Understanding Economics: Why Does Paper Money Have Value?

Bureau Of Engraving And Printing Prints New Anti-Counterfeit 100 Dollar Bills
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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.