Eli5: Money and Value


This is s perfect place for me to ask this question. My child says, “hey, I understand we give people money and they give us food, clothes, games, etc., but how is it worth anything? What gives it its value?”

He’s 7.

I tried to say money represents labor or hard work, which he understands as having value. I tried to say something like, well when people had to look and forage for food all day, they didn’t need money. But then we invented farming, so other people had more time to do other things. So if the iron maker needed food and the farmer didn’t need iron what do they do?

I think I did a good job explaining the problem, but not answering the question. So, what gives money its value?

Thanks in advance. I’m in the US, but I think even in his young brain he wasn’t asking specifically about dollars, I think this is a more general question about currency. Like I don’t think this is about the gold standard or returning to it. I think it’s more about how a currency can get value along with a little answer to the reason why currency is necessary. Which is actually a pretty smart question. For a child.

In: 0

Originally it was backed up by gold and people could physically exchange their notes for an amount of gold, during what was called the gold standard. However now it is just an acceptance that someone else will trade their goods for money or the reverse, it is that general acceptance which gives the money the value.

It’s a convenient way to barter without actually needing to exchange goods. Basically from your example, the iron worker would write the farmer a note saying “I owe you X amount of iron whenever you need it.” If the farmer trusts the iron worker, they would happily accept that note – and it has a value equal to the amount of wheat that the farmer gave the iron worker. Imagine this happens a lot, and instead of writing IOU notes with random amounts, the iron worker just starts to keep a bunch of notes with standardized amounts on them. So, when they need a pound of wheat, they give the farmer a note that says they owe them a pound of iron. The notes are only worth something because the farmer trusts the iron worker to keep their word. And they’re useful because the iron worker can get food without actually needing to give away any iron.

Those IOU notes are a starting point for currency.

Most money is backed by the government. I am willing to give you a sandwich in exchange for US dollars because I trust that I can take those US dollars and give them to the US government in exchange for something from them. I won’t ever actually do that because I don’t need anything from them, but I *could*. Back in the day, that “something from them” was something intrinsically valuable, usually physical bars of gold. You may not ever *want* the gold, but you know that the government has it and can give it to you.

Today, it’s backed by international trade agreements and international credit scores. That is, I will take US dollars from you because I know I can take those US dollars and exchange them for Mexican Pesos or Euros or Tanzanian Shillings or whatever. Those countries are willing to take the US dollars because of the trust between countries that the US will continue to take those dollars from them and give *them* things that they *do* need because they can’t get them – like weapons or military aid or disaster aid or whatever else the US can offer. Citizens also take US dollars because they know they can bring those dollars into the US and buy things from US citizens and businesses.

Part of that is that the US has its own credit score. Other countries trust that the United States will continue paying its debt (barring debt ceiling nonsense). The US dollar is worth a good amount because the US is pretty stable and people around the world continue to believe that the US won’t disappear any time soon. Compare that to a country at war like, unfortunately, Ukraine. If you’re a big investor, how willing are you to take Ukrainian hryvnia (their money) given that next year they may be conquered by Russia and cease to exist? (Not that I think it will happen: slava Ukraine.) Or, would you be willing to take money from a country that doesn’t have a stable economy, like Venezuela, so you have no idea how much their money will be worth *in their own country*?

So, most of the value of money comes from *trust*. I trust you that you will take my money because you trust me that I will take your money. We both trust that the government that issued that money will take it and give us things. Other governments trust our government to keep paying its debts so they give us some of *their* money now and we will give them more of our money later. And since that all keeps happening, there’s no reason *not* to continue trusting in the money and the exchange of it.

Ultimately, it’s faith. It’s a societal agreement that people will accept this paper in exchange for something that is scarce/useful/desirable BECAUSE other people will accept the same paper in exchange for something else that is scarce/useful/desirable.

Even gold is only “valuable” because everyone is convinced that everyone else will accept it in return for stuff. It does have some of its own intrinsic value in that it is useful for making certain things but that is a rather small portion of society’s obsession with the stuff.

Once people stop believing the money will be accepted by other people then it becomes “worthless” because everyone believes that nobody else will accept it, so they shouldn’t accept it either.

This idea plays out very interestingly in situations where economies are crashing, or during wartime where currency of different places are esteemed in different ways. Heck, in North Korea, the elite like to hoard dollars because they have more “faith” in it as a medium of exchange both domestically and internationally than they do in North Korean currency (which isn’t really internationally traded much).

Short of that you are either trading stuff directly (a pair of shoes for someone to fix my car for example) or trading stuff that will be a medium of exchange (like the idea about cigarettes in prison).

Money has value because everyone agrees it has value. I know that if you give me money, I can use it to get the things I need, and everyone I know will accept the money.

Your farming analogy is on the right track. Before money, people used the barter system, trading goods for other goods. One of the problems of the battery system is finding someone who has what you need **and** wants what you have, etc. But money had to be *invented*, so let’s carry the farming analogy through.

Let’s say you are a blacksmith and make horseshoes. You can trade horseshoes to get food, clothes, firewood, candy, whatever you need – as long as those people want horseshoes. If someone doesn’t have horses, your goods don’t have any value *to them*, so you need to trade something else. Maybe you find a third person who wants horseshoes and has something else to trade, etc. As you can imagine, this gets pretty inconvenient.

But what if you had something everyone needs?

Ok, this time let’s say you raise chickens, and everyone wants eggs. They’re good eating, so anyone can use them – in other words everyone *values* them. So you can trade your eggs for everything you need. But the people you traded eggs to can *also* trade them to anyone else. Maybe they hold onto a lot of eggs, carry them in their pockets, bring them to market, and so on. Now you have something that works a little like money.

But eggs are also really inconvenient – they’re bulky, hard to carry, and **fragile**. So someone comes to you and asks for an egg IOU. You draw a picture of an egg on a little slip of paper and agree that whoever has it can turn it in for an egg. They might ask you for more, and you draw a few Six Egg Bills and a Dozen Egg Bill and so on.

Congrats, you’ve invented money! Specifically an *exchangeable* currency. Now at the market people are trading your egg notes. They can carry a lot more in a wallet, and they aren’t accidentally cracking any eggs. Everyone agrees this works because 1) they can trade in the bills for eggs at your farm, and 2) everyone knows everyone else will take the egg bills, because everyone will want them.

This whole time you’ve been trading in people’s bills for your eggs, and spending your egg bills to buy everything you need, and it’s exhausting. Maybe one season you have an egg shortage and can’t keep up. Or maybe you just don’t want to be everyone’s egg bank anymore. So you tell everyone that you won’t exchange egg bills for eggs anymore at all.

So what happens? It’s it a catastrophe? Are all those paper egg notes worthless?

Turns out, everyone using your egg bills is using them way beyond what they’d every need for their own egg consumption. Workers are getting paid in egg bills, farmers sell grain for egg bills, the church is collecting egg bills in the offering plate, and the pub sells beer for egg bills. They really don’t care that the value of the bill is pegged to the egg, because everyone is using it for other things.

You still write egg bills. You pay for things in your egg bills, and sometimes you collect egg bills for the things you sell. Congratulations, you’ve made a modern paper currency.

In this analogy, you are the government. Eggs are gold (and sometimes silver historically), and egg bills are dollars. The government collects taxes in dollars, so nearly everyone needs at least some dollars. The government pays its employees in dollars and buys things it needs in dollars. And everyone agrees that dollars are valuable because everyone else will accept dollars for things.