I often tell my students that the most important phrase on any money is the words “In God We Trust” printed on American currency. First Amendment considerations aside, I tell them, this statement encapsulates the source of any money’s value and reminds us of the fact that the strength of its value may rise and fall. That source of value is, simply, our collective faith that it has value. As long as we continue to believe in its value, money will, in fact, have value. That same faith in its value, however, may be degraded, as well.
Money, by itself, gives us little—or no—utility. If we had enough of it we could use it as a building material or as a source of fuel; but, it offers us little else. Its value comes (primarily) from its characteristic as a medium of exchange in trade for goods that do provide utility. So, a $20 bill is valuable to me because I have faith that I can exchange it for a few gallons of gasoline or a sandwich or a bottle of wine. The owner of the store where I shop is willing to accept my $20 in exchange for his gas, sandwiches, and wine because he has faith that he can exchange it for additional inventory for his store or for the labor inputs of his employees. So, this chain of economic actors who believe in money’s value is a self-fulfilling prophecy.
On the other hand, if members of this chain begin to lose faith in others’ willingness to accept a given amount of money in an exchange, then that same $20 would fetch me fewer gallons of gas or a less-desirable bottle of wine. If we begin to feel that the government is printing new $20 bills faster than refiners, bakeries, and vintners are producing more food, gasoline and wine, we may lose faith in the stability of money’s value and experience a similar result in its exchange value. In either case, our loss of faith in money leads us to require more of it in exchange for the same goods. This is inflation.
Some argue that the solution to this reliance on faith is to use gold as money, or to use only paper currency that is backed by gold. But, gold is no less reliant on our faith in its value than is paper money. The only real difference is that we’ve had several millennia to learn that gold mines operate much more slowly than do printing presses—or, at least, we’ve had enough time to learn that the one dimension of money that is particularly fleeting is our faith in government’s ability to manage its supply prudently.