What money actually is
Money has no value of its own. It's a promise that others will give you something for it. That works as long as enough people trust it, and because new money keeps being added, the same amount buys you less over time.
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. The baker still gives you bread for it, because she knows her flour supplier will take the note too. And the supplier takes it because his landlord does. Money is a promise that gets passed around.
Three jobs
It does three jobs. You can pay with it. You can compare prices, because everything is quoted in euros. And you can keep value for later. It does the last job worst.
Money without gold backing
Money used to be tied to gold. Today it isn't. Central banks and ordinary banks can increase the amount of money. If it grows faster than the amount of goods there are to buy, each euro is worth a little less.
What happens in a checking account
You don't notice that in your current account. The same number sits there every year, but it buys a bit less. If Maria had €5,000 in her account ten years ago and still has it today, she can buy noticeably less with it than back then. Everything else on this site starts from that thought.
Economists call the three jobs medium of exchange, unit of account and store of value. Today's money is called fiat money. There's no gold or commodity behind it. It counts because the state declares it legal tender, and above all because everyone expects it will still be accepted tomorrow.
How money is created
Most money isn't created at the central bank at all. It's created when banks lend. When Paul borrows €20,000 for a car, the bank credits the amount to his account without anyone having deposited those €20,000 beforehand. The money comes into being at that moment and disappears again when Paul repays the loan. The central bank only steers this from outside, mainly through the policy rate.
Money supply and inflation
Whether more money automatically leads to inflation is disputed. Economists like to write the relationship as M · V = P · Y. M is the amount of money, V how often a euro changes hands in a year, P the price level and Y everything that's produced. If V and Y stay the same and M rises, prices rise. In reality V and Y rarely stay the same. After 2008 central banks created a great deal of money, and prices still barely rose for years. That's why experts argue about monetary policy to this day.
Summary
- Money is a promise on other people's work and has no value of its own.
- Most money is created when banks make loans.
- Money is a poor way to store value, because the amount of it keeps growing.
Did you get it?
What three jobs does money do?
Paying, comparing prices and keeping value. It does the last one worst.
Where is most money created?
At commercial banks, when they make loans. The central bank only steers this indirectly.
Does more money always lead to inflation?
Not automatically. How often money changes hands and how much is produced change too. The link is real, but it doesn't run like clockwork.
Check your understanding
Your task
Maria has $5,000 in a bank account, and prices rise 2 percent per year for ten years. Calculate what the $5,000 is worth in today's purchasing power by dividing 5,000 by 1.02 to the power of 10. Write down which part of your own money this affects.
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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