governed by the Bretton Woods system, which created fixed
exchange rates that allowed governments to sell their gold to the United States
treasury at the price of $35 per ounce.
Believing
that this system undermined the U.S. economy, President Richard M. Nixon took
the country off the gold standard in 1971.
Fiat Money
Since
Nixon's ruling, the United States has operated on a system of fiat money, which
means our currency is not tied to any other commodity.
The
word "fiat" originates in the Latin, the imperative of the verb facere, "to
make or become."
Fiat money
is money whose value is not inherent but called into being by a human system.
So,
these pieces of paper in your pocket are just that: pieces of paper.
Why We Believe Paper Money Has
Value
So why
does a five-dollar bill have value and some other pieces of paper do not?
It’s
simple: Money is a both a good and a
method of exchange.
As a
good, it has a limited supply, and therefore there is a demand for it.
There
is a demand because people can use the money to purchase the goods and services
they need and want.
Goods
and services are what ultimately matter in the economy, and money is a way that
allows people to acquire the goods and services that they need or want.
They
earn this method of exchange by going to work, which is a contractual exchange
of one set of goods — labor, intellect, etc. — for another.
People
work to acquire money in the present to purchase goods and services in the
future.
Our
system of money operates on a mutual set of beliefs; as long as enough of us
believe in the value of money, for now, and in the future, the system will
work.
In the
United States, that faith is engendered and supported by the federal
government, which explains why the phrase "backed by the full faith and
credit of the government" means what it says and no more: the money may
have no intrinsic value, but you can trust using it because of its federal
backing.
Furthermore,
it is unlikely that money will be replaced in the near future because the
inefficiencies of a purely barter system, in which goods and services are
exchanged for other goods and services, are well known.
If one
currency is to be replaced by another, there will be a period in which you can
switch your old currency for new currency.
This is
what happened in Europe when countries switched over to the Euro.
So, our
currencies are not going to disappear entirely, although at some future time
you may be trading in the money you have now for some form of money that
supersedes it.
The Future Value of Money
Some
economists don't trust our system of fiat currency and believe we cannot
continue to declare that it has value.
If the
vast majority of us come to believe that our money won't be nearly as valuable
in the future as it is today, then our currency becomes inflated.
Inflation of
the currency, if it becomes excessive, causes people to want to get rid of
their money as quickly as possible.
Inflation,
and the rational way citizens react to it is bad for the economy. People will
not sign profitable deals that involve future payments because they’ll be
unsure what the value of money will be when they get paid.
Business
activity sharply declines because of this. Inflation causes all sorts of other
inefficiencies, from a café changing its prices every few minutes to a
homemaker taking a wheelbarrow full of money to the bakery in order to buy a
loaf of bread.
The
belief in money and the steady value of the currency are not innocuous things.
If
citizens lose faith in the money supply and believe that money will be
worthless in the future, economic activity can grind to a halt.
This is
one of the main reasons the U.S. Federal Reserve acts diligently to
keep inflation within bounds — a little is actually good, but too much can be
disastrous.
Supply and Demand
Money
is essentially a good, so as such is ruled by the axioms of supply and demand.
The
value of any good is determined by its supply and demand and the supply and
demand for other goods in the economy.
A price
for any good is the amount of money it takes to get that good.
Inflation
occurs when the price of goods increases — in other words when money becomes
less valuable relative to those other goods.
This
can occur when:
1.
The
supply of money goes up.
2.
The
supply of other goods goes down.
3.
Demand for money goes down.
4.
Demand
for other goods goes up.
The key
cause of inflation increases in the supply of money. Inflation can occur for
other reasons.
If a
natural disaster destroyed stores but left banks intact, we’d expect to see an
immediate rise in prices, as goods are now scarce relative to money.
These
kinds of situations are rare. For the most part, inflation is caused
when the money supply rises faster than the supply of other goods and services.
To
summarize, money has value because people believe that they will be able to
exchange this money for goods and services in the future.
This
belief will persist so long as people do not fear future inflation or the
failure of the issuing agency and its government.
Mike Moffatt
Writes extensively about economic
issues
Studied economics at four different universities
in three countries
Taught economics at both the university
and community college levels
Experience
Mike Moffatt is a former writer for
ThoughtCo who wrote articles about Economics for more than seven years. He
contributed 260 articles to ThoughtCo, mainly on economic issues including
free-market policy, as well as the economic effect of tariffs. Mike's
background in writing about Economics includes work for The Globe and Mail and
Rogers Communications publications. He was an assistant professor with the
Richard Ivey School of Business for more than 14 years and has served as the
director of Policy and Research for Canada 2020. Further, Mike held a position
as the chief innovation fellow at Innovation, Science and Economic Development
where he advised Deputy Ministers about policy. He is the senior director of
Smart Prosperity Institute, a national research and policy think tank in
Ottawa, Canada.
Education
Mike Moffatt received a Doctor of
Philosophy (Ph.D.) in Management Science from the Richard Ivey School of
Business in 2012. He also holds a Master Arts (M.A.) and a Bachelor Arts (B.A.)
in Economics.
Awards and Publications
Co-wrote A Review of the Economic Impact of Energy East on Ontario(Mowat
Center Energy Research Hub, 2015)
Making it Simple: Boosting Canadian competitiveness through
selective tariff elimination (Mowat Center Energy Research Hub, 2016)
Towards an Inclusive Innovative Canada (Canada 2020,
vol. 1, 2017)
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