page updated on July 18, 2015
Money is fascinating. Money lets you buy things you need and want. It also flows in interesting ways. Money represents what society values and how. If you understand money and its implications, you can the nature of work, your place in society, and the policies of government.
In these olden days, money wasn't a thing. Before you could go to the grocery store and buy a carton of organic, free-range, cage-free eggs, you either raised your own chickens or traded with someone who raised chickens to get eggs for your breakfast. Maybe you had an apple orchard and could trade one apple for two eggs. Maybe you raised potatoes and could trade one potato for one egg. Maybe you were a carpenter and could fix someone's roof in exchange for one egg every day through the winter.
Barter is this system where one person trades a good or service directly for another good or service.
Barter has its problems. If you want eggs but the other person already has apples, potatoes, and a new roof, you might have to trade with several people to get what the other person wants in exchange for eggs. If you mine diamonds, you might not want to trade a diamond for a basket of eggs, unless that basket holds hundreds of thousands of eggs. If you're a sculptor, you might not want to wheel around a wagon full of thousands of pounds of statues just to buy a sandwich for lunch.
What if the apples go bad before you can trade them for what you want? Now no one gets any apples (if they wanted them) and you've wasted all that time harvesting them only to feed them to worms or pigs without getting any value out of them. This is the problem of liquidity, or being able to turn an item of value you have into another item of value that you want.
Currency is a representation of value. Currency may have an inherent value, like a lump of copper, gold, or silver. A copper piece may be worth an egg. Two copper pieces may be worth an apple. A silver piece may buy you a nice meal, two mugs of beer, and a comfy bed for the night at the local in.
Currency may be a precious metal. Currency probably has a distinguishing characteristic (it's gold or silver, so it's relatively rare—not like leaves or boring rocks), such as the stamp of the local king or caesar or mayor. Currency is generally accepted as valuable; you can translate it to apples or potatoes or a new roof. Even if not everyone agrees on the precise value of a copper (one apple? two apples?), everyone generally agrees to accept currency in trade for goods and services.
Now you can offer apples for eggs or copper pieces for eggs. You can carry a little pouch full of gold coins more easily than you can cart around a wagon full of heavy statues. You can sell all of your apples as you harvest them and store the currency and spend it only when you need it. You don't have to rush to get rid of every apple before they all spoil.
Currency is a storage mechanism for value.
Currency based on precious metals has a problem. There's a limited supply of gold and silver and copper in the world. If there are only a thousand copper pieces in the world and you have 500 apples and your neighbor has 500 eggs, and if an egg and an apple are each worth a single copper piece apiece, then the math works out.
What happens next year, when you have 600 apples and your neighbor has 600 eggs and there are still only 1000 copper pieces? What happens when the potato farmer down the street has 1000 potatoes to sell?
Either someone has to find more copper or the relative value of each apple and potato and egg has to go down. That's not ideal.
Back in the slightly less olden days, governments and banks and other entities put together a system where they would issue a piece of paper which represented an amount of gold or silver or other precious metal. If you took that paper to the issuing entity, you could redeem it for the proper amount of gold or silver or copper.
Reserve currency is the system where a bank holds this precious metal in reserve for its depositors.
That didn't solve the problem that the total value produced by the farmers in your neighborhood might grow faster than the available gold and silver and copper. Then someone realized that it currency is just a representation of value (the real value of labor and goods and services) and that not everyone was going to redeem paper currency for gold and silver at the same time. In fact, maybe one in ten people—maybe one in twenty—would go to the bank and ask for gold in exchange for paper currency.
If that fact held true, the bank need only keep one gold coin in reserve for every ten or twenty pieces of paper representing one gold coin. It could hold only gold if it wanted, if everyone agreed that to treat twenty silver coins worth one gold coin. In effect, a bank could hold a fraction of the precious metals for which it had issued paper currency. This is a fractional reserve system.
This mechanism holds true pretty well. Sometimes, more people wanted to exchange their paper currency for the reserve commodity, but it was relatively rare. (It's dangerous when it happens, but there are ways to work around that, and that's a different story.)
Fractional reserve banking helped deal with the problem that you and your farmer friends produce more goods and services every year, but it didn't address the fact that there's still a limited amount of gold, silver, and copper in the world. Once you've mined all of the easy gold and picked up all of the diamonds lying on the beaches of South Africa, you have to go to a lot more work to get more. It costs money to drill miles into the earth, and miners eat a lot of eggs and potatoes.
Along the way, people started studying money and currency and value and the production of entire societies. These economists developed theories, some of which turned out to be pretty good at describing behavior of large groups of people and some of which turned out to be pretty good at suggesting ways to manage money and currency to help society as a whole.
Remember how it was possible for people to ask for gold and silver coins in exchange for paper currency? Remember how the bank only had a fraction of the coins they would need if everyone asked for gold and silver at the same time? That happened. It happened a few times. It was really bad for a few people, devastatingly bad.
