Money is arguably one of the most important things in the world. While happiness and joy might outrank it, at least on your uplifting Instagram feed, money does seem to make things easier.
When you actually stop and think about paper money though, you’re left with a perplexing conundrum. There’s nothing inherently valuable about these banknotes, so why do they have any value at all?
Over time, how paper money is valued has changed, so to understand how modern money is worth anything, first we have to look back to the early days of paper money.
Gold and Silver
In the early days of governmental currency, money wasn’t paper, rather it was usually a coin made of a precious metal like gold or silver. The value of that money was intrinsic as the value of the metal that made it up. If you melted a gold coin down, you’d have the same amount of Gold as the coin was “worth”.
As this system of money became impractical, governments decided to come up with a new way of holding value in currency: paper money.
At first, paper money was backed by something called a Gold standard. This meant that a dollar bill or many other nation’s currencies could be exchanged for an exact amount of gold. This also meant that theoretically, the US held the equivalent value of gold in reserve as there was paper currency in circulation. Banks wouldn’t just be able to cash your checks, but they could give you gold or silver directly in exchange for your paper money based on an exchange rate set by the U.S. (or other) Government.
All this worked well until in 1971, the U.S. abandoned the gold standard for their currency. President Nixon believed that the gold standard undermined the core U.S. economy, which is what led him to move to a system we have today: Fiat currency.
The U.S. and many countries around the world currently operate off of a fiat money system, which means that paper money isn’t tied to any other thing or commodity. Ultimately, this means that modern paper money’s value isn’t inherent, but it depends upon human thought and valuation.
So if the paper money isn’t actually worth anything, why do we give it value?
Dollar bills and other modern bills have value because it is viewed as both a good and a method of exchange.
This means that it is in limited supply, i.e. the U.S. treasury or other countries’ treasuries don’t print an unlimited amount of money. As a method of exchange, people see cash a means of exchanging goods, or rather sellers are willing to accept money for their products or services.
As you might be able to infer, money’s value depends on a large part of the latter reason, it’s usefulness as a method of exchange. If people stop wanting to accept the U.S. dollar or any other currency for their goods and services, then we see inflation or devaluation.
Modern money operates on the belief that the money holds value and will in the future. This belief is usually backed by the federal government of a country, meaning that as long as the government is strong and healthy, the money will likely have great value.
Conversely, this is also why we’ve seen massive nearly unimaginable inflation in Venezuela as their government has fallen apart in recent years.
The Future of Money
While many economists don’t like the system of Fiat money that we currently have, it’s unlikely to go away anytime soon. That means that the future of any given fiat currency depends solely on user sentiment.
The value of fiat currency decreases when the supply of said money goes up, the supply of other goods go down, the demand for money goes down, or when the demand for other goods goes up. The four principles are core to how fiat money changes value, or inflates or deflates its price.
So, at the end of the day, modern money has value because we say it does and believe it will in the future. How does that make you feel about the $20 in your pocket?