As you probably know from Economics 101, anything bought and sold obeys the law of supply and demand. Given a fixed supply, the more something is in demand the more the price goes up. The less it is in demand the lower the price. Given a fixed demand, the more supply of something there is the lower the price. The less supply there is the higher the price. If you think about some examples this all makes intuitive sense.
Let’s say you are selling apples. If you have only 5 apples and you are the only seller you will have the opportunity to see this first hand. If people REALLY want apples, you will be able to sell them for a high price each. If nobody is wanting apples your price will go down down down until that 5th apple is sold or goes bad.
Similarly if there is only demand for about 10 apples your price will be greatly affected by whether or not you have 5 apples on hand or 20.
How does this affect money itself?
The more money is out there circulating in the system, the less value each dollar will possess, kind of like the price of the apples. Similarly if the population expands, or a lot of people get jobs, or more goods and services are produced with the same amount of work the value represented by each dollar goes up (known as deflation – inflation is the opposite effect). The Fed has a delicate balancing job to do to keep the amount of money in circulation matching the amount of value being produced in the economy. Keeping inflation low is another way of saying that this balance is kept very well but tilted slightly in the governments favor. Inflation is the measure of effective tax the government takes on every dollar. The government is the one who owes the debt represented by the dollar bill so it is to their advantage to keep the value of that dollar decreasing if possible (inflation). Deflation would be bad (for the government) because then the government would owe more value with it’s debts. Too much inflation and people around the world will not want to be holding many dollars and hence the demand on the dollar will go down (also bad for the government). Demand for the dollar is important for the government because it is in so much debt. It needs many many people to want to hold dollars or dollar valued assets and debts.
M0 is the name for the money supply of actual cash – dollars and coins.
M1 is the name for the money supply of M0 plus checking deposits at banks (short term money). This is set by the federal reserve board.
M2 is the name for the money supply of M1 plus savings deposits and money markets (medium term stuff).
M3 includes large scale and long term deposits (along with M2).
If there is more than one currency in the picture then each currency not only holds some real value of goods and services, but can in theory be exchanged for an equivalent real value in that other currency. If both currencies are well managed you can exchange value back and forth between those two currencies (minus an exchange fee each time). If one or more of the currencies are not managed well there will be compounding effects of the exchange itself. The more people are exchanging in one direction the more demand for that currency goes up and the demand for the other goes down (and it’s supply goes up). The currencies will start to take on intrinsic value or devalue – based on the look of the bills or coins or the perceived cache of the country or governing personalities, etc.
Back in colonial times bankers were not as sophisticated or educated about all the interrelated factors mentioned above. They also had limited information on what was going on in society, so they had a very tough time of balancing the money supply. Actually, there were very few ways of controlling the value of the currency and little coordination from one bank or mint to another. In short, there were varying values to each “dollar” from each state or bank and over time the values would appreciate or depreciate significantly. Holding money itself was a risky venture in and of itself. “Real money” (gold, silver, diamonds, horses(!)) was the only truly safe way of conducting reliable transactions when the currency was fluctuating. The history of the Fed explains more about how we advanced to where we are today.