Diamond Enthusiast
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Kitty, this is a great question with a more complex answer than you might want.
I recall one of my first economics classes. The professor took a dollar bill out of his wallet and asked, "What good is this?" It was raining outside, so he held it over his head and said, "It wouldn't be very useful to keep the rain off of me today now, would it?"
Money is, quite simply, an easy medium of exchange. Years ago, when there was no money, people simply exchanged things they had, or services they could provide, for things other people had or services they could provide. This is a barter system - "I will give you a quart of my freshest goat milk if you will give me a ride into town."
But this made transactions difficult. What if you wanted some corn, but all you had to exchange was a horse? That wouldn't be fair, now, would it? Thus societies developed their own forms of money. To some, where gold was valued, gold was made into smaller pieces that could be exchanged for various goods and services. Others may have used chickens or other livestock as a form of exchange - the smaller it could be broken down, the more "fair" and easy it was to use as money.
Fast forard to recent history. In the United States, we have money in denominations as small as one penny. When I was growing up a penny would still buy a piece of bubble gum. They are still needed to give correct change and pay the extra penny or so in sales tax. Thus, the currency and coins we have issued can be broken down into very small denominations and are useful for making purchases. Who wants to take a chicken to the store to pay for a six pack of beer?
But very little of our money supply is in the form of coins and currency. Much of it is in bank deposits. A branch bank where I used to work usually kept less than a few hundred thousand dollars in its vault, yet deposits from clients at the branch were in the tens of millions of dollars. There is no way a bank can come up with enough cash to cash out its depositors if they all want their money at once (known as a "run" on the bank).
In the United States, money is backed by the full faith and credit of the government. In some places, money is backed up by gold deposits. Some people think we should still do this - it is called the "gold standard." Other nations also back up their money with their "full faith and credit." Because the credit of some nations is in doubt, its money is not highly valued. The Russian ruble, for example, has gone through periods where it had no exchange value in the United States. Mexican pesos and other more perilous currencies have gone through periods of great devaluation. We are not immune to the process ourselves!
Now, what about all of that new money that is printed? Quite often, when new money is printed, old currency is destroyed. Quite frankly, it wears out. Further, we have been trying to get older currency that is more easily counterfeited off the street.
When new money is printed without a corresponding amount of money being destroyed, the money supply increases. That usually means that its value decreases, and is inflationary. If there is more cash around to pay for the same amount of stuff, then the stuff usually costs more.
But there are other ways that we create money. In fact, it is usually not printed - it is more often simply credited to someone's account by the Federal government. The main way that the Federal Reserve creates money is called "open market operations" in which the government buys or sells securities (usually government bonds).
When the Fed buys securities, usually from a commercial bank, it credits that bank with a deposit that is nothing more than an electronic transfer. Thus, money is created. It can, conversely, decrease the money supply by selling securities.
But the money creation process doesn't stop there. Banks are allowed to lend a certain portion of their deposits. When they do that - "poof" - the money is used and deposited back into their bank, or perhaps another bank as people pay for things with their loans. Then a portion of that money can be loaned, and so on and so forth. Thus an electronic transfer to a bank from the Federal Reserve, when it purchases securities, will result in several times that amount in new deposits.
Kinda scary, isn't it? Most of the money sloshing around begins with an electronic signal from the Federal Reserve. The Fed must thus exercise great caution and subscribe to well thought policy before tinkering with the money supply. It is a big stakes game that affects interest rates, inflation, and a whole host of other economic factors.
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