Paper money is issued by governments around the world and is used by people to store value and purchase goods they need for their everyday lives. Paper money has value because a large number of people agree to its value so it becomes useful as a bartering tool. Instead of trading sheep, shells or grain, we now rely on paper money because it has a common use for almost everyone.
Origins of Paper Money
The first use of paper money by a Western nation occurred in 1685 when a French officer in the military paid the troops using parts of playing cards that represented that amount of money that they were supposed to be paid. In 1690, the Massachusetts colony began issuing paper shillings that could be used to pay taxes. This paper currency was used to represent payments from the government and had value because it was accepted by the government to pay debts.
What is the Gold Standard?
For a long time, paper money was backed by gold that was held by the government that issued the paper currency. For example, when the United States originally issued paper currency individuals knew that they could go to the government and trade a dollar bill for an equally valued piece of gold. This standard was restrictive because it required the government to hold enough gold to back its currency.
History of the Gold Standard
England was the first country to officially take on the gold standard in 1821. The fact that the British government backed its money with gold that could be redeemed gave people more confidence in the paper money and Britain's trade increased. Germany adopted the gold standard 1871 and many more followed by the end of the century. The governments worked with each other until World War I shattered the ideal conditions under which the gold standard flourished. As the British pound and American dollar became the dominant currencies, many smaller countries began to stockpile these currencies rather than stockpiling gold. After World War II, the gold standard began to lose effectiveness because gold was traded freely, and in 1971 the gold standard was officially abandoned.
Today paper money has value because everyone agrees on its usefulness. You can take a dollar bill to almost any store - even in many foreign countries - and know that you will be able to purchase the goods that you need. In the same way, merchants that accept the paper money know that they will be able to spend it on what they need.
Over time, the prices of goods and services increase because there are more dollars competing for fewer goods which drives the price of the goods upward. The purchasing power of the paper money decreases because it cannot buy as much as it used to. Inflation is measured in terms of how much prices increase over a year. For example, if a $100 item costs $103 a year later, the inflation rate is 3 percent.