What money actually is
Money isn't a value in itself, it's a voucher for other people's output. It only works as long as enough people believe in it, and there's constantly more of it, which is why it loses purchasing power.
Learning objective: After this lesson, you can explain why money has no value of its own and why it keeps losing purchasing power.
A twenty-euro note is printed paper. It isn't worth anything because the paper is valuable, it's worth something because the baker will give you bread for it. And the baker takes it because he knows his supplier will take it too.
So money is a promise, passed from hand to hand. It has three jobs: you can pay with it, compare prices with it, and store value with it. It does the third job worst of all.
Money used to be tied to gold. It no longer is. Central banks and commercial banks can expand the money supply. When the amount of money grows faster than the amount of goods, each individual note becomes worth less.
That's exactly why money in a checking account isn't a safe thing, it's a slow loss. The same number sits there, but you get a bit less for it every year. That's the starting point for everything that follows on this site.
Economists distinguish three functions: medium of exchange, unit of account, and store of value. Modern money is fiat money: it has no intrinsic worth and no backing by a physical good. Its value rests on legal-tender status and, more importantly, on market participants' confidence that it will remain stable.
By far the largest share of the money supply isn't created by the central bank, but through lending by commercial banks. When a bank issues a loan, it credits the borrower's account without that amount having been deposited beforehand. Deposit money is created at the moment of lending and disappears again when the loan is repaid. The central bank steers this process indirectly through the policy rate and reserve requirements.
For the relationship between money supply and the price level, the quantity equation M · V = P · Y offers a framework, with M the money supply, V the velocity of circulation, P the price level, and Y real output. It's an identity, not a causal claim: if M rises while V and Y stay constant, P rises. In practice, V and Y aren't constant, which is why an expansion of the money supply doesn't mechanically translate into inflation. This is exactly why the debate over monetary policy remains permanently contested.
Summary
- Money is a promise on other people's output, not a value in itself.
- Most money is created through bank lending.
- Money makes a poor store of value, because its supply keeps growing.
Did you get it?
What three functions does money serve?
Medium of exchange, unit of account, and store of value. It performs the last one worst.
Where is most money actually created?
At commercial banks, through lending, not at the central bank.
Does a larger money supply necessarily lead to inflation?
No. Velocity of circulation and real output also change. The relationship is real, but not mechanical.
Check your understanding
Sources and further reading
- The Deutsche Bundesbank (Germany's central bank) explains that the vast majority of book money is created not by the central bank, but through lending by commercial banks. View source ↗
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