Monopoly Money
When Money Stops Representing Objects — Post #6
In the analogy from yesterday…
The money was backed by grain. Users of the money trusted they could return their paper or coins for grain, because the money (notes and coins) represented how much grain there was.
Now let’s imagine the guy making the notes (the writer), needed a way to pay the guards to keep the grain safe. He could just write a few more notes in exchange for their work because, after all, the money represents value and the guards are providing a value.
So he does.
He also writes himself a few so that he can have grain because he has been busy exchanging grain for notes all day and needs to eat.
This causes a shift in what the money represents. It no longer just represents the amount of grain in the vaults. It now represents the total value in the system (amount of grain + the value of keeping the grain safe). The better the guards and the more honest the writer, the more trust is built over time. And trust is valuable.
However, if everyone demands grain at the same time, there will not be enough. But it is unlikely that everyone will need to exchange money for grain at the same time, so the system works.
Now let’s go a step further.
If the money is only backed by the trust in the system (and not something like grain) it is called fiat money. This is because it now represents trust in the writer and guards, but does not actually represent anything intrinsically valuable. This works fine. Until it doesn’t.
If the guards and writers make notes which do not represent actual value, then people will trust the system less. For example: pretend the writer started making tons of notes to buy booze. This puts more money in the economy then there is value. Now, each piece of money is worth less than it was initially, because of this the price of goods (objects) will rise. This is called inflation. Inflation can also happen when goods become more expensive. In either inflationary scenario, the money is worth less. The opposite phenomenon is called deflation (goods cost less and money is worth more).
Vocabulary:
Fiat Money: created for the purpose of being money, but not representing anything
Intrinsic: valued for things other than exchange
Inflation: ability to buy less with $1
Deflation: ability to buy more with $1
This is post #6. The others are located here.
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