Explanation of the Value of Money
- Before money, people bartered for goods and services: If a neighbor had a particularly attractive citrus tree, a person offered some wine or textiles for exchange. A PBS piece explained that as of 9,000 to 6,000 B.C., agricultural commodities became a unit of exchange. In 1,200 B.C, the Chinese and African civilizations used cowrie shells as a unit of currency. Over time, governments used precious metals such as silver, gold and copper to make coinage. Coins were then used as a vehicle for and facilitator of trade: This way, people could purchase a wider variety of goods and services. Sometimes, nations still accepted payment in the form of scarce commodities: Roman warriors were paid in salt, and in the 1600s, the Dutch used tulips as a trading commodity. In each of these cases, the value derived from the item's rarity.
- In 1933, the American government decided it would be more convenient if paper currency did not have to be backed by a precious, rare commodity such as gold or silver. Dollars today are backed by the guarantee of the U.S. government but cannot be redeemed for gold. By removing this gold standard, nations could print as much or as little currency as the needs of the economy dictated. In turn, the production of goods and services did not have to hinge on the availability of a scarce resource.
- Though the dollar's value no longer hinged on commodities, the value of money still depends on the amount of it in circulation. When the money supply increases, the value of money declines. The increased amount of money in circulation over the past 100 years is the reason why one dollar today purchases much less than a hundred years ago. If a country opens its borders to trade, additional considerations come into play. For instance, if the United States increases the money supply and makes the dollar worth less, it becomes more expensive for American businesses to purchase materials from overseas. On the other hand, if the dollar is too strong based on few dollars circulating in the money supply, foreign businesses will not want to purchase goods from American companies because those exports are more expensive.
- The amount of money in circulation, and thus, the value of money, is controlled by a few parties: The Federal Reserve, foreign central banks and financial institutions. The Federal Reserve raises the nominal interest rate to contract the money supply and lowers it to increase the amount of money. Foreign central banks buy and sell dollars on the FOREX market, which also affects the money supply.