When you look at our monetary system as it exists today, why does our money have value? Open up your wallet and take a look at a dollar bill. Ask yourself, "Why is this dollar bill valuable?" It's a piece of paper that say "One Dollar" on it. What makes that piece of paper have value? What relationship does it have to any sort of durable goods in the world?
The simple answer is that a dollar has value because the vast majority of people believe that it has value and are willing to accept it as a medium of exchange whereupon they provide a good or service, and then they use it as a medium of exchange, and obtain goods or services with their dollars. So, dollar bills are valuable because people want them and are willing to accept them in exchange for goods or services. But it's a piece of paper, right? Well, yes, actually it is. But, it's a piece of paper that people are willing to accept in payment for goods and services.
But why do people accept paper in payment for their goods and services? Well, look at that dollar bill again. There's a phrase on there, "This note is legal tender for all debts, public and private." Well, what does that mean? It means that a merchant has to accept that piece of paper in payment for their goods or services. You probably have a credit card in your wallet, too, right? Have you ever engaged in any sort of economic activity with someone who does not want to accept your credit card? Think of thinks like buying cookies from a girl scout going door to door. Chances are she doesn't accept a credit card in payment. But she will accept the $1 bills from your wallet. If you incur a debt to her by accepting cookies and agreeing to payment, then you give her several the $1 bills from your wallet in exchange for the cookies.
So, you believe that a dollar bill has value. The girl scout believes that a dollar bill has value, multiply that by hundreds of millions of people in the United States. That's why a dollar bill has value. All of those hundreds of millions of people are required to accept that dollar bill as a medium of exchange, and all of those people believe that they will be able to use it as a medium of exchange. Surely, the government must keep gold in vaults to back the dollar bills though.
Actually, the value of the US dollar is not pegged to any amount of precious metal. The way that dollar bills are created is basically by the Federal Reserve running a printing press. There's a byzantine picture with Congress and the Federal reserve, but, the essential, basic fact is that dollar bills come from a printing press. Why does counterfeiting carry a steep penalty? It undermines the value of the billions upon billions of dollar bills in circulation. It increases the money supply which drives down the value of money. It's a basic economic principle that an abundance in the supply of something will drive down the value of that thing. Money is a thing, in that sense.
Congress has the power to do the same thing, though. They can run printing presses, and create money that people are legally required to accept as payment for debts. What happens if Congress gets carried away? Zimbabwe or the Weimar Republic, where you use a wheelbarrow to take your money to the market, and your wallet to bring home your groceries. Congress wouldn't inflate the currency, would they, after all, they're supposed to look out for the United States.
If you have a change jar, reach in and pull out a quarter. Run your finger along the edge. Those are called reeds, and there is a very valid historical reason that they are on your coins. I have to go on a bit of an historic tangent here. Going back to the times of the Roman Empire, if not even further, the Emperors or their eunuchs, minions, or whoever decided to launch and invasion or fund a project or something special. They didn't want to raise taxes, because that would probably tick off a rich senator who would bribe the Praetorian Guard to stick a dagger in his back, so, they figured out another really neat trick. They realized that they could shave around the edges or their coins, then they'd use that metal to make more coins. Presto! More money! But people got wise to that idea, and started cutting vertical slots in the edges of coins. Then the government had to figure out another way to debase the currency. So they melted down the coins and mixed the precious metals with cheaper substitutes. Presto! More money. So people spent the cheaper coins and kept the valuable ones. Things went through a few changes, but eventually we ended up where we are today.
The financial system is complicated, but basically, the Federal Reserve creates money at the request of Congress, and that money goes into circulation. Congress has assumed trillions of dollars of debt, remember, they also have the power to create money, that is legal tender for all debts public and private. As long as they keep the printing presses under control, things go relatively well. If they don't, Argentina happens.
What happens when the girl scout doesn't want the dollar bill in your wallet in exchange for cookies?