It revealed something, though.
Money is a representation of value. The dollar bill you have in your pocket (or the loonie coin, if you are in Canada) isn't worth much on its own. It's not really worth something because you can trade it for a few flakes of gold or several grams of silver or a copper statue of an elephant. It's worth something because you can take it to someone who raises chickens to lay eggs or runs an apple orchard or fixes roofs or grows potatoes and trade it to that person for eggs, apples, potatoes, or a new roof.
That piece of paper or that coin with a bird on it represents value. People roughly agree on that value. (The collective group of people agreeing on the value of goods and services and, yes, currency, is a market.)
When you exchange a piece of paper for eggs or potatoes, it doesn't really matter that the recipient can exchange that same piece of paper for gold or silver. After all, precious metals are unwieldy. What's more important is that the person selling you eggs or potatoes can use that paper currency to buy whatever he or she wants, without going through gold.
Currency is valuable because everyone believes it's valuable—because everyone accepts it in trade for goods and services. The actual gold and silver behind the currency is irrelevant in practice. Hold that thought.
How did the world go from small kingdoms and villages to individual banks with their own special money to large governments which all respect dollars? To make a long story short, it's two secrets. One, if you pay taxes to the United States government, you can only pay your taxes in US dollars. Two, the US government has a monopoly on the supply of US dollars.
If you have a government as large as the US government (or the Canadian government or the Chinese government or whichever government; the principle matters more than the specific example) and you can only pay taxes to that government in the government's currency, that currency has a lot of value. Any taxable work you do where you get paid in currency has to pay you in a currency that you can convert to currency you can use to pay taxes. That means dollars in the US. You can call this legal tender—money you use for paying taxes.
The US government also has a monopoly on printing dollars. No one else can print dollars. (Fake dollars are counterfeit, and the US Secret Service will chase you down and everyone knows counterfeit dollars aren't worth anything because they're counterfeit. Yes, that's circular reasoning, but it's important that it is circular reasoning.) The US government (through the Federal Reserve, which is another story) can issue more dollars and it can retire dollars. It can increase or decrease the number of dollars in circulation every year. If there are 600 apples and 600 potatoes and that's everything the US produces this year, it can manipulate the dollar so that there are 1200 dollars in circulation instead of 1000. (That's the theory anyhow. It works a lot better when you're talking about billions of apples and potatoes, because you probably have $20 in your wallet right now. The principle applies though.)
Because the US government can change the number of dollars in circulation, the value of the dollar relative to gold could change. A dollar's worth of gold in 1890 was a lot more gold than a dollar's worth of gold in 1990 or 2013. Keep in mind that the amount of gold in the world is small and the size of the US economy (let alone the global economy) is a lot larger than in 1890 or even 1980.
In the not-so-olden days, you could take a dollar bill into a bank and ask to get a dollar's worth of gold. The value of a dollar was tied to gold. The Federal Reserve held gold in, well, reserve in places like Fort Knox. Yet the number of eggs and potatoes produced by the US grew every year faster than the amount of gold held in Fort Knox. Besides that, almost no one cared that you could exchange a dollar for an ever-decreasing amount of gold. The value of a dollar wasn't that it represented a few flakes of gold. It was that you could pay your taxes with it, that you could buy or sell eggs and potatoes and apples with it, and that everyone else agreed.
Oh, and the US government promised that if you lent it money in dollars, it'd pay you back in dollars.
That's really big. United States currency is valuable because this is a believable promise. If you can trust someone to pay you back when you lend them money, you're more likely to lend them money. If they have a monopoly on producing that money, that's even better. They're not going to go bankrupt. They can print more money.
Yes, you have to be able to trust them not to print so much money that that currency is as worthless as dirty little rocks on the side of the road, but that's a different problem.
Fiat currency is a currency with value based on the declaration of a trusted entity and the belief in the stability of that entity. The dollar is valuable even if it's not tied to gold or silver or copper. Even if you couldn't go into a bank and trade a dollar bill for a few flakes of gold, the dollar bill is still worth something. Why? Because the US government says it is, and everyone believes it. The dollar's worth a dollar because of declaration and belief. We have a special name for this.
This isn't a blind faith. United States currency is valuable because the United States government issues it and accepts it to pay taxes. Those dollars make the US government work. If you loan the one entity with a monopoly on producing dollars money—if you loan the US government money—it'll pay you back in dollars. The stability of the global financial system depends on people believing this. Then again, the stability of the currency system depended on people believing that a copper coin was worth one apple or one egg or that two pieces of gold was worth a new roof and maybe a brick wall. The stability of the barter system depended on liquidity.
This is the foundation of modern economics, especially macroeconomics. Studying how money moves in and out of markets can help improve the lives of individuals and nations. Furthermore, understanding currency and fiat currency can help you understand investment, banking, finance, and other topics like Bitcoin and cryptocurrency—but that's a topic for another article.