Where does Money get its value from?
Have you ever pondered how money itself obtains its value? You probably have but you didn’t ask yourself that question in that way. You would’ve asked it like this, “How is it that I can go to Mexico and buy 10 times as much for $1 as I could in the US? I will attempt to enlighten you on this subject.
Up until 1971, The US Dollar was backed by gold. This means that at any point you could trade your Dollars in for gold (in theory). Today, Dollars are tied to a system called Fiat Money (Fiat-Latin for Faith). The reason for this was because the US economy was far exceeding the world’s gold supply. Today, it’s backed by the fact that if you use a Dollar, you have faith that you will receive a product in return. That product is the called Gross Domestic Product.
You learned that wealth is assets, not money in chapter 1. The US Dollar is based Gross Domestic Product (GDP). GDP is the total amount of products and services produced within a country’s borders in a certain time, usually one year. Click here for the specific definition.
Currency is directly tied into a country’s GDP. Also known as Production. How’s that? Well, imagine that four people started a country. They obviously need a form of currency for their respective countries. The first guy named Adam names his currency the Alpha Dollar and his country produces one fork. The second guy named Ben names his currency the Bravo Dollar and his country produces one spoon. The third guy named Chuck names his currency the Charlie Dollar and his country produces one knife. The last guy named Don Names his currency the Delta Dollar and his country produces nothing. Remember, Currency is based on goods produced.
Adam might want to buy Ben’s spoon with Adam’s own currency, the Alpha Dollar. Will Ben accept Adam’s currency? Yes. Ben might want to buy Chuck’s knife with Ben’s own currency, the Bravo Dollar. Will Chuck accept Ben’s currency? Yes. Chuck may want to buy Adam’s fork with Chuck’s own currency, the Charlie Dollar. Will Adam accept Chuck’s currency? Yes. This scenario may continue to play out each year. It may get to the point that although each country has their own form of currency, they never actually make purchases with their own currency because one of the other guys will have current possession of their currency.
So what of Don’s currency, the Delta Dollar? Don wanted to purchase products, but did Adam, Ben or Charlie accept his currency? No. The reason was because they didn’t have any faith that they would be able to receive a product if they went to Don’s country to exchange the Delta Dollar. In other words, there was no production activity in Don’s country during that year. Don’s money was worthless.
On the other hand, Adam gets a bright idea to make two Alpha Dollars so he could buy more products. What happens? Well, Ben and Chuck catch on to the trick and now demand that Adam pays two Alpha Dollars instead of one. Why? The reason is the same as the situation with Don. They don’t have faith that they will receive two products from Adam’s country. They’re right because if Ben and Chuck tried to exchange each of their Alpha Dollars for one fork, one would get the fork while the other gets stuck with a worthless Alpha Dollar in their hand. Adam attempted to inflate his Alpha Dollar. This is commonly known as inflation.
Ben’s country decides to produce two spoons thereby doubling production in his country. What happens? Ben’s Bravo Dollar has double the buying power it once did. Now Ben can go to another country Such as Chuck’s country and buy his knife for half a Bravo Dollar or 50 Bravo Cents. The reason is because Chuck has faith that he will still get two of Ben’s spoons for 50 Bravo Cents each.
Now the United States today has a $15 Trillion GDP. The next five biggest Country’s in terms of GDP added together wouldn’t match the United States. That’s why US Dollar is the strongest and most stable currency on Earth. But, it’s being threatened by bad economic policies. We will dive into these bad policies in the future chapters.