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The global monetary system is what's called a Fiat system in which money is a storage medium for purchasing power and a substitute for barter. Each dollar bill, euro, yen, gold ingot, or whatever currency you choose enables you to buy things as the need or want arises, thus making the barter system (trading one service or product for another) mostly obsolete.
Money then enables enterprises to development and societies to establish subspecializations, thus fostering a sort of dynamic progression toward the future.
For example, before there was money, anyone who owned land produced their own necessities and traded the surplus with other people for the things they needed.
Money changed that system by its inherent ability to store purchasing power, thus giving people the opportunity to make plans for the future and to specialize. In other words, if you're a good wheat farmer, then you can specialize in wheat, and buy your equipment, hire workers, and look for neighbors' land to buy to expand your wheat farm.
Markets and central banks then value the relative worth of the paper (currency) based on the perception of how a particular country is governing itself, the current state of its economy, and the effects the interplay of those two factors have on interest rates.
Money's money because we say it's money
Most of the world's money is called fiat money, meaning it is accepted as money because a government says that it's legal tender, and the public has enough confidence and faith in the money's ability to serve as a storage medium for purchasing power. A fiat system is based on a government's mandate that the paper currency it prints is legal tender for making financial transactions. Legal tender means that the money is backed by the full faith and credit of the government that issues it. In other words, the government promises to be good for it.
Fiat money is the opposite of commodity money, which is money that's based on a valuable commodity, a method of valuation that was used in the past. At times, the commodity itself actually was used as money. For instance, the use of gold, grain, and even furs and other animal products as commodity money preceded the current fiat system.
Where money comes from
Central banks create money either by printing it or by buying bonds in the treasury market. When central banks buy bonds, they usually buy their own country's treasury bonds, and their purchases are made from banks that own bonds. The money from the central banks goes to the bank vaults, and becomes loan-making capital.
When the Fed wants to increase the money supply in the U.S., it buys bonds from banks in the open market and uses a pretty simple formula to calculate how much money it actually is creating.
Instead of using gold as the basis for the monetary system — as was the custom until 1971, the Fed requires its member banks to keep certain specific amounts of money on reserve as a means of keeping a lid on the uncontrolled expansion of fiat money — in other words, to keep the money supply from exploding. These reserve requirements are the major safeguard of the system.
When the economy slows down, the Fed attempts to jump-start it by lowering interest rates. The Fed lowers interest rates by injecting money into the system. The monetary injection is sort of like a flu shot for an ailing economy. But instead of a vaccine, the Fed injects money into the system by buying bonds from the banks.
To keep the system from becoming inflationary, the Fed keeps a lid on how much banks can actually lend by using a bank reserve management system. The reserve management system, to be sure, is not an exact science, but over the long haul, it tends to work as long as the public buys the validity of the system, which in the United States, it does.
Here's how the reserve requirements work:
- If the current formula calls for a 10 percent reserve ratio, it means that for every dollar that a bank keeps in reserve, it can lend ten dollars to its clients.
- At the same time, if the Fed buys $500 million in bonds in the open market, it creates $5 billion in new money that makes its way to the public via bank loans.
- The reverse, or opposite, is true when the Fed wants to tighten credit and slow down the economy. It sells bonds to banks, thus draining money from the system, again based on the reserve formula.
Fiat money is created (and gotten rid of) out of thin air, but the process isn't by hocus-pocus from some wizard's wand. Its power comes from its use as accurate storage for purchasing power that is based on
- The public's acceptance of the legal-tender mandate. See the earlier section on "Money's money because we say it's money."
- The market's expectations that a government's promise to make its currency legal tender, by law, will hold.
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