A Basic Primer on Money – What it is and How it Works

by Ian Tartt

Money is used by so many people and affects so many areas of our lives, but what exactly is money? Where does it come from, how does it get its value, and are there better options than what we have now?

Simply put, money is a means by which two or more individuals can trade with each other and acts as a proof of value for such trade. But before we continue, let’s look at how trade has evolved over time, beginning with barter. Barter, the purest form of trade, involves trading one good directly for another (ie trading a bucket of milk for a dozen eggs). This works, but it’s clumsy in many ways. For one thing, barter can involve goods of all shapes, sizes, and weights; it’s difficult and awkward to carry or drag around such objects. And what if something happened to them? Many types of goods are fragile or could go bad over time, which further limits their usefulness for trade.

The drawbacks of barter caused people to look for alternative ways of trading with each other. This is where money comes in. As mentioned previously, money is designed to facilitate trade between and act as proof of value for two or more individuals. While most modern forms of money are issued and controlled by a government-run central bank, this is not the only way in which money can be created or used. Anything that people are willing to accept as money can be used as such. Despite this, not all money is created equal.

What are some qualities of good money? Well, we’ve looked at some problems resulting from barter in a previous paragraph, and by flipping them around, we can turn them into qualities of good money. Good money should be fairly lightweight so it can be easily carried around. It should be durable so it retains its value over time and is resistant to being damaged or destroyed. Being made of scarce materials, so that its natural value is high and remains as such, is another important characteristic of good money.

Historically, many different objects have been used as money, including tobacco leaves and seashells. Whenever people were allowed to choose what they wanted to use as money, however, precious metals such as gold and silver tended to be their preferences. Both satisfied all the previous characteristics of good money, which is why many different cultures and societies used them, and why they continued to be used as money in the US until relatively recently. This is known as commodity money because the money is made of a valuable commodity.

Over time, there were changes in how money was used. People began to deposit their precious metals in banks, and in return they’d get receipts verifying their deposits. When they wanted to withdraw their money, they’d hand in the receipts and get their money back. It wasn’t long before the receipts began to be used as money. Because there were valuable commodities backing up the receipts, it was easier to use the receipts than to carry around metals or deposit/withdraw them as needed. This type of system in which the money is backed by a valuable commodity is called hard money.

Eventually, and usually at the point of a sword by decree of a political ruler, both commodity and hard money began to be replaced by fiat currency. Instead of being made from or backed by a valuable commodity, fiat currency has “value” simply because the government says it does. Usually accompanying a fiat currency system are legal tender laws designed to prevent people from using alternative currencies. This is necessary for a fiat currency system because, given the choice between money with a great deal of purchasing power and which retains its value over time or money with little purchasing power and which loses value over time, most people would gladly choose the former.

Let’s talk about inflation for a bit. When most people think inflation, they think of it as the increase in prices of goods and services. While this is an effect of inflation, actual inflation is the increase in the supply of money. The law of supply and demand tells us that when the supply of a good increases while demand remains constant, the value of that good falls. This applies to money as well. If the money supply is increased, the purchasing power of each unit of money decreases. As a result of the decline in purchasing power, prices increase. Here’s an analogy that may be helpful: if you have workers who can each lift four hundred pounds, you’ll only need ten of them to lift an object that weighs four thousand pounds. If you have workers who can each lift two hundred pounds, you’ll need twenty of them to lift that same object. So it goes with money.

How do the different monetary systems compare as far as inflation is concerned? Commodity money, due to its being made of scarce resources, is difficult to inflate. If gold coins are used as money, inflating the money supply would involve digging up more gold, which is tiresome, time-consuming, and costly. And since we haven’t been able to synthesize gold, there is a natural limit as to how much gold can be used as money. Commodity money can be inflated in a few other ways, however. Adding base metals to a gold coin removes some weight from the coin while still keeping the weight the same; this allows more coins containing gold to be made and used because less gold is being used in each coin, which lowers the value of the coins. Similarly, making the size of the coins smaller, perhaps by cutting off some metal, is another way to inflate gold coins. Both of these practices have been used throughout the course of history to inflate commodity money. So although commodity money offers a strong check against inflation, it is not immune to inflation.

Hard money, which is backed by a valuable commodity but not made of one, also offers a strong check against inflation. However, hard money can be inflated more easily because banks (whether they’re central banks or commercial banks) tend to issue more receipts than they have deposits (a practice called fractional reserve banking). Because the commodity is separate from the units of money, hard money offers less resistance to inflation than commodity money.

You may see where this is going by now. Fiat currency, being neither being made of a valuable commodity nor backed by one, offers the least protection against inflation. If it’s made of common materials that can be easily harvested and turned into money, as most fiat currencies are, then countless units of fiat currency can easily be printed and distributed. Most people under a system of fiat currency have no problem accepting and using it, in part because it’s easy to carry around and store, and also because they’re not aware of how any other system could work or the ways in which it would be better.

Fiat currency systems are common today because they’re hugely beneficial to governments. The ability to print money whenever they like allows them to finance virtually anything they can think of. War, welfare programs, handouts and special favors to friends, and almost everything else within various governments that have been built up over the last hundred or so years have been financed to a large degree by inflation. Additionally, inflation allows these to be provided without enormous tax increases. There is still the loss of purchasing power and subsequent increase in prices, called the inflation tax, but this is less noticeable and detestable for most people than outright tax increases (especially since the increase in prices is often blamed on “greedy businessmen” rather than bad monetary policies). For these reasons, fiat currency is the least stable, easiest to inflate, most common, and most damaging monetary system.

If fiat currency systems are the easiest for governments to use to increase their power, then commodity money systems are the hardest to use for such purposes. As such, they provide the greatest protection against government growth and abuse, and offer the best chance at having a stable economy. Given all this, it’s no wonder that governments over time have moved away from commodity money and embraced fiat currency.

An article of this length can’t possible explore everything there is to know about money. As such, this was intended merely to be an introduction to money and a run-through of some components that are rarely discussed nowadays. Some great resources for more information on this subject are Murray Rothbard’s speeches about the Gold Standard Before the Civil War and the Founding of the Federal Reserve, “End the Fed” by Ron Paul, and “Capitalism: The Unknown Ideal” by Ayn Rand. For something as commonplace and influential as money, it would benefit everyone, including this author, to learn more about what it is and how it works.

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