Why does that green paper in your wallet have any value?
It doesn’t have any intrinsic value, nor is it convertible by law to another physical object of value.
The value of such money – called fiat money – is abstract. It simply comes from the government’s fiat: Latin for “it shall be.”
It hasn’t always been this way.
From gold to paper
Since at least the 6th century B.C., trades were made with objects of real value, such as gold or silver coins.
These coins would be exchangeable wherever the recipient wanted to trade them, because of the value people place on the material they were made from.
This system gradually evolved towards representative money, which are objects such as paper pieces or copper coins that merely represent, but are exchangeable for their value in another commodity (such as a precious metal).
A currency backed by gold is called a gold standard.
In the U.S., the dollar was exchangeable for gold right up until 1933, when FDR banned private ownership and ended the convertibility of the dollar to gold, except in foreign markets.
Then, in 1971, the Nixon Shock ended the convertibility of the dollar to gold for foreign currencies as well.
From then on, the value of the precious metal was determined by the supply and demand of foreign exchange markets.
The move towards fiat money has been spurred on by crises.
FDR ended the convertibility of the precious metal due to private “hoarding”, which kept it outside of the economy, and Nixon ended the last vestige of the gold standard because other countries were demanding the value of their dollars in gold, threatening to empty the United States’ reserve.
Changing to a fiat system allows the government, through the Federal Reserve, to have much greater control of the economy in times of crisis.
Critics argue that the purchasing power of the dollar has dropped drastically since gold convertibility ended, by some estimates as much as 88% since 1970.
However, others say that the end was inevitable, as the amount of money spent by the U.S. government in 1971 simply exceeded the value of the gold it held. The old system, the argument states, restrained the economy by tying it to a physically scarce commodity.
Any currency is a fiat currency, researchers say, since it relies on the supply and demand of the money being used as a means of exchange.
In other words – it doesn’t matter whether you tie the value of a currency to the supply and demand of any precious metal, or to the supply and demand of that currency on the global marketplace.
Whichever view you hold – that dollar in your pocket isn’t likely to lose its value soon.