I've become completely fascinated in trying to figure out what what is going on in the financial world, and trying to understand how money works. I could go on for hours, but in brief here's where I'm at:
1) In a basic economy, we could all be self-sufficient - meaning we would have to grow our own food, build and fix our own equipment, cut our own hair, etc.
2) Being able to specialize is more efficient, at least in the thing you specialize in. If I do nothing but make soap all day, for example, I can make more soap, and probably better and more quickly, than somebody who tries to make soap after plowing the wheat fields, feeding the ostriches and fixing the toaster.
3) If I can trade my soap for someone else's wheat, at a fair ratio, we both come out ahead. This is bartering.
4) Bartering is a pain in the ass. You have a bunch of ostrich meat and want some of my soap, but I don't particularly care for ostrich burgers. Now what?
5) Money, that's what. Instead of you waiting for me to acquire a taste for ostrich delicacies, you can "sell" your meat to someone who does like it, in exchange for a commonly accepted unit of value. Then you can give that "money" to me and I'll give you some soap, because I know I can then give that money to someone else for something I really want (like licorice allsorts).
6) Money only works if everyone agrees to it. If the guy who make the allsorts doesn't accept the money you gave me, I have a problem. And I'm unlikely to take your money next time you need a bar of soap.
7) For money to work, it needs to be easily divisible. If we decided to use bicycles as money, we'd have a hard time buying something for half a bicycle. Well, a unicycle might work, but you can see how this would get tricky.
8) Money should also be consistent (the fancy word is "fungible"). Meaning a unit of money is the same everywhere. If I accept your bicycle for my soap, is this bicycle worth more, less or the same as another bicycle (maybe with a banana seat and tasseled handlebars, or a 24-gear ultralight mountainbike) also being used as money.
9) It's very handy if what we use for money is compact. Firewood might make an acceptable form of money, but if you needed to buy anything of value, you'd need a truckload to pay for it.
10) Most importantly, whatever we use for money should be in limited supply. If we decide to use pineapples as currency, then all you'd need to do is open a pineapple plantation and you'd be rich after a couple of growing seasons.
11) A good choice for money is one that is relatively permanent. Having a vault full of decomposed pineapples wouldn't really be a good store of value. Basically, money is a unit of measure, and it would be nice if the measuring stick didn't change, physically or otherwise.
12) Also, if pineapples were money and I knew you had a plantation, I might charge you two pineapples for a bar of soap today, but five pineapples next year. Because I know there are more pineapples around, especially compared to my limited supply of handcrafted soap. This is inflation, which when you get down to it is nothing more than your basic supply and demand.
13) If I didn't know you were creating pineapples out of thin air, I would continue to think they were in constant supply, and would likely continue to charge only two pineapples for my soap. So, inflation doesn't happen immediately - there is a time lag between the increase in the amount of money and the awareness that this is happening.
14) If you create more pineapples and I don't start charging you more pineapples for my soap, then pretty soon you would be able to buy all my soap and still have pineapples left over to spend elsewhere. In other words you'd grow rich - at my expense - only because you created more units of money. Not because you suddenly became more efficient or better at anything.
15) OK, growing pineapples does have some inherent value added. You can eat them too. It's almost better for a currency to have no other practical use. Using pineapples can get confusing because sometimes you would want a pineapple as a store of value to trade for something else later on, and sometimes you might just be hungry for a pineapple. Or think of copper pennies: if the price of copper were three cents per penny, it would make sense to buy a bunch of pennies and melt them down into plumbing parts for resale. Which also takes them out of circulation and impacts the money supply-demand curve (eventually making it hard to know what a penny is really worth - is it one cent as money, or three cents as a slug of base metal?).
16) Reducing the money supply - taking money out of circulation - is deflation. Eventually, the money that's left is worth more because there's less of it. Or to say it another way, under deflation your money is worth more compared to stuff, so prices go down (eventually). When deflation happens, keeping your money under the mattress is actually a good thing. Because loans and debt are considered part of the money supply, a lot of people think that financial crisis will result in significant defaults - bad debts to be written off - which would shrink the money supply and cause deflation. I'm not so sure I fully understand this, but of the parts I think I do understand I'm not sure I agree. Even if imploding loans are deflationary, it seems to be more than offset by the Fed injecting more money into the system. Ben Bernanke's theory of the great depression is that is was caused by deflation, and now thinks it's better to print money and drop it from helicopters than to risk repeating that deflation. I have no idea if his theory is correct or not, but I am convinced if there's any hint of deflation on Bernanke's watch then the Fed will throw trillions of new dollars at it.
17) If you have a lot of debt and the interest payments are expensive, deflation makes it more expensive while inflation makes it easier to pay in the future. If you promise to pay me two pineapples a year for a bar of my soap, you'll find it harder to pay next year if your pineapple crop is decimated by monkeys. On the other hard, you'll be laughing at how cheap my soap is if you have a bumper crop and are able to grow ten times more pineapples next year. Inflation can be a deliberate strategy for a country which controls its own money supply to lessen its debt burden.
18) The economy is a complicated system and nobody has pinpoint control over it or can predict exactly what will happen, or in what time frame. Central bankers are piloting huge supertankers, not little motorboats, and navigation is slow to respond and imprecise. Quantitative easing and other money-creating tricks for the purpose of avoiding deflation, stimulating the economy or whatever reason, can very easily go too far in the other (inflationary) direction. Or could have other unpredicted results.
19) At some point, if you grow so many pineapples that the world is anyone can get as many as they like, then nobody wants pineapples anymore and they become worthless. You'll have to give me something else if you want my soap.
So, basically money is an easy way to convert soap into licorice allsorts, as long as everyone agrees to it and promises to keep doing so into the future. Big changes in the supply of money have a direct impact on what it can be exchanged for and how much.