How Currency Works


You may have heard your parents or grandparents talk about how different things were when they were your age. It only cost a nickel to see a movie. Gas was 30 cents per gallon. A brand new car might cost about $5,000. In the intervening years, prices have risen, sometimes drastically. Seeing a movie in the theater now costs about $8; gas can cost more than $2 per gallon in some places; and few new cars cost less than $15,000. That's inflation.

Inflation is when a certain form of currency starts to have less value over time. It is caused mainly by two things: people's perception of value, and the economic principle of supply and demand.

We have already examined some of the ways that people's perceptions of a currency's value can affect its value. This effect causes inflation by directly affecting the value of the money. When currency was still on a gold standard, inflation often happened when people started to worry that the government or bank wouldn't be able to redeem their cash for gold. If you had a dollar that was worth an ounce of gold, but people thought the government only had half of the gold required to redeem it, then dollars would start being traded at a value of half an ounce of gold.

Supply problems have had far more dramatic inflationary effects. Throughout history, governments have tried to solve financial problems by simply printing more money. This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much.

After World War I, Germany was forced to pay war reparations of about $33 billion. It was virtually impossibly for the nation to produce that much actual output, so the government's only choice was to print more and more money, none of which was backed by gold. This resulted in some of the worst inflation ever recorded. By late 1923, it took 42 billion German marks to buy one U.S. cent! It took 726 billion marks to buy something that had cost just one mark in 1919.