When our ancestors wanted something, they had to exchange goods or services to get it. For argument’s sake, let’s call the two people in the exchange Fred and Barney, in a world where the only goods consumed are brontosaurus burgers and bowls of Fruity Pebbles™. If Fred has a brontosaurus burger but wants some Fruity Pebbles and Barney has some Fruity Pebbles but wants a brontosaurus burger, Fred and Barney can work out an exchange where they can both get what they want.
Fred decides that the brontosaurus burger takes more time to make (on account of hunting down the brontosaurus), so he would be willing to exchange one brontosaurus burger for three bowls of Fruity Pebbles. Lucky for Fred, Barney has three bowls of Fruity Pebbles and he’s been jonesing for a brontosaurus burger, so an exchange takes place.
But, what happens if Fred still has the brontosaurus burger and Barney still has the Fruity Pebbles, but Fred doesn’t want Barney’s Fruity Pebbles because instead he wants to buy a new house in Bedrock? The real estate agent probably won’t want to be paid in 5,000 Brontosaurus Burgers, if Fred even has that many. Maybe the real estate agent doesn’t want any brontosaurus burgers in the first place and would prefer to be paid in cereal boxes anyway.
Exchanging becomes difficult when people have to exchange goods that have very different values and aren’t interested in whatever good the other person has. In the long run, it will be easier to convert their goods into a value that can be stored and is transferable, like dollars. Maybe the bedrock banker determines that the value of one dollar equals a bowl of fruity pebbles. Now, if Fred pays the real estate agent in dollars, the real estate agent can buy any combination of brontosaurus burgers and fruity pebbles.In a large marketplace where there are many buyers and sellers of various goods, having currency makes exchanges easier.
Instead of using fruity pebbles to mark the value of currency, countries like the US used to use the gold standard, where a unit of a currency is worth a certain amount of gold. However, this means that if the value of gold, or fruity pebbles for that matter, drops suddenly, it impacts the whole economy. It also requires the US to be able to hold enough gold to cover the amount of dollars in circulation, so the US left the gold standard in 1970.
How money is created
Money has gotten a lot more complicated since the days of using fruity pebbles as an exchange medium. There is a lot of money in the economy that exists just as a number in a bank account but isn’t backed up by anything material like gold or even paper money. Because we store money electronically, it makes creating new money a lot easier.
If I deposit $1,000 into my bank, although my account will still show that I have $1,000, the bank may have actually lent most of that money out to someone else; the amount the bank has to keep available is called the reserve ratio. If my bank’s reserve ratio is 10%, they only have to keep $100 of my money in the bank and can lend the rest out.
The bank is pretty sure that not everyone will come take all their money out of the bank at once, so they only hold onto some of the money. If everybody did try to take their money out at the same time, it would play out like in It’s a Wonderful Life (see how it worked here). Now, the federal government ensures your money up to a certain dollar amount, so that issues like this are less common.
But, I digress. If someone, let’s call her Kate, decides she needs a $900 loan from my bank to finance something, she can go to my bank and ask for that loan. The bank will make her an account where they will type in “$900”, and give her my money. But the catch here is that my money still shows up in my account, too. Because the bank knows I’m not going to go use all of that money right away, they loan it out. Now instead of there being $1,000 in new money in the system, there is $1,900.
Then when Kate deposits that money in her account at her bank, that bank will do the same thing and lend out 90% of it. This cycle continues, and $1,000 in initial deposits can eventually create nearly $10,000 in the economy.
While the way that money is created is complicated, it also allows for more growth in the economy. If Fred wanted to take out a loan to finance his Brontosaurus Burger venture, even if they had dollars instead of just exchanging goods, it would be really hard for him to get a big loan if there were a limited number of sand dollars in circulation. Creating dollars allows banks to give more loans and ultimately finance more growth in the economy.