What makes the pound in your pocket – or your bank account – money? Why are people willing to accept currency in exchange for goods and services?
These days, there is nothing physical underwriting the value of the pound or the dollar, or any other currency for that matter. Such currencies are popularly known as “fiat” currencies. Put simply, they are backed by the strength of the economies and the governments that issue them and that demand taxes be paid in them.
However, this wasn’t always the case. In the past, commodities of various sorts were often used as money. The most popular such commodities have been the precious metals, and gold in particular.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
The “gold standard” describes a monetary system where paper currencies are exchangeable for gold at a fixed rate. Put very simply, the idea behind the gold standard is that it prevents countries from living beyond their means. If a country needs to hang on to enough gold to back its currency, then it makes much harder for governments to manipulate the money supply.
However, the rigidity of the gold standard also has drawbacks. An inflexible money supply in theory makes it harder for central banks to adjust for economic conditions. Perhaps more pertinently, history shows that when the gold standard has proved overly restrictive, governments simply abandon it. For example, most countries abandoned the gold standard between the First and Second World Wars.
After the Second World War, the world went back onto a form of the gold standard. Under the Bretton Woods agreement, the US dollar was backed by gold, and the rest of the world’s currencies traded at fixed exchange rates against the dollar.
However, in the late 1960s, mounting US spending – partly on the Vietnam war – threatened to cause a run on America’s gold reserves as foreign countries lined up to swap their dollars for gold.
As a result, in 1971, president Richard Nixon severed the link between the dollar and gold. By 1973, most major currencies were free floating and the US dollar was no longer tied to the yellow metal.
Of course, the monetary system is constantly evolving. As the prospect of fully digital currencies becomes reality, we may see another shift in the near future.
To learn more, subscribe to MoneyWeek magazine.
-
Christmas at Chatsworth: review of The Cavendish Hotel at BaslowMoneyWeek Travel Matthew Partridge gets into the festive spirit at The Cavendish Hotel at Baslow and the Christmas market at Chatsworth
-
Tycoon Truong My Lan on death row over world’s biggest bank fraudProperty tycoon Truong My Lan has been found guilty of a corruption scandal that dwarfs Malaysia’s 1MDB fraud and Sam Bankman-Fried’s crypto scam
-
What is a dividend yield?Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
-
High earners to pay nearly £2000 more in tax due to fiscal dragVideos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
-
What is a deficit?Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
-
Too embarrassed to ask: what is moral hazard?Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
-
Too embarrassed to ask: what is contagion?Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
-
Too embarrassed to ask: what is a marginal tax rate?Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
-
Too embarrassed to ask: what is stagflation?Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
-
Too embarrassed to ask: what is the metaverse?Videos The term “metaverse” sounds like something out of a science fiction novel (and it is). But what does it actually mean?
