Jim drove his cart over to Bill’s farm. He had a hundred bails of hay stacked in the back. When he got to Bill’s farm Bill’s son unloaded the hay and Bill gave Jim an IOU for 200 pounds of wheat.

Jim thanked Bill and headed off to town. When he got to town he went to the blacksmith to have his mare’s shoes replaced. He gave the IOU from Bill for 200 pounds of wheat to the blacksmith. The blacksmith handed him 3 IOU’s from Bill for 50 pounds each of wheat.

Jim thanked the blacksmith and headed over to the general store. There he picked up a bolt of cloth for his wife a box of 50 rounds of .45 Colt, and 50 pounds of flour. He handed the store clerk to of Bill’s 50 pound IOU’s. The clerk gave him back a 20 pound IOU and a 5 pound IOU.

Jim headed back home.

He had just traded 5000 pounds of hay for new shoes for his mare, cloth for his wife, cartridges for his pistol, flour for his food and he still had 1875 pounds of hay in his pocket.

Money is just a token used to indicate a certain amount of value. The value of that token is set by the trust of the people using that token.

In our example, Bill has promised that he will exchange any of his IOUs for the face value in wheat grain. In this he has set the value.

The blacksmith didn’t need or want hay or grain. He wants a pig to turn into food. He can trade the IOUs he got from Jim to some pig farmer in exchange for a pig. At no time did he have to transfer large bulky goods.

The blacksmith is mostly trading his time for the IOUs. He is selling his labor. The general store is selling convenience and storage in exchange for IOUs

The general store uses some form of barter or trade, including Bill’s IOUs, to purchase things that he doesn’t need in order to store them in his store. Since he has limited shelf space he can’t have everything. He is investing his wealth into his stock. While that stock is sitting on the shelves or warehouse he can’t use it for anything else.

The general store is also trading wealth for transportation. They are paying to have goods transported from where they are available to the store for resale.

If you have ever gone into a hardware store to purchase just a couple of bolts, screws or nuts, you are paying for that storage. The store has thousands of dollars invested in that stock of every type of nut, bolt, washer, and screw that normal people could want.

But what happens if Bill dies and his wife and children just up and go. Are Bill’s IOUs worth anything at that point?

Yes. They are worth exactly what people believe they are worth. If anybody else wants to match the face value in pounds of wheat then those IOUs are stable in value.

Even if nobody is willing to trade a 20# IOU for 20# of wheat, those IOUs still have value. It might be the case that instead of getting 20# of wheat for a 20# IOU you can only get 10# of wheat. Is the IOU worth less?

Maybe not. If you can still get your horse shoed for a 50# IOU and you can still get cartridges, cloth and flour from the general store with Bill’s IOUs, then they still have value.

The difference is that the value of Bill’s IOUs are no longer backed with physical wheat. It is backed by the concept of value assigned by each person that uses those IOUs to exchange wealth.

Here are some of the problems though, if Bill’s IOUs can be faked, counterfeited, then there is the possibility for bad actors to create IOUs without adding value to the system. To many counterfeit IOUs and the value of the IOUs will drop, as will the trust in those IOUs.

It is also possible for Bill to create more IOUs than he has grain to back. As long as everybody believes that the IOUs are backed by actual wheat, this doesn’t matter. As soon as people understand that Bill just creates more IOUs when he wants to buy something they will start to distrust his IOUs. This is inflation.

All money is, is a token to indicate value. That token holds that value as long as people believe in the token and as long as IOUs are not being injected into the economy with no added value. I.e. counterfeiting and printing them.